Bulletin No. 2006-25June 19, 2006

HIGHLIGHTSOF THIS ISSUEThese synopses are intended only as aids to the reader inidentifying the subject matter covered. They may not berelied upon as authoritative interpretations.

INCOME TAX

Rev. Rul. 2006–30, page 1134.Interest rates; underpayments and overpayments. Therate of interest determined under section 6621 of the Codefor the calendar quarter beginning July 1, 2006, will be 8 per-cent for overpayments (7 percent in the case of a corporation),8 percent for underpayments, and 10 percent for large corpo-rate underpayments. The rate of interest paid on the portion ofa corporate overpayment exceeding $10,000 will be 5.5 per-cent.

Rev. Rul. 2006–31, page 1133.Regulated investment company (RIC). This ruling modifiesRev. Rul. 2006–1 to extend until September 30, 2006, thetransition period provided by that ruling, and clarifies that Rev.Rul. 2006–1 was not intended to preclude a conclusion thatincome from certain instruments (such as structured notes)that create a commodity exposure for the holder is qualifyingincome under section 851(b)(2) of the Code. Rev. Rul. 2006–1modified and clarified.

T.D. 9263, page 1063.Final regulations under section 199 of the Code relate to thededuction for income attributable to domestic production activ-ities. Section 199 was enacted as part of the American JobsCreation Act (AJCA) of 2004, and allows a deduction equal to 3percent (for 2005 and 2006) of the lesser of the qualified pro-duction activities income of the taxpayer for the taxable year, orthe taxable income of the taxpayer for the taxable year, subjectto certain limits. The applicable percentage rises to 6 percentfor 2007, 2008, and 2009, and 9 percent for 2010 and sub-sequent years. Notice 2005–14 obsoleted for taxable yearsbeginning on or after June 1, 2006.

Notice 2006–51, page 1144.Renewable electricity production and refined coal pro-duction; calendar year 2006 inflation adjustment factorand reference prices. This notice announces the calendaryear 2006 inflation adjustment factor and reference prices forthe renewable electricity production credit and refined coal pro-duction credit under section 45 of the Code.

Rev. Proc. 2006–28, page 1147.Guidance is provided to individuals who fail to meet the eligi-bility requirements of section 911(d)(1) of the Code becauseadverse conditions in a foreign country preclude the individu-als from meeting those requirements. A list of the country fortax year 2005 and the date that country is subject to the sec-tion 911(d)(4) waiver is provided.

EMPLOYEE PLANS

Notice 2006–55, page 1146.Weighted average interest rate update; 30-year Trea-sury securities. The weighted average interest rate for June2006 and the resulting permissible range of interest rates usedto calculate current liability and to determine the required con-tribution are set forth.

EXCISE TAX

Notice 2006–50, page 1141.This notice announces that the Service will follow the holding ofAm. Bankers Ins. Group v. United States, 408 F.3d 1328 (11thCir. 2005). The notice provides related guidance to taxpayersand collectors. Notice 2005–79 revoked.

Finding Lists begin on page ii.

The IRS MissionProvide America’s taxpayers top quality service by helpingthem understand and meet their tax responsibilities and by

applying the tax law with integrity and fairness to all.

IntroductionThe Internal Revenue Bulletin is the authoritative instrument ofthe Commissioner of Internal Revenue for announcing officialrulings and procedures of the Internal Revenue Service and forpublishing Treasury Decisions, Executive Orders, Tax Conven-tions, legislation, court decisions, and other items of generalinterest. It is published weekly and may be obtained from theSuperintendent of Documents on a subscription basis. Bulletincontents are compiled semiannually into Cumulative Bulletins,which are sold on a single-copy basis.

It is the policy of the Service to publish in the Bulletin all sub-stantive rulings necessary to promote a uniform application ofthe tax laws, including all rulings that supersede, revoke, mod-ify, or amend any of those previously published in the Bulletin.All published rulings apply retroactively unless otherwise indi-cated. Procedures relating solely to matters of internal man-agement are not published; however, statements of internalpractices and procedures that affect the rights and duties oftaxpayers are published.

Revenue rulings represent the conclusions of the Service on theapplication of the law to the pivotal facts stated in the revenueruling. In those based on positions taken in rulings to taxpayersor technical advice to Service field offices, identifying detailsand information of a confidential nature are deleted to preventunwarranted invasions of privacy and to comply with statutoryrequirements.

Rulings and procedures reported in the Bulletin do not have theforce and effect of Treasury Department Regulations, but theymay be used as precedents. Unpublished rulings will not berelied on, used, or cited as precedents by Service personnel inthe disposition of other cases. In applying published rulings andprocedures, the effect of subsequent legislation, regulations,

court decisions, rulings, and procedures must be considered,and Service personnel and others concerned are cautionedagainst reaching the same conclusions in other cases unlessthe facts and circumstances are substantially the same.

The Bulletin is divided into four parts as follows:

Part I.—1986 Code.This part includes rulings and decisions based on provisions ofthe Internal Revenue Code of 1986.

Part II.—Treaties and Tax Legislation.This part is divided into two subparts as follows: Subpart A,Tax Conventions and Other Related Items, and Subpart B, Leg-islation and Related Committee Reports.

Part III.—Administrative, Procedural, and Miscellaneous.To the extent practicable, pertinent cross references to thesesubjects are contained in the other Parts and Subparts. Alsoincluded in this part are Bank Secrecy Act Administrative Rul-ings. Bank Secrecy Act Administrative Rulings are issued bythe Department of the Treasury’s Office of the Assistant Sec-retary (Enforcement).

Part IV.—Items of General Interest.This part includes notices of proposed rulemakings, disbar-ment and suspension lists, and announcements.

The last Bulletin for each month includes a cumulative indexfor the matters published during the preceding months. Thesemonthly indexes are cumulated on a semiannual basis, and arepublished in the last Bulletin of each semiannual period.

The contents of this publication are not copyrighted and may be reprinted freely. A citation of the Internal Revenue Bulletin as the source would be appropriate.

For sale by the Superintendent of Documents, U.S. Government Printing Office, Washington, DC 20402.

June 19, 2006 2006–25 I.R.B.

Part I. Rulings and Decisions Under the Internal Revenue Codeof 1986Section 199.—IncomeAttributable to DomesticProduction Activities26 CFR 1.199–1: Income attributable to domesticproduction activities.

T.D. 9263

DEPARTMENT OFTHE TREASURYInternal Revenue Service26 CFR Parts 1 and 602

Income Attributable toDomestic Production Activities

AGENCY: Internal Revenue Service(IRS), Treasury.

ACTION: Final regulations.

SUMMARY: This document contains fi-nal regulations concerning the deductionfor income attributable to domestic pro-duction activities under section 199 of theInternal Revenue Code. Section 199 wasenacted as part of the American Jobs Cre-ation Act of 2004 (Act). The regulationswill affect taxpayers engaged in certain do-mestic production activities.

DATES: Effective Date: These regulationsare effective June 1, 2006.

Date of Applicability: For date of appli-cability, see §§1.199–8(i) and 1.199–9(k).

FOR FURTHER INFORMATIONCONTACT: Concerning §§1.199–1,1.199–3, 1.199–6, and 1.199–8,Paul Handleman or Lauren RossTaylor, (202) 622–3040; concern-ing §1.199–2, Alfred Kelley, (202)622–6040; concerning §1.199–4(c)and (d), Richard Chewning, (202)622–3850; concerning all other pro-visions of §1.199–4, Jeffery Mitchell,(202) 622–4970; concerning §1.199–7,Ken Cohen, (202) 622–7790; concern-ing §1.199–9, Martin Schaffer, (202)622–3080 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collection of information con-tained in these final regulations has beenreviewed and approved by the Officeof Management and Budget in accor-dance with the Paperwork Reduction Act(44 U.S.C. 3507) under control number1545–1966. Responses to this collec-tion of information are mandatory so thatpatrons of agricultural and horticulturalcooperatives may claim the section 199deduction.

An agency may not conduct or sponsor,and a person is not required to respondto, a collection of information unless thecollection of information displays a validcontrol number assigned by the Office ofManagement and Budget.

The estimated annual burden per re-spondent varies from 15 minutes to 10hours, depending on individual circum-stances, with an estimated average of 3hours.

Comments concerning the accuracyof this burden estimate and sugges-tions for reducing this burden shouldbe sent to the Internal Revenue Service,Attn: IRS Reports Clearance Officer,SE:W:CAR:MP:T:T:SP, Washington, DC20224, and to the Office of Manage-ment and Budget, Attn: Desk Officer forthe Department of the Treasury, Officeof Information and Regulatory Affairs,Washington, DC 20503.

Books or records relating to this col-lection of information must be retained aslong as their contents may become mate-rial in the administration of any internalrevenue law. Generally, tax returns and taxreturn information are confidential, as re-quired by 26 U.S.C. 6103.

Background

This document amends 26 CFR part1 to provide rules relating to the deduc-tion for income attributable to domesticproduction activities under section 199of the Internal Revenue Code (Code).Section 199 was added to the Code bysection 102 of the American Jobs Creation

Act of 2004 (Public Law 108–357, 118Stat. 1418) (Act), and amended by section403(a) of the Gulf Opportunity Zone Actof 2005 (Public Law 109–135, 119 Stat.25) (GOZA) and section 514 of the TaxIncrease Prevention and ReconciliationAct of 2005 (Public Law 109–222, 120Stat. 345) (TIPRA). On January 19, 2005,the IRS and Treasury Department issuedNotice 2005–14, 2005–1 C.B. 498, provid-ing interim guidance on section 199. OnNovember 4, 2005, the IRS and TreasuryDepartment published in the Federal Reg-ister proposed regulations under section199 (REG–105847–05, 2005–47 I.R.B.987 [70 FR 67220]) (proposed regula-tions). On January 11, 2006, the IRS andTreasury Department held a public hearingon the proposed regulations. Written andelectronic comments responding to theproposed regulations were received. Thispreamble describes the most significantcomments received by the IRS and Trea-sury Department. Because of the largevolume of comments received, however,the IRS and Treasury Department are notable to address all of the comments in thispreamble. After consideration of all ofthe comments, the proposed regulationsare adopted as amended by this Trea-sury decision. Contemporaneous withthe publication of these final regulations,temporary (T.D. 9262, 2006–24 I.R.B.1040) and proposed (REG–111578–06,2006–24 I.R.B. 1060) regulations havebeen published involving the treatmentunder section 199 of computer softwareprovided to customers over the Internet.

General Overview

Section 199(a)(1) allows a deductionequal to 9 percent (3 percent in the case oftaxable years beginning in 2005 or 2006,and 6 percent in the case of taxable yearsbeginning in 2007, 2008, or 2009) of thelesser of (A) the qualified production ac-tivities income (QPAI) of the taxpayer forthe taxable year, or (B) taxable income (de-termined without regard to section 199) forthe taxable year (or, in the case of an indi-vidual, adjusted gross income (AGI)).

Section 199(b)(1) limits the deductionfor a taxable year to 50 percent of the W–2

2006–25 I.R.B. 1063 June 19, 2006

wages paid by the taxpayer during the cal-endar year that ends in such taxable year.For this purpose, section 199(b)(2) definesthe term W–2 wages to mean, with respectto any person for any taxable year of suchperson, the sum of the amounts describedin section 6051(a)(3) and (8) paid by suchperson with respect to employment of em-ployees by such person during the calen-dar year ending during such taxable year.The term W–2 wages does not include anyamount that is not properly included in areturn filed with the Social Security Ad-ministration on or before the 60th day afterthe due date (including extensions) for thereturn. Section 199(b)(3) provides that theSecretary shall prescribe rules for the ap-plication of section 199(b) in the case of anacquisition or disposition of a major por-tion of either a trade or business or a sep-arate unit of a trade or business during thetaxable year.

Section 514(a) of TIPRA amended sec-tion 199(b)(2) by excluding from the termW–2 wages any amount that is not prop-erly allocable to domestic production grossreceipts (DPGR) for purposes of section199(c)(1). The IRS and Treasury Depart-ment plan on issuing regulations on theamendments made to section 199(b)(2) bysection 514 of TIPRA.

Qualified Production Activities Income

Section 199(c)(1) defines QPAI for anytaxable year as an amount equal to the ex-cess (if any) of (A) the taxpayer’s DPGRfor such taxable year, over (B) the sum of(i) the cost of goods sold (CGS) that are al-locable to such receipts; and (ii) other ex-penses, losses, or deductions (other thanthe deduction under section 199) that areproperly allocable to such receipts.

Section 199(c)(2) provides that the Sec-retary shall prescribe rules for the properallocation of items described in section199(c)(1) for purposes of determiningQPAI. Such rules shall provide for theproper allocation of items whether or notsuch items are directly allocable to DPGR.

Section 199(c)(3) provides special rulesfor determining costs in computing QPAI.Under these special rules, any item orservice brought into the United States istreated as acquired by purchase, and itscost is treated as not less than its value im-mediately after it enters the United States.A similar rule applies in determining the

adjusted basis of leased or rented prop-erty when the lease or rental gives rise toDPGR. If the property has been exportedby the taxpayer for further manufacture,the increase in cost or adjusted basismust not exceed the difference betweenthe value of the property when exportedand its value when brought back into theUnited States after further manufacture.

Section 199(c)(4)(A) defines DPGR tomean the taxpayer’s gross receipts that arederived 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 inwhole or in significant part within theUnited States; (II) any qualified film pro-duced by the taxpayer; or (III) electricity,natural gas, or potable water (collectively,utilities) produced by the taxpayer in theUnited States; (ii) in the case of a taxpayerengaged in the active conduct of a con-struction trade or business, constructionof real property performed in the UnitedStates by the taxpayer in the ordinarycourse of such trade or business; or (iii) inthe case of a taxpayer engaged in the activeconduct of an engineering or architecturalservices trade or business, engineeringor architectural services performed in theUnited States by the taxpayer in the ordi-nary course of such trade or business withrespect to the construction of real propertyin the United States.

Section 199(c)(4)(B) excepts fromDPGR gross receipts of the taxpayer thatare derived from: (i) the sale of food andbeverages prepared by the taxpayer at aretail establishment; (ii) the transmissionor distribution of utilities; or (iii) the lease,rental, license, sale, exchange, or otherdisposition of land.

Section 199(c)(4)(C) provides thatgross receipts derived from the manufac-ture or production of any property de-scribed in section 199(c)(4)(A)(i)(I) shallbe treated as meeting the requirements ofsection 199(c)(4)(A)(i) if (i) such prop-erty is manufactured or produced by thetaxpayer pursuant to a contract with theFederal Government, and (ii) the FederalAcquisition Regulation requires that titleor risk of loss with respect to such propertybe transferred to the Federal Governmentbefore the manufacture or production ofsuch property is complete.

Section 199(c)(4)(D) provides that forpurposes of section 199(c)(4), if all of theinterests in the capital and profits of a part-nership are owned by members of a sin-gle expanded affiliated group (EAG) at alltimes during the taxable year of such part-nership, the partnership and all membersof such group shall be treated as a singletaxpayer during such period.

Section 199(c)(5) defines QPP to mean:(A) tangible personal property; (B) anycomputer software; and (C) any propertydescribed in section 168(f)(4) (certainsound recordings).

Section 199(c)(6) defines a qualifiedfilm to mean any property described insection 168(f)(3) if not less than 50 per-cent of the total compensation relating toproduction of the property is compensationfor services performed in the United Statesby actors, production personnel, directors,and producers. The term does not includeproperty with respect to which recordsare required to be maintained under 18U.S.C. 2257 (generally, films, videotapes,or other matter that depict actual sexuallyexplicit conduct and are produced in wholeor in part with materials that have beenmailed or shipped in interstate or foreigncommerce, or are shipped or transportedor are intended for shipment or transporta-tion in interstate or foreign commerce).

Section 199(c)(7) provides that DPGRdoes not include any gross receipts of thetaxpayer derived from property leased, li-censed, or rented by the taxpayer for useby any related person. However, DPGRmay include such property if the propertyis held for sublease, sublicense, or rent, oris subleased, sublicensed, or rented, by therelated person to an unrelated person forthe ultimate use of the unrelated person.See footnote 29 of H.R. Conf. Rep. No.755, 108th Cong. 2d Sess. 260 (2004)(Conference Report). A person is treatedas related to another person if both personsare treated as a single employer under ei-ther section 52(a) or (b) (without regard tosection 1563(b)), or section 414(m) or (o).

Pass-thru Entities

Section 199(d)(1)(A) provides that, inthe case of a partnership or S corpora-tion, (i) section 199 shall be applied at thepartner or shareholder level, (ii) each part-ner or shareholder shall take into accountsuch person’s allocable share of each item

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described in section 199(c)(1)(A) or (B)(determined without regard to whether theitems described in section 199(c)(1)(A)exceed the items described in section199(c)(1)(B)), and (iii) each partner orshareholder shall be treated for purposesof section 199(b) as having W–2 wagesfor the taxable year in an amount equalto the lesser of (I) such person’s allocableshare of the W–2 wages of the partnershipor S corporation for the taxable year (asdetermined under regulations prescribedby the Secretary), or (II) 2 times 9 percent(3 percent in the case of taxable yearsbeginning in 2005 or 2006, and 6 percentin the case of taxable years beginning in2007, 2008, or 2009) of so much of suchperson’s QPAI as is attributable to itemsallocated under section 199(d)(1)(A)(ii)for the taxable year.

Section 514(b) of TIPRA amendedsection 199(d)(1)(A)(iii) to provide in-stead that each partner or shareholdershall be treated for purposes of section199(b) as having W–2 wages for thetaxable year equal to such person’s al-locable share of the W–2 wages of thepartnership or S corporation for the tax-able year (as determined under regulationsprescribed by the Secretary). The IRSand Treasury Department plan on issuingregulations on the amendments made tosection 199(d)(1)(A)(iii) by section 514 ofTIPRA.

Section 199(d)(1)(B) provides that, inthe case of a trust or estate, (i) the itemsreferred to in section 199(d)(1)(A)(ii) (asdetermined therein) and the W–2 wagesof the trust or estate for the taxable year,shall be apportioned between the benefi-ciaries and the fiduciary (and among thebeneficiaries) under regulations prescribedby the Secretary, and (ii) for purposes ofsection 199(d)(2), AGI of the trust or es-tate shall be determined as provided in sec-tion 67(e) with the adjustments describedin such paragraph.

Section 199(d)(1)(C) provides that theSecretary may prescribe rules requiringor restricting the allocation of items andwages under section 199(d)(1) and mayprescribe such reporting requirements asthe Secretary determines appropriate.

Individuals

In the case of an individual, sec-tion 199(d)(2) provides that the deduc-

tion is equal to the applicable percentof the lesser of the taxpayer’s (A) QPAIfor the taxable year, or (B) AGI for thetaxable year determined after applyingsections 86, 135, 137, 219, 221, 222, and469, and without regard to section 199.

Patrons of Certain Cooperatives

Section 199(d)(3)(A) provides that anyperson who receives a qualified paymentfrom a specified agricultural or horticul-tural cooperative shall be allowed for thetaxable year in which such payment is re-ceived a deduction under section 199(a)equal to the portion of the deduction al-lowed under section 199(a) to such coop-erative which is (i) allowed with respect tothe portion of the QPAI to which such pay-ment is attributable, and (ii) identified bysuch cooperative in a written notice mailedto such person during the payment perioddescribed in section 1382(d).

Section 199(d)(3)(B) provides that thetaxable income of a specified agriculturalor horticultural cooperative shall not be re-duced under section 1382 by reason of thatportion of any qualified payment as doesnot exceed the deduction allowable undersection 199(d)(3)(A) with respect to suchpayment.

Section 199(d)(3)(C) provides that, forpurposes of section 199, the taxable in-come of a specified agricultural or hor-ticultural cooperative shall be computedwithout regard to any deduction allowableunder section 1382(b) or (c) (relating to pa-tronage dividends, per-unit retain alloca-tions, and nonpatronage distributions).

Section 199(d)(3)(D) provides that,for purposes of section 199, a specifiedagricultural or horticultural cooperativedescribed in section 199(d)(3)(F)(ii) shallbe treated as having MPGE in whole orin significant part any QPP marketed bythe organization that its patrons have soMPGE.

Section 199(d)(3)(E) provides that, forpurposes of section 199(d)(3), the termqualified payment means, with respectto any person, any amount that (i) is de-scribed in section 1385(a)(1) or (3), (ii) isreceived by such person from a specifiedagricultural or horticultural cooperative,and (iii) is attributable to QPAI with re-spect to which a deduction is allowed tosuch cooperative under section 199(a).

Section 199(d)(3)(F) provides that, forpurposes of section 199(d)(3), the termspecified agricultural or horticultural co-operative means an organization to whichpart I of subchapter T applies that is en-gaged (i) in the MPGE in whole or in sig-nificant part of any agricultural or horti-cultural product, or (ii) in the marketing ofagricultural or horticultural products.

Expanded Affiliated Group

Section 199(d)(4)(A) provides that allmembers of an EAG are treated as a singlecorporation for purposes of section 199.Section 199(d)(4)(B) provides that anEAG is an affiliated group as defined insection 1504(a), determined by substitut-ing “more than 50 percent” for “at least 80percent” each place it appears and withoutregard to section 1504(b)(2) and (4).

Section 199(d)(4)(C) provides that, ex-cept as provided in regulations, the sec-tion 199 deduction is allocated among themembers of the EAG in proportion to eachmember’s respective amount (if any) ofQPAI.

Trade or Business Requirement

Section 199(d)(5) provides that sec-tion 199 is applied by taking into accountonly items that are attributable to the ac-tual conduct of a trade or business.

Alternative Minimum Tax

Section 199(d)(6) provides that, forpurposes of determining the alternativeminimum taxable income under section55, (A) QPAI shall be determined withoutregard to any adjustments under sections56 through 59, and (B) in the case of acorporation, section 199(a)(1)(B) shallbe applied by substituting “alternativeminimum taxable income” for “taxableincome.”

Unrelated Business Taxable Income

Section 199(d)(7) provides that, forpurposes of determining the tax imposedby section 511, section 199(a)(1)(B) shallbe applied by substituting “unrelatedbusiness taxable income” for “taxable in-come.”

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Authority to Prescribe Regulations

Section 199(d)(8) authorizes the Secre-tary to prescribe such regulations as arenecessary to carry out the purposes of sec-tion 199, including regulations that pre-vent more than one taxpayer from being al-lowed a deduction under section 199 withrespect to any activity described in section199(c)(4)(A)(i).

Effective Date

The effective date of section 199 insection 102(e) of the Act was amendedby section 403(a)(19) of the GOZA. Sec-tion 102(e)(1) of the Act provides that theamendments made by section 102 of theAct shall apply to taxable years begin-ning after December 31, 2004. Section102(e)(2) of the Act provides that, in de-termining the deduction under section 199,items arising from a taxable year of a part-nership, S corporation, estate, or trust be-ginning before January 1, 2005, shall notbe taken into account for purposes of sec-tion 199(d)(1). Section 514(c) of TIPRAprovides that the amendments made bysection 514 apply to taxable years begin-ning after May 17, 2006, the enactmentdate of TIPRA.

Summary of Comments andExplanation of Provisions

Taxable Income

The section 199 deduction is not takeninto account in computing any net operat-ing loss (NOL) or the amount of any NOLcarryback or carryover. Thus, except asotherwise provided in §1.199–7(c)(2) ofthe final regulations (concerning the por-tion of a section 199 deduction allocatedto a member of an EAG), the section 199deduction cannot create, or increase, theamount of an NOL deduction.

For purposes of section 199(a)(1)(B),taxable income is determined without re-gard to section 199 and without regardto any amount excluded from gross in-come pursuant to section 114 of the Codeor pursuant to section 101(d) of the Act.Thus, any extraterritorial income exclu-sion or amount excluded from gross in-come pursuant to section 101(d) of the Actdoes not reduce taxable income for pur-poses of section 199(a)(1)(B), even though

such excluded amounts are taken into ac-count in determining QPAI.

Wage Limitation

The final regulations give the Secretaryauthority to provide for methods of cal-culating W–2 wages. Contemporaneouswith the publication of these final regu-lations, Rev. Proc. 2006–22, 2006–23I.R.B. 1033, has been published and pro-vides for taxable years beginning on or be-fore May 17, 2006, the enactment date ofTIPRA, the same three methods of calcu-lating W–2 wages as were contained inNotice 2005–14 and the proposed regula-tions. It is expected that any new revenueprocedure applicable for taxable years be-ginning after May 17, 2006, will containmethods for calculating W–2 wages sim-ilar to the three methods in Rev. Proc.2006–22. The methods are included ina revenue procedure rather than the finalregulations so that if changes are made toForm W–2, “Wage and Tax Statement,” anew revenue procedure can be issued re-flecting those changes more promptly thanan amendment to the final regulations.

Taxpayers have inquired whether remu-neration paid to employees for domesticservices in a private home of the employer,which remuneration may be reported onSchedule H (Form 1040), “HouseholdEmployment Taxes,” or, under certainconditions, on Form 941, “Employer’sQUARTERLY Federal Tax Return,” are in-cluded in W–2 wages. Such remunerationis generally excepted from wages for in-come tax withholding purposes by section3401(a)(3) of the Code. Section 199(b)(5)provides that section 199 shall be appliedby only taking into account items that areattributable to the actual conduct of a tradeor business. Payments to employees of ataxpayer for domestic services in a privatehome of the taxpayer are not attributableto the actual conduct of a trade or businessof the taxpayer. Accordingly, such pay-ments are not included in W–2 wages forpurposes of section 199(b)(2).

The IRS and Treasury Department havealso received numerous inquiries concern-ing whether amounts paid to workers whoreceive Forms W–2 from professional em-ployer organizations (PEOs), or employeeleasing firms, may be included in the W–2wages of the clients of the PEOs or em-ployee leasing firms. In order for wages

reported on a Form W–2 to be includedin the determination of W–2 wages of ataxpayer, the Form W–2 must be for em-ployment by the taxpayer. Employees ofthe taxpayer are defined in §1.199–2(a)(1)of the final regulations as including onlycommon law employees of the taxpayerand officers of a corporate taxpayer. Thus,the issue of whether the payments to theemployees are included in W–2 wages de-pends on an application of the commonlaw rules in determining whether the PEO,the employee leasing firm, or the clientis the employer of the worker. As notedin §1.199–2(a)(2) of the final regulations,taxpayers may take into account wages re-ported on Forms W–2 issued by other par-ties provided that the wages reported onthe Forms W–2 were paid to employees ofthe taxpayer for employment by the tax-payer. However, with respect to individu-als who taxpayers assert are their commonlaw employees for purposes of section 199,taxpayers are reminded of their duty to filereturns and apply the tax law on a consis-tent basis.

Commentators also raised the issue ofwhether an individual filing as part of ajoint return may include wages paid by hisor her spouse to employees of his or herspouse in determining the amount of theindividual’s W–2 wages for purposes ofthe section 199 deduction. The examplegiven was an individual who had a tradeor business reported on Schedule C (Form1040) with QPAI but no W–2 wages, andthe individual’s spouse had W–2 wagesin a second trade or business reported onSchedule C (Form 1040) but no QPAI.Section 1.199–2(a)(4) of the final regu-lations provides that married individualswho file a joint return are treated as onetaxpayer for purposes of determining W–2wages. Therefore, an individual filing aspart of a joint return may take into ac-count wages paid to employees of his orher spouse in determining the amount ofW–2 wages provided the wages are paidin a trade or business of the spouse and theother requirements of the final regulationsare met. In contrast, if the taxpayer and thetaxpayer’s spouse file separate returns, thetaxpayer may not use the spouse’s wagesin determining the taxpayer’s W–2 wagesfor purposes of the taxpayer’s section 199deduction because they are not consideredone taxpayer.

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Domestic Production Gross Receipts

Commentators suggested that rulessimilar to the de minimis rules providedin §§1.199–1(d)(2) (gross receipts alloca-tion), 1.199–3(h)(4) (embedded services),1.199–3(l)(1)(ii) (construction services),and 1.199–3(m)(4) (engineering or archi-tectural services) of the proposed regula-tions, under which taxpayers may treat deminimis amounts of non-DPGR as DPGR,should be available in the opposite situ-ation. Thus, for example, if a taxpayer’sgross receipts that are allocable to DPGRare less than 5 percent of its overall grossreceipts for the taxable year, the commen-tators suggested that the final regulationsallow the taxpayer to treat those grossreceipts as non-DPGR. The IRS and Trea-sury Department agree with this sugges-tion, and the final regulations provide suchrules for the provisions discussed aboveas well as under §1.199–3(l)(4)(iv)(B) forutilities.

Several comments were received re-garding the burden imposed by the re-quirement in the proposed regulations thatQPAI be computed on an item-by-itembasis (rather than on a division-by-di-vision, or product line-by-product linebasis). Several commentators urged theIRS and Treasury Department to limitthe item-by-item standard to the require-ments of §1.199–3 in determining DPGR(that is, the lease, rental, license, sale,exchange, or other disposition require-ment, the in-whole-or-in-significant-partrequirement, etc.). Specifically, the com-mentators argued that the item-by-itemstandard is inconsistent with the cost al-location methods provided in §1.199–4.The IRS and Treasury Department agreewith this comment. Therefore, the finalregulations clarify that the item-by-itemstandard applies solely for purposes ofthe requirements of §1.199–3 noted abovein determining whether the gross receiptsderived from an item are DPGR. The finalregulations also provide that a taxpayermust determine, using any reasonablemethod that is satisfactory to the Secretarybased on all of the facts and circumstances,whether gross receipts qualify as DPGRon an item-by-item basis.

The proposed regulations provide thatan item is defined as the property offeredfor lease, rental, license, sale, exchange orother disposition to customers that meets

the requirements of section 199. The pro-posed regulations also provide several ex-amples to illustrate this rule. Some com-mentators observed that the examples in-volving a manufacturer of toy cars thatsold the cars to toy stores appear to im-ply that, in the case of property offeredfor lease, rental, license, sale, exchangeor other disposition by a wholesaler, theitem is defined with reference to the prop-erty offered for sale to retail consumers bythe wholesaler’s customer. The rules fordefining an item, and the related exam-ples, have been clarified in the final reg-ulations to provide that an item is definedwith reference to the property offered bythe taxpayer for lease, rental, license, sale,exchange or other disposition to the tax-payer’s customers in the normal course ofthe taxpayer’s business, whether the tax-payer is a wholesaler or a retailer.

The proposed regulations provide that,if the property offered for lease, rental,license, sale, exchange or other disposi-tion by the taxpayer does not meet the re-quirements of section 199, then the tax-payer must treat as the item any portionof that property that does meet those re-quirements. In a case where two or moreportions of the property meet the require-ments of section 199, commentators in-quired whether the two or more portionsare properly treated as a single item oras two or more items. The final regu-lations generally are consistent with therules of the proposed regulations, and pro-vide that if the gross receipts derived fromthe lease, rental, license, sale, exchange orother disposition of the property offered inthe normal course of a taxpayer’s businessdo not qualify as DPGR, then any com-ponent of such property is treated as theitem, provided the gross receipts attribut-able to the component qualify as DPGR.Allowing more than one component to betreated as a single item would effectivelypermit taxpayers to define an item as anycombination of components that, in the ag-gregate, meets the requirements of section199, a result that the IRS and Treasury De-partment believe could lead to significantdistortions. Thus, the IRS and TreasuryDepartment believe that treating two ormore components of the property offeredfor lease, rental, license, sale, exchange orother disposition by the taxpayer as sepa-rate items is the appropriate result. The fi-nal regulations clarify that, if the property

offered for lease, rental, license, sale, ex-change or other disposition by the taxpayerdoes not meet the requirements of section199, then each component that meets therequirements of §1.199–3 must be treatedas a separate item and such componentmay not be combined with a componentthat does not meet the requirements to betreated as an item. The final regulationsprovide examples illustrating this rule. Itfollows that the de minimis rule for embed-ded services and nonqualifying property,as well as any other de minimis exceptionthat is applied at the item level, must be ap-plied separately to each component of theproperty that is treated as a separate item.

The proposed regulations provide thatgross receipts derived from a lease, rental,license, sale, exchange or other dispo-sition of qualifying property constituteDPGR even if the taxpayer has alreadyrecognized gross receipts from a previouslease, rental, license, sale, exchange orother disposition of the property. The IRSand Treasury Department recognize thatin some cases, such as where the originalitem (for example, steel) that was MPGEor produced by the taxpayer within theUnited States is disposed of by the tax-payer, and incorporated by another personinto other property (for example, an au-tomobile) that is subsequently acquiredby the taxpayer, it would be extremelydifficult for the taxpayer to identify theitem the gross receipts of which constituteDPGR upon lease, rental, license, sale, ex-change or other disposition of the acquiredproperty. Therefore, the final regulationsprovide that if a taxpayer cannot reason-ably determine without undue burden andexpense whether the acquired propertycontains any of the original qualifyingproperty, or the amount, grade, or kindof the original qualifying property, thatthe taxpayer MPGE or produced withinthe United States, then the taxpayer is notrequired to determine whether any portionof the acquired property qualifies as anitem. In such cases, the taxpayer maytreat any gross receipts derived from thedisposition of the acquired property thatare attributable to the original qualifyingproperty as non-DPGR.

The proposed regulations provide that,for purposes of the requirement to allo-cate gross receipts between DPGR andnon-DPGR, if a taxpayer can, without un-due burden or expense, specifically iden-

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tify where an item was manufactured, or ifthe taxpayer uses a specific identificationmethod for other purposes, then the tax-payer must use that specific identificationmethod to determine DPGR. One com-mentator observed that Notice 2005–14applies a readily available rather than anundue burden or expense standard for thispurpose, and questioned whether the pro-posed regulations were intended to imposea substantively different standard. Thestandard was changed in the proposed reg-ulations in response to comments receivedon Notice 2005–14. The commentatorswere concerned that taxpayers would berequired under Notice 2005–14 to usespecific identification to allocate grossreceipts under section 199 if their infor-mation systems contained the informationnecessary to use specific identification,even if capturing such information wouldrequire costly system reconfigurations.The undue burden and expense standard,however, was not intended to expand thescope of the requirement to use specificidentification to include taxpayers forwhom the information necessary to usethat method is not readily available intheir existing systems. Accordingly, thefinal regulations utilize both terms.

Commentators were concerned that thedisposition of qualifying property wouldnot give rise to DPGR if provided as partof a service related contract. However,the proposed regulations in Example 4 in§1.199–3(d)(5) already address this issueby illustrating a qualifying disposition re-sulting in DPGR as part of a service re-lated contract. In that example, Y is hiredto reconstruct and refurbish unrelated cus-tomers’ tangible personal property. Y in-stalls the replacement parts (QPP) that YMPGE within the United States. The ex-ample concludes that Y’s gross receiptsfrom the MPGE of the replacement partsare DPGR. The final regulations retain thisexample and include other examples ofservice related contracts that also involvethe disposition of qualifying property giv-ing rise to DPGR if all of the other section199 requirements are met.

The proposed regulations provide that,if a taxpayer recognizes and reports on aFederal income tax return for a taxableyear gross receipts that the taxpayer identi-fies as DPGR, then the taxpayer must treatthe CGS related to such receipts as relat-ing to DPGR, even if they are incurred in

a subsequent taxable year. The final reg-ulations retain this rule in §1.199–4(b)(2).One commentator questioned whether thisrule applies to CGS incurred in a taxableyear to which section 199 applies, if thegross receipts were recognized in a taxableyear prior to the effective date of section199 but would have qualified as DPGR inthat taxable year if section 199 had been ineffect. The IRS and Treasury Departmentbelieve that all gross receipts and costsmust be allocated between DPGR and non-DPGR on a year-by-year basis, and the fi-nal regulations provide that for taxpayersusing the section 861 method or the simpli-fied deduction method, CGS that relates togross receipts recognized in a taxable yearprior to the effective date of section 199must be allocated to non-DPGR.

For items that are disposed of undercontracts that span two or more taxableyears, the final regulations permit the useof historical data to allocate gross receiptsbetween DPGR and non-DPGR. If a tax-payer makes allocations using historicaldata, and subsequently updates the data,then the taxpayer must use the more recentor updated data, starting in the taxable yearin which the update is made.

Two commentators suggested that thefinal regulations permit taxpayers to clas-sify multi-year contracts for purposes ofsection 199 with reference to their clas-sification under section 460. For exam-ple, if a contract is classified as a con-struction contract under section 460, thecommentators suggested that the contractalso be classified as a construction con-tract under section 199. The IRS and Trea-sury Department have determined, how-ever, that the statutory requirements un-der sections 199 and 460, and the regula-tions thereunder, are sufficiently differentthat it would not be appropriate for the fi-nal regulations to permit the classificationof multi-year contracts under section 460to determine whether the requirements ofsection 199 are met with respect to thatcontract. Accordingly, the final regula-tions do not adopt this suggestion.

By the Taxpayer

One commentator suggested a simplify-ing convention to determine which partyto a contract manufacturing arrangementhas the benefits and burdens of ownershipunder Federal income tax principles. The

commentator requested that the final reg-ulations permit unrelated parties to a con-tract manufacturing arrangement to desig-nate, through a written and signed agree-ment between the parties, which of themshall be treated for purposes of section 199as engaging in MPGE activities conductedpursuant to the arrangement. The final reg-ulations do not adopt the commentator’ssuggestion. The IRS and Treasury Depart-ment continue to believe that the benefitsand burdens of ownership must be deter-mined based on all of the facts and circum-stances and a designation of benefits andburdens would not be appropriate.

Government Contracts

Section 403(a)(7) of the GOZA addednew section 199(c)(4)(C), which containsa special rule for certain government con-tracts. The final regulations clarify thatthe special rule for government contractsalso applies to gross receipts derived fromcertain subcontracts to manufacture orproduce property for the Federal gov-ernment. See The Joint Committee onTaxation Staff, Technical Explanation ofthe Revenue Provisions of H.R. 4440, TheGulf Opportunity Zone Act of 2005, 109thCong., 1st Sess. 77 (2005).

In Whole or in Significant Part

The proposed regulations, like Notice2005–14, provide generally that QPP isMPGE in whole or in significant part bythe taxpayer within the United States onlyif the taxpayer’s MPGE activity in theUnited States is substantial in nature. Al-though some language in the section 199substantial-in-nature requirement bearssimilarities to language in the definitionof manufacture in §1.954–3(a)(4), the twostandards are different both in purposeand in substance. Whether operationsare substantial in nature is relevant un-der section 954 in determining whethermanufacturing has occurred. By contrast,the substantial-in-nature requirement un-der section 199 is relevant in determin-ing whether the MPGE activity, alreadydetermined to have occurred under therequirement provided in §1.199–3(d) ofthe proposed regulations (§1.199–3(e) ofthe final regulations), was performed inwhole or in significant part by the taxpayerwithin the United States. Accordingly, asstated in the preamble to Notice 2005–14,

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case law and other precedent under sec-tion 954 are not relevant for purposes ofthe substantial-in-nature requirement un-der section 199. Nor are they relevantfor purposes of determining whether anactivity is an MPGE activity under section199. Similarly, the regulations under sec-tion 199 are not relevant for purposes ofsection 954.

Because the substantial-in-nature re-quirement is generally applied by takinginto account all of the facts and circum-stances, both the proposed regulationsand Notice 2005–14 provide a safe harborunder which the in-whole-or-in-signifi-cant-part requirement is satisfied if thetaxpayer’s conversion costs (that is, directlabor and related factory burden) are 20percent or more of the taxpayer’s CGSwith respect to the property. Commenta-tors expressed confusion concerning therelated factory burden component of thissafe harbor, and suggested that overheadbe substituted for related factory burden inthe final regulations. Commentators fur-ther noted that not all transactions yieldingDPGR under section 199 involve CGS(for example, a lease, rental, or licenseof QPP). In response to these comments,the IRS and Treasury Department havechanged the safe harbor in the final reg-ulations. The final regulations providethat the in-whole-or-in-significant-partrequirement is satisfied if the taxpayer’sdirect labor and overhead to MPGE theQPP within the United States account for20 percent or more of the taxpayer’s CGS,or in a transaction without CGS (for exam-ple, a lease, rental, or license) account for20 percent or more of the taxpayer’s un-adjusted depreciable basis of the QPP. Noinference is intended regarding any similarsafe harbor under the Code, including thesafe harbor in §1.954–3(a)(4)(iii). For tax-payers subject to section 263A, overheadis all costs required to be capitalized undersection 263A except direct materials anddirect labor. For taxpayers not subject tosection 263A, overhead may be computedusing any reasonable method that is satis-factory to the Secretary based on all of thefacts and circumstances, but may not in-clude any cost, or amount of any cost, thatwould not be required to be capitalizedunder section 263A if the taxpayer weresubject to section 263A. In no event aresection 174 costs, and the cost of creatingintangible assets, attributable to tangible

personal property ever treated as directlabor and overhead, and taxpayers shouldexclude such costs from their CGS or un-adjusted depreciable basis, as applicable.

However, the final regulations also clar-ify that, in the case of computer softwareand sound recordings, research and exper-imental expenditures under section 174 re-lating to the computer software or soundrecordings, the cost of creating intangi-ble assets for computer software or soundrecordings, and (in the case of computersoftware) costs of developing the com-puter software that are described in Rev.Proc. 2000–50, 2000–2 C.B. 601 (soft-ware development costs), are included inboth direct labor and overhead and CGS orunadjusted depreciable basis for purposesof the safe harbor, even if the costs areincurred in a prior taxable year. In addi-tion, the final regulations also clarify thatthis is the case whether the computer soft-ware or sound recording is itself the itemfor purposes of section 199, or is affixedor added to tangible personal property andthe taxpayer treats the combined propertyas computer software or a sound record-ing under the rules of §1.199–3(i)(5)). Inthe case where the taxpayer produces com-puter software and manufactures part ofthe tangible personal property to which thecomputer software is affixed, the taxpayermay combine the direct labor and overheadfor the computer software and tangible per-sonal property produced or manufacturedby the taxpayer in determining whether itmeets the safe harbor.

The final regulations provide that, inapplying the safe harbor to an item for thetaxable year, all computer software devel-opment costs, any cost of creating intangi-ble assets for computer software or soundrecordings, and section 174 costs (for com-puter software or sound recordings), in-cluding those paid or incurred in a priortaxable year, must be allocated over theestimated number of units of the item ofwhich the taxpayer expects to dispose. Anexample of this rule is provided in the finalregulations.

The proposed regulations provide thatan EAG member must take into account allof the previous MPGE or production activ-ities of the other members of the EAG indetermining whether its MPGE or produc-tion activities are substantial in nature. Ithas been suggested that this rule be modi-fied to allow the EAG member to take into

account all MPGE or production activitiesof the other EAG members rather than justthe previous MPGE or production activi-ties of the members. The final regulationsdo not adopt this suggestion because theIRS and Treasury Department believe thatthe EAG member must determine whetherits MPGE or production activities meet thesubstantial-in-nature requirement at or be-fore the time EAG member disposes of theproperty. Similar rules apply for purposesof the safe harbor under §1.199–3(g)(3)(i).

Section 3.04(5)(d) of Notice 2005–14generally provides that design and devel-opment activities must be disregarded inapplying the general substantial-in-naturerequirement and the safe harbor for tangi-ble personal property. The proposed reg-ulations clarify that research and exper-imental activities under section 174 andthe creation of intangibles do not qual-ify as substantial in nature. A commen-tator questioned whether, with respect totangible personal property, activities thatconstitute both an MPGE activity as wellas a section 174 activity must nonethe-less be excluded from the determination ofwhether the taxpayer’s MPGE of the QPPis substantial in nature because all section174 activities are disregarded in makingsuch a determination. The IRS and Trea-sury Department continue to believe that,with the exception of computer softwareand sound recordings, it is not appropri-ate to include any section 174 activities inthe determination of whether the MPGEof QPP is substantial in nature. However,the IRS and Treasury Department recog-nize that, although section 174 costs arenot required to be capitalized under sec-tion 263A to the produced property, a tax-payer may capitalize such costs to the QPPunder section 263A. Accordingly, the fi-nal regulations permit, as a matter of ad-ministrative convenience, a taxpayer to in-clude such costs as CGS or unadjusted de-preciable basis for purposes of the 20 per-cent safe harbor.

A commentator asked that the final reg-ulations clarify that gross receipts relatingto computer software updates that are pro-vided as part of a computer software main-tenance contract qualify as DPGR if all ofthe requirements of section 199(c)(4) aremet. The final regulations include an ex-ample demonstrating that gross receipts re-lating to computer software updates mayqualify as DPGR even if the computer

2006–25 I.R.B. 1069 June 19, 2006

software updates are provided pursuant toa computer software maintenance agree-ment.

The preamble to the proposed regula-tions states that the creation and licens-ing of copyrighted business informationreports do not constitute the MPGE of QPPbecause the database is not QPP. However,it has come to the attention of the IRS andTreasury Department that some businessinformation reports published by the tax-payer may qualify as QPP, for example,business information reports published bythe taxpayer in books that qualify as QPP.Therefore, no inference should be drawnfrom the preamble to the proposed regu-lations as to whether business informationreports qualify for the section 199 deduc-tion.

The proposed regulations provide in§1.199–3(f)(2) that QPP will be treated asMPGE in significant part by the taxpayerwithin the United States if the MPGE ofthe QPP by the taxpayer within the UnitedStates is substantial in nature taking intoaccount all of the facts and circumstances,including the relative value added by, andrelative cost of, the taxpayer’s MPGEactivity within the United States, the na-ture of the property, and the nature of theMPGE activity that the taxpayer performswithin the United States.

One commentator suggested that, if ataxpayer manufactures a key component ofQPP and purchases the rest of the compo-nents, the fact that the taxpayer manufac-tured the key component should satisfy thesubstantial-in-nature requirement with re-spect to the QPP that incorporates the keycomponent. For example, X manufacturescomputer chips within the United States.X installs the computer chips that it man-ufactures in computers that X purchasesfrom unrelated persons and sells the fin-ished computers individually to customers.Although the computer chips are key com-ponents of the computers and the com-puters will not operate without them, themanufacture of the key components doesnot, by itself, satisfy the substantial-in-na-ture requirement with respect to the fin-ished computers and the taxpayer’s activi-ties with respect to the finished computersmust meet either the substantial-in-naturerequirement under §1.199–3(g)(2) or thesafe harbor under §1.199–3(g)(3) of the fi-nal regulations. The final regulations con-tain an example to illustrate this rule.

In Example 4 in §1.199–3(f)(4) ofthe proposed regulations, X licenses aqualified film to Y for duplication of thefilm onto DVDs. Y purchases the DVDsfrom an unrelated person. The exam-ple concludes that unless Y satisfies thesafe harbor under §1.199–3(f)(3) of theproposed regulations, Y’s income for du-plicating X’s qualified film onto DVDsis non-DPGR because the duplication isnot substantial in nature relative to theDVD with the film. One commentatordisagreed with the conclusion in this ex-ample because duplicating a DVD mayinvolve considerable activities. This ex-ample and other examples illustrating thesubstantial-in-nature requirement havebeen removed from the final regulationsbecause the determination of what is sub-stantial in nature is determined based onall the facts and circumstances. No in-ference should be drawn as to whether anactivity is, or is not, substantial in natureby the removal of any example.

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

Section 1.199–3(h)(1) of the pro-posed regulations provides that applicableFederal income tax principles apply todetermine whether a transaction is, insubstance, a lease, rental, license, sale,exchange, or other disposition of QPP,whether it is a service, or whether it issome combination thereof. In the pream-ble to the proposed regulations, the IRSand Treasury Department acknowledgethat the short-term nature of a transactiondoes not, by itself, render the transactiona service for purposes of section 199 andthat many transactions include both ser-vice and property rental elements. Thepreamble further states that not everytransaction in which property is used inconnection with providing a service tocustomers, however, constitutes a mixtureof services and rental for which alloca-tion of gross receipts is appropriate andprovides an example of a video arcadethat features video game machines that thetaxpayer MPGE. The machines remain inthe taxpayer’s possession during the cus-tomers’ use. The example concludes thatgross receipts derived from customers’ useof the machines at the taxpayer’s arcadeare not derived from the lease, rental, li-cense, sale, exchange, or other disposition

of the machines. Rather, the machines areused to provide a service and, thus, thegross receipts are non-DPGR. While thegeneral rule stated in §1.199–3(h)(1) ofthe proposed regulations is retained in thefinal regulations under §1.199–(3)(I)(1),the preamble example is not included inthe final regulations because the determi-nation of whether a transaction is a serviceor a rental is based upon all the factsand circumstances. No inference shouldbe drawn as to whether the transactionconstitutes a service or rental (or somecombination thereof) by the removal ofthe example.

Section 1.199–3(h)(1) of the proposedregulations provides that the value of prop-erty received by a taxpayer in a taxableexchange of QPP MPGE in whole or insignificant part within the United States,a qualified film produced by the taxpayer,or utilities produced by the taxpayer in theUnited States, for an unrelated person’sproperty is DPGR for the taxpayer. How-ever, unless the taxpayer meets all of therequirements under section 199 with re-spect to any further MPGE by the taxpayerof the QPP or any further production bythe taxpayer of the film or utilities receivedin the taxable exchange, any gross receiptsderived from the sale by the taxpayer of theproperty received in the taxable exchangeare non-DPGR, because the taxpayer didnot MPGE or produce such property, evenif the property was QPP, a qualified film,or utilities in the hands of the other partyto the transaction.

A commentator requested that, withregard to certain taxable exchanges, thefinal regulations provide a safe harborthat would accommodate long-standingindustry accounting practices for these ex-changes. The final regulations provide asafe harbor whereby the gross receipts de-rived by the taxpayer from the sale of eligi-ble property (as defined later) received ina taxable exchange, net of any adjustmentsbetween the parties involved in the taxableexchange to account for differences in theeligible property exchanged (for example,location differentials and product differ-entials), may be treated as the value of theeligible property received by the taxpayerin the taxable exchange. In addition, if thetaxpayer engages in any further MPGEor production activity with respect to theeligible property received in the taxableexchange, then, unless the taxpayer meets

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the in-whole-or-in significant-part require-ment under §1.199–3(g)(1) with respect tothe property sold, the taxpayer must alsovalue the property sold without taking intoaccount the gross receipts attributable tothe further MPGE or production activity.The final regulations define eligible prop-erty as oil, natural gas, and petrochemicals,or products derived from oil, natural gas,petrochemicals, or any other property orproduct designated by publication in theInternal Revenue Bulletin. Under the safeharbor, the taxable exchange is deemed tooccur on the date of the sale of the eligibleproperty received in the exchange to theextent that the sale occurs no later than thelast day of the month following the monthin which the exchanged eligible propertyis received by the taxpayer.

The proposed regulations provide that,in the case of gross receipts derived froma lease of QPP or a qualified film, the en-tire amount of the lease income, includingany interest that is not separately stated,is considered derived from the lease ofthe QPP or qualified film. Commentatorsnoted that many leases of personal prop-erty separately state a finance or interestcomponent. The IRS and Treasury De-partment believe that Congress intendedfor all financing or interest componentsof a lease of qualifying property to beconsidered DPGR (assuming all the otherrequirements of section 199 are met). Ac-cordingly, the final regulations providethat all financing and interest componentsof a lease of qualifying property are con-sidered to be derived from the lease ofsuch qualifying property.

Section 1.199–3(h)(4) of the proposedregulations provides exceptions to the gen-eral rule that DPGR does not include grossreceipts derived from services or nonqual-ifying property. The exceptions are forembedded qualified warranties, delivery,operating manuals, and installation. Thefinal regulations retain these exceptionsand provide a new exception for embed-ded computer software maintenance con-tracts. None of these exceptions, which al-low gross receipts attributable to such em-bedded services and nonqualifying prop-erty to be treated as DPGR, is available if,in the normal course of the taxpayer’s tradeor business, the price for the service ornonqualifying property is separately statedor is separately offered to the customer.

One commentator asked for clarifica-tion concerning the meaning of the termnormal course of a taxpayer’s trade orbusiness and when something would beconsidered to be separately stated or sepa-rately offered to a customer. The purposeof the exceptions is to reduce the bur-den on a taxpayer of having to allocatea portion of its gross receipts to thesecommonly occurring types of servicesand property if the taxpayer does not nor-mally price or offer such items separately.Whether a taxpayer separately offers orstates the price for such an item in thenormal course of its trade or business de-pends on the facts and circumstances. If,for example, a taxpayer separately statesthe price for installation for a few of itscustomers on a case by case basis, then thetaxpayer may be considered to have notseparately stated the price of installation inthe normal course of its trade or business.The requirements have been changed inthe final regulations to clarify that thenormal-course-of-trade-or-business re-quirement applies to both the separatelystated price prong and the separately of-fered prong of the embedded services andnonqualifying property rules.

Several comments were received con-cerning the rule in the proposed regula-tions under which gross receipts attribut-able to advertising in newspapers, maga-zines, telephone directories, or periodicalsmay qualify as DPGR to the extent that thegross receipts, if any, derived from the dis-position of those printed materials quali-fies as DPGR. The final regulations clar-ify that this list is not limited to these fourtypes of printed materials, and that the ruleapplies to other similar printed materials.

Section 3 of Notice 2005–14 explainsthat the basis for the rule relating to adver-tising income is that such income is inex-tricably linked to the gross receipts (if any)derived from the disposition of the printedmaterials listed in the proposed regula-tions. After considering the comments re-ceived, the IRS and Treasury Departmentbelieve that the same reasoning applies inthe case of a qualified film (for example,a television program). Accordingly, therule for advertising has been extended inthe final regulations to apply to qualifiedfilms. The wording of the advertising rulehas been changed to clarify that the amountof gross receipts attributable to the dispo-sition of the printed materials or qualified

film does not limit the amount of gross re-ceipts attributable to the advertising thatmay be treated as DPGR under the rule. Inaddition, the final regulations clarify thatthere need be no gross receipts attributableto the disposition of the printed materialsor qualified film for the gross receipts fromthe advertising to qualify as DPGR.

One commentator requested that thefinal regulations recognize that gross re-ceipts derived from the sale of advertisingslots in live or delayed television broad-casts (that are produced by the taxpayerand that otherwise meet the requirementsfor a qualified film) are DPGR. Whilelive and delayed television programmingmay otherwise meet the requirements tobe treated as a qualified film, in order forthe gross receipts derived from advertis-ing slots to be DPGR, there must also bea qualifying disposition of the qualifiedfilm. The IRS and Treasury Departmentcontinue to believe that a live or delayedtelevision broadcast of a qualified film isnot a lease, rental, license, sale, exchangeor other disposition of the qualified film.Commentators noted, however, that if thelive or delayed television programming islicensed to an unrelated cable company,then the license of the programming isa qualifying disposition that gives riseto DPGR and if the rule for advertisingwere extended to qualified films, then theportion of the advertising receipts relatingto the license of the qualified film wouldalso be DPGR. The IRS and Treasury De-partment agree with these comments, andthe final regulations provide examples toclarify these points.

Qualifying Production Property

Under §1.199–3(i)(5)(i) of the pro-posed regulations, if a taxpayer MPGEcomputer software or sound recordingsthat is affixed or added to tangible per-sonal property by the taxpayer (for exam-ple, a computer diskette or an appliance),then the taxpayer may treat the tangiblepersonal property as computer softwareor sound recordings, as applicable. Acommentator questioned whether this ruleshould apply if, for example, a taxpayerhires an unrelated person to affix computersoftware or sound recordings produced bythe taxpayer to a compact disc. In responseto this comment, the final regulations havedropped the by-the-taxpayer requirement

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in this context. A similar rule has beenprovided for qualified films.

Qualified Films

Section §1.199–3(j)(1) of the proposedregulations provides that, a qualified filmmeans any motion picture film or videotape under section 168(f)(3), or live or de-layed television programming, if not lessthan 50 percent of the total compensationpaid to all actors, production personnel,directors, and producers relating to theproduction of the motion picture film,video tape, or television programmingis compensation for services performedin the United States by those individu-als. One commentator was concerned thatthe list of production personnel describedunder §1.199–3(j)(1) of the proposedregulations diminishes the general ruleunder §1.199–3(j)(5) that compensationfor services includes all direct and indi-rect compensation costs required to becapitalized under section 263A for filmproducers under §1.263A–1(e)(2) and (3).The commentator also stated that it maybe difficult to determine which persons areproduction personnel. The final regula-tions under §1.199–3(k)(1) clarify that thelist of production personnel is not exclu-sive, and that compensation for servicesincludes all direct and indirect compensa-tion costs required to be capitalized under§1.263A–1(e)(2) and (3).

In response to questions received bythe IRS and Treasury Department, thefinal regulations clarify that actors mayinclude players, newscasters, or any otherpersons performing in a qualified film.The final regulations also clarify thatthe not-less-than–50-percent-of-the-to-tal-compensation requirement is deter-mined by reference to all compensationpaid in the production of the film and iscalculated using a fraction. The numer-ator of the fraction is the compensationpaid by the taxpayer to actors, productionpersonnel, directors, and producers forservices relating to the production of thefilm (production services) performed inthe United States, and the denominator isthe sum of the total compensation paid bythe taxpayer to all such individuals regard-less of where the production services areperformed and the total compensation paidby others to all such individuals regardlessof where the production services are per-

formed. The final regulations provide anexample of this calculation.

Tangible Personal Property and RealProperty

Commentators requested that the fi-nal regulations define tangible personalproperty and real property for purposesof section 199. The final regulations de-fine tangible personal property as anytangible property other than land, realproperty described in the constructionrules in §1.199–3(m)(1), computer soft-ware described in §1.199–3(j)(3), soundrecordings described in §1.199–3(j)(4), aqualified film described in §1.199–3(k)(1),and utilities described in §1.199–3(l). Inresponse to commentators’ suggestions,the final regulations further define tan-gible personal property as also includingany gas (other than natural gas describedin §1.199–3(l)(2)), chemicals, and simi-lar property, for example, steam, oxygen,hydrogen, and nitrogen.

The final regulations define the termreal property to mean buildings (includ-ing items that are structural componentsof such buildings), inherently permanentstructures (as defined in §1.263A–8(c)(3))other than machinery (as defined in§1.263A–8(c)(4)) (including items thatare structural components of such inher-ently permanent structures), inherentlypermanent land improvements, oil andgas wells, and infrastructure (as definedin §1.199–3(m)(4)). Property MPGE bya taxpayer that is not real property in thehands of such taxpayer, but that may beincorporated into real property by anothertaxpayer, is not treated as real propertyby the producing taxpayer (for example,bricks, nails, paint, and windowpanes).Structural components of buildings andinherently permanent structures includeproperty such as walls, partitions, doors,wiring, plumbing, central air conditioningand heating systems, pipes and ducts, el-evators and escalators, and other similarproperty. In addition, an entire utility plantincluding both the shell and the interiorwill be treated as an inherently permanentstructure.

Construction of Real Property

One commentator recommended thatDPGR derived from the construction ofreal property as well as DPGR from en-

gineering and architectural services for aconstruction project include W–2 wagesearned as an employee. At the time thetaxpayer performs construction activities,or engineering or architectural services,the taxpayer must be engaged in a tradeor business that is considered construc-tion, engineering or architectural servicesfor purposes of the North American In-dustry Classification System (NAICS).W–2 wages earned by an employee arenot earned in connection with a trade orbusiness that is considered construction,or engineering or architectural services,for purposes of the NAICS. Consequently,this recommendation has not been adoptedin the final regulations.

The proposed regulations includewithin the definition of construction ser-vices activities relating to drilling an oilwell and mining pursuant to which the tax-payer could deduct intangible drilling anddevelopment costs under section 263(c)and §1.612–4, and development expendi-tures for a mine or natural deposit undersection 616. The IRS and Treasury De-partment are aware that in many situationstaxpayers provide these services with re-spect to property owned by another party,and therefore such taxpayers are ineligibleto claim the deductions for such costs un-der the provisions described above. Thelanguage of the final regulations has beenchanged to clarify that taxpayers providingsuch services are engaging in constructionservices that may qualify under section199.

The preamble to the proposed regula-tions states that commentators requestedthat qualifying construction activities in-clude construction activities related to oiland gas wells. The preamble further statesthat the proposed regulations provide as amatter of administrative grace that quali-fying construction activities include activ-ities relating to drilling an oil well. Simi-larly, under §1.199–3(l)(2) of the proposedregulations, construction activities includeactivities relating to drilling an oil well. Acommentator noted the inadvertent omis-sion of gas wells and the final regulationscorrect the omission.

The proposed regulations provide thatDPGR does not include gross receipts at-tributable to the sale or other dispositionof land (including zoning, planning, enti-tlement costs, and other costs capitalizedinto the land such as grading and demo-

June 19, 2006 1072 2006–25 I.R.B.

lition of structures under section 280B).Commentators contended that gradingand demolition are construction-relatedactivities, and that gross receipts attribut-able to these activities should qualify asDPGR. After considering the comments,the IRS and Treasury Department believeit is appropriate to apply to grading anddemolition activities the same rule that theproposed regulations apply to other con-struction activities, such as landscapingand painting. Accordingly, services suchas grading, demolition, clearing, excavat-ing, and any other activities that physicallytransform the land are activities constitut-ing construction only if these services areperformed in connection with other activi-ties (whether or not by the same taxpayer)that constitute the erection or substantialrenovation of real property. The IRS andTreasury Department continue to believethat gross receipts attributable to the saleor other disposition of land (includingzoning, planning, and entitlement costs)are properly considered gross receipts at-tributable to the land, not to a qualifyingconstruction activity, and, therefore, arenon-DPGR.

In response to a suggestion by a com-mentator, the final regulations provide thata taxpayer engaged in a construction ac-tivity must make a reasonable inquiry or areasonable determination whether the ac-tivity relates to the erection or substantialrenovation of real property in the UnitedStates.

The proposed regulations contain an ex-ample of an electrical contractor who pur-chases wires, conduits, and other electricalmaterials that the contractor installs in con-struction projects in the United States andthat are considered structural components.The example concludes that the gross re-ceipts that the contractor derives from in-stalling these materials are derived fromconstruction, but that the gross receipts at-tributable to the purchased materials arenot. Commentators objected to this result,contending that it places an unreasonableadministrative burden on taxpayers per-forming construction activities. The finalregulations, including the example, pro-vide that, in such circumstances, the tax-payer performing the construction servicesis not required to allocate gross receiptsto the purchased materials and treat suchgross receipts as non-DPGR, provided thematerials and supplies are consumed in the

construction project or become part of theconstructed real property.

Section 199(c)(4)(A), as amended bythe GOZA, requires that a taxpayer beengaged in the active conduct of a con-struction trade or business for the tax-payer’s construction activity to qualifyunder section 199. The proposed regu-lations provide that a taxpayer may nottreat as DPGR gross receipts derived fromconstruction unless the taxpayer is en-gaged in a construction trade or businesson a regular and ongoing basis. Com-mentators expressed concern that thisrequirement would preclude constructionproject-specific joint ventures or partner-ships, a common business structure in theconstruction industry, from qualifying un-der section 199. Typically, such entitiesare formed for the purpose of a specificconstruction project, and are terminated ordissolved when the project is completed.The final regulations continue to requirethat a taxpayer be engaged in a regular andongoing construction trade or business,but provide a safe harbor rule under whichentities formed specifically for purposesof a particular construction project mayqualify. Under the safe harbor rule, ifa taxpayer is engaged in a constructiontrade or business, then the taxpayer will beconsidered to be engaged in such trade orbusiness on a regular and ongoing basis ifthe taxpayer derives gross receipts from anunrelated person by selling or exchangingthe constructed real property within 60months of the date on which constructionis complete.

Commentators also expressed concernthat taxpayers would not meet the require-ment of being engaged in a constructionbusiness on a regular and ongoing basis ifthe taxpayer is newly-formed or otherwiseis in the first taxable year of a new con-struction trade or business. Although sometaxpayers may meet the regular-and-on-going-business requirement under the safeharbor rule discussed previously, the finalregulations provide that, in the case of anewly-formed trade or business or a tax-payer in its first taxable year, the taxpayerwill satisfy the regular-and-ongoing-basisrequirement if it reasonably expects to beengaged in a construction trade or businesson a regular and ongoing basis.

The IRS and Treasury Departmentreceived a comment requesting clar-ification of the land safe harbor of

§1.199–3(l)(5)(ii) of the proposed reg-ulations. Under the land safe harbor, thetaxpayer is permitted to allocate grossreceipts between real property other thanland, and land, according to a formula.The taxpayer must reduce gross receiptsby the costs of the land and any other costscapitalized to the land, plus a percentageof those costs, and costs related to DPGRmust be reduced by the costs of the landand any other costs capitalized to the land.The percentage ranges from 5 to 15 per-cent, depending upon the length of timethe taxpayer held the land. The commen-tator asked whether the holding periodof a previous owner of the land wouldbe attributed to the new owner, and whatrules apply for purposes of computing thenew owner’s cost basis. Generally, if anexisting provision of the Code or regula-tions would apply to require attribution ofthe holding period of a previous owner ofproperty to a new owner, the same ruleswill apply in the case of a previous owner’sholding period in land for purposes of theland safe harbor rule of section 199. Forexample, the holding period of the previ-ous owner (P) would carry over to the newowner (N) under existing Federal incometax principles if P were a partner in part-nership N, and P contributed the land to N.The same result would apply if, instead,the land was distributed by partnership Pto N, its partner. In the case of partnershipor other pass-thru entity, the land safe har-bor is applied at the partnership or otherpass-thru entity level and is not applied atthe partner or owner level.

With regard to the land safe harbor dis-cussed in the preceding paragraph, the pro-posed regulations state that the length oftime a taxpayer is deemed to hold the landbegins on the date the taxpayer acquiresthe land, including the date the taxpayerenters into the first option to acquire all ora portion of the land, and ends on the datethe taxpayer sells each item of real prop-erty on the land. Commentators stated thatdevelopment of the land generally does notbegin until the land is acquired and any op-tion to acquire land is based on the land’sfair market value. Because developers arepaying fair market value, the commenta-tors suggested that the period for deter-mining the percentage should not includeany option period. The IRS and TreasuryDepartment generally agree with the com-mentator’s suggestion, and the final reg-

2006–25 I.R.B. 1073 June 19, 2006

ulations do not include the option periodexcept where the option does not includeprovisions to adjust the purchase price toapproximate fair market value.

Example 1 in §1.199–3(m)(5)(iii) of theproposed regulations provides that X, whois in a construction trade or business underNAICS Code 23 on a regular and ongoingbasis, purchases a building and retains Y,a general contractor, to perform construc-tion services in connection with a substan-tial renovation of the building. The exam-ple concludes that X’s gross receipts de-rived from the disposition of the buildingare non-DPGR, and that Y’s gross receiptsfrom amounts paid to it by X are DPGR.In addition, the example illustrates thatgross receipts of subcontractors hired by Yqualify as DPGR. Some commentators in-ferred from this example that the taxpayermust, at a minimum, be a legally desig-nated general contractor before its grossreceipts may qualify as DPGR. The ex-ample was not intended to imply that ataxpayer must be a licensed general con-tractor. The final regulations clarify thatactivities constituting construction includeactivities typically performed by a gen-eral contractor, or that constitute generalcontractor-level work, such as activitiesrelating to management and oversight ofthe construction process (for example, ap-provals, periodic inspection of the progressof the construction project, and requiredjob modifications). The example has beenmodified in the final regulations to illus-trate that the person hired by the build-ing owner, although not a licensed gen-eral contractor, qualifies as engaging inconstruction activities by virtue of provid-ing management and oversight of the con-struction process.

Several commentators recommendedthat the final regulations provide that, forpurposes of the de minimis exception of§1.199–3(l)(5)(ii) (regarding construc-tion services), gross receipts attributableto land be disregarded for purposes ofcalculating the de minimis exception. Inresponse to the comments, the final reg-ulations clarify that, if a taxpayer appliesthe land safe harbor, then the gross re-ceipts excluded under the land safe harborare excluded in determining total grossreceipts under the de minimis exception.The final regulations also provide that, ifa taxpayer does not apply the land safeharbor and uses any reasonable method

(for example, an appraisal of the land)to allocate gross receipts attributable tothe land to non-DPGR, then a taxpayerapplies the de minimis exception by ex-cluding such gross receipts derived fromthe sale, exchange, or other disposition ofthe land from total gross receipts.

A commentator requested that the defi-nition of construction activities not be lim-ited to direct activities and should includeservices incidental to the performanceof such activities. As an administrativeconvenience, the final regulations providethat construction activities include certainadministrative support services such asbilling and secretarial services performedby the taxpayer. The final regulationsprovide a similar rule for engineering andarchitectural services.

Engineering and Architectural Services

A commentator suggested that the defi-nition of engineering and architectural ser-vices include services related to the inspec-tion or evaluation of real property afterconstruction has been completed. The fi-nal regulations do not adopt this sugges-tion because engineering and architecturalservices relating to post-construction ac-tivities are not activities constituting con-struction.

Allocation of Cost of Goods Sold andDeductions

A commentator requested clarificationas to whether a taxpayer’s CGS allocableto DPGR is determined using the methodsof accounting used to compute CGS for thetaxpayer’s books or financial statements orthe methods of accounting used to com-pute CGS in determining Federal taxableincome. Section 1.199–4(b) of the pro-posed regulations provides that CGS is de-termined under the methods of accountingthat the taxpayer uses to compute Federaltaxable income. Accordingly, this sectionhas not been modified and the final regu-lations continue to provide that, in deter-mining CGS allocable to DPGR, CGS isdetermined using the methods of account-ing that the taxpayer uses to compute itsFederal taxable income.

Consistent with both the proposed reg-ulations and Notice 2005–14, the final reg-ulations continue to provide three methodsfor allocating and apportioning deductions

(that is, the section 861 method, the simpli-fied deduction method, and the small busi-ness simplified overall method). However,modifications have been made in the fi-nal regulations to the qualification require-ments of the simplified deduction method.

Under the simplified deduction method,a taxpayer’s expenses, losses, or deduc-tions (deductions) (other than a net op-erating loss deduction) are apportionedbetween DPGR and non-DPGR basedon relative gross receipts. The proposedregulations permit a taxpayer to use thesimplified deduction method if it has aver-age annual gross receipts of $25,000,000or less, or total assets at the end of the tax-able year of $10,000,000 or less. Severalcommentators requested that the aver-age annual gross receipts threshold forthe simplified deduction method be ei-ther increased or removed. In responseto these comments, the IRS and TreasuryDepartment have modified the eligibilityrequirements for the simplified deductionmethod. Under the final regulations, ataxpayer may use the simplified deduc-tion method if it has average annual grossreceipts of $100,000,000 or less, or totalassets at the end of the taxable year of$10,000,000 or less. The IRS and Trea-sury Department continue to believe thatfor taxpayers above these thresholds thesection 861 method is the appropriatemethod for allocating and apportioningdeductions for purposes of determiningQPAI.

Under the land safe harbor providedin §1.199–3(l)(5)(ii) of the proposed reg-ulations, a taxpayer may allocate grossreceipts between the proceeds from thesale, exchange, or other disposition ofreal property constructed by the taxpayerand land by reducing its costs related toDPGR under §1.199–4 by the cost of landand other costs capitalized to the land(land costs) and reducing its DPGR bythose land costs plus a percentage. Un-der the small business simplified overallmethod, a taxpayer’s CGS and deductionsare apportioned between DPGR and otherreceipts based on relative gross receipts.Commentators have questioned whethera taxpayer that uses the small businesssimplified overall method would have toreallocate land costs using the allocationformula provided by that method eventhough such costs have already been al-located in accordance with the land safe

June 19, 2006 1074 2006–25 I.R.B.

harbor. The final regulations clarify thata taxpayer that uses the land safe harborto allocate gross receipts between realproperty constructed by the taxpayer andland does not take into account under thesmall business simplified overall methodprovided in §1.199–4(f) the costs that havealready been taken into account for pur-poses of section 199 pursuant to the landsafe harbor.

Expanded Affiliated Groups

The proposed regulations provide gen-erally that if a member of an EAG (thedisposing member) derives gross receiptsfrom the lease, rental, license, sale, ex-change, or other disposition of QPP, aqualified film, or utilities MPGE or pro-duced by another member or members ofthe same EAG, the disposing member istreated as conducting the activities con-ducted by each other member of the EAGwith respect to the QPP, qualified film, orutilities in determining whether its grossreceipts are DPGR. A question arose as towhen the determination of whether corpo-rations are members of the same EAG forpurposes of the attribution of activities isto be made. The final regulations clarifythat attribution of activities between mem-bers of the same EAG is tested at the timethat the disposing member disposes of theQPP, qualified film, or utilities. Examplesare provided to illustrate this provision.

Section 1.199–1(d) of the proposed reg-ulations provides a de minimis rule thatallows a taxpayer to treat all of its grossreceipts as DPGR if less than 5 percentof the taxpayer’s total gross receipts arenon-DPGR. The proposed regulations pro-vide that the 5 percent threshold is deter-mined at the corporation level, rather thanat the EAG or consolidated group level.Several commentators requested that theIRS and Treasury Department reconsiderthis position and apply the threshold at theEAG or consolidated group level.

The de minimis rule is intended to elim-inate the burden to a taxpayer of allocat-ing gross receipts between DPGR and non-DPGR when less than 5 percent of its to-tal gross receipts are non-DPGR. Apply-ing this de minimis rule at the EAG levelwould create many burdensome issues forthe EAG and its members, including addi-tional information reporting and circular-ity problems that could require members

to compute QPAI twice and, thus, wouldnot further the policy goals of providingde minimis rules to ease a taxpayer’s ad-ministrative burdens. As a result, the IRSand Treasury Department continue to be-lieve that, with respect to a corporation thatis a member of an EAG but not a memberof a consolidated group, the application ofthis threshold at the EAG member level isappropriate.

However, with respect to a consolidatedgroup, §1.1502–13(c)(1)(i) and (c)(4) re-quires that the separate entity attributes ofa company’s intercompany items or cor-responding items must be redetermined tothe extent necessary to produce the effectas if the consolidated group members en-gaged in an intercompany transaction weredivisions of a single corporation. If the deminimis rule were applied at the consoli-dated group member level, then a differ-ent result could apply to the consolidatedgroup than would apply if the consolidatedgroup members were divisions of a singlecorporation. Accordingly, with respect toa consolidated group, the final regulationsprovide that the de minimis rule is appliedat the consolidated group level, rather thanat the consolidated group member level.

Similarly, with respect to a corporationthat is a member of an EAG but not a mem-ber of a consolidated group, the new deminimis rule that allows a taxpayer to treatall of its gross receipts as non-DPGR ifless than 5 percent of the taxpayer’s to-tal gross receipts are DPGR is determinedat the EAG member level, rather than atthe EAG group level. However, with re-spect to a consolidated group, the final reg-ulations provide that this de minimis ruleis applied at the consolidated group level,rather than at the consolidated group mem-ber level.

Consolidated Groups

A commentator was concerned thatthe license of an intangible asset betweenmembers of a consolidated group couldreduce the section 199 deduction availableto the members of a consolidated group,because the licensee member’s royaltyexpense would reduce the group’s QPAI,but the licensor member’s royalty in-come from the license would not increasethe group’s QPAI. The commentator re-quested that language be added to thefinal regulations to provide that the inter-

company transaction rules of §1.1502–13shall be taken into account for purposesof determining the QPAI and DPGR of aconsolidated group.

As specifically noted in the preambleto the proposed regulations, the regula-tions under §1.1502–13(c) already ensurethat the section 199 deduction cannot bereduced on account of an intercompanytransaction. As discussed above concern-ing the application of the de minimis rulesthat allow treatment of gross receipts asDPGR or non-DPGR, §1.1502–13(c)(1)(i)and (c)(4) requires that the separate en-tity attributes of a company’s intercom-pany items or corresponding items mustbe redetermined to the extent necessary toproduce the effect as if the consolidatedgroup members engaged in an intercom-pany transaction were divisions of a singlecorporation. There is nothing in the pro-posed regulations that would prevent thisrule from applying. In fact, several ex-amples specifically illustrate the applica-tion of these rules. An additional exam-ple concerning the license of an intangiblebetween members of a consolidated grouphas been added to the final regulations.

Another commentator requested clarifi-cation of the application of §1.199–7(b)(2)of the proposed regulations where theEAG is comprised of more than one con-solidated group. Section 1.199–7(b)(2) ofthe proposed regulations (§1.199–7(b)(3)of the final regulations) provides that,in determining the taxable income of anEAG, if a member of an EAG has anNOL carryback or carryover to the taxableyear, then the amount of the NOL usedto offset taxable income cannot exceedthe taxable income of that member. Thefinal regulations continue to treat a con-solidated group as a single member ofthe EAG. Accordingly, if a consolidatedgroup has a consolidated NOL (CNOL)carryback or carryover, the amount ofthe CNOL used to offset taxable incomecannot exceed the consolidated group’staxable income, and may not be used tooffset taxable income of other members ofthe EAG, whether separate corporationsor consolidated groups. An example hasbeen provided to illustrate this provision.

Trade or Business Requirement

Pursuant to section 199(d)(5),§§1.199–1 through 1.199–9 are applied

2006–25 I.R.B. 1075 June 19, 2006

by taking into account only items that areattributable to the actual conduct of a tradeor business. An individual engaged inthe actual conduct of a trade or businessmust apply §§1.199–1 through 1.199–9by taking into account in computing QPAIonly items that are attributable to thattrade or business (or trades or businesses)and any items allocated from a pass-thruentity engaged in a trade or business.Compensation received by an individualemployee for services performed as anemployee is not considered gross receiptsfor purposes of computing QPAI under§§1.199–1 through 1.199–9. Similarly,any costs or expenses paid or incurred byan individual employee with respect tothose services performed as an employeeare not considered CGS or deductions ofthat employee for purposes of computingQPAI under §§1.199–1 through 1.199–9.For purposes of the trade-or-business re-quirement, a trust or estate is treated as anindividual.

Pass-thru Entities

As noted above, section 514(b) ofTIPRA amended section 199(d)(1)(A)(iii)with respect to a partner’s or shareholder’sshare of W–2 wages from a partnership orS corporation for taxable years beginningafter May 17, 2006. Section 1.199–9 ofthe final regulations contains guidancefor pass-thru entities with taxable yearsbeginning on or before May 17, 2006. Ataxpayer must apply §1.199–9 to a taxableyear beginning on or before May 17, 2006,if that taxpayer applies §§1.199–1 through1.199–8 to the taxable year. The portionsof §1.199–3 relating to qualifying in-kindpartnerships and EAG partnerships, andall of §1.199–5 relating to pass-thru enti-ties, in the final regulations are reservedfor taxable years beginning after May 17,2006. The IRS and Treasury Departmentintend to issue regulations that take intoaccount the amendments made to section199(d)(1)(A)(iii) for pass-thru entities.

Section 199 applies at the owner levelin a manner consistent with the economicarrangement of the owners of the pass-thruentity. Under the proposed regulations,each owner computes its section 199 de-duction by taking into account its distribu-tive or proportionate share of the pass-thruentity’s items (including items of incomeand gain, as well as items of loss and de-

duction not otherwise disallowed by theCode), CGS allocated to such items of in-come, and gross receipts included in suchitems of income. Generally, section 199 isapplied at the shareholder, partner, or sim-ilar level. For a non-grantor trust or estate,this level may refer to one or more benefi-ciaries, the trust or estate, or both.

Section 199(d)(1)(A)(iii), however,limits the amount of W–2 wages from apartnership or S corporation that may beused by each partner or shareholder tocompute the partner’s or shareholder’ssection 199 deduction. Pursuant to theauthority granted in section 199(d)(1)(C),the final regulations provide that this wagelimitation will apply to non-grantor trustsand estates in the same way it applies topartnerships and S corporations. Thus, forall purposes of this wage limitation, refer-ences in the final regulations to pass-thruentities include not only partnerships andS corporations, but also all non-grantortrusts and estates.

The final regulations clarify that thesection 199 deduction has no effect on ashareholder’s adjusted basis in the stock ofan S corporation or a partner’s adjusted ba-sis in an interest in a partnership becausethe section 199 deduction is not describedin section 1367(a) or section 705(a). How-ever, the shareholder’s or partner’s propor-tionate or distributive share of the S cor-poration or partnership items that are in-cluded in computing the shareholder’s orpartner’s section 199 deduction will affectthe shareholder’s or partner’s adjusted ba-sis under the rules of section 1367(a) orsection 705(a).

The proposed regulations provide thatdeductions of a partnership that otherwisewould be taken into account in comput-ing the partner’s section 199 deduction aretaken into account only if and to the extentthe partner’s distributive share of those de-ductions from all of the partnership’s ac-tivities is not disallowed by section 465,469, or 704(d), or any other provision ofthe Code. If only a portion of the partner’sdistributive share of the losses or deduc-tions is allowed for a taxable year, a pro-portionate share of those allowable lossesor deductions that are allocated to the part-ner’s share of the partnership’s qualifiedproduction activities, determined in a man-ner consistent with sections 465, 469, and704(d), and any other applicable provisionof the Code (disallowed losses), is taken

into account in computing the section 199deduction for that taxable year. To the ex-tent that any of the disallowed losses areallowed in a later taxable year, the partnertakes into account a proportionate share ofthose losses in computing its QPAI for thatlater taxable year.

In response to comments received, theIRS and Treasury Department intend toissue separate guidance by publication inthe Internal Revenue Bulletin regardingthe treatment of disallowed losses in de-termining a taxpayer’s section 199 deduc-tion. As a matter of administrative conve-nience and to reduce complexity for tax-payers, the final regulations clarify thatdisallowed losses of the taxpayer that aredisallowed for taxable years beginning onor before December 31, 2004, are not takeninto account in a later taxable year for pur-poses of computing the taxpayer’s QPAIfor that later taxable year regardless ofwhether the disallowed losses are allowedfor other purposes. The final regulationsprovide that similar rules concerning dis-allowed losses apply to taxpayers that arenot partners or S corporation shareholders.See §1.199–8(h).

Generally, in the case of a pass-thruentity, the calculations required to de-termine QPAI (that is, the allocation orapportionment of gross receipts, CGS, ordeductions) are performed at the ownerlevel. Notice 2005–14 and the proposedregulations provide that a partnership orS corporation that is a qualifying smalltaxpayer may use the small businesssimplified overall method to apportionCGS and deductions between DPGR andnon-DPGR. This rule is not included in thefinal regulations, except that §1.199–9(k)permits a partnership or S corporation thatis a qualifying small taxpayer to use thesmall business simplified overall methodto apportion CGS and deductions betweenDPGR and non-DPGR at the entity levelunder §1.199–4(f) of the proposed regula-tions. In addition, §1.199–9(b)(1)(ii) and(c)(1)(ii) of the final regulations providesthat the Secretary may, by publication inthe Internal Revenue Bulletin, permit apartnership or S corporation to calculate apartner’s or shareholder’s share of QPAIat the entity level.

If a partnership or S corporation cal-culates a partner’s or shareholder’s shareof QPAI at the entity level, the owner’sshare of QPAI and W–2 wages from the

June 19, 2006 1076 2006–25 I.R.B.

partnership or S corporation are combinedwith the owner’s QPAI and W–2 wagesfrom other sources. The final regulationsalso clarify that, if a pass-thru entity cal-culates QPAI at the entity level, then gen-erally the owner of the pass-thru entity isnot permitted to use another cost alloca-tion method to reallocate the costs of thepass-thru entity regardless of the methodused by the pass-thru entity’s owner toallocate or apportion costs. A taxpayerthat receives QPAI from a partnership orS corporation does not take into accountany gross receipts, income, assets, deduc-tions, or other items of the partnership orS corporation when the taxpayer allocatesand apportions deductions to determine thetaxpayer’s QPAI from other sources.

Regarding the rule allowing partner-ships that extract, refine, or process oilor natural gas to attribute these activitiesto their partners, some commentators re-quested that the rule be expanded to otherindustries that operate in a substantiallysimilar manner. The exception for theoil and gas industry was provided in theproposed regulations to prevent a clearlyqualifying activity from being disquali-fied under section 199 because of severaldecades-long industry practices. Amongthe historical industry practices taken intoaccount by the IRS and Treasury De-partment in establishing the oil and gasexception was the fact that for decadesthe oil and gas industry generally hasoperated in a business model in which apartnership produces qualifying propertyand distributes such property in-kind to itspartners (generally engaged themselves inthe production of oil and gas), generallythe partnership does not derive any grossreceipts from the produced property, theproperty is marketed and sold exclusivelyand separately by each partner as competi-tors, and generally there is no marketingor sale by the partnership of the producedproperty, and no joint marketing or sale ofthe distributed property by any of the part-ners. In addition, the partnership typicallyqualifies to elect out of subchapter K.

In response to the requests that this attri-bution rule be expanded to industries thathistorically have operated in a manner sub-stantially similar to the oil and gas indus-try, the final regulations provide that, if apartnership that MPGE or produces prop-erty is a qualifying in-kind partnership (asdefined later), then each partner may be

treated as MPGE or producing the prop-erty MPGE or produced by the partnershipthat is distributed to that partner. If a part-ner of a qualifying in-kind partnership de-rives gross receipts from the lease, rental,license, sale, exchange, or other disposi-tion of the property that was MPGE or pro-duced by the qualifying in-kind partner-ship, then, provided such partner is a part-ner of the qualifying in-kind partnership atthe time the partner disposes of the prop-erty, the partner is treated as conductingthe MPGE or production activities previ-ously conducted by the qualifying in-kindpartnership with respect to that property.For this purpose, a qualifying in-kind part-nership is defined in §1.199–9(i)(2) of thefinal regulations to include only certainpartnerships operating solely in a desig-nated industry: oil and gas, petrochemical,or electricity generation. Partnerships inother industries with substantially similarhistorical industry practices may be desig-nated by the IRS and Treasury Departmentas qualifying in-kind partnerships by pub-lication in the Internal Revenue Bulletin.

The proposed regulations provide that,if an EAG partnership (as defined in§1.199–9(j)(2) of the final regulations)MPGE or produces property and dis-tributes, leases, rents, licenses, sells, ex-changes, or otherwise disposes of thatproperty to a member of an EAG of whichthe partners of the EAG partnership aremembers, then the MPGE or productionactivity conducted by the EAG partnershipwill be treated as having been conductedby the disposing member of the EAG.Similarly, if one or more members of anEAG of which the partners of an EAGpartnership are members MPGE or pro-duces property and contributes, leases,rents, licenses, sells, exchanges, or other-wise disposes of that property to the EAGpartnership, then the MPGE or productionactivity conducted by the EAG member(or members) will be treated as havingbeen conducted by the EAG partnership.A question arose as to when a corporationneeds to be a member of an EAG of whichthe partners of the EAG partnership aremembers for attribution of MPGE or pro-duction activities to take place. The finalregulations clarify that attribution of suchactivities between an EAG partnership andmembers of the EAG of which the partnersof the EAG partnership are members isdetermined at the time that the EAG part-

nership disposes of the property (in thecase of property MPGE or produced by anEAG member or members) or at the timethat the member or members of the EAG ofwhich the partners of the EAG partnershipare members dispose of the property (inthe case of property MPGE or producedby the EAG partnership). Attribution iseffective only for those taxable years thatthe disposing or producing member is amember of the EAG of which the partnersof the EAG partnership are members forthe entire taxable year of the EAG partner-ship. The final regulations also clarify thatEAG partnerships, the partners of whichare members of the same EAG, may at-tribute their production activities betweenthemselves on a similar basis, providedthat the producing EAG partnership andthe disposing EAG partnership are ownedby members of the same EAG for theentire taxable year of the respective EAGpartnership that includes the date on whichthe disposing EAG partnership disposesof the property.

Because the sale of an interest in a pass-thru entity does not reflect the realizationof DPGR by that entity, DPGR generallydoes not include gain or loss recognized onthe sale, exchange or other disposition ofan interest in the entity. However, consis-tent with Notice 2005–14 and the proposedregulations, if section 751(a) or (b) applies,then gain or loss attributable to partnershipassets giving rise to ordinary income undersection 751(a) or (b), the sale, exchange, orother disposition of which would give riseto an item of DPGR, is taken into accountin computing the partner’s section 199 de-duction.

One commentator stated that manycommercial real estate developers disposeof commercial real property by selling in-terests in special purpose partnerships thathold commercial real property. Because asale, exchange or other disposition of thecommercial real property may result insection 1231 gain rather than ordinary in-come, the commentator suggested that thedefinition of inventory items be expandedfor purposes of §1.199–9(e) by treatingsection 751(d) as not containing the words“and other than property described in sec-tion 1231.” As a result, a sale or exchangeof an interest in a partnership that holdscommercial real property would gener-ate DPGR if a sale or exchange of thecommercial real property would gener-

2006–25 I.R.B. 1077 June 19, 2006

ate DPGR regardless of whether the saleor exchange would result in ordinary in-come. The final regulations do not includethe commentator’s suggestion becausethe rule in §1.199–9(e) applies aggregatetreatment to a sale or exchange of a part-nership interest only to the extent section751 specifically allows such treatment.Modifying the explicit terms of section751(d) as suggested would be inconsistentwith the purposes of section 751 and sec-tion 199.

Statistical Sampling

In the preamble to the proposed regu-lations, the IRS and Treasury Departmentinvited taxpayers to submit comments onissues relating to section 199 includingwhether taxpayers can apply statisticalsampling to section 199, what specificareas of section 199 statistical samplingcould be applied to, and whether appli-cation of statistical sampling should belimited to specific areas of section 199.Comments were received on statisticalsampling and the IRS and Treasury De-partment are considering those commentsand intend to issue subsequent guidanceaddressing the application of statisticalsampling for purposes of section 199.

Elections under the Section 861Regulations

The preamble to the proposed regula-tions states that, because the provisionsof section 199 may cause taxpayers toreconsider previously made elections un-der §§1.861–8 through 1.861–17 and§§1.861–8T through 1.861–14T (the sec-tion 861 regulations), the IRS and Trea-sury Department intend to issue a revenueprocedure granting taxpayers automaticconsent to change certain of those elec-tions. In the proposed regulations, theIRS and Treasury Department requestedcomments on which elections should beincluded in such a revenue procedure andthe appropriate time period during whichthe automatic consent should apply. Sev-eral commentators urged promulgationof such a revenue procedure, and severalcomments specifically requested that therevenue procedure provide taxpayers au-tomatic consent for more than one taxableyear to change previously made elections.

The IRS and Treasury Department in-tend to issue a revenue procedure that

provides taxpayers automatic consent tochange certain elections relating to theapportionment of interest expense andresearch and experimental expendituresunder the section 861 regulations. It isintended that the automatic consent af-forded under the revenue procedure willprovide taxpayers the consent required by§§1.861–8T(c)(2) and 1.861–9(i)(2), withrespect to the apportionment of interestexpense, and by §1.861–17(e), with re-spect to the apportionment of research andexperimental expenditures, to change anelection, effective for a taxpayer’s firsttaxable year beginning after December 31,2004 (the taxpayer’s 2005 taxable year).In addition, it is intended that the revenueprocedure will provide taxpayers the con-sent required by those regulations for ataxpayer’s taxable year immediately fol-lowing the taxpayer’s 2005 taxable year,but, in such case, a taxpayer would not beprovided automatic consent to change anyelection that first took effect with respectto the taxpayer’s 2005 taxable year.

Financial and Administrative Burden

Several commentators objected to thecomplexity of the proposed regulations,and to the financial and administrative bur-den that the commentators believe the reg-ulations will impose on taxpayers (particu-larly on small businesses). The complexityand burden of the regulations are a func-tion of the statutory language and frame-work of section 199, which are complexand contain many requirements. For ex-ample, with the exception of a few specificservices (namely, construction, architec-ture, and engineering) only gross receiptsderived from certain dispositions of certainproperty qualify under the statute. In ad-dition, in the case of manufacturing activ-ities, the property must be manufacturedby the taxpayer in whole or in significantpart within the United States. Also, un-der section 199, costs must be allocated be-tween qualifying and nonqualifying grossreceipts. All of these statutory require-ments (and others) potentially necessitatethat taxpayers obtain information, makedeterminations and computations, and re-tain records that might not otherwise be re-quired for business purposes. In the case ofpartnerships and S corporations, the statuterequires that the deduction be computedat the owner level, necessitating the shar-

ing between entity and owner of informa-tion that might not be needed for purposesother than section 199. Both the proposedand the final regulations provide a numberof safe harbors and de minimis rules thatare intended to balance the need for com-pliance with these statutory requirementsagainst the burden imposed on taxpayers.

In the preamble to the proposed regu-lations, the IRS and Treasury Departmentcertify that the collection of informationrequired under the proposed regulations(relating to information to be provided bycooperatives to their patrons) will not havea significant economic impact on a sub-stantial number of small entities, and there-fore that a Regulatory Flexibility Analy-sis is not required by the Regulatory Flex-ibility Act (RFA). One commentator as-serted that the certification did not providesufficient information for small entities todetermine the impact the regulations willhave on their businesses. The commenta-tor also contended that the IRS and Trea-sury Department, in making the certifica-tion, failed to consider burdens imposed bythe proposed regulations on other small en-tities, such as partnerships and S corpora-tions, that are required under the regula-tions to provide certain information to theirowners.

The IRS and Treasury Department be-lieve that the certification for the proposedregulations, as well as for these final reg-ulations, is appropriate and complies withthe requirements of the RFA. With respectto cooperatives, the regulations providecooperatives with specific rules about theinformation they must provide to patronsunder section 199. The IRS and Trea-sury Department believe that cooperativeshave the necessary information to com-ply with this requirement. The IRS andTreasury Department continue to believethat this requirement is the only collec-tion of information in the regulations thatis within the scope of the RFA. Certainother recordkeeping and reporting require-ments of the regulations relating to infor-mation sharing between pass-thru entities(partnerships and S corporations) and theirowners are subsumed within other existingincome tax regulations that currently re-quire that such entities report to their own-ers all information that is necessary for theowners to determine their tax liability.

June 19, 2006 1078 2006–25 I.R.B.

Effective Date

Section 199 applies to taxable yearsbeginning after December 31, 2004. Sec-tions 1.199–1 through 1.199–8 are appli-cable for taxable years beginning on orafter June 1, 2006. For a taxable yearbeginning on or before May 17, 2006,the enactment date of TIPRA, a taxpayermay apply §§1.199–1 through 1.199–9provided that the taxpayer applies all pro-visions in §§1.199–1 through 1.199–9 tothe taxable year. For a taxable year begin-ning after May 17, 2006, and before June1, 2006, a taxpayer may apply §§1.199–1through 1.199–8 provided that the tax-payer applies all provisions in §§1.199–1through 1.199–8 to the taxable year. Sec-tion 1.199–9 may not be applied to ataxable year that begins after May 17,2006.

For a taxpayer who chooses not to relyon these final regulations for a taxableyear beginning before June 1, 2006, theguidance on section 199 that applies tosuch taxable year is contained in Notice2005–14, 2005–1 C.B. 498. In addition,a taxpayer also may rely on the provisionsof REG–105847–05, 2005–47 I.R.B. 987(see §601.601(d)(2)) for a taxable yearbeginning before June 1, 2006. If Notice2005–14 and REG–105847–05 includedifferent rules for the same particular is-sue, then a taxpayer may rely on either therule set forth in Notice 2005–14 or the ruleset forth in REG–105847–05. However,if REG–105847–05 includes a rule thatwas not included in Notice 2005–14, thena taxpayer is not permitted to rely on theabsence of a rule to apply a rule contraryto REG–105847–05. For taxable yearsbeginning after May 17, 2006, and beforeJune 1, 2006, a taxpayer may not applyNotice 2005–14, REG–105847–05, or anyother guidance under section 199 in a man-ner inconsistent with amendments made tosection 199 by section 514 of TIPRA. Indetermining the deduction under section199, items arising from a taxable year of apartnership, S corporation, estate, or trustbeginning before January 1, 2005, shallnot be taken into account for purposes ofsection 199(d)(1). Members of an EAGthat are not members of a consolidatedgroup may each apply the effective daterules without regard to how other mem-bers of the EAG apply the effective daterules.

EFFECT ON OTHER DOCUMENTS

Notice 2005–14, 2005–1 C.B. 498, isobsolete for taxable years beginning on orafter June 1, 2006.

Special Analyses

It has been determined that this Trea-sury decision is not a significant regula-tory action as defined in Executive Or-der 12866. Therefore, a regulatory assess-ment is not required. It is hereby certifiedthat the collection of information in thisregulation will not have a significant eco-nomic impact on a substantial number ofsmall entities. This certification is basedupon the fact that any burden on cooper-atives is minimal. Accordingly, a Regula-tory Flexibility Analysis under the Regula-tory Flexibility Act (5 U.S.C. chapter 6) isnot required. Pursuant to section 7805(f)of the Code, the notice of proposed rule-making was submitted to the Chief Coun-sel for Advocacy of the Small BusinessAdministration for comment on its impacton small business.

Drafting Information

The principal authors of these reg-ulations are Paul Handleman andLauren Ross Taylor, Office of the As-sociate Chief Counsel (Passthroughs andSpecial Industries), IRS. However, otherpersonnel from the IRS and TreasuryDepartment participated in their develop-ment.

* * * * *

Adoption of Amendments to theRegulations

Accordingly, 26 CFR parts 1 and 602are amended as follows:

PART 1—INCOME TAXES

Paragraph 1. The authority citation forpart 1 is amended by adding entries to read,in part, as follows:

Authority: 26 U.S.C. 7805 * * *Section 1.199–1 also issued under

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

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

26 U.S.C. 199(d).

Section 1.199–4 also issued under26 U.S.C. 199(d).

Section 1.199–5 also issued under26 U.S.C. 199(d).

Section 1.199–6 also issued under26 U.S.C. 199(d).

Section 1.199–7 also issued under26 U.S.C. 199(d).

Section 1.199–8 also issued under26 U.S.C. 199(d).

Section 1.199–9 also issued under26 U.S.C. 199(d). * * *

Par. 2. Sections 1.199–0 through1.199–9 are added to read as follows:

§1.199–0 Table of contents.

This section lists the section headingsthat appear in §§1.199–1 through 1.199–9.

§1.199–1 Income attributable to domesticproduction activities.

(a) In general.(b) Taxable income and adjusted gross

income.(1) In general.(2) Examples.(c) Qualified production activities in-

come.(d) Allocation of gross receipts.(1) In general.(2) Reasonable method of allocation.(3) De minimis rules.(i) DPGR.(ii) Non-DPGR.(4) Example.(e) Certain multiple-year transactions.(1) Use of historical data.(2) Percentage of completion method.(3) Examples.

§1.199–2 Wage limitation.

(a) Rules of application.(1) In general.(2) Wages paid by entity other than

common law employer.(3) Requirement that wages must be re-

ported on return filed with the Social Se-curity Administration.

(i) In general.(ii) Corrected return filed to correct a

return that was filed within 60 days of thedue date.

(iii) Corrected return filed to correct areturn that was filed later than 60 days afterthe due date.

(4) Joint return.

2006–25 I.R.B. 1079 June 19, 2006

(b) Application in the case of a taxpayerwith a short taxable year.

(c) Acquisition or disposition of a tradeor business (or major portion).

(d) Non-duplication rule.(e) Definition of W–2 wages.(1) In general.(2) Limitation on W–2 wages for tax-

able years beginning after May 17, 2006,the enactment date of the Tax Increase Pre-vention and Reconciliation Act of 2005.[Reserved].

(3) Methods for calculating W–2wages.

§1.199–3 Domestic production grossreceipts.

(a) In general.(b) Related persons.(1) In general.(2) Exceptions.(c) Definition of gross receipts.(d) Determining domestic production

gross receipts.(1) In general.(2) Special rules.(3) Exception.(4) Examples.(e) Definition of manufactured, pro-

duced, grown, or extracted.(1) In general.(2) Packaging, repackaging, labeling,

or minor assembly.(3) Installing.(4) Consistency with section 263A.(5) Examples.(f) Definition of by the taxpayer.(1) In general.(2) Special rule for certain government

contracts.(3) Subcontractor.(4) Examples.(g) Definition of in whole or in signifi-

cant part.(1) In general.(2) Substantial in nature.(3) Safe harbor.(i) In general.(ii) Unadjusted depreciable basis.(iii) Computer software and sound

recordings.(4) Special rules.(i) Contract with unrelated persons.(ii) Aggregation.(5) Examples.(h) Definition of United States.

(i) Derived from the lease, rental, li-cense, sale, exchange, or other disposition.

(1) In general.(i) Definition.(ii) Lease income.(iii) Income substitutes.(iv) Exchange of property.(A) Taxable exchanges.(B) Safe harbor.(C) Eligible property.(2) Examples.(3) Hedging transactions.(i) In general.(ii) Currency fluctuations.(iii) Effect of identification and non-

identification.(iv) Other rules.(4) Allocation of gross receipts.(i) Embedded services and non-quali-

fied property.(A) In general.(B) Exceptions.(ii) Non-DPGR.(iii) Examples.(5) Advertising income.(i) Tangible personal property.(ii) Qualified film.(iii) Examples.(6) Computer software.(i) In general.(ii) through (v) [Reserved].(7) Qualifying in-kind partnership for

taxable years beginning after May 17,2006, the enactment date of the Tax In-crease Prevention and Reconciliation Actof 2005. [Reserved].

(8) Partnerships owned by members ofa single expanded affiliated group for tax-able years beginning after May 17, 2006,the enactment date of the Tax Increase Pre-vention and Reconciliation Act of 2005.[Reserved].

(9) Non-operating mineral interests.(j) Definition of qualifying production

property.(1) In general.(2) Tangible personal property.(i) In general.(ii) Local law.(iii) Intangible property.(3) Computer software.(i) In general.(ii) Incidental and ancillary rights.(iii) Exceptions.(4) Sound recordings.(i) In general.(ii) Exception.

(5) Tangible personal property withcomputer software or sound recordings.

(i) Computer software and soundrecordings.

(ii) Tangible personal property.(k) Definition of qualified film.(1) In general.(2) Tangible personal property with a

film.(i) Film not produced by a taxpayer.(ii) Film produced by a taxpayer.(A) Qualified film.(B) Nonqualified film.(3) Derived from a qualified film.(i) In general.(ii) Exceptions.(4) Compensation for services.(5) Determination of 50 percent.(6) Exception.(7) Examples.(l) Electricity, natural gas, or potable

water.(1) In general.(2) Natural gas.(3) Potable water.(4) Exceptions.(i) Electricity.(ii) Natural gas.(iii) Potable water.(iv) De minimis exception.(A) DPGR.(B) Non-DPGR.(5) Example.(m) Definition of construction per-

formed in the United States.(1) Construction of real property.(i) In general.(ii) Regular and ongoing basis.(A) In general.(B) New trade or business.(iii) De minimis exception.(A) DPGR.(B) Non-DPGR.(2) Activities constituting construction.(i) In general.(ii) Tangential services.(iii) Other construction activities.(iv) Administrative support services.(v) Exceptions.(3) Definition of real property.(4) Definition of infrastructure.(5) Definition of substantial renovation.(6) Derived from construction.(i) In general.(ii) Qualified construction warranty.(iii) Exceptions.(iv) Land safe harbor.(A) In general.

June 19, 2006 1080 2006–25 I.R.B.

(B) Determining gross receipts andcosts.

(v) Examples.(n) Definition of engineering and archi-

tectural services.(1) In general.(2) Engineering services.(3) Architectural services.(4) Administrative support services.(5) Exceptions.(6) De minimis exception for perfor-

mance of services in the United States.(i) DPGR.(ii) Non-DPGR.(7) Example.(o) Sales of certain food and beverages.(1) In general.(2) De minimis exception.(3) Examples.(p) Guaranteed payments.

§1.199–4 Costs allocable to domesticproduction gross receipts.

(a) In general.(b) Cost of goods sold allocable to do-

mestic production gross receipts.(1) In general.(2) Allocating cost of goods sold.(i) In general.(ii) Gross receipts recognized in an ear-

lier taxable year.(3) Special rules for imported items or

services.(4) Rules for inventories valued at mar-

ket or bona fide selling prices.(5) Rules applicable to inventories ac-

counted 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 resalemethod for additional section 263A costs.

(7) Examples.(c) Other deductions properly allocable

to domestic production gross receipts orgross income attributable to domestic pro-duction gross receipts.

(1) In general.(2) Treatment of net operating losses.(3) W–2 wages.(d) Section 861 method.(1) In general.(2) Deductions for charitable contribu-

tions.

(3) Research and experimental expen-ditures.

(4) Deductions allocated or apportionedto gross receipts treated as domestic pro-duction gross receipts.

(5) Treatment of items from a pass-thruentity reporting qualified production activ-ities income.

(6) Examples.(e) Simplified deduction method.(1) In general.(2) Eligible taxpayer.(3) Total assets.(i) In general.(ii) Members of an expanded affiliated

group.(4) Members of an expanded affiliated

group.(i) In general.(ii) Exception.(iii) Examples.(f) Small business simplified overall

method.(1) In general.(2) Qualifying small taxpayer.(3) Total costs for the current taxable

year.(i) In general.(ii) Land safe harbor.(4) Members of an expanded affiliated

group.(i) In general.(ii) Exception.(iii) Examples.(5) Trusts and estates.(g) Average annual gross receipts.(1) In general.(2) Members of an expanded affiliated

group.

§1.199–5 Application of section 199to pass-thru entities for taxable yearsbeginning after May 17, 2006, theenactment date of the Tax IncreasePrevention and Reconciliation Act of2005. [Reserved].

§1.199–6 Agricultural and horticulturalcooperatives.

(a) In general.(b) Cooperative denied section 1382 de-

duction for portion of qualified payments.(c) Determining cooperative’s taxable

income.(d) Special rule for marketing coopera-

tives.(e) Qualified payment.

(f) Specified agricultural or horticul-tural cooperative.

(g) Written notice to patrons.(h) Additional rules relating to

passthrough of section 199 deduction.(i) W–2 wages.(j) Recapture of section 199 deduction.(k) Section is exclusive.(l) No double counting.(m) Examples.

§1.199–7 Expanded affiliated groups.

(a) In general.(1) Definition of expanded affiliated

group.(2) Identification of members of an ex-

panded affiliated group.(i) In general.(ii) Becoming or ceasing to be a mem-

ber of an expanded affiliated group.(3) Attribution of activities.(i) In general.(ii) Special rule.(4) Examples.(5) Anti-avoidance rule.(b) Computation of expanded affiliated

group’s section 199 deduction.(1) In general.(2) Example.(3) Net operating loss carrybacks and

carryovers.(c) Allocation of an expanded affili-

ated group’s section 199 deduction amongmembers of the expanded affiliated group.

(1) In general.(2) Use of section 199 deduction to cre-

ate or increase a net operating loss.(d) Special rules for members of the

same consolidated group.(1) Intercompany transactions.(2) Attribution of activities in the con-

struction of real property and the perfor-mance of engineering and architecturalservices.

(3) Application of the simplified deduc-tion method and the small business simpli-fied overall method.

(4) Determining the section 199 deduc-tion.

(i) Expanded affiliated group consistsof consolidated group and non-consoli-dated group members.

(ii) Expanded affiliated group consistsonly of members of a single consolidatedgroup.

2006–25 I.R.B. 1081 June 19, 2006

(5) Allocation of the section 199 de-duction of a consolidated group among itsmembers.

(e) Examples.(f) Allocation of income and loss by a

corporation that is a member of the ex-panded affiliated group for only a portionof the year.

(1) In general.(i) Pro rata allocation method.(ii) Section 199 closing of the books

method.(iii) Making the section 199 closing of

the books election.(2) Coordination with rules relat-

ing to the allocation of income under§1.1502–76(b).

(g) Total section 199 deduction for acorporation that is a member of an ex-panded affiliated group for some or all ofits taxable year.

(1) Member of the same expanded affil-iated group for the entire taxable year.

(2) Member of the expanded affiliatedgroup for a portion of the taxable year.

(3) Example.(h) Computation of section 199 deduc-

tion for members of an expanded affiliatedgroup with different taxable years.

(1) In general.(2) Example.

§1.199–8 Other rules.

(a) In general.(b) Individuals.(c) Trade or business requirement.(1) In general.(2) Individuals.(3) Trusts and estates.(d) Coordination with alternative mini-

mum tax.(e) Nonrecognition transactions.(1) In general.(i) Sections 351, 721, and 731.(ii) Exceptions.(A) Section 708(b)(1)(B).(B) Transfers by reason of death.(2) Section 1031 exchanges.(3) Section 381 transactions.(f) Taxpayers with a 52–53 week tax-

able year.(g) Section 481(a) adjustments.(h) Disallowed losses or deductions.(i) Effective dates.(1) In general.(2) Pass-thru entities.(3) Non-consolidated EAG members.

(4) Computer software provided to cus-tomers over the Internet. [Reserved].

§1.199–9 Application of section 199to pass-thru entities for taxable yearsbeginning on or before May 17, 2006,the enactment date of the Tax IncreasePrevention and Reconciliation Act of2005.

(a) In general.(b) Partnerships.(1) In general.(i) Determination at partner level.(ii) Determination at entity level.(2) Disallowed losses or deductions.(3) Partner’s share of W–2 wages.(4) Transition percentage rule for W–2

wages.(5) Partnerships electing out of sub-

chapter K.(6) Examples.(c) S corporations.(1) In general.(i) Determination at shareholder level.(ii) Determination at entity level.(2) Disallowed losses or deductions.(3) Shareholder’s share of W–2 wages.(4) Transition percentage rule for W–2

wages.(d) Grantor trusts.(e) Non-grantor trusts and estates.(1) Allocation of costs.(2) Allocation among trust or estate and

beneficiaries.(i) In general.(ii) Treatment of items from a trust or

estate reporting qualified production activ-ities income.

(3) Beneficiary’s share of W–2 wages.(4) Transition percentage rule for W–2

wages.(5) Example.(f) Gain or loss from the disposition of

an interest in a pass-thru entity.(g) Section 199(d)(1)(A)(iii) wage lim-

itation and tiered structures.(1) In general.(2) Share of W–2 wages.(3) Example.(h) No attribution of qualified activities.(i) Qualifying in-kind partnership.(1) In general.(2) Definition of qualifying in-kind

partnership.(3) Special rules for distributions.(4) Other rules.(5) Example.

(j) Partnerships owned by members ofa single expanded affiliated group.

(1) In general.(2) Attribution of activities.(i) In general.(ii) Attribution between EAG partner-

ships.(iii) Exception to attribution.(3) Special rules for distributions.(4) Other rules.(5) Examples.(k) Effective dates.

§1.199–1 Income attributable to domesticproduction activities.

(a) In general. A taxpayer may deductan amount equal to 9 percent (3 percentin the case of taxable years beginning in2005 or 2006, and 6 percent in the case oftaxable years beginning in 2007, 2008, or2009) of the lesser of the taxpayer’s qual-ified production activities income (QPAI)(as defined in paragraph (c) of this section)for the taxable year, or the taxpayer’s tax-able income for the taxable year (or, in thecase of an individual, adjusted gross in-come). The amount of the deduction al-lowable under this paragraph (a) for anytaxable year cannot exceed 50 percent ofthe W–2 wages of the employer for the tax-able year (as determined under §1.199–2).The provisions of this section apply solelyfor purposes of section 199 of the InternalRevenue Code.

(b) Taxable income and adjusted grossincome—(1) In general. For purposes ofparagraph (a) of this section, the definitionof taxable income under section 63 applies,except that taxable income is determinedwithout regard to section 199 and with-out regard to any amount excluded fromgross income pursuant to section 114 orpursuant to section 101(d) of the Ameri-can Jobs Creation Act of 2004, Public Law108–357, 118 Stat. 1418 (Act). In thecase of individuals, adjusted gross incomefor the taxable year is determined after ap-plying sections 86, 135, 137, 219, 221,222, and 469, and without regard to sec-tion 199 and without regard to any amountexcluded from gross income pursuant tosection 114 or pursuant to section 101(d)of the Act. For purposes of determiningthe tax imposed by section 511, paragraph(a) of this section is applied using unre-lated business taxable income. Except asprovided in §1.199–7(c)(2), the deduction

June 19, 2006 1082 2006–25 I.R.B.

under section 199 is not taken into accountin computing any net operating loss or theamount of any net operating loss carrybackor carryover.

(2) Examples. The following examplesillustrate the application of this paragraph(b):

Example 1. X, a corporation that is not part ofan expanded affiliated group (EAG) (as defined in§1.199–7), engages in production activities that gen-erate QPAI and taxable income (without taking intoaccount the deduction under this section and an NOLdeduction) of $600 in 2010. During 2010, X incursW–2 wages as defined in §1.199–2(e) of $300. X hasan NOL carryover to 2010 of $500. X’s deduction un-der this section for 2010 is $9 (.09 x (lesser of QPAIof $600 and taxable income of $100 ($600 taxable in-come - $500 NOL)). Because the wage limitation is$150 (50% x $300), X’s deduction is not limited.

Example 2. (i) Facts. X, a corporation that is notpart of an EAG, engages in production activities thatgenerate QPAI and taxable income (without takinginto account the deduction under this section and anNOL deduction) of $100 in 2010. X has an NOL car-ryover to 2010 of $500 that reduces its taxable incomefor 2010 to $0. X’s deduction under this section for2010 is $0 (.09 x (lesser of QPAI of $100 and taxableincome of $0)).

(ii) Carryover to 2011. X’s taxable income forpurposes of determining its NOL carryover to 2011is $100. Accordingly, X’s NOL carryover to 2011 is$400 ($500 NOL carryover to 2010 - $100 NOL usedin 2010).

(c) Qualified production activities in-come. QPAI for any taxable year is anamount equal to the excess (if any) of thetaxpayer’s domestic production gross re-ceipts (DPGR) (as defined in §1.199–3)over the sum of—

(1) The cost of goods sold (CGS) that isallocable to such receipts; and

(2) Other expenses, losses, or deduc-tions (other than the deduction allowed un-der this section) that are properly alloca-ble to such receipts. See §§1.199–3 and1.199–4.

(d) Allocation of gross receipts—(1) Ingeneral. A taxpayer must determine theportion of its gross receipts for the tax-able year that is DPGR and the portion ofits gross receipts that is non-DPGR. Ap-plicable Federal income tax principles ap-ply to determine whether a transaction is,in substance, a lease, rental, license, sale,exchange, or other disposition the grossreceipts of which may constitute DPGR(assuming all the other requirements of§1.199–3 are met), whether it is a servicethe gross receipts of which may constitutenon-DPGR, or some combination thereof.For example, if a taxpayer leases quali-fying production property (QPP) (as de-

fined in §1.199–3(j)(1)) and in connectionwith that lease, also provides services, thetaxpayer must allocate its gross receiptsfrom the transaction using any reasonablemethod that is satisfactory to the Secre-tary based on all of the facts and circum-stances and that accurately identifies thegross receipts that constitute DPGR andnon-DPGR.

(2) Reasonable method of allocation.Factors taken into consideration in deter-mining whether the taxpayer’s method ofallocating gross receipts between DPGRand non-DPGR is reasonable includewhether the taxpayer uses the most accu-rate information available; the relationshipbetween the gross receipts and the methodused; the accuracy of the method chosenas compared with other possible methods;whether the method is used by the tax-payer for internal management or otherbusiness purposes; whether the method isused for other Federal or state income taxpurposes; the time, burden, and cost of us-ing alternative methods; and whether thetaxpayer applies the method consistentlyfrom year to year. Thus, if a taxpayer hasthe information readily available and can,without undue burden or expense, specif-ically identify whether the gross receiptsderived from an item are DPGR, then thetaxpayer must use that specific identifi-cation to determine DPGR. If a taxpayerdoes not have information readily avail-able to specifically identify whether thegross receipts derived from an item areDPGR or cannot, without undue burdenor expense, specifically identify whetherthe gross receipts derived from an item areDPGR, then the taxpayer is not requiredto use a method that specifically identifieswhether the gross receipts derived from anitem are DPGR.

(3) De minimis rules—(i) DPGR. Allof a taxpayer’s gross receipts may betreated as DPGR if less than 5 percentof the taxpayer’s total gross receipts arenon-DPGR (after application of the ex-ceptions provided in §1.199–3(i)(4)(i)(B),(l)(4)(iv)(A), (m)(1)(iii)(A), (n)(6)(i), and(o)(2) that may result in gross receiptsbeing treated as DPGR). If the amountof the taxpayer’s gross receipts that arenon-DPGR equals or exceeds 5 percent ofthe taxpayer’s total gross receipts, then,except as provided in paragraph (d)(3)(ii)of this section, the taxpayer is requiredto allocate all gross receipts between

DPGR and non-DPGR in accordance withparagraph (d)(1) of this section. If a cor-poration is a member of an EAG, but isnot a member of a consolidated group,then the determination of whether lessthan 5 percent of the taxpayer’s total grossreceipts are non-DPGR is made at thecorporation level. If a corporation is amember of a consolidated group, then thedetermination of whether less than 5 per-cent of the taxpayer’s total gross receiptsare non-DPGR is made at the consolidatedgroup level. In the case of an S corpora-tion, partnership, trust (to the extent notdescribed in §1.199–9(d)) or estate, orother pass-thru entity, the determination ofwhether less than 5 percent of the pass-thruentity’s total gross receipts are non-DPGRis made at the pass-thru entity level. Inthe case of an owner of a pass-thru entity,the determination of whether less than 5percent of the owner’s total gross receiptsare non-DPGR is made at the owner level,taking into account all gross receipts ofthe owner from its other trade or businessactivities and the owner’s share of thegross receipts of the pass-thru entity.

(ii) Non-DPGR. All of a taxpayer’sgross receipts may be treated asnon-DPGR if less than 5 percent of thetaxpayer’s total gross receipts are DPGR(after application of the exceptions pro-vided in §1.199–3(i)(4)(ii), (l)(4)(iv)(B),(m)(1)(iii)(B), and (n)(6)(ii) that mayresult in gross receipts being treated asnon-DPGR). If a corporation is a mem-ber of an EAG, but is not a member of aconsolidated group, then the determina-tion of whether less than 5 percent of thetaxpayer’s total gross receipts are DPGRis made at the corporation level. If a cor-poration is a member of a consolidatedgroup, then the determination of whetherless than 5 percent of the taxpayer’s totalgross receipts are DPGR is made at theconsolidated group level. In the case ofan S corporation, partnership, trust (to theextent not described in §1.199–9(d)) orestate, or other pass-thru entity, the deter-mination of whether less than 5 percentof the pass-thru entity’s total gross re-ceipts are DPGR is made at the pass-thruentity level. In the case of an owner ofa pass-thru entity, the determination ofwhether less than 5 percent of the owner’stotal gross receipts are DPGR is made atthe owner level, taking into account allgross receipts of the owner from its other

2006–25 I.R.B. 1083 June 19, 2006

trade or business activities and the owner’sshare of the gross receipts of the pass-thruentity.

(4) Example. The following exampleillustrates the application of this para-graph (d):

Example. X derives its gross receipts from thesale of gasoline refined by X within the United Statesand the sale of refined gasoline that X acquired bypurchase from an unrelated person. If at least 5% ofX’s gross receipts are derived from gasoline refinedby X within the United States (that qualify as DPGRif all the other requirements of §1.199–3 are met) andat least 5% of X’s gross receipts are derived from theresale of the acquired gasoline (that do not qualify asDPGR), then X does not qualify for the de minimisrules under paragraphs (d)(3)(i) and (ii) of this sec-tion, and X must allocate its gross receipts betweenthe gross receipts derived from the sale of gasolinerefined by X within the United States and the grossreceipts derived from the resale of the acquired gaso-line. If less than 5% of X’s gross receipts are derivedfrom the resale of the acquired gasoline, then, X mayeither allocate its gross receipts between the gross re-ceipts derived from the gasoline refined by X withinthe United States and the gross receipts derived fromthe resale of the acquired gasoline, or, pursuant toparagraph (d)(3)(i) of this section, X may treat all ofits gross receipts derived from the sale of the refinedgasoline as DPGR. If X’s gross receipts attributableto the gasoline refined by X within the United Statesconstitute less than 5% of X’s total gross receipts,then, X may either allocate its gross receipts betweenthe gross receipts derived from the gasoline refinedby X within the United States and the gross receiptsderived from the resale of the acquired gasoline, or,pursuant to paragraph (d)(3)(ii) of this section, X maytreat all of its gross receipts derived from the sale ofthe refined gasoline as non-DPGR.

(e) Certain multiple-year transac-tions—(1) Use of historical data. If ataxpayer recognizes and reports gross re-ceipts from advance payments or othersimilar payments on a Federal income taxreturn for a taxable year, then the tax-payer’s use of historical data in making anallocation of gross receipts from the trans-action between DPGR and non-DPGRmay constitute a reasonable method. If ataxpayer makes allocations using histor-ical data, and subsequently updates thedata, then the taxpayer must use the morerecent or updated data, starting in the tax-able year in which the update is made.

(2) Percentage of completion method.A taxpayer using a percentage of comple-tion method under section 460 must deter-mine the ratio of DPGR and non-DPGRusing a reasonable method that is satis-factory to the Secretary based on all ofthe facts and circumstances that accuratelyidentifies the gross receipts that constituteDPGR. See paragraph (d)(2) of this sec-

tion for the factors taken into considera-tion in determining whether the taxpayer’smethod is reasonable.

(3) Examples. The following examplesillustrate the application of this paragraph(e):

Example 1. On December 1, 2007, X, a calen-dar year accrual method taxpayer, sells for $100 aone-year computer software maintenance agreementthat provides for (i) computer software updates that Xexpects to produce in the United States, and (ii) cus-tomer support services. At the end of 2007, X uses areasonable method that is satisfactory to the Secretarybased on all of the facts and circumstances to allocate60% of the gross receipts ($60) to the computer soft-ware updates and 40% ($40) to the customer supportservices. X treats the $60 as DPGR in 2007. At theexpiration of the one-year agreement on November30, 2008, no computer software updates are providedby X. Pursuant to paragraph (e)(1) of this section, be-cause X used a reasonable method that is satisfactoryto the Secretary based on all of the facts and circum-stances to identify gross receipts as DPGR, X is notrequired to make any adjustments to its 2007 Federalincome tax return (for example, by amended return)or in 2008 for the $60 that was properly treated asDPGR in 2007, even though no computer softwareupdates were provided under the contract.

Example 2. X manufactures automobiles withinthe United States and sells 5-year extended warrantiesto customers. The sales price of the warranty is basedon historical data that determines what repairs andservices are performed on an automobile during the5-year period. X sells the 5-year warranty to Y for$1,000 in 2007. Under X’s method of accounting,X recognizes warranty revenue when received. Us-ing historical data, X concludes that 60% of the grossreceipts attributable to a 5-year warranty will be de-rived from the sale of parts (QPP) that X manufac-tures within the United States, and 40% will be de-rived from the sale of purchased parts X did not man-ufacture and non-qualifying services. X’s method ofallocating its gross receipts with respect to the 5-yearwarranty between DPGR and non-DPGR is a reason-able method that is satisfactory to the Secretary basedon all of the facts and circumstances. Therefore, Xproperly treats $600 as DPGR in 2007.

Example 3. The facts are the same as in Example2 except that in 2009 X updates its historical data.The updated historical data show that 50% of thegross receipts attributable to a 5-year warranty willbe derived from the sale of parts (QPP) that X man-ufactures within the United States and 50% will bederived from the sale of purchased parts X did notmanufacture and non-qualifying services. In 2009, Xsells a 5-year warranty for $1,000 to Z. Under all ofthe facts and circumstances, X’s method of allocationis still a reasonable method. Relying on its updatedhistorical data, X properly treats $500 as DPGR in2009.

Example 4. The facts are the same as in Exam-ple 2 except that Y pays for the 5-year warranty overtime ($200 a year for 5 years). Under X’s methodof accounting, X recognizes each $200 payment asit is received. In 2009, X updates its historical dataand the updated historical data show that 50% of thegross receipts attributable to a 5-year warranty willbe derived from the sale of QPP that X manufac-

tures within the United States and 50% will be de-rived from the sale of purchased parts X did not man-ufacture and non-qualifying services. Under all of thefacts and circumstances, X’s method of allocation isstill a reasonable method. When Y makes its $200payment for 2009, X, relying on its updated histori-cal data, properly treats $100 as DPGR in 2009.

§1.199–2 Wage limitation.

(a) Rules of application—(1) In gen-eral. The provisions of this section ap-ply solely for purposes of section 199 ofthe Internal Revenue Code. The amount ofthe deduction allowable under §1.199–1(a)(section 199 deduction) to a taxpayer forany taxable year shall not exceed 50 per-cent of the W–2 wages (as defined in para-graph (e) of this section) of the taxpayer.For this purpose, except as provided inparagraph (a)(3) of this section and para-graph (b) of this section, the Forms W–2,“Wage and Tax Statement,” used in deter-mining the amount of W–2 wages are thoseissued for the calendar year ending dur-ing the taxpayer’s taxable year for wagespaid to employees (or former employees)of the taxpayer for employment by the tax-payer. For purposes of this section, em-ployees of the taxpayer are limited to em-ployees of the taxpayer as defined in sec-tion 3121(d)(1) and (2) (that is, officersof a corporate taxpayer and employees ofthe taxpayer under the common law rules).See paragraph (a)(3) of this section for therequirement that W–2 wages must havebeen included in a return filed with the So-cial Security Administration (SSA) within60 days after the due date (including exten-sions) of the return.

(2) Wages paid by entity other thancommon law employer. In determiningW–2 wages, a taxpayer may take into ac-count any wages paid by another entity andreported by the other entity on Forms W–2with the other entity as the employer listedin Box c of the Forms W–2, provided thatthe wages were paid to employees of thetaxpayer for employment by the taxpayer.If the taxpayer is treated as an employerdescribed in section 3401(d)(1) becauseof control of the payment of wages (thatis, the taxpayer is not the common lawemployer of the payee of the wages), thepayment of wages may not be included indetermining W–2 wages of the taxpayer.If the taxpayer is paying wages as an agentof another entity to individuals who arenot employees of the taxpayer, the wages

June 19, 2006 1084 2006–25 I.R.B.

may not be included in determining theW–2 wages of the taxpayer.

(3) Requirement that wages must bereported on return filed with the SocialSecurity Administration—(i) In general.The term W–2 wages shall not include anyamount that is not properly included in areturn filed with SSA on or before the 60thday after the due date (including exten-sions) for such return. Under §31.6051–2of this chapter, each Form W–2 and thetransmittal Form W–3, “Transmittal ofWage and Tax Statements,” together con-stitute an information return to be filedwith SSA. Similarly, each Form W–2c,“Corrected Wage and Tax Statement,”and the transmittal Form W–3 or W–3c,“Transmittal of Corrected Wage and TaxStatements,” together constitute an infor-mation return to be filed with SSA. Indetermining whether any amount has beenproperly included in a return filed withSSA on or before the 60th day after thedue date (including extensions) for suchreturn, each Form W–2 together with itsaccompanying Form W–3 shall be con-sidered a separate information return andeach Form W–2c together with its accom-panying Form W–3 or Form W–3c shallbe considered a separate information re-turn. Section 31.6071(a)–1(a)(3) of thischapter provides that each informationreturn in respect of wages as defined in theFederal Insurance Contributions Act or ofincome tax withheld from wages whichis required to be made under §31.6051–2of this chapter shall be filed on or beforethe last day of February (March 31 if filedelectronically) of the year following thecalendar year for which it is made, exceptthat if a tax return under §31.6011(a)–5(a)of this chapter is filed as a final return fora period ending prior to December 31, theinformation statement shall be filed on orbefore the last day of the second calendarmonth following the period for which thetax return is filed. Corrected Forms W–2are required to be filed with SSA on orbefore the last day of February (March31 if filed electronically) of the year fol-lowing the year in which the correctionis made, except that if a tax return under§31.6011(a)–5(a) is filed as a final returnfor a period ending prior to December 31for the period in which the correction ismade, the corrected Forms W–2 are re-quired to be filed by the last day of the

second calendar month following the pe-riod for which the final return is filed.

(ii) Corrected return filed to correct areturn that was filed within 60 days of thedue date. If a corrected information re-turn (Return B) is filed with SSA on orbefore the 60th day after the due date (in-cluding extensions) of Return B to correctan information return (Return A) that wasfiled with SSA on or before the 60th dayafter the due date (including extensions)of the information return (Return A) andparagraph (a)(3)(ii) of this section does notapply, then the wage information on Re-turn B must be included in determiningW–2 wages. If a corrected information re-turn (Return D) is filed with SSA later thanthe 60th day after the due date (includingextensions) of Return D to correct an in-formation return (Return C) that was filedwith SSA on or before the 60th day afterthe due date (including extensions) of theinformation return (Return C), then if Re-turn D reports an increase (or increases) inwages included in determining W–2 wagesfrom the wage amounts reported on ReturnC, then such increase (or increases) on Re-turn D shall be disregarded in determiningW–2 wages (and only the wage amountson Return C may be included in determin-ing W–2 wages). If Return D reports a de-crease (or decreases) in wages included indetermining W–2 wages from the amountsreported on Return C, then, in determiningW–2 wages, the wages reported on ReturnC must be reduced by the decrease (or de-creases) reflected on Return D.

(iii) Corrected return filed to correct areturn that was filed later than 60 days af-ter the due date. If an information return(Return F) is filed to correct an informa-tion return (Return E) that was not filedwith SSA on or before the 60th day afterthe due date (including extensions) of Re-turn E, then Return F (and any subsequentinformation returns filed with respect toReturn E) will not be considered filed onor before the 60th day after the due date(including extensions) of Return F (or thesubsequent corrected information return).Thus, if a Form W–2c (or corrected FormW–2) is filed to correct a Form W–2 thatwas not filed with SSA on or before the60th day after the due date (including ex-tensions) of the information return includ-ing the Form W–2 (or to correct a FormW–2c relating to a information return in-cluding a Form W–2 that had not been filed

with SSA on or before the 60th day af-ter the due date (including extensions) ofthe information return including the FormW–2), then the information return includ-ing this Form W–2c (or corrected FormW–2) shall not be considered to have beenfiled with SSA on or before the 60th dayafter the due date (including extensions)for this information return including theForm W–2c (or corrected Form W–2), re-gardless of when the information return in-cluding the Form W–2c (or corrected FormW–2) is filed.

(4) Joint return. An individual and hisor her spouse are considered one taxpayerfor purposes of determining the amount ofW–2 wages for a taxable year, providedthat they file a joint return for the taxableyear. Thus, an individual filing as part ofa joint return may include the wages ofemployees of his or her spouse in deter-mining W–2 wages, provided the employ-ees are employed in a trade or businessof the spouse and the other requirementsof this section are met. However, a mar-ried taxpayer filing a separate return fromhis or her spouse for the taxable year maynot include the wages of employees of thetaxpayer’s spouse in determining the tax-payer’s W–2 wages for the taxable year.

(b) Application in the case of a taxpayerwith a short taxable year. In the case ofa taxpayer with a short taxable year, sub-ject to the rules of paragraph (a) of this sec-tion, the W–2 wages of the taxpayer for theshort taxable year shall include only thosewages paid during the short taxable yearto employees of the taxpayer, only thoseelective deferrals (within the meaning ofsection 402(g)(3)) made during the shorttaxable year by employees of the taxpayerand only compensation actually deferredunder section 457 during the short taxableyear with respect to employees of the tax-payer. The Secretary shall have the au-thority to issue published guidance settingforth the method that is used to calculateW–2 wages in case of a taxpayer with ashort taxable year. See paragraph (e)(3) ofthis section.

(c) Acquisition or disposition of a tradeor business (or major portion). If a tax-payer (a successor) acquires a trade orbusiness, the major portion of a trade orbusiness, or the major portion of a separateunit of a trade or business from anothertaxpayer (a predecessor), then, for pur-poses of computing the respective section

2006–25 I.R.B. 1085 June 19, 2006

199 deduction of the successor and of thepredecessor, the W–2 wages paid for thatcalendar year shall be allocated betweenthe successor and the predecessor basedon whether the wages are for employmentby the successor or for employment by thepredecessor. Thus, in this situation, theW–2 wages are allocated based on whetherthe wages are for employment for a periodduring which the employee was employedby the predecessor or for employment fora period during which the employee wasemployed by the successor, regardless ofwhich permissible method for Form W–2reporting is used.

(d) Non-duplication rule. Amounts thatare treated as W–2 wages for a taxableyear under any method shall not be treatedas W–2 wages of any other taxable year.Also, an amount shall not be treated asW–2 wages by more than one taxpayer.

(e) Definition of W–2 wages—(1) Ingeneral. Under section 199(b)(2), the termW–2 wages means, with respect to any per-son for any taxable year of such person,the sum of the amounts described in sec-tion 6051(a)(3) and (8) paid by such per-son with respect to employment of em-ployees by such person during the calen-dar year ending during such taxable year.Thus, the term W–2 wages includes thetotal amount of wages as defined in sec-tion 3401(a); the total amount of elec-tive deferrals (within the meaning of sec-tion 402(g)(3)); the compensation deferredunder section 457; and for taxable yearsbeginning after December 31, 2005, theamount of designated Roth contributions(as defined in section 402A).

(2) Limitation on W–2 wages for tax-able years beginning after May 17, 2006,the enactment date of the Tax Increase Pre-vention and Reconciliation Act of 2005.[Reserved].

(3) Methods for calculating W–2 wages.The Secretary may provide by publicationin the Internal Revenue Bulletin (see§601.601(d)(2)(ii)(b) of this chapter) formethods to be used in calculating W–2wages, including W–2 wages for shorttaxable years. For example, see Rev.Proc. 2006–22, 2006–23 I.R.B. 1033) (see§601.601(d)(2) of this chapter).

§1.199–3 Domestic production grossreceipts.

(a) In general. The provisions of thissection apply solely for purposes of sec-tion 199 of the Internal Revenue Code(Code). Domestic production gross re-ceipts (DPGR) are the gross receipts (asdefined in paragraph (c) of this section) ofthe taxpayer that are—

(1) Derived from any lease, rental, li-cense, sale, exchange, or other disposition(as defined in paragraph (i) of this section)of—

(i) Qualifying production property(QPP) (as defined in paragraph (j)(1) ofthis section) that is manufactured, pro-duced, grown, or extracted (MPGE) (asdefined in paragraph (e) of this section)by the taxpayer (as defined in paragraph(f) of this section) in whole or in signifi-cant part (as defined in paragraph (g) ofthis section) within the United States (asdefined in paragraph (h) of this section);

(ii) Any qualified film (as defined inparagraph (k) of this section) produced bythe taxpayer; or

(iii) Electricity, natural gas, or potablewater (as defined in paragraph (l) of thissection) (collectively, utilities) producedby the taxpayer in the United States;

(2) Derived from, in the case of a tax-payer engaged in the active conduct of aconstruction trade or business, construc-tion of real property (as defined in para-graph (m) of this section) performed in theUnited States by the taxpayer in the ordi-nary course of such trade or business; or

(3) Derived from, in the case of a tax-payer engaged in the active conduct of anengineering or architectural services tradeor business, engineering or architecturalservices (as defined in paragraph (n) of thissection) performed in the United Statesby the taxpayer in the ordinary course ofsuch trade or business with respect to theconstruction of real property in the UnitedStates.

(b) Related persons—(1) In general.DPGR does not include any gross receiptsof the taxpayer derived from propertyleased, licensed, or rented by the taxpayerfor use by any related person. A personis treated as related to another person ifboth persons are treated as a single em-ployer under either section 52(a) or (b)(without regard to section 1563(b)), orsection 414(m) or (o). Any other person

is an unrelated person for purposes of§§1.199–1 through 1.199–9.

(2) Exceptions. Notwithstanding para-graph (b)(1) of this section, gross receiptsderived from any QPP or qualified filmleased or rented by the taxpayer to a re-lated person may qualify as DPGR if theQPP or qualified film is held for subleaseor rent, or is subleased or rented, by the re-lated person to an unrelated person for theultimate use of the unrelated person. Sim-ilarly, notwithstanding paragraph (b)(1) ofthis section, gross receipts derived fromthe license of QPP or a qualified film toa related person for reproduction and sale,exchange, lease, rental, or sublicense to anunrelated person for the ultimate use of theunrelated person may qualify as DPGR.

(c) Definition of gross receipts. Theterm gross receipts means the taxpayer’sreceipts for the taxable year that are rec-ognized under the taxpayer’s methods ofaccounting used for Federal income taxpurposes for the taxable year. If the grossreceipts are recognized in an intercom-pany transaction within the meaning of§1.1502–13, see also §1.199–7(d). For thispurpose, gross receipts include total sales(net of returns and allowances) and allamounts received for services. In addition,gross receipts include any income frominvestments and from incidental or out-side sources. For example, gross receiptsinclude interest (including original issuediscount and tax-exempt interest withinthe meaning of section 103), dividends,rents, royalties, and annuities, regardlessof whether the amounts are derived in theordinary course of the taxpayer’s trade ofbusiness. Gross receipts are not reducedby cost of goods sold (CGS) or by thecost of property sold if such property isdescribed in section 1221(a)(1), (2), (3),(4), or (5). Gross receipts do not includethe amounts received in repayment of aloan or similar instrument (for example,a repayment of the principal amount of aloan held by a commercial lender) and,except to the extent of gain recognized,do not include gross receipts derived froma non-recognition transaction, such as asection 1031 exchange. Finally, gross re-ceipts do not include amounts received bythe taxpayer with respect to sales tax orother similar state and local taxes if, underthe applicable state or local law, the taxis legally imposed on the purchaser of thegood or service and the taxpayer merely

June 19, 2006 1086 2006–25 I.R.B.

collects and remits the tax to the taxing au-thority. If, in contrast, the tax is imposedon the taxpayer under the applicable law,then gross receipts include the amountsreceived that are allocable to the paymentof such tax.

(d) Determining domestic productiongross receipts—(1) In general. For pur-poses of §§1.199–1 through 1.199–9, ataxpayer determines, using any reasonablemethod that is satisfactory to the Secretarybased on all of the facts and circum-stances, whether gross receipts qualify asDPGR on an item-by-item basis (and not,for example, on a division-by-division,product line-by-product line, or transac-tion-by-transaction basis).

(i) The term item means the property of-fered by the taxpayer in the normal courseof the taxpayer’s business for lease, rental,license, sale, exchange, or other disposi-tion (for purposes of this paragraph (d),collectively referred to as disposition) tocustomers, if the gross receipts from thedisposition of such property qualify asDPGR; or

(ii) If paragraph (d)(1)(i) of this sec-tion does not apply to the property, thenany component of the property describedin paragraph (d)(1)(i) of this section istreated as the item, provided that the grossreceipts from the disposition of the prop-erty described in paragraph (d)(1)(i) ofthis section that are attributable to suchcomponent qualify as DPGR. Each com-ponent that meets the requirements underthis paragraph (d)(1)(ii) must be treatedas a separate item and a component thatmeets the requirements under this para-graph (d)(1)(ii) may not be combined witha component that does not meet these re-quirements.

(2) Special rules. The following spe-cial rules apply for purposes of paragraph(d)(1) of this section:

(i) For purposes of paragraph (d)(1)(i)of this section, in no event may a singleitem consist of two or more properties un-less those properties are offered for dis-position, in the normal course of the tax-payer’s business, as a single item (regard-less of how the properties are packaged).

(ii) In the case of property customarilysold by weight or by volume, the item isdetermined using the custom of the indus-try (for example, barrels of oil).

(iii) In the case of construction activi-ties and services or engineering and archi-

tectural services, a taxpayer may use anyreasonable method that is satisfactory tothe Secretary based on all of the facts andcircumstances to determine what construc-tion activities and services or engineeringor architectural services constitute an item.

(3) Exception. If a taxpayer MPGEQPP within the United States or producesa qualified film or produces utilities in theUnited States that it disposes of, and thetaxpayer leases, rents, licenses, purchases,or otherwise acquires property that con-tains or may contain the QPP, qualifiedfilm, or the utilities (or a portion thereof),and the taxpayer cannot reasonably de-termine, without undue burden and ex-pense, whether the acquired property con-tains any of the original QPP, qualifiedfilm, or utilities MPGE or produced by thetaxpayer, then the taxpayer is not requiredto determine whether any portion of theacquired property qualifies as an item forpurposes of paragraph (d)(1) of this sec-tion. Therefore, the gross receipts derivedfrom the disposition of the acquired prop-erty may be treated as non-DPGR. Simi-larly, the preceding sentences shall apply ifthe taxpayer can reasonably determine thatthe acquired property contains QPP, a qual-ified film, or utilities (or a portion thereof)MPGE or produced by the taxpayer, butcannot reasonably determine, without un-due burden or expense, how much, or whattype, grade, etc., of the QPP, qualified film,or utilities MPGE or produced by the tax-payer the acquired property contains.

(4) Examples. The following examplesillustrate the application of paragraph (d)of this section:

Example 1. Q manufactures leather and rubbershoe soles in the United States. Q imports shoe up-pers, which are the parts of the shoe above the sole.Q manufactures shoes for sale by sewing or otherwiseattaching the soles to the imported uppers. Q offersthe shoes for sale to customers in the normal courseof Q’s business. If the gross receipts derived from thesale of the shoes do not qualify as DPGR under thissection, then under paragraph (d)(1)(ii) of this sec-tion, Q must treat the sole as the item if the grossreceipts derived from the sale of the sole qualify asDPGR under this section.

Example 2. The facts are the same as in Exam-ple 1 except that Q also buys some finished shoesfrom unrelated persons and resells them to retail shoestores. Q offers all shoes (manufactured and pur-chased) for sale to customers, in the normal courseof Q’s business, in individual pairs, and requires nominimum quantity order. Q ships the shoes in boxes,each box containing as many as 50 pairs of shoes. Afull, or partially full, box may contain some shoes thatQ manufactured, and some that Q purchased. Underparagraph (d)(2)(i) of this section, Q cannot treat a

box of 50 (or fewer) pairs of shoes as an item, be-cause Q offers the shoes for sale in the normal courseof Q’s business in individual pairs.

Example 3. R manufactures toy cars in the UnitedStates. R also purchases cars that were manufacturedby unrelated persons. R offers the cars for sale tocustomers, in the normal course of R’s business, insets of three, and requires no minimum quantity or-der. R sells the three-car sets to toy stores. A three-carset may contain some cars manufactured by R andsome cars purchased by R. If the gross receipts de-rived from the sale of the three-car sets do not qualifyas DPGR under this section, then, under paragraph(d)(1)(ii) of this section, R must treat a toy car in thethree-car set as the item, provided the gross receiptsderived from the sale of the toy car qualify as DPGRunder this section.

Example 4. The facts are the same as Example 3except that R offers the toy cars for sale individuallyto customers in the normal course of R’s business,rather than in sets of three. R’s customers resell theindividual toy cars at three for $10. Frequently, thisresults in retail customers purchasing three individualcars in one transaction. In determining R’s DPGR,under paragraph (d)(2)(i) of this section, each toy caris an item and R cannot treat three individual toy carsas one item, because the individual toy cars are notoffered for sale in sets of three by R in the normalcourse of R’s business.

Example 5. The facts are the same as in Example3 except that R offers the toy cars for sale to customersin the normal course of R’s business both individuallyand in sets of three. The results are the same as Ex-ample 3 with respect to the three-car sets. The resultsare the same as in Example 4 with respect to the indi-vidual toy cars that are not included in the three-carsets and offered for sale individually. Thus, R has twoitems, an individual toy car and a set of three toy cars.

Example 6. S produces television sets in theUnited States. S also produces the same model oftelevision set outside the United States. In bothcases, S packages the sets one to a box. S sells thetelevision sets to large retail consumer electronicsstores. S requires that its customers purchase a min-imum of 100 television sets per order. With respectto a particular order by a customer of 100 televisionsets, some were manufactured by S in the UnitedStates, and some were manufactured by S outsidethe United States. Under paragraph (d)(2)(i) of thissection, a minimum order of 100 television sets is theitem provided that the gross receipts derived fromthe sale of the 100 television sets qualify as DPGR.

Example 7. T produces in bulk form in theUnited States the active ingredient for a pharmaceu-tical product. T sells the active ingredient in bulkform to FX, a foreign corporation. This sale qualifiesas DPGR assuming all the other requirements of thissection are met. FX uses the active ingredient toproduce the finished dosage form drug. FX sells thedrug in finished dosage to T, which sells the drug tocustomers. Assume that T knows how much of theactive ingredient is in the finished dosage. Underparagraph (d)(1)(ii) of this section, if T’s gross re-ceipts derived from the sale of the finished dosage donot qualify as DPGR under this section, then T musttreat the active ingredient component as the itembecause the gross receipts attributable to the activeingredient qualify as DPGR under this section. Theexception in paragraph (d)(3) of this section does not

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apply because T can reasonably determine withoutundue burden or expense that the finished dosagecontains the active ingredient and the quantity of theactive ingredient in the finished dosage.

Example 8. U produces steel within the UnitedStates and sells its steel to a variety of customers, in-cluding V, an unrelated person, who uses the steel forthe manufacture of equipment. V also purchases steelfrom other steel producers. For its steel operations, Upurchases equipment from V that may contain steelproduced by U. U sells the equipment after 5 years.If U cannot reasonably determine without undue bur-den and expense whether the equipment contains anysteel produced by U, then, under paragraph (d)(3) ofthis section, U may treat the gross receipts derivedfrom sale of the equipment as non-DPGR.

Example 9. The facts are the same as in Example8 except that U knows that the equipment purchasedfrom V does contain some amount of steel producedby U. If U cannot reasonably determine without un-due burden and expense how much steel producedby U the equipment contains, then, under paragraph(d)(3) of this section, U may treat the gross receiptsderived from sale of the equipment as non-DPGR.

Example 10. W manufactures sunroofs, stereos,and tires within the United States. W purchases auto-mobiles from unrelated persons and installs the man-ufactured components in the automobiles. W, in thenormal course of W’s business, sells the automobileswith the components to customers. If the gross re-ceipts derived from the sale of the automobiles withthe components do not qualify as DPGR under thissection, then under paragraph (d)(1)(ii) of this sec-tion, W must treat each component (sunroofs, stereos,and tires) that it manufactures as a separate item if thegross receipts derived from the sale of each compo-nent qualify as DPGR under this section.

Example 11. X manufacturers leather soleswithin the United States. X purchases shoe uppers,metal eyelets, and laces. X manufactures shoes bysewing or otherwise attaching the soles to the uppers;attaching the metal eyelets to the shoes; and thread-ing the laces through the eyelets. X, in the normalcourse of X’s business, sells the shoes to customers.If the gross receipts derived from the sale of theshoes do not qualify as DPGR under this section,then under paragraph (d)(1)(ii) of this section, Xmust treat the sole as the item if the gross receiptsderived from the sale of the sole qualify as DPGRunder this section. X may not treat the shoe upper,metal eyelets or laces as part of the item becauseunder paragraph (d)(1)(ii) of this section the sole isthe component that is treated as the item.

Example 12. Y manufactures glass windshieldsfor automobiles within the United States. Y pur-chases automobiles from unrelated persons and in-stalls the windshields in the automobiles. Y, in thenormal course of Y’s business, sells the automobileswith the windshields to customers. If the automobileswith the windshields do not meet the requirements forbeing an item, then, under paragraph (d)(1)(ii) of thissection, Y must treat each windshield that it manu-factures as an item if the gross receipts derived fromthe sale of the windshield qualify as DPGR under thissection. Y may not treat any other portion of the au-tomobile as part of the item because under paragraph(d)(1)(ii) of this section the windshield is the compo-nent.

(e) Definition of manufactured, pro-duced, grown, or extracted—(1) In gen-eral. Except as provided in paragraphs(e)(2) and (3) of this section, the termMPGE includes manufacturing, produc-ing, growing, extracting, installing, de-veloping, improving, and creating QPP;making QPP out of scrap, salvage, or junkmaterial as well as from new or raw mate-rial by processing, manipulating, refining,or changing the form of an article, or bycombining or assembling two or morearticles; cultivating soil, raising livestock,fishing, and mining minerals. The termMPGE also includes storage, handling,or other processing activities (other thantransportation activities) within the UnitedStates related to the sale, exchange, orother disposition of agricultural products,provided the products are consumed inconnection with or incorporated into theMPGE of QPP, whether or not by the tax-payer. Pursuant to paragraph (f)(1) of thissection, the taxpayer must have the bene-fits and burdens of ownership of the QPPunder Federal income tax principles dur-ing the period the MPGE activity occursin order for gross receipts derived fromthe MPGE of QPP to qualify as DPGR.

(2) Packaging, repackaging, labeling,or minor assembly. If a taxpayer pack-ages, repackages, labels, or performs mi-nor assembly of QPP and the taxpayer en-gages in no other MPGE activity with re-spect to that QPP, the taxpayer’s packag-ing, repackaging, labeling, or minor as-sembly does not qualify as MPGE with re-spect to that QPP.

(3) Installing. If a taxpayer installsQPP and engages in no other MPGE ac-tivity with respect to the QPP, the tax-payer’s installing activity does not qual-ify as an MPGE activity. Notwithstandingparagraph (i)(4)(i)(B)(4) of this section, ifthe taxpayer installs QPP MPGE by thetaxpayer and, except as provided in para-graph (f)(2) of this section, the taxpayerhas the benefits and burdens of ownershipof the QPP under Federal income tax prin-ciples during the period the installing ac-tivity occurs, then the portion of the in-stalling activity that relates to the QPP isan MPGE activity.

(4) Consistency with section 263A. Ataxpayer that has MPGE QPP for the tax-able year should treat itself as a producerunder section 263A with respect to theQPP unless the taxpayer is not subject to

section 263A. A taxpayer that currently isnot properly accounting for its productionactivities under section 263A, and wishesto change its method of accounting tocomply with the producer requirementsof section 263A, must follow the appli-cable administrative procedures issuedunder §1.446–1(e)(3)(ii) for obtainingthe Commissioner’s consent to a changein accounting method (for further guid-ance, for example, see Rev. Proc. 97–27,1997–1 C.B. 680, or Rev. Proc. 2002–9,2002–1 C.B. 327, whichever applies (see§601.601(d)(2) of this chapter)).

(5) Examples. The following examplesillustrate the application of this paragraph(e):

Example 1. A, B, and C are unrelated persons andare not cooperatives to which Part I of subchapter Tof the Code applies. B grows agricultural products inthe United States and sells them to A, who owns agri-cultural storage bins in the United States. A stores theagricultural products and has the benefits and burdensof ownership under Federal income tax principles ofthe agricultural products while they are being stored.A sells the agricultural products to C, who processesthem into refined agricultural products in the UnitedStates. The gross receipts from A’s, B’s, and C’s ac-tivities are DPGR from the MPGE of QPP.

Example 2. The facts are the same as in Ex-ample 1 except that B grows the agricultural prod-ucts outside the United States and C processes theminto refined agricultural products outside the UnitedStates. Pursuant to paragraph (e)(1) of this section,the gross receipts derived by A from its sale of theagricultural products to C are DPGR from the MPGEof QPP within the United States. B’s and C’s re-spective MPGE activities occur outside the UnitedStates and, therefore, their respective gross receiptsare non-DPGR.

Example 3. Y is hired to reconstruct and refur-bish unrelated customers’ tangible personal property.As part of the reconstruction and refurbishment, Yinstalls purchased replacement parts that constituteQPP in the customers’ property. Y’s installationof purchased replacement parts does not qualify asMPGE pursuant to paragraph (e)(3) of this sectionbecause Y did not MPGE the replacement parts.

Example 4. The facts are the same as in Example3 except that Y manufactures the replacement parts ituses for the reconstruction and refurbishment of cus-tomers’ tangible personal property. Y has the bene-fits and burdens of ownership under Federal incometax principles of the replacement parts during the re-construction and refurbishment activity and while in-stalling the parts. Y’s gross receipts derived fromthe MPGE of the replacement parts and Y’s gross re-ceipts derived from the installation of the replacementparts, which is an MPGE activity pursuant to para-graph (e)(3) of this section, are DPGR (assuming allthe other requirements of this section are met).

Example 5. Z MPGE QPP within the UnitedStates. The following activities are performed byZ as part of the MPGE of the QPP while Z has thebenefits and burdens of ownership under Federalincome tax principles: materials analysis and selec-

June 19, 2006 1088 2006–25 I.R.B.

tion, subcontractor inspections and qualifications,testing of component parts, assisting customers intheir review and approval of the QPP, routine produc-tion inspections, product documentation, diagnosisand correction of system failure, and packaging forshipment to customers. Because Z MPGE the QPP,these activities performed by Z are part of the MPGEof the QPP.

Example 6. X purchases automobiles fromunrelated persons and customizes them by addingground effects, spoilers, custom wheels, specializedpaint and decals, sunroofs, roof racks, and similaraccessories. X does not manufacture any of theaccessories. X’s activity is minor assembly underparagraph (e)(2) of this section which is not anMPGE activity.

Example 7. Y manufactures furniture in theUnited States that it sells to unrelated persons. Yalso engraves customers’ names on pens and pencilspurchased from unrelated persons and sells the pensand pencils to such customers. Although Y’s salesof furniture qualify as DPGR if all the other require-ments of this section are met, Y must determinewhether its gross receipts derived from the sale ofthe pens and pencils qualify as DPGR. Y’s status asa manufacturer of furniture in the United States doesnot carry over to its other activities.

Example 8. X produces computer software withinthe United States. In 2007, X enters into an agree-ment with Y, an unrelated person, under which X willmanage Y’s networks using computer software thatX produced. Pursuant to the terms of the agreement,X also provides to Y for Y’s use on Y’s own hard-ware computer software that X produced (additionalcomputer software). Assume that, based on all of thefacts and circumstances, the transaction between Xand Y relating to the additional computer software isa lease or sale of the additional computer software.Y pays X monthly fees of $100 under the agreementduring 2007. No separate charge for the additionalcomputer software is stated in the agreement or in themonthly invoices that X provides to Y. The portionof X’s gross receipts that is derived from the lease orsale of the additional computer software is DPGR (as-suming all the other requirements of this section aremet).

(f) Definition of by the taxpayer—(1)In general. With the exception of the rulesapplicable to an expanded affiliated group(EAG) under §1.199–7, qualifying in-kindpartnerships under §1.199–9(i), EAG part-nerships under §1.199–9(j), and govern-ment contracts under paragraph (f)(2) ofthis section, only one taxpayer may claimthe deduction under §1.199–1(a) withrespect to any qualifying activity underparagraphs (e)(1), (k)(1), and (l)(1) of thissection performed in connection with thesame QPP, or the production of a qualifiedfilm or utilities. If one taxpayer performs aqualifying activity under paragraph (e)(1),(k)(1), or (l)(1) of this section pursuant toa contract with another party, then onlythe taxpayer that has the benefits and bur-dens of ownership of the QPP, qualified

film, or utilities under Federal incometax principles during the period in whichthe qualifying activity occurs is treated asengaging in the qualifying activity.

(2) Special rule for certain governmentcontracts. Gross receipts derived from theMPGE of QPP in whole or in significantpart within the United States will be treatedas gross receipts derived from the lease,rental, license, sale, exchange, or other dis-position of QPP MPGE by the taxpayerin whole or in significant part within theUnited States notwithstanding the require-ments of paragraph (f)(1) of this sectionif—

(i) The QPP is MPGE by the taxpayerwithin the United States pursuant to a con-tract with the Federal government; and

(ii) The Federal Acquisition Regulation(Title 48, Code of Federal Regulations) re-quires that title or risk of loss with respectto the QPP be transferred to the Federalgovernment before the MPGE of the QPPis completed.

(3) Subcontractor. If a taxpayer (sub-contractor) enters into a contract or agree-ment to MPGE QPP on behalf of a tax-payer to which paragraph (f)(2) of this sec-tion applies, and the QPP under the con-tract or agreement is subject to paragraph(f)(2)(ii) of this section, then, notwith-standing the requirements of paragraph(f)(1) of this section, the subcontractor’sgross receipts derived from the MPGE ofthe QPP in whole or in significant partwithin the United States will be treatedas gross receipts derived from the lease,rental, license, sale, exchange, or otherdisposition of QPP MPGE by the sub-contractor in whole or in significant partwithin the United States.

(4) Examples. The following examplesillustrate the application of this paragraph(f):

Example 1. X designs machines that it uses in itstrade or business. X contracts with Y, an unrelatedperson, for the manufacture of the machines. Thecontract between X and Y is a fixed-price contract.The contract specifies that the machines will be man-ufactured in the United States using X’s design. Xowns the intellectual property attributable to the de-sign and provides it to Y with a restriction that Y mayonly use it during the manufacturing process and hasno right to exploit the intellectual property. The con-tract specifies that Y controls the details of the man-ufacturing process while the machines are being pro-duced; Y bears the risk of loss or damage during man-ufacturing of the machines; and Y has the economicloss or gain upon the sale of the machines based onthe difference between Y’s costs and the fixed price.Y has legal title during the manufacturing process and

legal title to the machines is not transferred to X untilfinal manufacturing of the machines has been com-pleted. Based on all of the facts and circumstances,pursuant to paragraph (f)(1) of this section Y has thebenefits and burdens of ownership of the machinesunder Federal income tax principles during the periodthe manufacturing occurs and, as a result, Y is treatedas the manufacturer of the machines.

Example 2. X designs and engineers machinesthat it sells to customers. X contracts with Y, an un-related person, for the manufacture of the machines.The contract between X and Y is a cost-reimbursabletype contract. Assume that X has the benefits andburdens of ownership of the machines under Federalincome tax principles during the period the manufac-turing occurs except that legal title to the machines isnot transferred to X until final manufacturing of themachines is completed. Based on all of the facts andcircumstances, X is treated as the manufacturer of themachines under paragraph (f)(1) of this section.

Example 3. X manufactures machines within theUnited States pursuant to a contract with the Federalgovernment and the Federal Acquisition Regulationrequires that the title or risk of loss with respect to themachines be transferred to the Federal governmentbefore X completes manufacture of the machines. Xsubcontracts with Y, an unrelated person, for the man-ufacture of components for the machines that Y man-ufactures within the United States. Assume that themachines manufactured by X, and the components forthe machines manufactured by Y, are QPP. Both themachines and components are subject to the FederalAcquisition Regulation that requires title or risk ofloss with respect to the machines and components betransferred to the Federal government before manu-facturing of the machines and components are com-plete. Under paragraph (f)(2) of this section, the grossreceipts derived by X from the manufacture withinthe United States of the machines for the Federal gov-ernment are treated as having been derived from thelease, rental, license, sale, exchange, or other dispo-sition of the machines manufactured by X in wholeor in significant part within the United States. Underparagraph (f)(3) of this section, the gross receipts de-rived by Y from the manufacture within the UnitedStates of the components for X are also treated ashaving been derived from the lease, rental, license,sale, exchange, or other disposition of the compo-nents manufactured by Y in whole or in significantpart within the United States.

(g) Definition of in whole or in signif-icant part—(1) In general. QPP must beMPGE in whole or in significant part bythe taxpayer and in whole or in significantpart within the United States to qualify un-der section 199(c)(4)(A)(i)(I). If a taxpayerenters into a contract with an unrelated per-son for the unrelated person to MPGE QPPfor the taxpayer and the taxpayer has thebenefits and burdens of ownership of theQPP under applicable Federal income taxprinciples during the period the MPGE ac-tivity occurs, then, pursuant to paragraph(f)(1) of this section, the taxpayer is con-sidered to MPGE the QPP under this sec-tion. The unrelated person must perform

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the MPGE activity on behalf of the tax-payer in whole or in significant part withinthe United States in order for the taxpayerto satisfy the requirements of this para-graph (g)(1).

(2) Substantial in nature. QPP willbe treated as MPGE in significant partby the taxpayer within the United Statesfor purposes of paragraph (g)(1) of thissection if the MPGE of the QPP by thetaxpayer within the United States is sub-stantial in nature taking into account all ofthe facts and circumstances, including therelative value added by, and relative costof, the taxpayer’s MPGE activity withinthe United States, the nature of the QPP,and the nature of the MPGE activity thatthe taxpayer performs within the UnitedStates. The MPGE of a key component ofQPP does not, in itself, meet the substan-tial-in-nature requirement with respect tothe QPP under this paragraph (g)(2). Inthe case of tangible personal property (asdefined in paragraph (j)(2) of this section),research and experimental activities undersection 174 and the creation of intangi-ble assets are not taken into account indetermining whether the MPGE of QPPis substantial in nature for any QPP otherthan computer software (as defined inparagraph (j)(3) of this section) and soundrecordings (as defined in paragraph (j)(4)of this section). Thus, for example, a tax-payer may take into account its design anddevelopment activities when determiningwhether its MPGE of computer softwareis substantial in nature.

(3) Safe harbor—(i) In general. A tax-payer will be treated as having MPGE QPPin whole or in significant part within theUnited States for purposes of paragraph(g)(1) of this section if, in connection withthe QPP, the direct labor and overhead ofsuch taxpayer to MPGE the QPP withinthe United States account for 20 percent ormore of the taxpayer’s CGS of the QPP,or in a transaction without CGS (for ex-ample, a lease, rental, or license) accountfor 20 percent or more of the taxpayer’sunadjusted depreciable basis (as definedin paragraph (g)(3)(ii) of this section) inthe QPP. For taxpayers subject to section263A, overhead is all costs required to becapitalized under section 263A except di-rect materials and direct labor. For taxpay-ers not subject to section 263A, overheadmay be computed using any reasonablemethod that is satisfactory to the Secretary

based on all of the facts and circumstances,but may not include any cost, or amount ofany cost, that would not be required to becapitalized under section 263A if the tax-payer were subject to section 263A. Re-search and experimental expenditures un-der section 174 and the costs of creatingintangible assets are not taken into accountin determining direct labor or overhead forany tangible personal property. However,for a special rule regarding computer soft-ware and sound recordings, see paragraph(g)(3)(iii) of this section. In the case oftangible personal property (as defined inparagraph (j)(2) of this section), researchand experimental expenditures under sec-tion 174 and any other costs incurred inthe creation of intangible assets may beexcluded from CGS or unadjusted depre-ciable basis for purposes of determiningwhether the taxpayer meets the safe harborunder this paragraph (g)(3).

(ii) Unadjusted depreciable basis. Theterm unadjusted depreciable basis meansthe basis of property for purposes of sec-tion 1011 without regard to any adjust-ments described in section 1016(a)(2) and(3). This basis does not reflect the reduc-tion in basis for—

(A) Any portion of the basis the tax-payer properly elects to treat as an expenseunder section 179 or 179C; or

(B) Any adjustments to basis providedby other provisions of the Code and theregulations under the Code (for example,a reduction in basis by the amount of thedisabled access credit pursuant to section44(d)(7)).

(iii) Computer software and soundrecordings. In determining direct laborand overhead under paragraph (g)(3)(i) ofthis section, the costs of direct labor andoverhead for developing computer soft-ware as described in Rev. Proc. 2000–50,2000–2 C.B. 601 (see §601.601(d)(2) ofthis chapter), research and experimentalexpenditures under section 174, and anyother costs of creating intangible assets forcomputer software and sound recordingsare treated as direct labor and overhead.These costs must be included in the tax-payer’s CGS or unadjusted depreciablebasis of computer software and soundrecordings for purposes of determiningwhether the taxpayer meets the safe harborunder paragraph (g)(3)(i) of this section. Ifthe taxpayer expects to lease, rent, license,sell, exchange, or otherwise dispose of

computer software or sound recordingsover more than one taxable year, the costsof developing computer software as de-scribed in Rev. Proc. 2000–50, 2000–2C.B. 601, research and experimental ex-penditures under section 174, and anyother costs of creating intangible assetsfor computer software and sound record-ings must be allocated over the estimatednumber of units that the taxpayer expectsto lease, rent, license, sell, exchange, orotherwise dispose of.

(4) Special rules—(i) Contract with anunrelated person. If a taxpayer enters intoa contract with an unrelated person for theunrelated person to MPGE QPP within theUnited States for the taxpayer, and the tax-payer is considered to MPGE the QPP pur-suant to paragraph (f)(1) of this section,then, for purposes of the substantial-in-na-ture requirement under paragraph (g)(2)of this section and the safe harbor un-der paragraph (g)(3)(i) of this section, thetaxpayer’s MPGE or production activitiesor direct labor and overhead shall includeboth the taxpayer’s MPGE or productionactivities or direct labor and overhead toMPGE the QPP within the United States aswell as the MPGE or production activitiesor direct labor and overhead of the unre-lated person to MPGE the QPP within theUnited States under the contract.

(ii) Aggregation. In determiningwhether the substantial-in-nature require-ment under paragraph (g)(2) of this sectionor the safe harbor under paragraph (g)(3)(i)of this section is met at the time the tax-payer disposes of an item of QPP—

(A) An EAG member must take into ac-count all of the previous MPGE or produc-tion activities or direct labor and overheadof the other members of the EAG;

(B) An EAG partnership (as defined in§1.199–9(j)) must take into account all ofthe previous MPGE or production activ-ities or direct labor and overhead of allmembers of the EAG in which the partnersof the EAG partnership are members (aswell as the previous MPGE or productionactivities of any other EAG partnershipsowned by members of the same EAG);

(C) A member of an EAG in whichthe partners of an EAG partnership aremembers must take into account all of theprevious MPGE or production activitiesor direct labor and overhead of the EAGpartnership (as well as those of any othermembers of the EAG and any previous

June 19, 2006 1090 2006–25 I.R.B.

MPGE or production activities of anyother EAG partnerships owned by mem-bers of the same EAG); and

(D) A partner of a qualifying in-kindpartnership (as defined in §1.199–9(i))must take into account all of the previousMPGE or production activities or direct la-bor and overhead of the qualifying in-kindpartnership.

(5) Examples. The following examplesillustrate the application of this paragraph(g):

Example 1. X purchases from Y, an unrelated per-son, unrefined oil extracted outside the United States.X refines the oil in the United States. The refining ofthe oil by X is an MPGE activity that is substantial innature.

Example 2. X purchases gemstones and preciousmetal from outside the United States and then usesthese materials to produce jewelry within the UnitedStates by cutting and polishing the gemstones, melt-ing and shaping the metal, and combining the finishedmaterials. X’s MPGE activities are substantial in na-ture under paragraph (g)(2) of this section. Therefore,X has MPGE the jewelry in significant part within theUnited States.

Example 3. (i) Facts. X operates an automobileassembly plant in the United States. In connectionwith such activity, X purchases assembled engines,transmissions, and certain other components from Y,an unrelated person, and X assembles all of the com-ponent parts into an automobile. X also conductsstamping, machining, and subassembly operations,and X uses tools, jigs, welding equipment, and othermachinery and equipment in the assembly of automo-biles. On a per-unit basis, X ’s selling price and costsof such automobiles are as follows:

Selling price: $2,500Cost of goods sold:

Material — Acquired from Y: $1,475Direct labor and overhead: $325Total cost of goods sold: $1,800

Gross profit: $700Administrative and selling expenses: $300Taxable income: $400

(ii) Analysis. Although X’s direct labor and over-head are less than 20% of total CGS ($325/$1,800,or 18%) and X is not within the safe harbor underparagraph (g)(3)(i) of this section, the activities con-ducted by X in connection with the assembly of anautomobile are substantial in nature under paragraph(g)(2) of this section taking into account the natureof X’s activity and the relative value of X’s activity.Therefore, X’s automobiles will be treated as MPGEin significant part by X within the United States forpurposes of paragraph (g)(1) of this section.

Example 4. X imports into the United StatesQPP that is partially manufactured. Assume that Xcompletes the manufacture of the QPP within theUnited States and X’s completion of the manufac-turing of the QPP within the United States satisfiesthe in-whole-or-in-significant-part requirement un-der paragraph (g)(1) of this section. Therefore, X’sgross receipts from the lease, rental, license, sale,exchange, or other disposition of the QPP qualify asDPGR if all other applicable requirements under thissection are met.

Example 5. X manufactures QPP in significantpart within the United States and exports the QPP forfurther manufacture outside the United States. X re-tains title to the QPP while the QPP is being furthermanufactured outside the United States. AssumingX meets all the requirements under this section forthe QPP after the further manufacturing, X’s grossreceipts derived from the lease, rental, license, sale,exchange, or other disposition of the QPP will be con-sidered DPGR, regardless of whether the QPP is im-ported back into the United States prior to the lease,rental, license, sale, exchange, or other disposition ofthe QPP.

Example 6. X is a retailer within the United Statesthat sells cigars and pipe tobacco that X purchasesfrom an unrelated person. While being displayed andoffered for sale by X, the cigars and pipe tobacco ageon X’s shelves in a room with controlled temperatureand humidity. Although X’s cigars and pipe tobaccomay become more valuable as they age, the gross re-ceipts derived by X from the sale of the cigars and

pipe tobacco are non-DPGR because the aging of thecigars and pipe tobacco while being displayed and of-fered for sale by X does not qualify as an MPGE ac-tivity that is substantial in nature.

Example 7. X incurs $1,000,000 in computersoftware development costs in direct labor and over-head to develop computer software. X begins pro-ducing the computer software and expects to licenseone million copies of the computer software. In de-termining its direct labor and overhead for the com-puter software under paragraph (g)(3)(i) of this sec-tion, X must allocate under paragraph (g)(3)(iii) ofthis section the $1,000,000 to the computer softwareX expects to produce. Thus, for each copy of thecomputer software produced by X, $1 ($1,000,000 incomputer software development costs/one million es-timated number of units to be licensed) in computersoftware development costs are treated as direct laborand overhead.

Example 8. X creates computer software for mi-crowave ovens. X also manufactures the electric mo-tors used in the ovens. X purchases the other compo-nents of the microwave ovens from unrelated persons.X sells each microwave oven individually to cus-tomers. Assume that X’s assembly of the finished mi-crowave ovens is not minor assembly. To determinewhether the manufacture of the microwave ovens sat-isfies the safe harbor under paragraph (g)(3)(i) of thissection, X’s direct labor and overhead include X’sdirect labor and overhead for creating the computersoftware, manufacturing the electric motors, and as-sembling the finished microwave ovens that are of-fered for sale.

Example 9. X designs shirts within the UnitedStates, but X cuts and sews the shirts outside of theUnited States. Because X’s design activity is the cre-ation of an intangible, its design activity is not takeninto account in determining whether the manufactureof the shirts is substantial in nature under paragraph(g)(2) of this section, and the costs X incurs in creat-ing the design of the shirts are not direct labor or over-head under paragraph (g)(3)(i) of this section. There-

fore, X has not MPGE the shirts in significant partwithin the United States.

Example 10. X manufactures computer chipswithin the United States. X installs the computerchips that it manufactures in computers that X pur-chases from unrelated persons and sells the finishedcomputers individually to customers. The computerchips are key components of the computers andthe computers will not operate without them. Themanufacture of the computer chips is not, in itself,substantial in nature with respect to the finishedcomputers. Therefore, the taxpayer’s MPGE ac-tivities must meet either the substantial-in-naturerequirement under paragraph (g)(2) of this section,or the safe harbor under paragraph (g)(3) of this sec-tion, in order to qualify with respect to the finishedcomputers.

(h) Definition of United States. Forpurposes of this section, the term UnitedStates includes the 50 states, the Districtof Columbia, the territorial waters of theUnited States, and the seabed and subsoilof those submarine areas that are adjacentto the territorial waters of the United Statesand over which the United States has ex-clusive rights, in accordance with interna-tional law, with respect to the explorationand exploitation of natural resources. Theterm United States does not include pos-sessions and territories of the United Statesor the airspace or space over the UnitedStates and these areas.

(i) Derived from the lease, rental, li-cense, sale, exchange, or other disposi-tion—(1) In general—(i) Definition. Theterm derived from the lease, rental, license,sale, exchange, or other disposition is de-fined as, and limited to, the gross receiptsdirectly derived from the lease, rental, li-

2006–25 I.R.B. 1091 June 19, 2006

cense, sale, exchange, or other dispositionof QPP, a qualified film, or utilities, even ifthe taxpayer has already recognized grossreceipts from a previous lease, rental, li-cense, sale, exchange, or other dispositionof the same QPP, qualified film, or utili-ties. Applicable Federal income tax prin-ciples apply to determine whether a trans-action is, in substance, a lease, rental, li-cense, sale, exchange, or other disposition,whether it is a service, or whether it is somecombination thereof.

(ii) Lease income. The financing andinterest components of a lease of QPP or aqualified film are considered to be derivedfrom the lease of such QPP or qualifiedfilm. However, any portion of the leaseincome that is attributable to services ornon-qualified property as defined in para-graph (i)(4) of this section is not derivedfrom the lease of QPP or a qualified film.

(iii) Income substitutes. The proceedsfrom business interruption insurance, gov-ernmental subsidies, and governmentalpayments not to produce are treated asgross receipts derived from the lease,rental, license, sale, exchange, or otherdisposition to the extent that they aresubstitutes for gross receipts that wouldqualify as DPGR.

(iv) Exchange of property—(A) Tax-able exchanges. Except as provided inparagraph (i)(1)(iv)(B) of this section, thevalue of property received by a taxpayerin a taxable exchange of QPP MPGE inwhole or in significant part by the taxpayerwithin the United States, a qualified filmproduced by the taxpayer, or utilities pro-duced by the taxpayer within the UnitedStates is DPGR for the taxpayer (assumingall the other requirements of this sectionare met). However, unless the taxpayermeets all of the requirements under thissection with respect to any further MPGEby the taxpayer of the QPP or any furtherproduction by the taxpayer of the film orutilities received in the taxable exchange,any gross receipts derived from the saleby the taxpayer of the property received inthe taxable exchange are non-DPGR, be-cause the taxpayer did not MPGE or pro-duce such property, even if the propertywas QPP, a qualified film, or utilities in thehands of the other party to the transaction.

(B) Safe harbor. For purposes of para-graph (i)(1)(iv)(A) of this section, thegross receipts derived by the taxpayerfrom the sale of eligible property (as de-

fined in paragraph (i)(1)(iv)(C) of thissection) received in a taxable exchange,net of any adjustments between the par-ties involved in the taxable exchange toaccount for differences in the eligibleproperty exchanged (for example, locationdifferentials and product differentials),may be treated as the value of the eligibleproperty received by the taxpayer in thetaxable exchange. For purposes of thepreceding sentence, the taxable exchangeis deemed to occur on the date of thesale of the eligible property received inthe taxable exchange by the taxpayer, tothe extent the sale occurs no later thanthe last day of the month following themonth in which the exchanged eligibleproperty is received by the taxpayer. Inaddition, if the taxpayer engages in anyfurther MPGE or production activity withrespect to the eligible property receivedin the taxable exchange, then, unless thetaxpayer meets the in-whole-or-in-signif-icant-part requirement under paragraph(g)(1) of this section with respect to theproperty sold, for purposes of this para-graph (i)(1)(iv)(B), the taxpayer must alsovalue the property sold without taking intoaccount the gross receipts attributable tothe further MPGE or production activity.

(C) Eligible property. For purposes ofparagraph (i)(1)(iv)(B) of this section, eli-gible property is—

(1) Oil, natural gas (as described inparagraph (l)(2) of this section), or petro-chemicals, or products derived from oil,natural gas, or petrochemicals; or

(2) Any other property or product des-ignated by publication in the Internal Rev-enue Bulletin (see §601.601(d)(2)(ii)(b) ofthis chapter).

(2) Examples. The following exam-ples illustrate the application of paragraph(i)(1) of this section:

Example 1. X MPGE QPP in whole or in signif-icant part within the United States and uses the QPPin its business. After several years X sells the QPPthat it MPGE to Y. The gross receipts derived fromthe sale of the QPP to Y are DPGR (assuming all theother requirements of this section are met).

Example 2. X MPGE QPP within the UnitedStates and sells the QPP to Y, an unrelated person. Yleases the QPP for 3 years to Z, a taxpayer unrelatedto both X and Y, and shortly after Y enters into thelease with Z, X repurchases the QPP from Y subjectto the lease. At the end of the lease term, Z purchasesthe QPP from X. X’s proceeds derived from the saleof the QPP to Y, from the lease to Z (including anyfinancing and interest components of the lease), andfrom the sale of the QPP to Z all qualify as DPGR

(assuming all the other requirements of this sectionare met).

Example 3. X MPGE QPP within the UnitedStates and sells the QPP to Y, an unrelated person,for $25,000. X finances Y’s purchase of the QPP andreceives total payments of $35,000, of which $10,000relates to interest and finance charges. The $25,000qualifies as DPGR, but the $10,000 in interest andfinance charges do not qualify as DPGR because the$10,000 is not derived from the MPGE of QPP withinthe United States, but rather from X’s lending activ-ity.

Example 4. Cable company X charges sub-scribers $15 a month for its basic cable television. Y,an unrelated person, produces a qualified film withinthe meaning of paragraph (k)(1) of this section thatit licenses to X for $.10 per subscriber per month.The gross receipts derived by Y are derived from thelicense of a qualified film produced by Y and areDPGR (assuming all the other requirements of thissection are met).

Example 5. X manufactures cars within theUnited States. X also manufactures replacementparts within the United States. The replacement partsare QPP under paragraph (j)(1) of this section. Xoffers extended warranties to its customers. X sellsa car to Y. Y purchases an extended warranty andbrings the car to X’s service department for mainte-nance. X repairs the car and replaces damaged partswith replacement parts that X manufactured withinthe United States. The portion of X’s gross receiptsderived from the sale of the extended warranty relat-ing to the manufactured parts are DPGR.

(3) Hedging transactions—(i) In gen-eral. For purposes of this section, pro-vided that the risk being hedged relatesto QPP described in section 1221(a)(1)or relates to property described in section1221(a)(8) consumed in an activity giv-ing rise to DPGR, and provided that thetransaction is a hedging transaction withinthe meaning of section 1221(b)(2)(A) and§1.1221–2(b) and is properly identified asa hedging transaction in accordance with§1.1221–2(f), then—

(A) In the case of a hedge of pur-chases of property described in section1221(a)(1), gain or loss on the hedgingtransaction must be taken into account indetermining CGS;

(B) In the case of a hedge of sales ofproperty described in section 1221(a)(1),gain or loss on the hedging transactionmust be taken into account in determiningDPGR; and

(C) In the case of a hedge of pur-chases of property described in section1221(a)(8), gain or loss on the hedgingtransaction must be taken into account indetermining DPGR.

(ii) Currency fluctuations. For pur-poses of this section, in the case of a trans-action that manages the risk of currency

June 19, 2006 1092 2006–25 I.R.B.

fluctuations, the determination of whetherthe transaction is a hedging transactionwithin the meaning of §1.1221–2(b) ismade without regard to whether the trans-action is a section 988 transaction. See§1.1221–2(a)(4). The preceding sentenceapplies only to the extent that §1.988–5(b)does not apply.

(iii) Effect of identification and non-identification. If a taxpayer does not makean identification that satisfies all of the re-quirements of §1.1221–2(f) but the tax-payer has no reasonable grounds for treat-ing the transaction as other than a hedgingtransaction, then a loss from the transac-tion is taken into account under this para-graph (i)(3). If the inadvertent identifica-tion rule of §1.1221–2(g)(1)(ii) or the in-advertent error rule of §1.1221–2(g)(2)(ii)applies, then the taxpayer is treated as nothaving identified the transaction as a hedg-ing transaction or as having identified thetransaction as a hedging transaction, as thecase may be. If a taxpayer identifies atransaction as a hedging transaction in ac-cordance with §1.1221–2(f)(1), then—

(A) That identification is binding withrespect to loss for purposes of this para-graph (i)(3), whether or not all of therequirements of §1.1221–2(f) are satis-fied and whether or not the transaction isin fact a hedging transaction within themeaning of section 1221(b)(2)(A) and§1.1221–2(b), and

(B) This paragraph (i)(3) does not ap-ply to require gain to be taken into ac-count in determining CGS or DPGR, ifthe transaction is not in fact a hedgingtransaction within the meaning of section1221(b)(2)(A) and §1.1221–2(b).

(iv) Other rules. See §1.1221–2(e) forrules applicable to hedging by membersof a consolidated group and §1.446–4 forrules regarding the timing of income, de-ductions, gains, or losses with respect tohedging transactions.

(4) Allocation of gross receipts—(i)Embedded services and non-qualifiedproperty—(A) In general. Except as oth-erwise provided in paragraph (i)(4)(i)(B),paragraph (m) (relating to construction),and paragraph (n) (relating to engineer-ing and architectural services) of thissection, gross receipts derived from theperformance of services do not qualify asDPGR. In the case of an embedded ser-vice, that is, a service the price of which,in the normal course of the taxpayer’s

business, is not separately stated fromthe amount charged for the lease, rental,license, sale, exchange, or other disposi-tion of QPP, a qualified film, or utilities,DPGR include only the gross receipts de-rived from the lease, rental, license, sale,exchange, or other disposition of QPP, aqualified film, or utilities (assuming allthe other requirements of this section aremet) and not any receipts attributable tothe embedded service. In addition, DPGRdoes not include the gross receipts derivedfrom the lease, rental, license, sale, ex-change, or other disposition of propertythat does not meet all of the requirementsunder this section (non-qualified prop-erty). The allocation of the gross receiptsattributable to the embedded services ornon-qualified property will be deemedto be reasonable if the allocation reflectsthe fair market value of the embeddedservices or non-qualified property. Forexample, gross receipts derived from thelease, rental, license, sale, exchange, orother disposition of a replacement part thatis non-qualified property does not qualifyas DPGR. In addition, see §1.199–1(e)for other instances when an allocation ofgross receipts attributable to embeddedservices or non-qualified property will bedeemed reasonable.

(B) Exceptions. There are six ex-ceptions to the rules under paragraph(i)(4)(i)(A) of this section regarding em-bedded services and non-qualified prop-erty. A taxpayer may include in DPGR, ifall the other requirements of this sectionare met with respect to the underlyingitem of QPP, qualified films, or utilities towhich the embedded services or non-qual-ified property relate, the gross receiptsderived from—

(1) A qualified warranty, that is, awarranty (other than a computer softwaremaintenance agreement described in para-graph (i)(4)(i)(B)(5) of this section) thatis provided in connection with the lease,rental, license, sale, exchange, or otherdisposition of QPP, a qualified film, orutilities if, in the normal course of thetaxpayer’s business—

(i) The price for the warranty is not sep-arately stated from the amount charged forthe lease, rental, license, sale, exchange,or other disposition of the QPP, qualifiedfilm, or utilities; and

(ii) The warranty is neither separatelyoffered by the taxpayer nor separately bar-

gained for with customers (that is, a cus-tomer cannot purchase the QPP, qualifiedfilm, or utilities without the warranty);

(2) A qualified delivery, that is, a de-livery or distribution service that is pro-vided in connection with the lease, rental,license, sale, exchange, or other disposi-tion of QPP if, in the normal course of thetaxpayer’s business—

(i) The price for the delivery or distri-bution service is not separately stated fromthe amount charged for the lease, rental, li-cense, sale, exchange, or other dispositionof the QPP; and

(ii) The delivery or distribution serviceis neither separately offered by the tax-payer nor separately bargained for withcustomers (that is, a customer cannot pur-chase the QPP without the delivery or dis-tribution service);

(3) A qualified operating manual, thatis, a manual of instructions (including elec-tronic instructions) that is provided in con-nection with the lease, rental, license, sale,exchange, or other disposition of QPP, aqualified film or utilities if, in the normalcourse of the taxpayer’s business—

(i) The price for the manual is not sep-arately stated from the amount charged forthe lease, rental, license, sale, exchange,or other disposition of the QPP, qualifiedfilm, or utilities;

(ii) The manual is neither separately of-fered by the taxpayer nor separately bar-gained for with customers (that is, a cus-tomer cannot purchase the QPP, qualifiedfilm, or utilities without the manual); and

(iii) The manual is not provided inconnection with a training course for cus-tomers;

(4) A qualified installation, that is, aninstallation service (including minor as-sembly) for tangible personal property thatis provided in connection with the lease,rental, license, sale, exchange, or other dis-position of the tangible personal propertyif, in the normal course of the taxpayer’sbusiness—

(i) The price for the installation serviceis not separately stated from the amountcharged for the lease, rental, license, sale,exchange, or other disposition of the tan-gible personal property; and

(ii) The installation is neither separatelyoffered by the taxpayer nor separately bar-gained for with customers (that is, a cus-tomer cannot purchase the tangible per-

2006–25 I.R.B. 1093 June 19, 2006

sonal property without the installation ser-vice);

(5) Services performed pursuant to aqualified computer software maintenanceagreement. A qualified computer softwaremaintenance agreement is an agreementprovided in connection with the lease,rental, license, sale, exchange, or otherdisposition of the computer software thatentitles the customer to receive futureupdates, cyclical releases, rewrites of theunderlying software, or customer supportservices for the computer software if, inthe normal course of the taxpayer’s busi-ness—

(i) The price for the agreement is notseparately stated from the amount chargedfor the lease, rental, license, sale, ex-change, or other disposition of the com-puter software; and

(ii) The agreement is neither separatelyoffered by the taxpayer nor separately bar-gained for with customers (that is, a cus-tomer cannot purchase the computer soft-ware without the agreement); and

(6) A de minimis amount of gross re-ceipts from embedded services and non-qualified property for each item of QPP,qualified films, or utilities. For purposesof the preceding sentence, a de minimisamount of gross receipts from embeddedservices and non-qualified property is lessthan 5 percent of the total gross receipts de-rived from the lease, rental, license, sale,exchange, or other disposition of each itemof QPP, qualified films, or utilities. Inthe case of gross receipts derived from thelease, rental, license, sale, exchange, orother disposition of QPP, a qualified film,or utilities that are received over a periodof time (for example, a multi-year lease orinstallment sale), this de minimis excep-tion is applied by taking into account thetotal gross receipts for the entire period de-rived (and to be derived) from the lease,rental, license, sale, exchange, or otherdisposition of the item of QPP, qualifiedfilms, or utilities. For purposes of the pre-ceding sentence, if a taxpayer treats grossreceipts as DPGR under this de minimisexception, then the taxpayer must treat thegross receipts recognized in each taxableyear consistently as DPGR. The gross re-ceipts that the taxpayer treats as DPGR un-der paragraphs (i)(4)(i)(B)(1), (2), (3), (4),and (5) and (l)(4)(iv)(A) of this section aretreated as DPGR for purposes of applyingthis de minimis exception. This de minimis

exception does not apply if the price of aservice or non-qualified property is sepa-rately stated by the taxpayer, or if the ser-vice or non-qualified property is separatelyoffered or separately bargained for with thecustomer (that is, the customer can pur-chase the QPP, qualified film, or utilitieswithout the service or non-qualified prop-erty).

(ii) Non-DPGR. All of a taxpayer’sgross receipts derived from the lease,rental, license, sale, exchange or other dis-position of an item of QPP, qualified films,or utilities may be treated as non-DPGRif less than 5 percent of the taxpayer’stotal gross receipts derived from the lease,rental, license, sale, exchange or otherdisposition of that item are DPGR. In thecase of gross receipts derived from thelease, rental, license, sale, exchange, orother disposition of QPP, a qualified film,and utilities that are received over a periodof time (for example, a multi-year lease orinstallment sale), this paragraph (i)(4)(ii)is applied by taking into account the totalgross receipts for the entire period derived(and to be derived) from the lease, rental,license, sale, exchange, or other disposi-tion of the item of QPP, qualified films,or utilities. For purposes of the precedingsentence, if a taxpayer treats gross receiptsas non-DPGR under this de minimis ex-ception, then the taxpayer must treat thegross receipts recognized in each taxableyear consistently as non-DPGR.

(iii) Examples. The following examplesillustrate the application of this paragraph(i)(4):

Example 1. X MPGE QPP within the UnitedStates. As part of the sale of the QPP to Z, X trainsZ’s employees on how to use and operate the QPP. Noother services or property are provided to Z in con-nection with the sale of the QPP to Z. In the normalcourse of X’s business, the QPP and training servicesare separately stated in the sales contract. Because,in the normal course of the X’s business, the trainingservices are separately stated, the training services arenot treated as embedded services under the de min-imis exception in paragraph (i)(4)(i)(B)(6) of this sec-tion.

Example 2. The facts are the same as in Exam-ple 1 except that, in the normal course of X’s busi-ness, the training services are not separately stated inthe sales contract and the customer cannot purchasethe QPP without the training services. If the gross re-ceipts for the embedded training services are less than5% of the gross receipts derived from the sale of X’sQPP to Z, after applying the exceptions under para-graphs (i)(4)(i)(B)(1) through (5) of this section, thenthe gross receipts may be included in DPGR underthe de minimis exception in paragraph (i)(4)(i)(B)(6)of this section.

Example 3. X MPGE QPP within the UnitedStates. As part of the sale of the QPP to retailers,X charges a fee for delivering the QPP. In the nor-mal course of X’s business, the price of the QPP andthe delivery fee are separately stated in X’s sales con-tracts. Because, in the normal course of X’s busi-ness, the delivery fee is separately stated, the deliv-ery fee does not qualify as DPGR under the qualifieddelivery exception in paragraph (i)(4)(i)(B)(2) of thissection or the de minimis exception under paragraph(i)(4)(i)(B)(6) of this section. The result would be thesame even if the retailer’s customers cannot purchasethe QPP without paying the delivery fee.

Example 4. (i) Facts. X manufactures indus-trial sewing machines within the United States thatX offers for sale individually to customers. X en-ters into a single, lump-sum priced contract with Y,an unrelated person, and the contract has the follow-ing terms: X will manufacture industrial sewing ma-chines within the United States for Y; X will deliverthe industrial sewing machines to Y; X will provide aone-year warranty on the industrial sewing machines;X will provide operating manuals with the industrialsewing machines; X will provide 100 hours of train-ing and training manuals to Y’s employees on the useand maintenance of the industrial sewing machines;X will provide purchased spare parts for the industrialsewing machines; and X will provide a 3-year serviceagreement for the industrial sewing machines. In thenormal course of X’s business, none of the services orproperty described above are separately stated, sepa-rately offered or separately bargained for.

(ii) Analysis. The receipts for the manufactureof the industrial sewing machines are DPGR underparagraphs (e)(1) and (g) of this section (assumingall the other requirements of this section are met). Xmay include in DPGR the gross receipts derived fromdelivering the industrial sewing machines, which isa qualified delivery under paragraph (i)(4)(i)(B)(2)of this section; the gross receipts derived from theone-year warranty, which is a qualified warrantyunder paragraph (i)(4)(i)(B)(1) of this section; andthe gross receipts derived from the operating man-uals, which is a qualified operating manual underparagraph (i)(4)(i)(B)(3) of this section. If the grossreceipts allocable to each industrial sewing machinefor the embedded services consisting of the employeetraining and 3-year service agreement, and for thenon-qualified property consisting of the purchasedspare parts and the employee training manuals, whichare not qualified operating manuals, are in total lessthan 5% of the gross receipts derived from the saleof each industrial sewing machine to Y (after apply-ing the exceptions under paragraphs (i)(4)(i)(B)(1)through (5) of this section), then those gross receiptsmay be included in DPGR under the de minimisexception in paragraph (i)(4)(i)(B)(6) of this section.If, however, the gross receipts allocable to eachindustrial sewing machine for the embedded servicesand non-qualified property consisting of employeetraining, the 3-year service agreement, purchasedspare parts, and employee training manuals equalor exceed, in total, 5% of the gross receipts derivedfrom the sale of each industrial sewing machine toY (after applying the exceptions under paragraphs(i)(4)(i)(B)(1) through (5) of this section), then thosegross receipts do not qualify as DPGR under the deminimis exception in paragraph (i)(4)(i)(B)(6) of this

June 19, 2006 1094 2006–25 I.R.B.

section (and X must allocate gross receipts betweenDPGR and non-DPGR under §1.199–1(d)(1)).

(5) Advertising income—(i) Tangiblepersonal property. A taxpayer’s grossreceipts that are derived from the lease,rental, license, sale, exchange, or otherdisposition of newspapers, magazines,telephone directories, periodicals, andother similar printed publications that areMPGE in whole or in significant partwithin the United States include advertis-ing income from advertisements placed inthose media, but only if the gross receipts,if any, derived from the lease, rental, li-cense, sale, exchange, or other dispositionof the newspapers, magazines, telephonedirectories, or periodicals are (or wouldbe) DPGR.

(ii) Qualified film. A taxpayer’s grossreceipts that are derived from the lease,rental, license, sale, exchange, or other dis-position of a qualified film include adver-tising income and product-placement in-come with respect to that qualified film,that is, compensation for placing or inte-grating advertising or a product into thequalified film, but only if the gross re-ceipts, if any, derived from the qualifiedfilm are (or would be) DPGR.

(iii) Examples. The following examplesillustrate the application of this paragraph(i)(5):

Example 1. X MPGE, and sells, newspaperswithin the United States. X’s gross receipts fromthe newspapers include gross receipts derived fromthe sale of newspapers to customers and paymentsfrom advertisers to publish display advertising orclassified advertisements in X’s newspapers. X’sgross receipts described above are DPGR derivedfrom the sale of X’s newspapers.

Example 2. The facts are the same as in Exam-ple 1 except that X disposes of the newspapers freeof charge to customers, rather than selling them. X’sgross receipts from the display advertising or classi-fied advertisements are DPGR.

Example 3. X produces two live television pro-grams that are qualified films. X licenses the firsttelevision program to Y’s television station and X li-censes the second television program to Z’s televi-sion station. Z broadcasts the second television pro-gram on its station. Both television programs con-tain product placements and advertising for which Xreceived compensation. X and Y are unrelated per-sons. X and Z are non-consolidated members of anEAG. The gross receipts derived by X from licensingthe first television program to Y are DPGR. As a re-sult, pursuant to paragraph (i)(5)(ii) of this section, allof X’s product placement and advertising income forthe first television program is treated as gross receiptsthat are derived from the license of the qualified film.The gross receipts derived by X from licensing thesecond television program to Z are non-DPGR underparagraph (b)(1) of this section. Paragraph (b)(2) of

this section does not apply because Z’s broadcast ofthe second television program on Z’s television sta-tion is not a lease, rental, license, sale, exchange, orother disposition of the second television program.As a result, pursuant to paragraph (i)(5)(ii) of this sec-tion, none of X’s product placement and advertisingincome for the second television program is treatedas gross receipts derived from the qualified film.

Example 4. The facts are the same as in Example3 except that Z sublicenses to an unrelated person thetelevision program instead of broadcasting the tele-vision program on its station. The gross receipts de-rived by X from licensing the television program to Zare DPGR under paragraph (b)(2) of this section. Asa result, pursuant to paragraph (i)(5)(ii) of this sec-tion, X’s product placement and advertising incomefor the television program licensed to Z is treated asgross receipts derived from the qualified film. In ad-dition, Z’s receipts from the sublicense of the quali-fied film are DPGR under §1.199–7(a)(3)(i).

Example 5. X produces television programs thatare qualified films. X licenses the qualified filmsto Y, an unrelated person, and the license agreementprovides that X will receive advertising time slots aspart of its payments from Y under the license agree-ment. X’s gross receipts derived from the license ofthe qualified films to Y include income attributable tothe advertising time slots and are DPGR under para-graph (b)(2) of this section.

(6) Computer software—(i) In general.DPGR include the gross receipts of thetaxpayer that are derived from the lease,rental, license, sale, exchange, or other dis-position of computer software MPGE bythe taxpayer in whole or in significant partwithin the United States. Such gross re-ceipts qualify as DPGR even if the cus-tomer provides the computer software toits employees or others over the Internet.

(ii) through (v). [Reserved]. For furtherguidance, see §1.199–3T(i)(6)(ii) through(v).

(7) Qualifying in-kind partnership fortaxable years beginning after May 17,2006, the enactment date of the Tax In-crease Prevention and Reconciliation Actof 2005. [Reserved].

(8) Partnerships owned by members ofa single expanded affiliated group for tax-able years beginning after May 17, 2006,the enactment date of the Tax Increase Pre-vention and Reconciliation Act of 2005.[Reserved].

(9) Non-operating mineral interests.DPGR does not include gross receipts de-rived from non-operating mineral interests(for example, interests other than operat-ing mineral interests within the meaningof §1.614–2(b)).

(j) Definition of qualifying productionproperty—(1) In general. QPP means—

(i) Tangible personal property (as de-fined in paragraph (j)(2) of this section);

(ii) Computer software (as defined inparagraph (j)(3) of this section); and

(iii) Sound recordings (as defined inparagraph (j)(4) of this section).

(2) Tangible personal property—(i) Ingeneral. The term tangible personal prop-erty is any tangible property other thanland, real property described in paragraph(m)(3) of this section, and any property de-scribed in paragraph (j)(3), (j)(4), (k)(1),or (l) of this section. For purposes ofthe preceding sentence, tangible personalproperty also includes any gas (other thannatural gas described in paragraph (l)(2)of this section), chemical, and similarproperty, for example, steam, oxygen, hy-drogen, and nitrogen. Property such asmachinery, printing presses, transporta-tion and office equipment, refrigerators,grocery counters, testing equipment, dis-play racks and shelves, and neon and othersigns that are contained in or attached toa building constitutes tangible personalproperty for purposes of this paragraph(j)(2)(i). Except as provided in paragraphs(j)(5)(ii) and (k)(2)(i) of this section, com-puter software, sound recordings, andqualified films are not treated as tangiblepersonal property regardless of whetherthey are affixed to a tangible medium.However, the tangible medium to whichsuch property may be affixed (for exam-ple, a videocassette, a computer diskette,or other similar tangible item) is tangiblepersonal property.

(ii) Local law. In determining whetherproperty is tangible personal property, lo-cal law is not controlling.

(iii) Intangible property. The term tan-gible personal property does not includeproperty in a form other than in a tangi-ble medium. For example, mass-producedbooks are tangible personal property, butneither the rights to the underlying manu-script nor an online version of the book istangible personal property.

(3) Computer software—(i) In general.The term computer software means anyprogram or routine or any sequence ofmachine-readable code that is designedto cause a computer to perform a de-sired function or set of functions, and thedocumentation required to describe andmaintain that program or routine. Thus,for example, an electronic book availableonline or for download is not computer

2006–25 I.R.B. 1095 June 19, 2006

software. For purposes of this paragraph(j)(3), computer software also includes themachine-readable code for video gamesand similar programs, for equipment thatis an integral part of other property, andfor typewriters, calculators, adding andaccounting machines, copiers, duplicatingequipment, and similar equipment, regard-less of whether the code is designed to op-erate on a computer (as defined in section168(i)(2)(B)). Computer programs of allclasses, for example, operating systems,executive systems, monitors, compilersand translators, assembly routines, andutility programs, as well as applicationprograms, are included. Except as pro-vided in paragraph (j)(5) of this section,if the medium in which the software iscontained, whether written, magnetic, orotherwise, is tangible, then such mediumis considered tangible personal propertyfor purposes of this section.

(ii) Incidental and ancillary rights.Computer software also includes anyincidental and ancillary rights that arenecessary to effect the acquisition of thetitle to, the ownership of, or the right touse the computer software, and that areused only in connection with that specificcomputer software. Such incidental andancillary rights are not included in thedefinition of trademark or trade name un-der §1.197–2(b)(10)(i). For example, atrademark or trade name that is ancillaryto the ownership or use of a specific com-puter software program in the taxpayer’strade or business and is not acquired forthe purpose of marketing the computersoftware is included in the definition ofcomputer software and is not included inthe definition of trademark or trade name.

(iii) Exceptions. Computer softwaredoes not include any data or informationbase unless the data or information baseis in the public domain and is incidentalto a computer program. For this purpose,a copyrighted or proprietary data or infor-mation base is treated as in the public do-main if its availability through the com-puter program does not contribute signif-icantly to the cost of the program. For ex-ample, if a word-processing program in-cludes a dictionary feature that may beused to spell-check a document or anyportion thereof, then the entire program(including the dictionary feature) is com-puter software regardless of the form in

which the dictionary feature is maintainedor stored.

(4) Sound recordings—(i) In general.The term sound recordings means anyworks that result from the fixation of aseries of musical, spoken, or other soundsunder section 168(f)(4). The definition ofsound recordings is limited to the mastercopy of the recordings (or other copy fromwhich the holder is licensed to make andproduce copies), and, except as providedin paragraph (j)(5) of this section, if themedium (such as compact discs, tapes,or other phonorecordings) in which thesounds may be embodied is tangible, thenthe medium is considered tangible per-sonal property for purposes of paragraph(j)(2) of this section.

(ii) Exception. The term sound record-ings does not include the creation of copy-righted material in a form other than asound recording, such as lyrics or musiccomposition.

(5) Tangible personal property withcomputer software or sound record-ings—(i) Computer software and soundrecordings. If a taxpayer MPGE in wholeor in significant part computer softwareor sound recordings within the UnitedStates that is affixed or added to tangiblepersonal property (for example, a com-puter diskette, or an appliance), whetheror not the taxpayer MPGE such tangiblepersonal property in whole or in signifi-cant part within the United States, then forpurposes of this section—

(A) The computer software and the tan-gible personal property may be treated bythe taxpayer as computer software. If thetaxpayer treats the computer software andthe tangible personal property as computersoftware, activities the cost of which aredescribed in Rev. Proc. 2000–50, 2000–2C.B. 601, activities giving rise to researchand experimental expenditures under sec-tion 174, and the creation of intangibleassets for computer software are consid-ered in determining whether the taxpayer’sMPGE activity is substantial in nature un-der paragraph (g)(2) of this section. In de-termining direct labor and overhead underparagraph (g)(3)(i) of this section, the costsof direct labor and overhead for develop-ing the computer software as described inRev. Proc. 2000–50, 2000–2 C.B. 601, re-search and experimental expenditures un-der section 174, and any other costs ofcreating intangible assets for the computer

software are treated as direct labor andoverhead. These costs must be included inthe taxpayer’s CGS of the computer soft-ware for purposes of determining whetherthe taxpayer meets the safe harbor underparagraph (g)(3)(i) of this section. How-ever, any costs under section 174, and thecosts to create intangible assets, attribut-able to the tangible personal property arenot considered in determining whether thetaxpayer’s activity is substantial in natureunder paragraph (g)(2) of this section andare not direct labor and overhead underparagraph (g)(3)(i) of this section; and

(B) The sound recordings and the tan-gible personal property with the soundrecordings may be treated by the taxpayeras sound recordings. If the taxpayer treatsthe sound recordings and the tangiblepersonal property as sound recordings,activities giving rise to research and ex-perimental expenditures under section 174and the creation of intangible assets forsound recordings are considered in de-termining whether the taxpayer’s MPGEactivity is substantial in nature under para-graph (g)(2) of this section. In determiningdirect labor and overhead under paragraph(g)(3)(i) of this section, research and ex-perimental expenditures under section 174and any other costs of creating intangibleassets for sound recordings are treated asdirect labor and overhead. These costsmust be included in the taxpayer’s CGSof sound recordings for purposes of de-termining whether the taxpayer meets thesafe harbor under paragraph (g)(3)(i) ofthis section. However, any costs undersection 174, and the costs to create intan-gible assets, attributable to the tangiblepersonal property are not considered indetermining whether the taxpayer’s activ-ity is substantial in nature under paragraph(g)(2) of this section and are not direct la-bor and overhead under paragraph (g)(3)(i)of this section.

(ii) Tangible personal property. If a tax-payer MPGE tangible personal property(for example, a computer diskette or anappliance) in whole or in significant partwithin the United States but not the com-puter software or sound recordings thatis affixed or added to such tangible per-sonal property, then for purposes of thissection the tangible personal property withthe computer software or sound recordingsmay be treated by the taxpayer as tangiblepersonal property under paragraph (j)(2)

June 19, 2006 1096 2006–25 I.R.B.

of this section. Any costs under section174, and the costs to create intangible as-sets, attributable to the tangible personalproperty are not considered in determin-ing whether the taxpayer’s activity is sub-stantial in nature under paragraph (g)(2) ofthis section and are not direct labor or over-head under paragraph (g)(3)(i) of this sec-tion. For purposes of paragraph (g)(3) ofthis section, the taxpayer’s CGS (or unad-justed depreciable basis, if applicable) foreach item of tangible personal property in-cludes the taxpayer’s cost of leasing, rent-ing, licensing, buying, or otherwise acquir-ing the computer software or sound record-ings.

(k) Definition of qualified film—(1) Ingeneral. The term qualified film meansany motion picture film or video tape un-der section 168(f)(3), or live or delayedtelevision programming, if not less than50 percent of the total compensation paidto actors, production personnel, directors,and producers relating to the productionof the motion picture film, video tape, ortelevision programming is compensationpaid by the taxpayer for services relatingto the production of the film performedin the United States by those individuals.For purposes of this paragraph (k), ac-tors include players, newscasters, or anyother persons performing in a qualifiedfilm. The term production personnel in-cludes, for example, writers, choreogra-phers and composers providing servicesduring the production of a film, castingagents, camera operators, set designers,lighting technicians, make-up artists, andothers whose activities are directly relatedto the production of the film. Except asprovided in paragraph (k)(2) of this sec-tion, the definition of qualified film doesnot include tangible personal property em-bodying the qualified film, such as DVDsor videocassettes.

(2) Tangible personal property with afilm—(i) Film not produced by a taxpayer.If a taxpayer MPGE tangible personalproperty (for example, a DVD) in wholeor in significant part in the United Statesand a film not produced by a taxpayer isaffixed to the tangible personal property,then the taxpayer may treat the tangiblepersonal property with the affixed filmas tangible personal property, regardlessof whether the film is a qualified film.The determination of whether the grossreceipts of such a taxpayer derived from

the lease, rental, license, sale, exchange,or other disposition of the tangible per-sonal property with the affixed film areDPGR is made under the rules of this sec-tion. For purposes of paragraph (g)(2) ofthis section, in determining whether thetaxpayer’s MPGE activity is substantialin nature, the taxpayer must consider thevalue of the licensed film. For purposesof paragraph (g)(3) of this section, thetaxpayer’s CGS (or unadjusted deprecia-ble basis, as applicable) for each item oftangible personal property includes thetaxpayer’s cost of leasing, renting, licens-ing, buying, or otherwise acquiring thefilm.

(ii) Film produced by a taxpayer. If ataxpayer produces a film and the film isaffixed to tangible personal property (forexample, a DVD), then for purposes of thissection—

(A) Qualified film. If the film is aqualified film, the taxpayer may treat thetangible personal property, whether or notthe taxpayer MPGE such tangible personalproperty, to which the qualified film is af-fixed as part of the qualified film; and

(B) Nonqualified film. If the film isnot a qualified film (nonqualified film), ataxpayer cannot treat the tangible personalproperty to which the nonqualified film isaffixed as part of the nonqualified film.

(3) Derived from a qualified film—(i)In general. DPGR include the gross re-ceipts of a taxpayer that are derived fromany lease, rental, license, sale, exchange,or other disposition of any qualified filmproduced by such taxpayer.

(ii) Exceptions. The showing of a qual-ified film (for example, in a movie theateror by broadcast on a television station) by ataxpayer is not a lease, rental, license, sale,exchange, or other disposition of the qual-ified film by such taxpayer. Ticket salesfor viewing a qualified film do not con-stitute DPGR because the gross receiptsare not derived from the lease, rental, li-cense, sale, exchange, or other disposi-tion of a qualified film. Because a tax-payer that merely writes a screenplay orother similar material is not considered tohave produced a qualified film under para-graph (k)(1) of this section, the amountsthat the taxpayer receives from the saleof the script or screenplay, even if thescript is developed into a qualified film, arenot gross receipts derived from a qualifiedfilm. In addition, revenue from the sale of

film-themed merchandise is revenue fromthe sale of tangible personal property andnot gross receipts derived from a qualifiedfilm. Gross receipts derived from a licenseof the right to use or exploit the film char-acters are not gross receipts derived froma qualified film.

(4) Compensation for services. Theterm compensation for services means allpayments for services performed by actors(as described in paragraph (k)(1) of thissection), production personnel, directors,and producers, including participationsand residuals. In the case of a taxpayerthat uses the income forecast method ofsection 167(g) and capitalizes participa-tions and residuals into the adjusted basisof the qualified film, the taxpayer mustuse the same estimate of participationsand residuals for services performed byactors, production personnel, directors,and producers for purposes of this section.In the case of a taxpayer that excludesparticipations and residuals from the ad-justed basis of the qualified film undersection 167(g)(7)(D)(i), the taxpayer mustdetermine the compensation expected tobe paid for services performed by ac-tors, production personnel, directors, andproducers as participations and residu-als based on the total forecasted incomeused in determining income forecast de-preciation. Compensation for servicesincludes all direct and indirect compensa-tion costs required to be capitalized undersection 263A for film producers under§1.263A–1(e)(2) and (3). Compensationfor services is not limited to W–2 wagesand includes compensation paid to inde-pendent contractors.

(5) Determination of 50 percent.The not-less-than–50-percent-of-the-to-tal-compensation requirement under para-graph (k)(1) of this section is determinedby reference to all compensation paid inthe production of the film and is calcu-lated using a fraction. The numerator ofthe fraction is the compensation paid bythe taxpayer to actors, production person-nel, directors, and producers for servicesrelating to the production of the film (pro-duction services) performed in the UnitedStates, and the denominator is the sumof the total compensation paid by thetaxpayer to all such individuals regard-less of where the production services areperformed and the total compensationpaid by others to all such individuals re-

2006–25 I.R.B. 1097 June 19, 2006

gardless of where the production servicesare performed. A taxpayer may use anyreasonable method that is satisfactory tothe Secretary based on all of the factsand circumstances, including all historicinformation available, to determine thecompensation for services performed inthe United States by actors (as described inparagraph (k)(1) of this section), produc-tion personnel, directors, and producers,and the total compensation paid to thoseindividuals for services relating to the pro-duction of the film. Among the factorsto be considered in determining whethera taxpayer’s method of allocating com-pensation is reasonable is whether thetaxpayer uses that method consistentlyfrom one taxable year to another.

(6) Exception. A qualified film doesnot include property with respect to whichrecords are required to be maintained un-der 18 U.S.C. 2257. Section 2257 of Title18 requires maintenance of certain recordswith respect to any book, magazine, pe-riodical, film, videotape, or other matterthat—

(i) Contains one or more visual depic-tions made after November 1, 1990, of ac-tual sexually explicit conduct; and

(ii) Is produced in whole or in part withmaterials that have been mailed or shippedin interstate or foreign commerce, or isshipped or transported or is intended forshipment or transportation in interstate orforeign commerce.

(7) Examples. The following examplesillustrate the application of this paragraph(k):

Example 1. X produces a qualified film and du-plicates the film onto purchased DVDs. X sells theDVDs with the qualified film to customers. Underparagraph (k)(2)(ii)(A) of this section, X treats theDVD with the qualified film as a qualified film. Ac-cordingly, X’s gross receipts derived from the sale ofthe qualified film to customers are DPGR (assumingall the other requirements of this section are met).

Example 2. The facts are the same as in Example1 except that the film is a nonqualified film becausethe film does not satisfy the not-less-than–50-per-cent-of-the-total-compensation requirement under(k)(1) of this section and X manufactures the DVDsin the United States. Under paragraph (k)(2)(ii)(B)of this section, X cannot treat the DVD as part of thenonqualified film. X’s gross receipts (not includingthe gross receipts attributable to the nonqualifiedfilm) derived from the sale of the tangible personalproperty are DPGR (assuming all the other require-ments of this section are met).

Example 3. X produces live television programsthat are qualified films. X shows the programs on itsown television station. X sells advertising time slotsto advertisers for the television programs. Because

showing a qualified film on a television station is nota lease, rental, license, sale, exchange, or other dispo-sition pursuant to paragraph (k)(3)(ii) of this section,the advertising income X receives from advertisersis not derived from the lease, rental, license, sale, ex-change, or other disposition of the qualified films andis non-DPGR.

Example 4. The facts are the same as in Example3 except that X also licenses the qualified films to Y,an unrelated cable company that broadcasts X’s qual-ified films. As part of the license agreement, X cansell advertising time slots. Because X’s gross receiptsfrom Y are derived from the licensing of qualifiedfilms pursuant to paragraph (k)(3)(i) of this section,X’s gross receipts derived from licensing the quali-fied film are DPGR. In addition, the gross receiptsderived from the advertising income X receives thatis related to the qualified films licensed to Y is DPGRpursuant to paragraph (i)(5)(ii) of this section. Be-cause showing a qualified film on a television stationis not a lease, rental, license, sale, exchange, or otherdisposition pursuant to paragraph (k)(3)(ii) of thissection, the portion of the advertising income X de-rives from advertisers for the qualified films it broad-casts on its own television station is not derived fromthe lease, rental, license, sale, exchange, or other dis-position of the qualified films and is non-DPGR.

Example 5. X produces a qualified film and con-tracts with Y, an unrelated person, to duplicate thefilm onto DVDs. Y manufactures blank DVDs withinthe United States, duplicates X’s film onto the DVDsin the United States, and sells the DVDs with thequalified film to X who then sells them to customers.Y has all of the benefits and burdens of ownership un-der Federal income tax principles of the DVDs dur-ing the MPGE and duplication process. Assume Y’sactivities relating to manufacture of the blank DVDsand duplicating the film onto the DVDs collectivelysatisfy the safe harbor under paragraph (g)(3) of thissection. Y’s gross receipts from manufacturing theDVDs and duplicating the film onto the DVDs areDPGR (assuming all the other requirements of thissection are met). X’s gross receipts from the sale ofthe DVDs to customers are DPGR (assuming all theother requirements of this section are met).

Example 6. X creates a television program inthe United States that includes scenes from films li-censed by X from unrelated persons Y and Z. Assumethat Y and Z produced the films licensed by X. Thenot-less-than–50-percent-of-the-total-compensationrequirement under paragraph (k)(1) of this section isdetermined by reference to all compensation paid inthe production of the television program, includingthe films licensed by X from Y and Z, and is cal-culated using a fraction as described in paragraph(k)(5) of this section. The numerator of the fractionis the compensation paid by X to actors, productionpersonnel, directors, and producers for productionservices performed in the United States, and thedenominator is the sum of the total compensationpaid by X to such individuals regardless of wherethe production services are performed and the totalcompensation paid by Y and Z to actors, productionpersonnel, directors, and producers relating to theproduction of the films licensed by X (regardlessof where the services are performed). However, forpurposes of calculating the denominator, in deter-mining the total compensation paid by Y and Z, Xneed only include the total compensation paid by Y

and Z to actors, production personnel, directors, andproducers for the production of the scenes used by Xin creating its television program.

(l) Electricity, natural gas, or potablewater—(1) In general. DPGR includegross receipts derived from any lease,rental, license, sale, exchange, or otherdisposition of utilities produced by thetaxpayer in the United States if all otherrequirements of this section are met. In thecase of an integrated producer that bothproduces and delivers utilities, see para-graph (l)(4) of this section that describescertain gross receipts that do not qualifyas DPGR.

(2) Natural gas. The term natural gasincludes only natural gas extracted from anatural deposit and does not include, forexample, methane gas extracted from alandfill. In the case of natural gas, pro-duction activities include all activitiesinvolved in extracting natural gas fromthe ground and processing the gas intopipeline quality gas.

(3) Potable water. The term potablewater means unbottled drinking water. Inthe case of potable water, production ac-tivities include the acquisition, collection,and storage of raw water (untreated water),transportation of raw water to a water treat-ment facility, and treatment of raw waterat such a facility. Gross receipts attribut-able to any of these activities are includedin DPGR if all other requirements of thissection are met.

(4) Exceptions—(i) Electricity. Grossreceipts attributable to the transmission ofelectricity from the generating facility toa point of local distribution and gross re-ceipts attributable to the distribution ofelectricity to customers are non-DPGR.

(ii) Natural gas. Gross receipts attrib-utable to the transmission of pipeline qual-ity gas from a natural gas field (or, if treat-ment at a natural gas processing plant isnecessary to produce pipeline quality gas,from a natural gas processing plant) to alocal distribution company’s citygate (orto another customer) are non-DPGR. Like-wise, gross receipts of a local gas distri-bution company attributable to distributionfrom the citygate to the local customers arenon-DPGR.

(iii) Potable water. Gross receipts at-tributable to the storage of potable wa-ter after completion of treatment of thepotable water, as well as gross receipts at-

June 19, 2006 1098 2006–25 I.R.B.

tributable to the transmission and distribu-tion of potable water, are non-DPGR.

(iv) De minimis exception—(A) DPGR.Notwithstanding paragraphs (l)(4)(i), (ii),and (iii) of this section, if less than 5 per-cent of a taxpayer’s gross receipts derivedfrom a sale, exchange, or other disposi-tion of utilities are attributable to the trans-mission or distribution of the utilities andthe storage of potable water after comple-tion of treatment of the potable water, thenthe gross receipts derived from the lease,rental, license, sale, exchange, or other dis-position of the utilities that are attributableto the transmission and distribution of theutilities and the storage of potable water af-ter completion of treatment of the potablewater may be treated as being DPGR (as-suming all other requirements of this sec-tion are met). In the case of gross receiptsderived from the lease, rental, license, sale,exchange, or other disposition of utilitiesthat are received over a period of time (forexample, a multi-year lease or installmentsale), this de minimis exception is appliedby taking into account the total gross re-ceipts for the entire period derived (and tobe derived) from the lease, rental, license,sale, exchange, or other disposition of theutilities. For purposes of the precedingsentence, if a taxpayer treats gross receiptsas DPGR under this de minimis exception,then the taxpayer must treat the gross re-ceipts recognized in each taxable year con-sistently as DPGR.

(B) Non-DPGR. If less than 5 percent ofa taxpayer’s gross receipts derived from asale, exchange, or other disposition of util-ities are DPGR, then the gross receipts de-rived from the sale, exchange, or other dis-position of the utilities may be treated asnon-DPGR. In the case of gross receiptsderived from the lease, rental, license, sale,exchange, or other disposition of utilitiesthat are received over a period of time (forexample, a multi-year lease or installmentsale), this de minimis exception is appliedby taking into account the total gross re-ceipts for the entire period derived (andto be derived) from the lease, rental, li-cense, sale, exchange, or other dispositionof the utilities. For purposes of the preced-ing sentence, if a taxpayer treats gross re-ceipts as non-DPGR under this de minimisexception, then the taxpayer must treat thegross receipts recognized in each taxableyear consistently as non-DPGR.

(5) Example. The following exampleillustrates the application of this paragraph(l):

Example. X owns a wind turbine in the UnitedStates that generates electricity and Y owns a highvoltage transmission line that passes near X’s windturbine and ends near the system of local distribu-tion lines of Z. X sells the electricity produced atthe wind turbine to Z and contracts with Y to trans-mit the electricity produced at the wind turbine to Zwho sells the electricity to customers using Z’s dis-tribution network. The gross receipts received by Xfrom the sale of electricity produced at the wind tur-bine are DPGR. The gross receipts of Y derived fromtransporting X’s electricity to Z are non-DPGR underparagraph (l)(4)(i) of this section. Likewise, the grossreceipts of Z derived from distributing the electricityare non-DPGR under paragraph (l)(4)(i) of this sec-tion. If X made direct sales of electricity to customersin Z’s service area and Z receives remuneration forthe distribution of electricity, the gross receipts of Zare non-DPGR under paragraph (l)(4)(i) of this sec-tion. If X, Y, and Z are related persons (as defined inparagraph (b) of this section), then X, Y, and Z mustallocate gross receipts among the production activi-ties (that are DPGR), and the transmission and distri-bution activities (that are non-DPGR).

(m) Definition of construction per-formed in the United States—(1) Con-struction of real property—(i) In general.The term construction means activitiesand services relating to the constructionor erection of real property (as defined inparagraph (m)(3) of this section) in theUnited States by a taxpayer that, at thetime the taxpayer constructs the real prop-erty, is engaged in a trade or business (butnot necessarily its primary, or only, tradeor business) that is considered construc-tion for purposes of the North AmericanIndustry Classification System (NAICS)on a regular and ongoing basis. A tradeor business that is considered constructionunder the NAICS means a constructionactivity under the two-digit NAICS codeof 23 and any other construction activityin any other NAICS code provided theconstruction activity relates to the con-struction of real property such as NAICScode 213111 (drilling oil and gas wells)and 213112 (support activities for oil andgas operations). For purposes of this para-graph (m), the term construction projectmeans the construction activities and ser-vices treated as the item under paragraph(d)(2)(iii) of this section. Tangible per-sonal property (for example, appliances,furniture, and fixtures) that is sold as partof a construction project is not consideredreal property for purposes of this para-graph (m)(1)(i). In determining whetherproperty is real property, the fact that

property is real property under local lawis not controlling. Conversely, propertymay be real property for purposes of thisparagraph (m)(1)(i) even though under lo-cal law the property is considered tangiblepersonal property.

(ii) Regular and ongoing basis—(A)In general. For purposes of paragraph(m)(1)(i) of this section, a taxpayer en-gaged in a construction trade or businesswill be considered to be engaged in suchtrade or business on a regular and ongoingbasis if the taxpayer derives gross receiptsfrom an unrelated person by selling orexchanging the constructed real propertydescribed in paragraph (m)(3) of this sec-tion within 60 months of the date on whichconstruction is complete (for example, onthe date a certificate of occupancy is is-sued for the property).

(B) New trade or business. In the caseof a newly-formed trade or business or ataxpayer in its first taxable year, the tax-payer is considered to be engaged in a tradeor business on a regular and ongoing basisif the taxpayer reasonably expects that itwill engage in a trade or business on a reg-ular and ongoing basis.

(iii) De minimis exception—(A) DPGR.For purposes of paragraph (m)(1)(i) of thissection, if less than 5 percent of the totalgross receipts derived by a taxpayer from aconstruction project (as described in para-graph (m)(1)(i) of this section) are derivedfrom activities other than the constructionof real property in the United States (forexample, from non-construction activitiesor the sale of tangible personal property orland), then the total gross receipts derivedby the taxpayer from the project may betreated as DPGR from construction. If ataxpayer applies the land safe harbor un-der paragraph (m)(6)(iv) of this section,for a construction project (as described inparagraph (m)(1)(i) of this section), thenthe gross receipts excluded under the landsafe harbor are excluded in determiningtotal gross receipts under this paragraph(m)(1)(iii)(A). If a taxpayer does not applythe land safe harbor and uses any reason-able method (for example, an appraisal ofthe land) to allocate gross receipts attribut-able to the land to non-DPGR, then a tax-payer applies this paragraph (m)(1)(iii)(A)by excluding such gross receipts derivedfrom the sale, exchange, or other disposi-tion of the land from total gross receipts.In the case of gross receipts derived from

2006–25 I.R.B. 1099 June 19, 2006

construction that are received over a pe-riod of time (for example, an installmentsale), this de minimis exception is appliedby taking into account the total gross re-ceipts for the entire period derived (and tobe derived) from construction. For pur-poses of the preceding sentence, if a tax-payer treats gross receipts as DPGR un-der this de minimis exception, then the tax-payer must treat the gross receipts recog-nized in each taxable year consistently asDPGR.

(B) Non-DPGR. For purposes of para-graph (m)(1)(i) of this section, if less than5 percent of the total gross receipts de-rived by a taxpayer from a constructionproject qualify as DPGR, then the totalgross receipts derived by the taxpayer fromthe construction project may be treated asnon-DPGR. In the case of gross receiptsderived from construction that are receivedover a period of time (for example, an in-stallment sale), this de minimis exceptionis applied by taking into account the to-tal gross receipts for the entire period de-rived (and to be derived) from construc-tion. For purposes of the preceding sen-tence, if a taxpayer treats gross receipts asnon-DPGR under this de minimis excep-tion, then the taxpayer must treat the grossreceipts recognized in each taxable yearconsistently as non-DPGR.

(2) Activities constituting construc-tion—(i) In general. Activities constitut-ing construction are activities performedin connection with a project to erect or sub-stantially renovate real property, includingactivities performed by a general contrac-tor or that constitute activities typicallyperformed by a general contractor, for ex-ample, activities relating to managementand oversight of the construction processsuch as approvals, periodic inspection ofthe progress of the construction project,and required job modifications.

(ii) Tangential services. Activities con-stituting construction do not include tan-gential services such as hauling trash anddebris, and delivering materials, even if thetangential services are essential for con-struction. However, if the taxpayer per-forming construction also, in connectionwith the construction project, provides tan-gential services such as delivering materi-als to the construction site and removingits construction debris, then the gross re-ceipts derived from the tangential servicesare DPGR.

(iii) Other construction activities. Im-provements to land that are not capitaliz-able to the land (for example, landscap-ing) and painting are activities constitut-ing construction only if these activities areperformed in connection with other activi-ties (whether or not by the same taxpayer)that constitute the erection or substantialrenovation of real property and providedthe taxpayer meets the requirements underparagraph (m)(1) of this section. Servicessuch as grading, demolition (including de-molition of structures under section 280B),clearing, excavating, and any other activi-ties that physically transform the land areactivities constituting construction only ifthese services are performed in connectionwith other activities (whether or not by thesame taxpayer) that constitute the erectionor substantial renovation of real propertyand provided the taxpayer meets the re-quirements under paragraph (m)(1) of thissection. A taxpayer engaged in these ac-tivities must make a reasonable inquiry ora reasonable determination as to whetherthe activity relates to the erection or sub-stantial renovation of real property in theUnited States. Construction activities alsoinclude activities relating to drilling an oilor gas well and mining and include anyactivities the cost of which are intangibledrilling and development costs within themeaning of §1.612–4 or development ex-penditures for a mine or natural deposit un-der section 616.

(iv) Administrative support services. Ifthe taxpayer performing construction ac-tivities also provides, in connection withthe construction project, administrativesupport services (for example, billing andsecretarial services) incidental and nec-essary to such construction project, thenthese administrative support services areconsidered construction activities.

(v) Exceptions. The lease, license, orrental of equipment, for example, bulldoz-ers, generators, or computers, for use inthe construction of real property is not aconstruction activity under this paragraph(m)(2). The term construction does not in-clude any activity that is within the defini-tion of engineering and architectural ser-vices under paragraph (n) of this section.

(3) Definition of real property. Theterm real property means buildings (in-cluding items that are structural com-ponents of such buildings), inherentlypermanent structures (as defined in

§1.263A–8(c)(3)) other than machinery(as defined in §1.263A–8(c)(4)) (includ-ing items that are structural componentsof such inherently permanent structures),inherently permanent land improvements,oil and gas wells, and infrastructure (as de-fined in paragraph (m)(4) of this section).For purposes of the preceding sentence,an entire utility plant including both theshell and the interior will be treated as aninherently permanent structure. Propertyproduced by a taxpayer that is not realproperty in the hands of that taxpayer, butthat may be incorporated into real propertyby another taxpayer, is not treated as realproperty by the producing taxpayer (forexample, bricks, nails, paint, and window-panes). For purposes of this paragraph(m)(3), structural components of build-ings and inherently permanent structuresinclude property such as walls, partitions,doors, wiring, plumbing, central air con-ditioning and heating systems, pipes andducts, elevators and escalators, and othersimilar property.

(4) Definition of infrastructure. Theterm infrastructure includes roads, powerlines, water systems, railroad spurs, com-munications facilities, sewers, sidewalks,cable, and wiring. The term also includesinherently permanent oil and gas plat-forms.

(5) Definition of substantial renovation.The term substantial renovation means therenovation of a major component or sub-stantial structural part of real property thatmaterially increases the value of the prop-erty, substantially prolongs the useful lifeof the property, or adapts the property to anew or different use.

(6) Derived from construction—(i) Ingeneral. Assuming all the requirementsof this section are met, DPGR derivedfrom the construction of real propertyperformed in the United States includesthe proceeds from the sale, exchange, orother disposition of real property con-structed by the taxpayer in the UnitedStates (whether or not the property is soldimmediately after construction is com-pleted and whether or not the constructionproject is completed). DPGR derivedfrom the construction of real property in-cludes compensation for the performanceof construction services by the taxpayerin the United States. DPGR derived fromthe construction of real property includesgross receipts derived from materials and

June 19, 2006 1100 2006–25 I.R.B.

supplies consumed in the constructionproject or that become part of the con-structed real property, assuming all therequirements of this section are met.

(ii) Qualified construction warranty.DPGR derived from the construction ofreal property includes gross receipts fromany qualified construction warranty, thatis, a warranty that is provided in connec-tion with the constructed real propertyif, in the normal course of the taxpayer’sbusiness—

(A) The price for the construction war-ranty is not separately stated from theamount charged for the constructed realproperty; and

(B) The construction warranty is nei-ther separately offered by the taxpayer norseparately bargained for with customers(that is, the customer cannot purchase theconstructed real property without the con-struction warranty).

(iii) Exceptions. DPGR derived fromthe construction of real property per-formed in the United States does notinclude gross receipts derived from thesale, exchange, or other disposition ofreal property acquired by the taxpayereven if the taxpayer originally constructedthe property. In addition, DPGR derivedfrom the construction of real propertydoes not include gross receipts from thelease or rental of real property constructedby the taxpayer or, except as providedin paragraph (m)(2)(iii) of this section,gross receipts derived from the sale orother disposition of land (including zon-ing, planning, entitlement costs, and othercosts capitalized to the land).

(iv) Land safe harbor—(A) In general.For purposes of paragraph (m)(6)(i) of thissection, a taxpayer may allocate gross re-ceipts between the gross receipts derivedfrom the sale, exchange, or other disposi-tion of real property constructed by the tax-payer and the gross receipts derived fromthe sale, exchange, or other disposition ofland by reducing its costs related to DPGRunder §1.199–4 by the costs of the landand any other costs capitalized to the land(collectively, land costs) (including zon-ing, planning, entitlement costs, and othercosts capitalized to the land (except costsfor activities listed in paragraph (m)(2)(iii)of this section) and land costs in any com-mon improvements as defined in section2.01 of Rev. Proc. 92–29, 1992–1 C.B.748, (see §601.601(d)(2) of this chapter))

and by reducing its DPGR by those landcosts plus a percentage. Generally, the per-centage is based on the number of monthsthat elapse between the date the taxpayeracquires the land (not including any op-tions to acquire the land) and ends on thedate the taxpayer sells each item of realproperty on the land. However, a taxpayerwill be deemed, for purposes of this para-graph (m)(6)(iv)(A), to acquire the land onthe date the taxpayer entered into an optionagreement to acquire the land if the tax-payer acquired the land pursuant to suchoption agreement and the purchase price ofthe land under the option agreement doesnot approximate the fair market value ofthe land. In the case of a sale or dispo-sition of land between related persons (asdefined in paragraph (b)(1) of this section)for less than fair market value, for pur-poses of determining the percentage, thepurchaser or transferee of the land mustinclude the months during which the landwas held by the seller or transferor. Thepercentage is 5 percent for land held notmore than 60 months, 10 percent for landheld more than 60 months but not morethan 120 months, and 15 percent for landheld more than 120 months but not morethan 180 months. Land held by a taxpayerfor more than 180 months is not eligiblefor the safe harbor under this paragraph(m)(6)(iv)(A).

(B) Determining gross receipts andcosts. In the case of a taxpayer that uses thesmall business simplified overall methodof cost allocation under §1.199–4(f), grossreceipts derived from the sale, exchange,or other disposition of land, and costs at-tributable to the land, pursuant to the landsafe harbor under paragraph (m)(6)(iv)(A)of this section, are not taken into accountfor purposes of computing QPAI under§§1.199–1 through 1.199–9 except thatthe gross receipts are taken into accountfor determining eligibility for that methodof cost allocation. All other taxpayersmust treat the gross receipts derived fromthe sale, exchange, or other dispositionof land, pursuant to the land safe har-bor under paragraph (m)(6)(iv)(A) of thissection, as non-DPGR. In the case of apass-thru entity, if the pass-thru entitywould be eligible to use the small busi-ness simplified overall method of costallocation if the method were applied atthe pass-thru entity level, then the grossreceipts derived from the sale, exchange,

or other disposition of land, and costs al-located to the land, pursuant to the landsafe harbor under paragraph (m)(6)(iv)(A)of this section, are not taken into accountby the pass-thru entity or its owner orowners for purposes of computing QPAIunder §§1.199–1 through 1.199–9. Forpurposes of the preceding sentence, indetermining whether the pass-thru entitywould be eligible for the small businesssimplified overall method of cost alloca-tion, the gross receipts excluded pursuantto the land safe harbor under paragraph(m)(6)(iv)(A) of this section are takeninto account for determining eligibility forthat method of cost allocation. All otherpass-thru entities (including all trusts andestates described in §1.199–9(e)) musttreat the gross receipts attributable to thesale, exchange, or other disposition ofland, pursuant to the land safe harborunder paragraph (m)(6)(iv)(A) of this sec-tion, as non-DPGR.

(v) Examples. The following examplesillustrate the application of this paragraph(m)(6):

Example 1. A, who is in the trade or businessof construction under NAICS code 23 on a regularand ongoing basis, purchases a building in the UnitedStates and retains B, an unrelated person, to overseea substantial renovation of the building (within themeaning of paragraph (m)(5) of this section). Al-though not licensed as a general contractor, B per-forms general contractor level work and activities re-lating to management and oversight of the construc-tion process such as approvals, periodic inspection ofthe progress of the construction project, and requiredjob modifications. B retains C (a general contractor)to oversee day-to-day operations and hire subcontrac-tors. C hires D (a subcontractor) to install a new elec-trical system in the building as part of that substan-tial renovation. The amounts that B receives from Afor construction services, the amounts that C receivesfrom B for construction services, and the amountsthat D receives from C for construction services qual-ify as DPGR under paragraph (m)(6)(i) of this sectionprovided B, C, and D meet all of the requirements ofparagraph (m)(1) of this section. The gross receiptsthat A receives from the subsequent sale of the build-ing do not qualify as DPGR because A did not engagein any activity constituting construction under para-graph (m)(2) of this section even though A is in thetrade or business of construction. The results wouldbe the same if A, B, C, and D were members of thesame EAG under §1.199–7(a). However, if A, B, C,and D were members of the same consolidated group,see §1.199–7(d)(2).

Example 2. X is engaged as an electrical con-tractor under NAICS code 238210 on a regular andongoing basis. X purchases the wires, conduits, andother electrical materials that it installs in construc-tion projects in the United States. In a particular con-struction project, all of the wires, conduits, and otherelectrical materials installed by X for the operation

2006–25 I.R.B. 1101 June 19, 2006

of that building are considered structural componentsof the building. X’s gross receipts derived from in-stalling that property are derived from the construc-tion of real property under paragraph (m)(1) of thissection. In addition, pursuant to paragraph (m)(6)(i)of this section, X’s gross receipts derived from thepurchased materials qualify as DPGR because thewires, conduits, and other electrical materials are con-sumed during the construction of the building or be-come structural components of the building.

Example 3. X is engaged in a trade or business ona regular and ongoing basis that is considered con-struction under the two-digit NAICS code of 23. Xbuys unimproved land in the United States. X gets theland zoned for residential housing through an entitle-ment process. X grades the land and sells the land tohome builders who construct houses on the land. Thegross receipts that X derives from the sale of the landthat are attributable to the grading qualify as DPGRunder paragraphs (m)(2)(iii) and (6)(i) of this sectionbecause those services are undertaken in connectionwith a construction project in the United States. X’sgross receipts derived from the land including cap-italized costs of entitlements (including zoning) donot qualify as DPGR under paragraph (m)(6)(i) ofthis section because the gross receipts are not derivedfrom the construction of real property.

Example 4. The facts are the same as in Example3 except that X constructs roads, sewers, and side-walks, and installs power and water lines on the land.X conveys the roads, sewers, sidewalks, and powerand water lines to the local government and utilities.The gross receipts that X derives from the sale oflots that are attributable to grading, and the construc-tion of the roads, sewers, sidewalks, and power andwater lines (that qualify as infrastructure under para-graph (m)(4) of this section) are DPGR. X’s grossreceipts derived from the land including capitalizedcosts of entitlements (including zoning) do not qual-ify as DPGR under paragraph (m)(6)(i) of this sec-tion because the gross receipts are not derived fromthe construction of real property.

Example 5. (i) Facts. X, who is engaged in thetrade or business of construction under NAICS code23 on a regular and ongoing basis, constructs housingthat is real property under paragraph (m)(3) of thissection. On June 1, 2007, X pays $50,000,000 andacquires 1,000 acres of land that X will develop as anew housing development. In November 2007, afterthe expenditure of $10,000,000 for entitlement costs,X receives permits to begin construction. After thisexpenditure, X’s land costs total $60,000,000. Thedevelopment consists of 1,000 houses to be built onhalf-acre lots over 5 years. On January 31, 2012, thefirst house is sold for $300,000. Construction costsfor each house are $170,000. Common improve-ments consisting of streets, sidewalks, sewer lines,playgrounds, clubhouses, tennis courts, and swim-ming pools that X is contractually obligated or re-quired by law to provide cost $55,000 per lot. Thecommon improvements of $55,000 per lot include$30,000 in land costs underlying the common im-provements.

(ii) Land safe harbor. Pursuant to the land safeharbor under paragraph (m)(6)(iv) of this section, Xcalculates the basis for each house sold as $195,000(total costs of $255,000 ($170,000 in constructioncosts plus $55,000 in common improvements (in-cluding $30,000 in land costs) plus $30,000 in land

costs for the lot), which are reduced by land costsof $60,000). X calculates the DPGR for each housesold by taking the gross receipts of $300,000 andreducing that amount by land costs of $60,000 plusa percentage of $60,000. As X acquired the landon June 1, 2007, for each house sold on the landbetween January 31, 2012, and June 1, 2012, thepercentage reduction for X is 5% because X has heldthe land for not more than 60 months from the dateof acquisition. Thus, X’s DPGR for each house is$237,000 ($300,000 - $60,000 - $3,000) with costsfor each house of $195,000 ($255,000 - $60,000).For each house sold on the land between June 2,2012 and June 1, 2017, the percentage reductionfor X is 10% because X has held the land for morethan 60 months but not more than 120 months fromthe date of acquisition. Thus, of the $300,000 ofgross receipts, X’s DPGR for each house is $234,000($300,000 - $60,000 - $6,000) with costs for eachhouse of $195,000 ($255,000 - $60,000).

Example 6. The facts are the same as in Example5 except that on December 31, 2007, after X receivedthe permits to begin construction, X sold the entitledland to Y, an unrelated corporation, for $75,000,000.Y is engaged in a trade or business on a regularand ongoing basis that is considered constructionunder NAICS code 23. Y subsequently incurredthe construction costs and the costs of the commonimprovements, and Y sold the houses. Because Xdid not perform any construction activities, none ofX’s $75,000,000 in gross receipts derived from Y areDPGR and none of X’s costs are allocable to DPGR.Pursuant to the land safe harbor under paragraph(m)(6)(iv) of this section, Y calculates the basis foreach house sold as $195,000 (total costs of $270,000($170,000 in construction costs plus $62,500 incommon improvements (including $37,500 in landcosts) plus $37,500 in land costs for the lot), whichare reduced by land costs of $75,000). Y calculatesthe DPGR for each house sold by taking the gross re-ceipts of $300,000 and reducing that amount by landcosts of $75,000 plus a percentage of $75,000. AsY acquired the land on December 31, 2007, for thehouses sold on the land between January 31, 2012,and December 31, 2012, the percentage reduction forY is 5% because Y held the land for not more than60 months from the date of acquisition. Thus, of the$300,000 of gross receipts, the DPGR for each houseis $221,250 ($300,000 - $75,000 - $3,750) with costsfor each house of $195,000. For the houses sold onthe land between January 1, 2013, and December 31,2017, the percentage reduction for Y is 10% becauseY held the land for more than 60 months but not morethan 120 months from the date of acquisition. Thus,of the $300,000 of gross receipts, the DPGR for eachhouse is $217,500 ($300,000 - $75,000 - $7,500)with costs for each house of $195,000. The resultswould be the same if X and Y were members of thesame EAG, provided X and Y were not members ofthe same consolidated group.

Example 7. The facts are the same as in Exam-ple 6 except that Y is a member of the same consol-idated group as X. Pursuant to §1.1502–13(c)(1)(ii),Y’s holding period in the land includes the period oftime X held the land. In order to produce the sameeffect as if X and Y were divisions of a single corpo-ration (see §1.1502–13(c)(1)(i)), for each house soldbetween January 31, 2012, and June 1, 2012, Y’sDPGR are redetermined to be $237,000, the same as

X’s DPGR for houses sold between January 31, 2012,and June 1, 2012, in Example 5. Y’s costs for eachhouse do not have to be redetermined because Y’scosts are $195,000, the same as the costs would be ifX and Y were divisions of a single corporation. Foreach house sold between June 2, 2012, and June 1,2017, Y’s DPGR are redetermined to be $234,000,the same as X’s DPGR for each house sold betweenJune 2, 2012, and June 1, 2017, in Example 5. Y’scosts for each house do not have to be redeterminedbecause Y’s costs are $195,000, the same as the costswould be if X and Y were divisions of a single cor-poration.

Example 8. X, who is engaged in the trade orbusiness of construction under NAICS code 23 on aregular and ongoing basis, purchases land for devel-opment and builds an office building on the land. Yenters into a contract with X to purchase the officebuilding. As part of the contract, X is required to fur-nish the office space with desks, chairs, and lamps.Upon completion of the sale of the building, X usesthe land safe harbor under paragraph (m)(6)(iv) ofthis section to account for the land. After applica-tion of the land safe harbor, X uses the de minimisexception under paragraph (m)(1)(iii)(A) of this sec-tion in determining whether the gross receipts derivedfrom the sale of the desks, chairs, and lamps qualifyas DPGR. If the gross receipts derived from the saleof the desks, chairs, and lamps are less than 5% ofthe total gross receipts derived by X from the sale ofthe furnished office building (excluding any gross re-ceipts taken into account under the land safe harborpursuant to paragraph (m)(6)(iv)(B) of this section),then all of the gross receipts derived from the sale ofthe furnished office building, after the reduction un-der the land safe harbor, may be treated as DPGR.

(n) Definition of engineering and archi-tectural services—(1) In general. DPGRinclude gross receipts derived from en-gineering or architectural services per-formed in the United States for a con-struction project described in paragraph(m)(1)(i) of this section. At the timethe taxpayer performs the engineeringor architectural services, the taxpayermust be engaged in a trade or business(but not necessarily its primary, or only,trade or business) that is considered engi-neering or architectural services for pur-poses of the NAICS, for example NAICScodes 541330 (engineering services) or541310 (architectural services), on a reg-ular and ongoing basis. In the case of anewly-formed trade or business or a tax-payer in its first taxable year, a taxpayeris considered to be engaged in a trade orbusiness on a regular and ongoing basisif the taxpayer reasonably expects that itwill engage in a trade or business on aregular and ongoing basis. DPGR includegross receipts derived from engineeringor architectural services, including fea-sibility studies for a construction project

June 19, 2006 1102 2006–25 I.R.B.

in the United States, even if the plannedconstruction project is not undertaken oris not completed.

(2) Engineering services. Engineeringservices in connection with any con-struction project include any professionalservices requiring engineering educa-tion, training, and experience and theapplication of special knowledge of themathematical, physical, or engineeringsciences to those professional servicessuch as consultation, investigation, eval-uation, planning, design, or responsiblesupervision of construction (for the pur-pose of assuring compliance with plans,specifications, and design) or erection, inconnection with any construction project.

(3) Architectural services. Architec-tural services in connection with anyconstruction project include the offeringor furnishing of any professional servicessuch as consultation, planning, aestheticand structural design, drawings and spec-ifications, or responsible supervision ofconstruction (for the purpose of assuringcompliance with plans, specifications, anddesign) or erection, in connection with anyconstruction project.

(4) Administrative support services.If the taxpayer performing engineeringor architectural services also provides ad-ministrative support services (for example,billing and secretarial services) inciden-tal and necessary to such engineering orarchitectural services, then these admin-istrative support services are consideredengineering or architectural services.

(5) Exceptions. Engineering or archi-tectural services do not include post-con-struction services such as annual auditsand inspections.

(6) De minimis exception for perfor-mance of services in the United States—(i)DPGR. If less than 5 percent of the to-tal gross receipts derived by a taxpayerfrom engineering or architectural servicesperformed in the United States for a con-struction project (described in paragraph(m)(1)(i) of this section) are derived fromservices not relating to a constructionproject (for example, the services are per-formed outside the United States or inconnection with property other than realproperty), then the total gross receipts de-rived by the taxpayer may be treated asDPGR from engineering or architecturalservices performed in the United Statesfor the construction project. In the case

of gross receipts derived from engineeringor architectural services that are receivedover a period of time (for example, an in-stallment sale), this de minimis exceptionis applied by taking into account the totalgross receipts for the entire period derived(and to be derived) from engineering orarchitectural services. For purposes of thepreceding sentence, if a taxpayer treatsgross receipts as DPGR under this de min-imis exception, then the taxpayer musttreat the gross receipts recognized in eachtaxable year consistently as DPGR.

(ii) Non-DPGR. If less than 5 percentof the total gross receipts derived by ataxpayer from engineering or architecturalservices performed in the United States fora construction project qualify as DPGR,then the total gross receipts derived by thetaxpayer from engineering or architecturalservices performed in the United States forthe construction project may be treated asnon-DPGR. In the case of gross receiptsderived from engineering or architecturalservices that are received over a periodof time (for example, an installment sale),this de minimis exception is applied by tak-ing into account the total gross receiptsfor the entire period derived (and to bederived) from engineering or architecturalservices. For purposes of the precedingsentence, if a taxpayer treats gross receiptsas non-DPGR under this de minimis ex-ception, then the taxpayer must treat thegross receipts recognized in each taxableyear consistently as non-DPGR.

(7) Example. The following exampleillustrates the application of this paragraph(n):

Example. X is engaged in the trade or businessof providing engineering services under NAICS code541330 on a regular and ongoing basis. Y buys unim-proved land. Y hires X to provide engineering ser-vices for roads, sewers, sidewalks, and power and wa-ter lines that qualify as infrastructure under paragraph(m)(4) of this section and that will be constructed onY’s land. X’s gross receipts from engineering ser-vices for the infrastructure are DPGR. X’s gross re-ceipts from engineering services relating to land (ex-cept as provided in paragraph (m)(2)(iii) of this sec-tion) do not qualify as DPGR under paragraph (n)(1)of this section because the gross receipts are not de-rived from engineering services for a constructionproject described in paragraph (m)(1)(i) of this sec-tion.

(o) Sales of certain food and bever-ages—(1) In general. DPGR does not in-clude gross receipts of the taxpayer thatare derived from the sale of food or bev-erages prepared by the taxpayer at a re-

tail establishment. A retail establishmentis defined as tangible property (both realand personal) owned, leased, occupied, orotherwise used by the taxpayer in its tradeor business of selling food or beverages tothe public at which retail sales are made.In addition, a facility that prepares foodand beverages for take out service or deliv-ery is a retail establishment (for example,a caterer). If a taxpayer’s facility is a retailestablishment, then, for purposes of thissection, the taxpayer may allocate its grossreceipts between the gross receipts derivedfrom the retail sale of the food and bever-ages prepared and sold at the retail estab-lishment (that are non-DPGR) and grossreceipts derived from the wholesale sale ofthe food and beverages prepared and soldat the retail establishment (that are DPGRassuming all the other requirements of sec-tion 199 are met). Wholesale sales are de-fined as food and beverages held for resaleby the purchaser. The exception for salesof certain food and beverages also appliesto food and beverages for non-human con-sumption. A retail establishment does notinclude the bonded premises of a distilledspirits plant or wine cellar, or the premisesof a brewery (other than a tavern on thebrewery premises). See Chapter 51 of Ti-tle 26 of the United States Code and theimplementing regulations thereunder.

(2) De minimis exception. A taxpayermay treat a facility at which food or bev-erages are prepared as not being a retailestablishment if less than 5 percent of thegross receipts derived from the sale of foodor beverages at that facility during the tax-able year are attributable to retail sales.

(3) Examples. The following examplesillustrate the application of this paragraph(o):

Example 1. X buys coffee beans and roasts thosebeans at a facility in the United States, the only activ-ity of which is the roasting and packaging of coffeebeans. X sells the roasted coffee beans through a va-riety of unrelated third-party vendors and also sellsroasted coffee beans at X’s retail establishments. AtX’s retail establishments, X prepares brewed coffeeand other foods. To the extent that the gross receiptsof X’s retail establishments are derived from the saleof coffee beans roasted at the facility, the receipts areDPGR (assuming all the other requirements of thissection are met). To the extent the gross receipts ofX’s retail establishments are derived from the retailsale of brewed coffee or food prepared at the retail es-tablishments, the receipts are non-DPGR. However,pursuant to §1.199–1(d)(1)(ii), X must allocate partof the receipts from the retail sale of the brewed cof-fee as DPGR to the extent of the value of the coffee

2006–25 I.R.B. 1103 June 19, 2006

beans that were roasted at the facility and that wereused to brew coffee.

Example 2. Y operates a bonded winery withinthe United States. Bottles of wine produced by Y atthe bonded winery are sold to consumers at the tax-paid premises. Pursuant to paragraph (o)(1) of thissection, the bonded premises is not considered a re-tail establishment and is treated as separate and apartfrom the taxpaid premises, which is considered a re-tail establishment for purposes of paragraph (o)(1) ofthis section. Accordingly, the wine produced by Y inthe bonded premises and sold by Y from the taxpaidpremises is not considered to have been produced ata retail establishment, and the gross receipts derivedfrom the sales of the wine are DPGR (assuming allthe other requirements of this section are met).

(p) Guaranteed payments. DPGRdoes not include guaranteed paymentsunder section 707(c). Thus, partners,including partners in partnerships de-scribed in §1.199–9(i) and (j), may nottreat guaranteed payments as DPGR. See§1.199–9(b)(6) Example 5.

§1.199–4 Costs allocable to domesticproduction gross receipts.

(a) In general. The provisions of thissection apply solely for purposes of sec-tion 199 of the Internal Revenue Code(Code). To determine its qualified produc-tion activities income (QPAI) (as definedin §1.199–1(c)) for a taxable year, a tax-payer must subtract from its domesticproduction gross receipts (DPGR) (as de-fined in §1.199–3(a)) the cost of goodssold (CGS) allocable to DPGR and otherexpenses, losses, or deductions (deduc-tions), other than the deduction allowedunder section 199, that are properly allo-cable to such receipts. Paragraph (b) ofthis section provides rules for determiningCGS allocable to DPGR. Paragraph (c) ofthis section provides rules for determiningthe deductions that are properly allocableto DPGR. Paragraph (d) of this sectionprovides that a taxpayer generally mustdetermine deductions allocable to DPGRor to gross income attributable to DPGRusing §§1.861–8 through 1.861–17 and§§1.861–8T through 1.861–14T (the sec-tion 861 regulations), subject to the rulesin paragraph (d) of this section (the section861 method). Paragraph (e) of this sec-tion provides that certain taxpayers mayapportion deductions to DPGR using thesimplified deduction method. Paragraph(f) of this section provides a small businesssimplified overall method that a qualifyingsmall taxpayer may use to apportion CGSand deductions to DPGR.

(b) Cost of goods sold allocable to do-mestic production gross receipts—(1) Ingeneral. When determining its QPAI, ataxpayer must subtract from DPGR theCGS allocable to DPGR. A taxpayer de-termines its CGS allocable to DPGR inaccordance with this paragraph (b) or, ifapplicable, paragraph (f) of this section.In the case of a sale, exchange, or otherdisposition of inventory, CGS is equalto beginning inventory plus purchasesand production costs incurred during thetaxable year and included in inventorycosts, less ending inventory. CGS is de-termined under the methods of accountingthat the taxpayer uses to compute taxableincome. See sections 263A, 471, and472. If section 263A requires a taxpayerto include additional section 263A costs(as defined in §1.263A–1(d)(3)) in inven-tory, additional section 263A costs mustbe included in determining CGS. CGSallocable to DPGR also includes inventoryvaluation adjustments such as writedownsunder the lower of cost or market method.In the case of a sale, exchange, or otherdisposition (including, for example, theft,casualty, or abandonment) of non-inven-tory property, CGS for purposes of thissection includes the adjusted basis of theproperty. CGS allocable to DPGR for ataxable year may include the inventorycost and adjusted basis of qualifying pro-duction property (QPP) (as defined in§1.199–3(j)(1)), a qualified film (as de-fined in §1.199–3(k)(1)), or electricity,natural gas, and potable water (as definedin §1.199–3(l)) (collectively, utilities) thatwill generate (or have generated) DPGRnotwithstanding that the gross receipts at-tributable to the sale, lease, rental, license,exchange, or other disposition of the QPP,qualified film, or utilities will be, or havebeen, included in the computation of grossincome for a different taxable year. For ex-ample, advance payments that are DPGRmay be included in gross income under§1.451–5(b)(1)(i) in a different taxableyear than the related CGS allocable tothat DPGR. If gross receipts are treatedas DPGR pursuant to §1.199–1(d)(3)(i)or §1.199–3(i)(4)(i)(B)(6), (l)(4)(iv)(A),(m)(1)(iii)(A), (n)(6)(i), or (o)(2), thenCGS must be allocated to such DPGR.Similarly, if gross receipts are treated asnon-DPGR pursuant to §1.199–1(d)(3)(ii)or §1.199–3(i)(4)(ii), (l)(4)(iv)(B),(m)(1)(iii)(B), or (n)(6)(ii), then CGS

must be allocated to such non-DPGR. See§1.199–3(m)(6)(iv) for rules relating totreatment of certain costs in the case ofa taxpayer that uses the land safe harborunder that paragraph.

(2) Allocating cost of goods sold—(i) Ingeneral. A taxpayer must use a reasonablemethod that is satisfactory to the Secretarybased on all of the facts and circumstancesto allocate CGS between DPGR and non-DPGR. Whether an allocation method isreasonable is based on all of the facts andcircumstances including whether the tax-payer uses the most accurate informationavailable; the relationship between CGSand the method used; the accuracy of themethod chosen as compared with otherpossible methods; whether the method isused by the taxpayer for internal manage-ment or other business purposes; whetherthe method is used for other Federal orstate income tax purposes; the availabilityof costing information; the time, burden,and cost of using alternative methods; andwhether the taxpayer applies the methodconsistently from year to year. Depend-ing on the facts and circumstances, reason-able methods may include methods basedon gross receipts, number of units sold,number of units produced, or total produc-tion costs. Ordinarily, if a taxpayer uses amethod to allocate gross receipts betweenDPGR and non-DPGR, then the use of adifferent method to allocate CGS that isnot demonstrably more accurate than themethod used to allocate gross receipts willnot be considered reasonable. However, ifa taxpayer has information readily avail-able to specifically identify CGS allocableto DPGR and can specifically identify thatamount without undue burden or expense,CGS allocable to DPGR is that amount ir-respective of whether the taxpayer uses an-other allocation method to allocate grossreceipts between DPGR and non-DPGR.A taxpayer that does not have informationreadily available to specifically identifyCGS allocable to DPGR and that cannot,without undue burden or expense, specif-ically identify that amount is not requiredto use a method that specifically identifiesCGS allocable to DPGR.

(ii) Gross receipts recognized in an ear-lier taxable year. If a taxpayer (other thana taxpayer that uses the small business sim-plified overall method of paragraph (f) ofthis section) recognizes and reports grossreceipts on a Federal income tax return for

June 19, 2006 1104 2006–25 I.R.B.

a taxable year, and incurs CGS related tosuch gross receipts in a subsequent taxableyear, then regardless of whether the grossreceipts ultimately qualify as DPGR, thetaxpayer must allocate the CGS to—

(A) DPGR if the taxpayer identified therelated gross receipts as DPGR in the priortaxable year; or

(B) Non-DPGR if the taxpayer iden-tified the related gross receipts as non-DPGR in the prior taxable year or if thetaxpayer recognized under the taxpayer’smethods of accounting those gross receiptsin a taxable year to which section 199 doesnot apply.

(3) Special rules for imported itemsor services. The cost of any item or ser-vice brought into the United States (asdefined in §1.199–3(h)) without an arm’slength transfer price may not be treatedas less than its value immediately afterit entered the United States for purposesof determining the CGS to be used in thecomputation of QPAI. Similarly, the ad-justed basis of leased or rented propertythat gives rise to DPGR that has beenbrought into the United States (as definedin §1.199–3(h)) without an arm’s lengthtransfer price may not be treated as lessthan its value immediately after it enteredthe United States. When an item or ser-vice is imported into the United Statesthat had been exported by the taxpayer forfurther manufacture, the increase in costmay not exceed the difference between thevalue of the property when exported andthe value of the property when importedback into the United States after furthermanufacture. For this purpose, the valueof property is its customs value as definedin section 1059A(b)(1).

(4) Rules for inventories valued at mar-ket or bona fide selling prices. If partof CGS is attributable to inventory valu-ation adjustments, then CGS allocable toDPGR includes inventory adjustments toQPP that is MPGE in whole or in sig-nificant part within the United States, aqualified film produced by the taxpayer,or utilities produced by the taxpayer in theUnited States. Accordingly, taxpayers thatvalue inventory under §1.471–4 (invento-ries at cost or market, whichever is lower)or §1.471–2(c) (subnormal goods at bonafide selling prices) must allocate a propershare of such adjustments (for example,writedowns) to DPGR based on a reason-able method that is satisfactory to the Sec-

retary based on all of the facts and cir-cumstances. Factors taken into accountin determining whether the method is rea-sonable include whether the taxpayer usesthe most accurate information available;the relationship between the adjustmentand the allocation base chosen; the accu-racy of the method chosen as comparedwith other possible methods; whether themethod is used by the taxpayer for in-ternal management or other business pur-poses; whether the method is used for otherFederal or state income tax purposes; thetime, burden, and cost of using alterna-tive methods; and whether the taxpayer ap-plies the method consistently from year toyear. If a taxpayer has information read-ily available to specifically identify theproper amount of inventory valuation ad-justments allocable to DPGR, then the tax-payer must allocate that amount to DPGR.A taxpayer that does not have informationreadily available to specifically identifythe proper amount of inventory valuationadjustments allocable to DPGR and thatcannot, without undue burden or expense,specifically identify the proper amount ofinventory valuation adjustments allocableto DPGR, is not required to use a methodthat specifically identifies inventory valu-ations adjustments to DPGR.

(5) Rules applicable to inventories ac-counted for under the last-in, first-out(LIFO) inventory method—(i) In gen-eral. This paragraph applies to inventoriesaccounted for using the specific goodslast-in, first-out (LIFO) method or thedollar-value LIFO method. Whenever aspecific goods grouping or a dollar-valuepool contains QPP, qualified films, orutilities that produces DPGR and goodsthat do not, the taxpayer must allocateCGS attributable to that grouping or poolbetween DPGR and non-DPGR using areasonable method that is satisfactory tothe Secretary based on all of the factsand circumstances. Whether a methodof allocating CGS between DPGR andnon-DPGR is reasonable must be deter-mined in accordance with paragraph (b)(2)of this section. In addition, this paragraph(b)(5) provides methods that a taxpayermay use to allocate CGS for inventoriesaccounted for using the LIFO method.If a taxpayer uses the LIFO/FIFO ratiomethod provided in paragraph (b)(5)(ii)of this section or the change in relativebase-year cost method provided in para-

graph (b)(5)(iii) of this section, then thetaxpayer must use that method for all in-ventory accounted for under the LIFOmethod.

(ii) LIFO/FIFO ratio method. A tax-payer using the specific goods LIFOmethod or the dollar-value LIFO methodmay use the LIFO/FIFO ratio method.The LIFO/FIFO ratio method is appliedwith respect to all LIFO inventory of ataxpayer on a grouping-by-grouping orpool-by-pool basis. Under the LIFO/FIFOratio method, a taxpayer computes theCGS of a grouping or pool allocable toDPGR by multiplying the CGS of QPP,qualified films, or utilities in the groupingor pool that produced DPGR computedusing the first-in, first-out (FIFO) methodby the LIFO/FIFO ratio of the grouping orpool. The LIFO/FIFO ratio of a groupingor pool is equal to the total CGS of thegrouping or pool computed using the LIFOmethod over the total CGS of the groupingor pool computed using the FIFO method.

(iii) Change in relative base-year costmethod. A taxpayer using the dollar-valueLIFO method may use the change in rela-tive base-year cost method. The change inrelative base-year cost method is appliedwith respect to all LIFO inventory of a tax-payer on a pool-by-pool basis. The changein relative base-year cost method deter-mines the CGS allocable to DPGR by in-creasing or decreasing the total productioncosts (section 471 costs and additional sec-tion 263A costs) of QPP, a qualified film,or utilities that generate DPGR by a por-tion of any increment or liquidation of thedollar-value pool. The portion of an incre-ment or liquidation allocable to DPGR isdetermined by multiplying the LIFO valueof the increment or liquidation (expressedas a positive number) by the ratio of thechange in total base-year cost (expressedas a positive number) of the QPP, qualifiedfilm, or utilities that will generate DPGRin ending inventory to the change in to-tal base-year cost (expressed as a positivenumber) of all goods in the ending inven-tory. The portion of an increment or liq-uidation allocable to DPGR may be zerobut cannot exceed the amount of the incre-ment or liquidation. Thus, a ratio in excessof 1.0 must be treated as 1.0.

(6) Taxpayers using the simplifiedproduction method or simplified resalemethod for additional section 263A costs.A taxpayer that uses the simplified produc-

2006–25 I.R.B. 1105 June 19, 2006

tion method or simplified resale methodto allocate additional section 263A costs,as defined in §1.263A–1(d)(3), to end-ing inventory must follow the rules inparagraph (b)(2) of this section to deter-mine the amount of additional section263A costs allocable to DPGR. Alloca-ble additional section 263A costs includeadditional section 263A costs included inbeginning inventory as well as additionalsection 263A costs incurred during thetaxable year. Ordinarily, if a taxpayer usesthe simplified production method or thesimplified resale method, the additionalsection 263A costs should be allocated inthe same proportion as section 471 costsare allocated.

(7) Examples. The following examplesillustrate the application of this paragraph(b) and assume that the taxpayer does notuse the small business simplified overallmethod provided in paragraph (f) of thissection:

Example 1. Advance payments. T, a calendar yeartaxpayer, is a manufacturer of furniture in the United

States. Under its method of accounting, T includesadvance payments and other gross receipts derivedfrom the sale of furniture in gross income when thepayments are received. In December 2007, T receivesan advance payment of $5,000 from X with respectto an order of furniture to be manufactured for a to-tal price of $20,000. In 2008, T produces and sellsthe furniture to X. In 2008, T incurs $14,000 of sec-tion 471 and additional section 263A costs to producethe furniture ordered by X. T receives the remaining$15,000 of the contract price from X in 2008. As-suming that in 2007, T can reasonably determine thatall the requirements of §§1.199–1 and 1.199–3 willbe met with respect to the furniture, the advance pay-ment qualifies as DPGR in 2007. Assuming furtherthat all the requirements of §§1.199–1 and 1.199–3are met with respect to the furniture in 2008, the re-maining $15,000 of the contract price must be in-cluded in income and DPGR when received by Tin 2008. T must include the $14,000 it incurred toproduce the furniture in CGS and CGS allocable toDPGR in 2008. See §1.199–4(b)(2)(ii) for rules re-garding gross receipts and costs recognized in differ-ent taxable years.

Example 2. Use of standard cost method. X, acalendar year taxpayer, manufactures item A in a fac-tory located in the United States and item B in a fac-tory located in Country Y. Item A is produced by Xwithin the United States and the sale of A generates

DPGR. X uses the FIFO inventory method to accountfor its inventory and determines the cost of item Ausing a standard cost method. At the beginning ofits 2007 taxable year, X’s inventory contains 2,000units of item A at a standard cost of $5 per unit. Xdid not incur significant cost variances in previoustaxable years. During the 2007 taxable year, X pro-duces 8,000 units of item A at a standard cost of $6per unit. X determines that with regard to its pro-duction of item A it has incurred a significant costvariance. When X reallocates the cost variance to theunits of item A that it has produced, the productioncost of item A is $7 per unit. X sells 7,000 units ofitem A during the taxable year. X can identify fromits books and records that CGS related to the sales ofitem A during the taxable year are $45,000 ((2,000 x$5) + (5,000 x $7)). Accordingly, X has CGS alloca-ble to DPGR of $45,000.

Example 3. Change in relative base-year costmethod. (i) Y elects, beginning with the calendaryear 2007, to compute its inventories using the dol-lar-value, LIFO method under section 472. Y estab-lishes a pool for items A and B. Y produces item Awithin the United States and the sales of item A gen-erate DPGR. Y does not produce item B within theUnited States and the sale of item B does not gener-ate DPGR. The composition of the inventory for thepool at the base date, January 1, 2007, is as follows:

Item Unit Unit cost Total cost

A 2,000 $5.00 $10,000B 1,250 4.00 5,000

Total $15,000

(ii) Y uses a standard cost method to allocate alldirect and indirect costs (section 471 and additionalsection 263A costs) to the units of item A and itemB that it produces. During 2007, Y incurs $52,500 ofsection 471 costs and additional section 263A costs

to produce 10,000 units of item A and $114,000 ofsection 471 costs and additional section 263A coststo produce 20,000 units of item B.

(iii) The closing inventory of the pool at Decem-ber 31, 2007, contains 3,000 units of item A and 2,500

units of item B. The closing inventory of the poolat December 31, 2007, shown at base-year and cur-rent-year cost is as follows:

Item QuantityBase-year

cost AmountCurrent-year

cost Amount

A 3,000 $5.00 $15,000 $5.25 $15,750B 2,500 4.00 10,000 5.70 14,250

Totals $25,000 $30,000

(iv) The base-year cost of the closing LIFO in-ventory at December 31, 2007, amounts to $25,000,and exceeds the $15,000 base-year cost of the open-ing inventory for the taxable year by $10,000 (theincrement stated at base-year cost). The incrementvalued at current-year cost is computed by multiply-ing the increment stated at base-year cost by the ratio

of the current-year cost of the pool to total base-yearcost of the pool (that is, $30,000/$25,000, or 120%).The increment stated at current-year cost is $12,000($10,000 x 120%).

(v) The change in relative base-year cost of itemA is $5,000 ($15,000 - $10,000). The change in rel-ative base-year cost (the increment stated at base-

year cost) of the total inventory is $10,000 ($25,000- $15,000). The ratio of the change in base-year costof item A to the change in base-year cost of the totalinventory is 50% ($5,000/$10,000).

(vi) CGS allocable to DPGR is $46,500, com-puted as follows:

Current-year production costs related to DPGR $52,500

Less: Increment stated at current-year cost $12,000Ratio 50%

Total ( 6,000)

Total $46,500

June 19, 2006 1106 2006–25 I.R.B.

Example 4. Change in relative base-year costmethod. (i) The facts are the same as in Example 3except that, during the calendar year 2008, Y expe-riences an inventory decrement. During 2008, Y in-curs $66,000 of section 471 costs and additional sec-

tion 263A costs to produce 12,000 units of item A and$150,000 of section 471 costs and additional section263A costs to produce 25,000 units of item B.

(ii) The closing inventory of the pool at December31, 2008, contains 2,000 units of item A and 2,500

units of item B. The closing inventory of the pool atDecember 31, 2008, shown at base-year and current-year cost is as follows:

Item QuantityBase-year

cost AmountCurrent-year

cost Amount

A 2,000 $5.00 $10,000 $5.50 $11,000B 2,500 4.00 10,000 6.00 15,000

Totals $20,000 $26,000

(iii) The base-year cost of the closing LIFO inven-tory at December 31, 2008, amounts to $20,000, andis less than the $25,000 base-year cost of the opening

inventory for that taxable year by $5,000 (the decre-ment stated at base-year cost). This liquidation isreflected by reducing the most recent layer of incre-

ment. The LIFO value of the inventory at December31, 2008 is:

Base cost Index LIFO value

January 1, 2008, base cost $15,000 1.00 $15,000December 31, 2008, increment 5,000 1.20 6,000

Total $21,000

(iv) The change in relative base-year cost of itemA is $5,000 ($15,000 - $10,000). The change in rel-ative base-year cost of the total inventory is $5,000

($25,000 - $20,000). The ratio of the change in base-year cost of item A to the change in base-year cost ofthe total inventory is 100% ($5,000/$5,000).

(v) CGS allocable to DPGR is $72,000, computedas follows:

Current-year production costs related to DPGR $66,000Plus: LIFO value of decrement $6,000

Ratio 100%

Total 6,000

Total $72,000

Example 5. LIFO/FIFO ratio method. (i) Thefacts are the same as in Example 3 except that Y usesthe LIFO/FIFO ratio method to determine its CGSallocable to DPGR.

(ii) Y’s CGS related to item A on a FIFO basis is$46,750 ((2,000 units at $5) + (7,000 units at $5.25)).

(iii) Y’s total CGS computed on a LIFO basis is$154,500 (beginning inventory of $15,000 plus totalproduction costs of $166,500 less ending inventory of$27,000).

(iv) Y’s total CGS computed on a FIFO basis is$151,500 (beginning inventory of $15,000 plus totalproduction costs of $166,500 less ending inventory of$30,000).

(v) The ratio of Y’s CGS computed using theLIFO method to its CGS computed using the FIFOmethod is 102% ($154,500/$151,500). Y’s CGS re-lated to DPGR computed using the LIFO/FIFO ratiomethod is $47,685 ($46,750 x 102%).

Example 6. LIFO/FIFO ratio method. (i) Thefacts are the same as in Example 4 except that Y usesthe LIFO/FIFO ratio method to compute CGS alloca-ble to DPGR.

(ii) Y’s CGS related to item A on a FIFO basisis $70,750 ((3,000 units at $5.25) + (10,000 units at$5.50)).

(iii) Y’s total CGS computed on a LIFO basis is$222,000 (beginning inventory of $27,000 plus total

production costs of $216,000 less ending inventory of$21,000).

(iv) Y’s total CGS computed on a FIFO basis is$220,000 (beginning inventory of $30,000 plus totalproduction costs of $216,000 less ending inventory of$26,000).

(v) The ratio of Y’s CGS computed using theLIFO method to its CGS computed using the FIFOmethod is 101% ($222,000/$220,000). Y’s CGS re-lated to DPGR computed using the LIFO/FIFO ratiomethod is $71,457 ($70,750 x 101%).

(c) Other deductions properly alloca-ble to domestic production gross receiptsor gross income attributable to domesticproduction gross receipts—(1) In general.In determining its QPAI, a taxpayer mustsubtract from its DPGR, in addition to itsCGS allocable to DPGR, the deductionsthat are properly allocable to DPGR. A tax-payer generally must allocate and appor-tion these deductions using the rules of thesection 861 method. In lieu of the sec-tion 861 method, certain taxpayers may ap-portion these deductions using the simpli-fied deduction method provided in para-graph (e) of this section. Paragraph (f) of

this section provides a small business sim-plified overall method that may be usedby a qualifying small taxpayer, as definedin that paragraph. A taxpayer using thesimplified deduction method or the smallbusiness simplified overall method mustuse that method for all deductions. A tax-payer eligible to use the small businesssimplified overall method may choose atany time for any taxable year to use thesmall business simplified overall method,the simplified deduction method, or thesection 861 method for a taxable year. Ataxpayer eligible to use the simplified de-duction method may choose at any time forany taxable year to use the simplified de-duction method or the section 861 methodfor a taxable year.

(2) Treatment of net operating losses. Adeduction under section 172 for a net op-erating loss is not allocated or apportionedto DPGR or gross income attributable toDPGR.

2006–25 I.R.B. 1107 June 19, 2006

(3) W–2 wages. Although only W–2wages as described in §1.199–2 are takeninto account in computing the W–2 wagelimitation, all wages paid (or incurred inthe case of an accrual method taxpayer)in a taxpayer’s trade or business duringthe taxable year are taken into account incomputing QPAI for that taxable year.

(d) Section 861 method—(1) In gen-eral. Under the section 861 method, ataxpayer must allocate and apportion itsdeductions using the allocation and appor-tionment rules provided under the section861 regulations under which section 199is treated as an operative section de-scribed in §1.861–8(f). Accordingly, thetaxpayer applies the rules of the section861 regulations to allocate and appor-tion deductions (including, if applicable,its distributive share of deductions frompass-thru entities) to gross income attrib-utable to DPGR. Gross receipts that areallocable to land under the safe harbor pro-vided in §1.199–3(m)(6)(iv) are treated asnon-DPGR. See §1.199–3(m)(6)(iv)(B).If the taxpayer applies the allocation andapportionment rules of the section 861regulations for section 199 and anotheroperative section, then the taxpayer mustuse the same method of allocation andthe same principles of apportionment forpurposes of all operative sections (subjectto the rules provided in paragraphs (c)(2)and (d)(2) and (3) of this section). See§1.861–8(f)(2)(i).

(2) Deductions for charitable contribu-tions. Deductions for charitable contribu-tions (as allowed under section 170 andsection 873(b)(2) or 882(c)(1)(B)) must be

ratably apportioned between gross incomeattributable to DPGR and gross income at-tributable to non-DPGR based on the rela-tive amounts of gross income.

(3) Research and experimental expendi-tures. Research and experimental expendi-tures must be allocated and apportioned inaccordance with §1.861–17 without takinginto account the exclusive apportionmentrule of §1.861–17(b).

(4) Deductions allocated or ap-portioned to gross receipts treatedas domestic production gross re-ceipts. If gross receipts are treated asDPGR pursuant to §1.199–1(d)(3)(i) or§1.199–3(i)(4)(i)(B)(6), (l)(4)(iv)(A),(m)(1)(iii)(A), (n)(6)(i), or (o)(2), thendeductions must be allocated or appor-tioned to the gross income attributable tosuch DPGR. Similarly, if gross receiptsare treated as non-DPGR pursuant to§1.199–1(d)(3)(ii) or §1.199–3(i)(4)(ii),(l)(4)(iv)(B), (m)(1)(iii)(B), or (n)(6)(ii),then deductions must be allocated or ap-portioned to the gross income attributableto such non-DPGR.

(5) Treatment of items from a pass-thruentity reporting qualified productionactivities income. If, pursuant to§1.199–9(e)(2) or to the authority grantedin §1.199–9(b)(1)(ii) or (c)(1)(ii), a tax-payer must combine QPAI and W–2 wagesfrom a partnership, S corporation, trust (tothe extent not described in §1.199–9(d)) orestate with the taxpayer’s total QPAI andW–2 wages from other sources, then forpurposes of apportioning the taxpayer’sinterest expense under this paragraph§1.199–4(d), the taxpayer’s interest in

such partnership (and, where relevantin apportioning the taxpayer’s interestexpense, the partnership’s assets), the tax-payer’s shares in such S corporation, orthe taxpayer’s interest in such trust shallbe disregarded.

(6) Examples. The following examplesillustrate the operation of the section 861method. Assume in the following exam-ples that all corporations are calendar yeartaxpayers, that all taxpayers have suffi-cient W–2 wages as defined in §1.199–2(e)so that the section 199 deduction is notlimited under section 199(b)(1), and that,with respect to the allocation and appor-tionment of interest expense, §1.861–10Tdoes not apply.

Example 1. Section 861 method and no EAG. (i)Facts. X, a United States corporation that is not amember of an expanded affiliated group (EAG) (asdefined in §1.199–7), engages in activities that gener-ate both DPGR and non-DPGR. All of X’s productionactivities that generate DPGR are within StandardIndustrial Classification (SIC) Industry Group AAA(SIC AAA). All of X’s production activities that gen-erate non-DPGR are within SIC Industry Group BBB(SIC BBB). X is able to specifically identify CGS al-locable to DPGR and to non-DPGR. X incurs $900of research and experimentation expenses (R&E) thatare deductible under section 174, $300 of which areperformed with respect to SIC AAA and $600 ofwhich are performed with respect to SIC BBB. Noneof the R&E is legally mandated R&E as described in§1.861–17(a)(4) and none of the R&E is included inCGS. X incurs section 162 selling expenses that arenot includible in CGS and are definitely related to allof X’s gross income. For 2010, the adjusted basis ofX’s assets is $5,000, $4,000 of which generates grossincome attributable to DPGR and $1,000 of whichgenerates gross income attributable to non-DPGR.For 2010, X’s taxable income is $1,380 based on thefollowing Federal income tax items:

DPGR (all from sales of products within SIC AAA) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3,000Non-DPGR (all from sales of products within SIC BBB). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3,000CGS allocable to DPGR . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($600)CGS allocable to non-DPGR . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($1,800)Section 162 selling expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($840)Section 174 R&E-SIC AAA . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($300)Section 174 R&E-SIC BBB. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($600)Interest expense (not included in CGS) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($300)Charitable contributions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($180)

X’s taxable income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,380

(ii) X’s QPAI. X allocates and apportions its de-ductions to gross income attributable to DPGR un-der the section 861 method of this paragraph (d). Inthis case, the section 162 selling expenses are defi-nitely related to all of X’s gross income. Based onthe facts and circumstances of this specific case, ap-

portionment of those expenses between DPGR andnon-DPGR on the basis of X’s gross receipts is appro-priate. For purposes of apportioning R&E, X electsto use the sales method as described in §1.861–17(c).X elects to apportion interest expense under the taxbook value method of §1.861–9T(g). X has $2,400 of

gross income attributable to DPGR (DPGR of $3,000- CGS of $600 allocated based on X’s books andrecords). X’s QPAI for 2010 is $1,320, as shown be-low:

June 19, 2006 1108 2006–25 I.R.B.

DPGR (all from sales of products within SIC AAA) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3,000CGS allocable to DPGR . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($600)Section 162 selling expenses

($840 x ($3,000 DPGR/$6,000 total gross receipts)) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($420)Interest expense (not included in CGS)

($300 x ($4,000 (X’s DPGR assets)/$5,000 (X’s total assets))) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($240)

Charitable contributions (not included in CGS)

($180 x ($2,400 gross income attributable to DPGR/$3,600 total gross income)) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($120)

Section 174 R&E-SIC AAA . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($300)

X’s QPAI . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,320

(iii) Section 199 deduction determination. X’stentative deduction under §1.199–1(a) is $119 (.09x (lesser of QPAI of $1,320 and taxable income of$1,380)). Because the facts of this example assumethat X’s W–2 wages as defined in §1.199–2(e) aresufficient to avoid a limitation on the section 199 de-duction, X’s section 199 deduction for 2010 is $119.

Example 2. Section 861 method and EAG. (i)Facts. The facts are the same as in Example 1 ex-cept that X owns stock in Y, a United States corpora-tion, equal to 75% of the total voting power of stockof Y and 80% of the total value of stock of Y. X

and Y are not members of an affiliated group as de-fined in section 1504(a). Accordingly, the rules of§1.861–14T do not apply to X’s and Y’s selling ex-penses, R&E, and charitable contributions. X and Yare, however, members of an affiliated group for pur-poses of allocating and apportioning interest expense(see §1.861–11T(d)(6)) and are also members of anEAG. For 2010, the adjusted basis of Y’s assets is$45,000, $21,000 of which generates gross incomeattributable to DPGR and $24,000 of which generatesgross income attributable to non-DPGR. All of Y’sactivities that generate DPGR are within SIC Indus-

try Group AAA (SIC AAA). All of Y’s activities thatgenerate non-DPGR are within SIC Industry GroupBBB (SIC BBB). None of X’s and Y’s sales are toeach other. Y is not able to specifically identify CGSallocable to DPGR and non-DPGR. In this case, be-cause CGS is definitely related under the facts andcircumstances to all of Y’s gross receipts, apportion-ment of CGS between DPGR and non-DPGR basedon gross receipts is appropriate. For 2010, Y’s tax-able income is $1,910 based on the following Federalincome tax items:

DPGR (all from sales of products within SIC AAA) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3,000Non-DPGR (all from sales of products within SIC BBB). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3,000CGS allocated to DPGR . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($1,200)CGS allocated to non-DPGR . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($1,200)Section 162 selling expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($840)Section 174 R&E-SIC AAA . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($100)Section 174 R&E-SIC BBB. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($200)Interest expense (not included in CGS and not subject to

§1.861–10T). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($500)Charitable contributions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($50)

Y’s taxable income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,910

(ii) QPAI. (A) X’s QPAI. Determination of X’sQPAI is the same as in Example 1 except that interest

is apportioned to gross income attributable to DPGRbased on the combined adjusted bases of X’s and Y’s

assets. See §1.861–11T(c). Accordingly, X’s QPAIfor 2010 is $1,410, as shown below:

DPGR (all from sales of products within SIC AAA) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3,000CGS allocated to DPGR . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($600)Section 162 selling expenses

($840 x ($3,000 DPGR/$6,000 total gross receipts)) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($420)Interest expense (not included in CGS and not subject to

§1.861–10T) ($300 x ($25,000 (tax book value of X’sand Y’s DPGR assets)/$50,000 (tax book valueof X’s and Y’s total assets))) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($150)

Charitable contributions (not included in CGS)

($180 x ($2,400 gross income attributable to DPGR/$3,600 total gross income)) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($120)

Section 174 R&E-SIC AAA . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($300)

X’s QPAI . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,410

(B) Y’s QPAI. Y makes the same elections underthe section 861 method as does X. Y has $1,800 of

gross income attributable to DPGR (DPGR of $3,000- CGS of $1,200 allocated based on Y’s gross re-

ceipts). Y’s QPAI for 2010 is $1,005, as shown be-low:

2006–25 I.R.B. 1109 June 19, 2006

DPGR (all from sales of products within SIC AAA) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3,000CGS allocated to DPGR . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($1,200)Section 162 selling expenses

($840 x ($3,000 DPGR/$6,000 total gross receipts)) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($420)Interest expense (not included in CGS and not subject to

§1.861–10T) ($500 x ($25,000 (tax book value of X’sand Y’s DPGR assets)/$50,000 (tax book value of X’sand Y’s total assets))) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($250)

Charitable contributions (not included in CGS)

($50 x ($1,800 gross income attributable to DPGR/$3,600 total gross income)) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($25)

Section 174 R&E-SIC AAA . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($100)

Y’s QPAI . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,005

(iii) Section 199 deduction determination. Thesection 199 deduction of the X and Y EAG is de-termined by aggregating the separately determinedQPAI, taxable income, and W–2 wages of X and Y.See §1.199–7(b). Accordingly, the X and Y EAG’stentative section 199 deduction is $217 (.09 x (lesserof combined taxable incomes of X and Y of $3,290(X’s taxable income of $1,380 plus Y’s taxable in-come of $1,910) and combined QPAI of $2,415 (X’sQPAI of $1,410 plus Y’s QPAI of $1,005)). Becausethe facts of this example assume that the W–2 wagesof X and Y are sufficient to avoid a limitation on thesection 199 deduction, X and Y EAG’s section 199deduction for 2010 is $217. The $217 is allocated toX and Y in proportion to their QPAI. See §1.199–7(c).

(e) Simplified deduction method—(1)In general. An eligible taxpayer may usethe simplified deduction method to ap-portion deductions between DPGR andnon-DPGR. The simplified deductionmethod does not apply to CGS. Under thesimplified deduction method, a taxpayer’sdeductions (except the net operating lossdeduction as provided in paragraph (c)(2)of this section) are ratably apportionedbetween DPGR and non-DPGR basedon relative gross receipts. Accordingly,the amount of deductions for the cur-rent taxable year apportioned to DPGRis equal to the same proportion of thetotal deductions for the current taxableyear that the amount of DPGR bears tototal gross receipts. Gross receipts that areallocable to land under the safe harbor pro-vided in §1.199–3(m)(6)(iv) are treated asnon-DPGR. See §1.199–3(m)(6)(iv)(B).Whether a trust (to the extent not de-scribed in §1.199–9(d)) or an estate mayuse the simplified deduction method isdetermined at the trust or estate level. Ifa trust or estate qualifies to use the sim-plified deduction method, the simplifieddeduction method must be applied at thetrust or estate level, taking into accountthe trust’s or estate’s DPGR, non-DPGR,and other items from all sources, includ-

ing its distributive or allocable share ofthose items of any lower-tier entity, priorto any charitable or distribution deduction.Whether the owner of a pass-thru entitymay use the simplified deduction methodis determined at the level of the entity’sowner. If the owner of a pass-thru entityqualifies and uses the simplified deduc-tion method, then the simplified deductionmethod is applied at the level of the ownerof the pass-thru entity taking into accountthe owner’s DPGR, non-DPGR, and otheritems from all sources including its dis-tributive or allocable share of those itemsof the pass-thru entity.

(2) Eligible taxpayer. For purposes ofthis paragraph (e), an eligible taxpayer is—

(i) A taxpayer that has average annualgross receipts (as defined in paragraph (g)of this section) of $100,000,000 or less; or

(ii) A taxpayer that has total assets (asdefined in paragraph (e)(3) of this section)of $10,000,000 or less.

(3) Total assets—(i) In general. Forpurposes of the simplified deductionmethod, total assets means the total as-sets the taxpayer has at the end of thetaxable year. In the case of a C corpo-ration, the corporation’s total assets atthe end of the taxable year is the amountrequired to be reported on Schedule L ofForm 1120, “United States CorporationIncome Tax Return,” in accordance withthe Form 1120 instructions.

(ii) Members of an expanded affiliatedgroup. To compute the total assets of anEAG, the total assets at the end of thetaxable year of each corporation that is amember of the EAG at the end of the tax-able year that ends with or within the tax-able year of the computing member (asdescribed in §1.199–7(h)) are aggregated.For purposes of this paragraph, a consol-

idated group is treated as one member ofthe EAG.

(4) Members of an expanded affiliatedgroup—(i) In general. Whether the mem-bers of an EAG may use the simplifieddeduction method is determined by refer-ence to all the members of the EAG. If theaverage annual gross receipts of the EAGare less than or equal to $100,000,000 orthe total assets of the EAG are less thanor equal to $10,000,000, then each mem-ber of the EAG may individually deter-mine whether to use the simplified deduc-tion method, regardless of the cost alloca-tion method used by the other members.

(ii) Exception. Notwithstanding para-graph (e)(4)(i) of this section, all membersof the same consolidated group must usethe same cost allocation method.

(iii) Examples. The following examplesillustrate the application of paragraph (e)of this section:

Example 1. Corporations X, Y, and Z are theonly three members of an EAG. Neither X, Y, nor Zis a member of a consolidated group. X, Y, and Zhave average annual gross receipts of $20,000,000,$70,000,000, and $5,000,000, respectively. X, Y,and Z each have total assets at the end of the taxableyear of $5,000,000. Because the average annualgross receipts of the EAG are less than or equal to$100,000,000, each of X, Y, and Z may use eitherthe simplified deduction method or the section 861method.

Example 2. The facts are the same as in Example1 except that X and Y are members of the same con-solidated group. X, Y, and Z may use either the sim-plified deduction method or the section 861 method.However, X and Y must use the same cost allocationmethod.

Example 3. The facts are the same as in Example1 except that Z’s average annual gross receipts are$15,000,000. Because the average annual gross re-ceipts of the EAG are greater than $100,000,000 andthe total assets of the EAG at the end of the taxableyear are greater than $10,000,000, X, Y, and Z musteach use the section 861 method.

(f) Small business simplified overallmethod—(1) In general. A qualifying

June 19, 2006 1110 2006–25 I.R.B.

small taxpayer may use the small businesssimplified overall method to apportionCGS and deductions between DPGR andnon-DPGR. Under the small businesssimplified overall method, a taxpayer’stotal costs for the current taxable year(as defined in paragraph (f)(3) of thissection) are apportioned between DPGRand non-DPGR based on relative grossreceipts. Accordingly, the amount oftotal costs for the current taxable yearapportioned to DPGR is equal to thesame proportion of total costs for thecurrent taxable year that the amount ofDPGR bears to total gross receipts. To-tal gross receipts for this purpose donot include gross receipts that are allo-cated to land under the land safe harborprovided in §1.199–3(m)(6)(iv). See§1.199–3(m)(6)(iv)(B).

(2) Qualifying small taxpayer. Exceptas provided in paragraph (f)(5), for pur-poses of this paragraph (f), a qualifyingsmall taxpayer is—

(i) A taxpayer that has average annualgross receipts (as defined in paragraph (g)of this section) of $5,000,000 or less;

(ii) A taxpayer that is engaged in thetrade or business of farming that is not re-quired to use the accrual method of ac-counting under section 447; or

(iii) A taxpayer that is eligible to usethe cash method as provided in Rev. Proc.2002–28, 2002–1 C.B. 815 (that is, cer-tain taxpayers with average annual grossreceipts of $10,000,000 or less that arenot prohibited from using the cash methodunder section 448, including partnerships,S corporations, C corporations, or individ-uals). See §601.601(d)(2) of this chapter.

(3) Total costs for the current taxableyear—(i) In general. For purposes of thesmall business simplified overall method,total costs for the current taxable yearmeans the total CGS and deductions (ex-cluding the net operating loss deductionas provided in paragraph (c)(2) of thissection) for the current taxable year. Totalcosts for the current taxable year are de-termined under the methods of accountingthat the taxpayer uses to compute taxableincome.

(ii) Land safe harbor. A taxpayerthat uses the land safe harbor provided in§1.199–3(m)(6)(iv) must reduce total costsfor the current taxable year by the costs ofland and any other costs capitalized to theland (except costs for activities listed in

§1.199–3(m)(2)(iii)) prior to applying thesmall business simplified overall method.See §1.199–3(m)(6)(iv)(B). For example,if a taxpayer has $1,000 of total costsfor the current taxable year and $600 ofsuch costs is attributable to land underthe land safe harbor, then only $400 ofsuch costs is apportioned between DPGRand non-DPGR under the small businesssimplified overall method.

(4) Members of an expanded affiliatedgroup—(i) In general. Whether the mem-bers of an EAG may use the small businesssimplified overall method is determined byreference to all the members of the EAG.If the average annual gross receipts of theEAG are less than or equal to $5,000,000,the EAG (viewed as a single corporation)is engaged in the trade or business of farm-ing that is not required to use the accrualmethod of accounting under section 447,or the EAG (viewed as a single corpora-tion) is eligible to use the cash method asprovided in Rev. Proc. 2002–28, theneach member of the EAG may individuallydetermine whether to use the small busi-ness simplified overall method, regardlessof the cost allocation method used by theother members.

(ii) Exception. Notwithstanding para-graph (f)(4)(i) of this section, all membersof the same consolidated group must usethe same cost allocation method.

(iii) Examples. The following examplesillustrate the application of paragraph (f) ofthis section:

Example 1. Corporations L, M, and N are the onlythree members of an EAG. Neither L, M, nor N is amember of a consolidated group. L, M, and N haveaverage annual gross receipts for the current taxableyear of $1,000,000, $1,500,000, and $2,000,000, re-spectively. Because the average annual gross receiptsof the EAG are less than or equal to $5,000,000, eachof L, M, and N may use the small business simplifiedoverall method, the simplified deduction method, orthe section 861 method.

Example 2. The facts are the same as in Exam-ple 1 except that M and N are members of the sameconsolidated group. L, M, and N may use the smallbusiness simplified overall method, the simplified de-duction method, or the section 861 method. However,M and N must use the same cost allocation method.

Example 3. The facts are the same as in Example1 except that N has average annual gross receipts of$4,000,000. Unless the EAG, viewed as a single cor-poration, is engaged in the trade or business of farm-ing that is not required to use the accrual method ofaccounting under section 447, or the EAG, viewed asa single corporation, is eligible to use the cash methodas provided in Rev. Proc. 2002–28, because the aver-age annual gross receipts of the EAG are greater than

$5,000,000, L, M, and N are all ineligible to use thesmall business simplified overall method.

(5) Trusts and estates. Trusts and es-tates under §1.199–9(e) may not use thesmall business simplified overall method.

(g) Average annual gross receipts—(1)In general. For purposes of the simplifieddeduction method and the small busi-ness simplified overall method, averageannual gross receipts means the averageannual gross receipts of the taxpayer (in-cluding gross receipts attributable to thesale, exchange, or other disposition ofland under the land safe harbor providedin §1.199–3(m)(6)(iv)) for the 3 taxableyears (or, if fewer, the taxable years dur-ing which the taxpayer was in existence)preceding the current taxable year, even ifone or more of such taxable years beganbefore the effective date of section 199. Inthe case of any taxable year of less than 12months (a short taxable year), the gross re-ceipts shall be annualized by multiplyingthe gross receipts for the short period by12 and dividing the result by the numberof months in the short period.

(2) Members of an expanded affiliatedgroup. To compute the average annualgross receipts of an EAG, the gross re-ceipts, for the entire taxable year, of eachcorporation that is a member of the EAGat the end of its taxable year that ends withor within the taxable year of the comput-ing member are aggregated. For purposesof this paragraph, a consolidated group istreated as one member of the EAG.

§1.199–5 Application of section 199to pass-thru entities for taxable yearsbeginning after May 17, 2006, theenactment date of the Tax IncreasePrevention and Reconciliation Act of2005. [Reserved].

§1.199–6 Agricultural and horticulturalcooperatives.

(a) In general. A patron who receivesa qualified payment (as defined in para-graph (e) of this section) from a speci-fied agricultural or horticultural coopera-tive (cooperative) (as defined in paragraph(f) of this section) is allowed a deduc-tion under §1.199–1(a) (section 199 de-duction) for the taxable year the quali-fied payment is received for the portionof the cooperative’s section 199 deductionpassed through to the patron and identi-fied by the cooperative in a written no-

2006–25 I.R.B. 1111 June 19, 2006

tice mailed to the person during the pay-ment period described in section 1382(d).The provisions of this section apply solelyfor purposes of section 199 of the InternalRevenue Code (Code).

(b) Cooperative denied section 1382deduction for portion of qualified pay-ments. A cooperative must reduce its sec-tion 1382 deduction by an amount equalto the portion of any qualified paymentthat is attributable to the cooperative’ssection 199 deduction passed through tothe patron.

(c) Determining cooperative’s taxableincome. For purposes of determining itssection 199 deduction, the cooperative’staxable income is computed without takinginto account any deduction allowable un-der section 1382(b) or (c) (relating to pa-tronage dividends, per-unit retain alloca-tions, and nonpatronage distributions).

(d) Special rule for marketing coopera-tives. In the case of a cooperative engagedin the marketing of agricultural and/orhorticultural products described in para-graph (f) of this section, the cooperative istreated as having manufactured, produced,grown, or extracted (MPGE) (as definedin §1.199–3(e)) in whole or in significantpart (as defined in §1.199–3(g)) within theUnited States (as defined in §1.199–3(h))any agricultural or horticultural productsmarketed by the cooperative that its pa-trons have MPGE.

(e) Qualified payment. The term quali-fied payment means any amount of a pa-tronage dividend or per-unit retain allo-cation, as described in section 1385(a)(1)or (3) received by a patron from a co-operative, that is attributable to the por-tion of the cooperative’s qualified produc-tion activities income (QPAI) (as definedin §1.199–1(c)), for which the coopera-tive is allowed a section 199 deduction.For this purpose, patronage dividends andper-unit retain allocations include any ad-vances on patronage and per-unit retainspaid in money during the taxable year.

(f) Specified agricultural or horticul-tural cooperative. A specified agriculturalor horticultural cooperative means a coop-erative to which Part I of subchapter T ofthe Code applies and the cooperative hasMPGE in whole or significant part withinthe United States any agricultural or hor-ticultural product, or has marketed agri-cultural or horticultural products. For thispurpose, agricultural or horticultural prod-

ucts also include fertilizer, diesel fuel, andother supplies used in agricultural or hor-ticultural production.

(g) Written notice to patrons. In orderfor a patron to qualify for the section 199deduction, paragraph (a) of this section re-quires that the cooperative identify in awritten notice the patron’s portion of thesection 199 deduction that is attributableto the portion of the cooperative’s QPAIfor which the cooperative is allowed a sec-tion 199 deduction. This written noticemust be mailed by the cooperative to itspatrons no later than the 15th day of theninth month following the close of the tax-able year. The cooperative may use thesame written notice, if any, that it uses tonotify patrons of their respective alloca-tions of patronage dividends, or may use aseparate timely written notice(s) to complywith this section. The cooperative mustreport the amount of the patron’s section199 deduction on Form 1099-PATR, “Tax-able Distributions Received From Cooper-atives,” issued to the patron.

(h) Additional rules relating topassthrough of section 199 deduction.The cooperative may, at its discretion,pass through all, some, or none of thesection 199 deduction to its patrons. How-ever, the cooperative may not apply sec-tion 199(d)(3) and this section to anyportion of the section 199 deduction thatis not passed through to its patrons. Acooperative member of a federated coop-erative may pass through the section 199deduction it receives from the federatedcooperative to its member patrons. Pa-trons may claim the section 199 deductionfor the taxable year in which they receivethe written notice from the cooperativeinforming them of the section 199 amountwithout regard to the taxable income limi-tation under §1.199–1(a) and (b).

(i) W–2 wages. The W–2 wage limita-tion described in §1.199–2 shall be appliedat the cooperative level whether or not thecooperative chooses to pass through someor all of the section 199 deduction. Anysection 199 deduction that has been passedthrough by a cooperative to its patrons isnot subject to the W–2 wage limitation asecond time at the patron level.

(j) Recapture of section 199 deduction.If the amount of the section 199 deductionthat was passed through to patrons exceedsthe amount allowable as a section 199 de-duction as determined on audit or reported

on an amended return, then recapture of theexcess will occur at the cooperative levelin the taxable year the cooperative took theexcess section 199 deduction amount intoaccount.

(k) Section is exclusive. This sectionis the exclusive method for cooperativesand their patrons to compute the amount ofthe section 199 deduction. Thus, a patronmay not deduct any amount with respectto a patronage dividend or a per-unit retainallocation unless the requirements of thissection are satisfied.

(l) No double counting. To the extent acooperative passes through the section 199deduction to a patron, a qualified paymentreceived by the patron of the cooperativeis not taken in account for purposes of sec-tion 199.

(m) Examples. The following examplesillustrate the application of this section:

Example 1. (i) Cooperative X markets corngrown by its members within the United States forsale to retail grocers. For its calendar year ended De-cember 31, 2007, Cooperative X has gross receipts of$1,500,000, all derived from the sale of corn grownby its members within the United States. Cooper-ative X pays $370,000 for its members’ corn andits W–2 wages (as defined in §1.199–2(e)) for 2007total $130,000. Cooperative X has no other costs.Patron A is a member of Cooperative X. Patron A isa cash basis taxpayer and files Federal income taxreturns on a calendar year basis. All corn grown byPatron A in 2007 is sold through Cooperative X andPatron A is eligible to share in patronage dividendspaid by Cooperative X for that year.

(ii) Cooperative X is a cooperative described inparagraph (f) of this section. Accordingly, this sec-tion applies to Cooperative X and its patrons and allof Cooperative X’s gross receipts from the sale of itspatrons’ corn qualify as domestic production grossreceipts (as defined §1.199–3(a)). Cooperative X’sQPAI is $1,000,000. Cooperative X’s section 199 de-duction for its taxable year 2007 is $60,000 (.06 x$1,000,000). Because this amount is less than 50%of Cooperative X’s W–2 wages, the entire amount isallowed as a section 199 deduction subject to the rulesof section 199(d)(3) and this section.

Example 2. (i) The facts are the same as in Ex-ample 1 except that Cooperative X decides to passits entire section 199 deduction through to its mem-bers. Cooperative X declares a patronage dividendfor its 2007 taxable year of $1,000,000, which it payson March 15, 2008. Pursuant to paragraph (g) of thissection, Cooperative X notifies members in writtennotices that accompany the patronage dividend noti-fication that it is allocating to them the section 199 de-duction it is entitled to claim in the taxable year 2007.On March 15, 2008, Patron A receives a $10,000 pa-tronage dividend that is a qualified payment underparagraph (e) of this section from Cooperative X. Inthe notice that accompanies the patronage dividend,Patron A is designated a $600 section 199 deduction.Under paragraph (a) of this section, Patron A mustclaim a $600 section 199 deduction for the taxable

June 19, 2006 1112 2006–25 I.R.B.

year ending December 31, 2008, without regard tothe taxable income limitation under §1.199–1(a) and(b). Cooperative X must report the amount of PatronA’s section 199 deduction on Form 1099-PATR, “Tax-able Distributions Received From Cooperatives,” is-sued to Patron A for the calendar year 2008.

(ii) Under paragraph (b) of this section, Cooper-ative X is required to reduce its patronage dividenddeduction of $1,000,000 by the $60,000 section 199deduction passed through to members (whether or notCooperative X pays patronage on book or Federal in-come tax net earnings). As a consequence, Cooper-ative X is entitled to a patronage dividend deductionfor the taxable year ending December 31, 2007, inthe amount of $940,000 ($1,000,000 - $60,000) andto a section 199 deduction in the amount of $60,000($1,000,000 x .06). Its taxable income for 2007 is $0.

Example 3. (i) The facts are the same as in Ex-ample 1 except that Cooperative X paid out $500,000to its patrons as advances on expected patronage netearnings. In 2007, Cooperative X pays its patrons a$500,000 ($1,000,000 - $500,000 already paid) pa-tronage dividend in cash or a combination of cash andqualified written notices of allocation. Under para-graph (b) of this section and section 1382, Cooper-ative X is allowed a patronage dividend deductionof $440,000 ($500,000 - $60,000 section 199 deduc-tion), whether patronage net earnings are distributedon book or Federal income tax net earnings.

(ii) The patrons will have received a gross amountof $1,000,000 in qualified payments under paragraph(e) of this section from Cooperative X ($500,000 paidduring the taxable year as advances and the additional$500,000 paid as patronage dividends). If Coopera-tive X passes through its entire section 199 deductionto its members by providing the notice required byparagraph (g) of this section, then the patrons will beallowed a $60,000 section 199 deduction, resultingin a net $940,000 taxable distribution from Coopera-tive X. Pursuant to paragraph (l) of this section, the$1,000,000 received by the patrons from CooperativeX is not taken into account for purposes of section 199in the hands of the patrons.

§1.199–7 Expanded affiliated groups.

(a) In general. The provisions of thissection apply solely for purposes of sec-tion 199 of the Internal Revenue Code(Code). All members of an expanded affil-iated group (EAG) are treated as a singlecorporation for purposes of section 199.Notwithstanding the preceding sentence,except as otherwise provided in the Codeand regulations (see, for example, sections199(c)(7) and 267, §1.199–3(b), paragraph(a)(3) of this section, and the consolidatedreturn regulations), each member of anEAG is a separate taxpayer that computesits own taxable income or loss, qualifiedproduction activities income (QPAI) (asdefined in §1.199–1(c)), and W–2 wages(as defined in §1.199–2(e)). If membersof an EAG are also members of a consoli-

dated group, see paragraph (d) of this sec-tion.

(1) Definition of expanded affiliatedgroup. An EAG is an affiliated group asdefined in section 1504(a), determined bysubstituting more than 50 percent for atleast 80 percent each place it appears andwithout regard to section 1504(b)(2) and(4).

(2) Identification of members of an ex-panded affiliated group—(i) In general. Acorporation must determine if it is a mem-ber of an EAG on a daily basis.

(ii) Becoming or ceasing to be a mem-ber of an expanded affiliated group. Ifa corporation becomes or ceases to be amember of an EAG, the corporation istreated as becoming or ceasing to be amember of the EAG at the end of the dayon which its status as a member changes.

(3) Attribution of activities—(i) Ingeneral. If a member of an EAG (thedisposing member) derives gross receipts(as defined in §1.199–3(c)) from the lease,rental, license, sale, exchange, or otherdisposition (as defined in §1.199–3(i)) ofqualifying production property (QPP) (asdefined in §1.199–3(j)) that was manu-factured, produced, grown or extracted(MPGE) (as defined in §1.199–3(e)), inwhole or in significant part (as definedin §1.199–3(g)) in the United States (asdefined in §1.199–3(h)), a qualified film(as defined in §1.199–3(k)), or electricity,natural gas, or potable water (as definedin §1.199–3(l)) (collectively, utilities) thatwas produced in the United States, suchproperty was MPGE or produced by an-other corporation (or corporations), andthe disposing member is a member of thesame EAG as the other corporation (orcorporations) at the time that the disposingmember disposes of the QPP, qualifiedfilm, or utilities, then the disposing mem-ber is treated as conducting the previousactivities conducted by such other corpo-ration (or corporations) with respect to theQPP, qualified film, or utilities in deter-mining whether its gross receipts are do-mestic production gross receipts (DPGR)(as defined in §1.199–3(a)). With respectto a lease, rental, or license, the disposingmember is treated as having disposed ofthe QPP, qualified film, or utilities on thedate or dates on which it takes into accountthe gross receipts derived from the lease,rental, or license under its methods of ac-counting. With respect to a sale, exchange,

or other disposition, the disposing memberis treated as having disposed of the QPP,qualified film, or utilities on the date onwhich it ceases to own the QPP, qualifiedfilm, or utilities for Federal income taxpurposes, even if no gain or loss is takeninto account.

(ii) Special rule. Attribution of ac-tivities does not apply for purposes ofthe construction of real property under§1.199–3(m) or the performance of engi-neering and architectural services under§1.199–3(n). A member of an EAG mustengage in a construction activity under§1.199–3(m)(2), provide engineering ser-vices under §1.199–3(n)(2), or provide ar-chitectural services under §1.199–3(n)(3)in order for the member’s gross receipts tobe derived from construction, engineering,or architectural services.

(4) Examples. The following exam-ples illustrate the application of paragraph(a)(3) of this section. Assume that all tax-payers are calendar year taxpayers. Theexamples are as follows:

Example 1. Corporations M and N are membersof the same EAG. M is engaged solely in the tradeor business of manufacturing furniture in the UnitedStates that it sells to unrelated persons. N is engagedsolely in the trade or business of engraving compa-nies’ names on pens and pencils purchased from un-related persons and then selling the pens and pencilsto such companies. For purposes of this example, as-sume that if N was not a member of an EAG, its ac-tivities would not qualify as MPGE. Accordingly, al-though M’s sales of the furniture qualify as DPGR(assuming all the other requirements of §1.199–3 aremet), N’s sales of the engraved pens and pencils donot qualify as DPGR because neither N nor anothermember of the EAG MPGE the pens and pencils.

Example 2. For the entire 2007 year, Corpora-tions A and B are members of the same EAG. A isengaged solely in the trade or business of MPGE ma-chinery in the United States. A and B each own 45%of partnership C and unrelated persons own the re-maining 10%. C is engaged solely in the trade orbusiness of MPGE the same type of machinery in theUnited States as A. In 2007, B purchases and then re-sells the machinery MPGE in 2007 by A and C. B alsoresells machinery it purchases from unrelated per-sons. If only B’s activities were considered, B wouldnot qualify for the deduction under §1.199–1(a) (sec-tion 199 deduction). However, because at the timeB disposes of the machinery B is a member of theEAG that includes A, B is treated as conducting A’sprevious MPGE activities in determining whether B’sgross receipts from the sale of the machinery MPGEby A are DPGR. C is not a member of the EAG andthus C’s MPGE activities are not attributed to B indetermining whether B’s gross receipts from the saleof the machinery MPGE by C are DPGR. Accord-ingly, B’s gross receipts attributable to its sale of themachinery it purchases from A are DPGR (assumingall the other requirements of §1.199–3 are met). B’s

2006–25 I.R.B. 1113 June 19, 2006

gross receipts attributable to its sale of the machin-ery it purchases from C and from the unrelated per-sons are non-DPGR because no member of the EAGMPGE the machinery and because C does not qualifyas an EAG partnership.

Example 3. The facts are the same as in Example2 except that rather than reselling the machinery, Brents the machinery to unrelated persons and B takesthe gross receipts attributable to the rental of the ma-chinery into account under its methods of accountingin 2007, 2008, and 2009. In addition, as of the closeof business on December 31, 2008, A and B cease tobe members of the same EAG. With respect to the ma-chinery acquired from C and the unrelated persons,B’s gross receipts attributable to the rental of the ma-chinery in 2007, 2008, and 2009 are non-DPGR be-cause no member of the EAG MPGE the machineryand because C does not qualify as an EAG partner-ship. With respect to machinery acquired from A,B’s gross receipts in 2007 and 2008 attributable tothe rental of the machinery are DPGR because at thetime B takes into account the gross receipts derivedfrom the rental of the machinery under its methods ofaccounting, B is a member of the same EAG as A andB is treated as conducting A’s previous MPGE activ-ities. However, with respect to the rental receipts in2009, because A and B are not members of the sameEAG in 2009, B’s rental receipts are non-DPGR.

Example 4. For the entire 2007 year, Corpora-tion P owns over 50% of the stock of CorporationS. In 2007, P MPGE QPP in the United States andtransfers the QPP to S. On February 28, 2008, P dis-poses of stock of S, reducing P’s ownership of S be-low 50% and P and S cease to be members of the sameEAG. On June 30, 2008, S sells the QPP to an unre-lated person. Unless P’s transfer of the QPP to S tookplace in a transaction to which section 381(a) applies(see §1.199–8(e)(3)), because S is not a member ofthe same EAG as P on June 30, 2008, S is not treatedas conducting the activities conducted by P in deter-mining if S’s receipts are DPGR, notwithstanding thatP and S were members of the same EAG when PMPGE the QPP and when P transferred the QPP toS.

Example 5. For the entire 2007 year, Corpora-tions X and Y are unrelated corporations. In 2007, XMPGE QPP in the United States and sells the QPP toY. On August 31, 2008, X acquires over 50% of thestock of Y, thus making X and Y members of the sameEAG. On November 30, 2008, Y sells the QPP to anunrelated person. Because X and Y are members ofthe same EAG on November 30, 2008, Y is treated asconducting the activities conducted by X in 2007 indetermining if Y’s receipts are DPGR, notwithstand-ing that X and Y were not members of the same EAGwhen X MPGE the QPP nor when X sold the QPP toY.

(5) Anti-avoidance rule. If a transactionbetween members of an EAG is engagedin or structured with a principal purposeof qualifying for, or increasing the amountof, the section 199 deduction of the EAGor the portion of the section 199 deductionallocated to one or more members of theEAG, adjustments must be made to elim-inate the effect of the transaction on thecomputation of the section 199 deduction.

(b) Computation of expanded affiliatedgroup’s section 199 deduction—(1) Ingeneral. The section 199 deduction for anEAG is determined by the EAG by aggre-gating each member’s taxable income orloss, QPAI, and W–2 wages, if any. Forpurposes of this determination, a mem-ber’s QPAI may be positive or negative.A member’s taxable income or loss andQPAI shall be determined by reference tothe member’s methods of accounting.

(2) Example. The following exampleillustrates the application of paragraph(b)(1) of this section:

Example. Corporations X, Y, and Z, calendaryear taxpayers, are the only members of an EAGand are not members of a consolidated group. Xhas taxable income of $50,000, QPAI of $15,000,and W–2 wages of $1,000. Y has taxable incomeof ($20,000), QPAI of ($1,000), and W–2 wages of$750. Z has $0 taxable income and $0 QPAI, but hasW–2 wages of $2,000. In determining the EAG’ssection 199 deduction, the EAG aggregates eachmember’s taxable income or loss, QPAI, and W–2wages. Accordingly, the EAG has taxable incomeof $30,000 ($50,000 + ($20,000) + $0), QPAI of$14,000 ($15,000 + ($1,000) + $0), and W–2 wagesof $3,750 ($1,000 + $750 + $2,000).

(3) Net operating loss carrybacks andcarryovers. In determining the taxable in-come of an EAG, if a member of an EAGhas a net operating loss (NOL) carrybackor carryover to the taxable year, then theamount of the NOL used to offset taxableincome cannot exceed the taxable incomeof that member.

(c) Allocation of an expanded af-filiated group’s section 199 deductionamong members of the expanded affiliatedgroup—(1) In general. An EAG’s section199 deduction as determined in paragraph(b)(1) of this section is allocated amongthe members of the EAG in proportionto each member’s QPAI, regardless ofwhether the EAG member has taxable in-come or loss or W–2 wages for the taxableyear. For this purpose, if a member hasnegative QPAI, the QPAI of the membershall be treated as zero.

(2) Use of section 199 deduction tocreate or increase a net operating loss.Notwithstanding §1.199–1(b), if a mem-ber of an EAG has some or all of theEAG’s section 199 deduction allocatedto it under paragraph (c)(1) of this sec-tion and the amount allocated exceeds themember’s taxable income (determinedprior to allocation of the section 199 de-duction), the section 199 deduction willcreate an NOL for the member. Similarly,

if a member of an EAG, prior to the allo-cation of some or all of the EAG’s section199 deduction to the member, has an NOLfor the taxable year, the portion of theEAG’s section 199 deduction allocated tothe member will increase the member’sNOL.

(d) Special rules for members of thesame consolidated group—(1) Intercom-pany transactions. In the case of an in-tercompany transaction between consoli-dated group members S and B (as the termsintercompany transaction, S, and B are de-fined in §1.1502–13(b)(1)), S takes theintercompany transaction into account incomputing the section 199 deduction at thesame time and in the same proportion as Stakes into account the income, gain, deduc-tion, or loss from the intercompany trans-action under §1.1502–13.

(2) Attribution of activities in the con-struction of real property and the perfor-mance of engineering and architecturalservices. Notwithstanding paragraph(a)(3)(ii) of this section, a disposing mem-ber (as described in paragraph (a)(3)(i)of this section) is treated as conductingthe previous activities conducted by eachother member of its consolidated groupwith respect to the construction of realproperty under §1.199–3(m) and the per-formance of engineering and architecturalservices under §1.199–3(n), but only withrespect to activities performed during theperiod of consolidation.

(3) Application of the simplified de-duction method and the small businesssimplified overall method. For purposes ofapplying the simplified deduction methodunder §1.199–4(e) and the small busi-ness simplified overall method under§1.199–4(f), a consolidated group deter-mines its QPAI using its members’ DPGR,non-DPGR, cost of goods sold (CGS), andall other deductions, expenses, or losses(deductions), determined after applicationof §1.1502–13.

(4) Determining the section 199 deduc-tion—(i) Expanded affiliated group con-sists of consolidated group and non-con-solidated group members. In determiningthe section 199 deduction, if an EAGincludes corporations that are membersof the same consolidated group and cor-porations that are not members of thesame consolidated group, the consoli-dated taxable income or loss, QPAI, andW–2 wages, if any, of the consolidated

June 19, 2006 1114 2006–25 I.R.B.

group (and not the separate taxable in-come or loss, QPAI, and W–2 wages ofthe members of the consolidated group),are aggregated with the taxable income orloss, QPAI, and W–2 wages, if any, of thenon-consolidated group members. For ex-ample, if A, B, C, S1, and S2 are membersof the same EAG, and A, S1, and S2 aremembers of the same consolidated group(the A consolidated group), then the Aconsolidated group is treated as one mem-ber of the EAG. Accordingly, the EAG isconsidered to have three members, the Aconsolidated group, B, and C. The consol-idated taxable income or loss, QPAI, andW–2 wages, if any, of the A consolidatedgroup are aggregated with the taxable in-come or loss, QPAI, and W–2 wages, ifany, of B and C in determining the EAG’ssection 199 deduction.

(ii) Expanded affiliated group consistsonly of members of a single consolidatedgroup. If all the members of an EAG aremembers of the same consolidated group,the consolidated group’s section 199 de-duction is determined using the consoli-dated group’s consolidated taxable incomeor loss, QPAI, and W–2 wages, rather thanthe separate taxable income or loss, QPAI,and W–2 wages of its members.

(5) Allocation of the section 199 de-duction of a consolidated group among itsmembers. The section 199 deduction of aconsolidated group (or the section 199 de-duction allocated to a consolidated groupthat is a member of an EAG) is allocatedto the members of the consolidated groupin proportion to each consolidated groupmember’s QPAI, regardless of whether theconsolidated group member has separatetaxable income or loss or W–2 wages forthe taxable year. In allocating the sec-tion 199 deduction of a consolidated groupamong its members, any redeterminationof a corporation’s receipts, CGS, or otherdeductions from an intercompany trans-action under §1.1502–13(c)(1)(i) or (c)(4)for purposes of section 199 is not takeninto account. Also, for purposes of this al-location, if a consolidated group memberhas negative QPAI, the QPAI of the mem-ber shall be treated as zero.

(e) Examples. The following examplesillustrate the application of paragraphs (a)through (d) of this section:

Example 1. Corporations X and Y are membersof the same EAG but are not members of a consoli-dated group. All the activities described in this ex-

ample take place during the same taxable year. Xand Y each use the section 861 method described in§1.199–4(d) for allocating and apportioning their de-ductions. X incurs $5,000 in costs in manufacturinga machine, all of which are capitalized. X is entitledto a $1,000 depreciation deduction for the machine inthe current taxable year. X rents the machine to Y for$1,500. Y uses the machine in manufacturing QPPwithin the United States. Y incurs $1,400 of CGS inmanufacturing the QPP. Y sells the QPP to unrelatedpersons for $7,500. Pursuant to section 199(c)(7) and§1.199–3(b), X’s rental income is non-DPGR (and itsrelated costs are not attributable to DPGR). Accord-ingly, Y has $4,600 of QPAI (Y’s $7,500 DPGR re-ceived from unrelated persons - Y’s $1,400 CGS allo-cable to such receipts - Y’s $1,500 of rental expense),X has $0 of QPAI, and the EAG has $4,600 of QPAI.

Example 2. The facts are the same as in Example1 except that X and Y are members of the same con-solidated group. Pursuant to section 199(c)(7) and§1.199–3(b), X’s rental income ordinarily would notbe DPGR (and its related costs would not be allocableto DPGR). However, because X and Y are membersof the same consolidated group, §1.1502–13(c)(1)(i)provides that the separate entity attributes of X’sintercompany items or Y’s corresponding items,or both, may be redetermined in order to producethe same effect as if X and Y were divisions of asingle corporation. If X and Y were divisions ofa single corporation, X and Y would have QPAIof $5,100 ($7,500 DPGR received from unrelatedpersons - $1,400 CGS allocable to such receipts- $1,000 depreciation deduction). To obtain thissame result for the consolidated group, X’s rentalincome is redetermined as DPGR, which resultsin the consolidated group having $9,000 of DPGR(the sum of Y’s DPGR of $7,500 + X’s DPGR of$1,500) and $3,900 of costs allocable to DPGR(the sum of Y’s $1,400 CGS + Y’s $1,500 rentalexpense + X’s $1,000 depreciation expense). Forpurposes of determining how much of the consoli-dated group’s section 199 deduction is allocated toX and Y, pursuant to paragraph (d)(5) of this section,the redetermination of X’s rental income as DPGRunder §1.1502–13(c)(1)(i) is not taken into account(X’s costs are considered to be allocable to DPGRbecause they are allocable to the consolidated groupderiving DPGR). Accordingly, for this purpose, Xis deemed to have ($1,000) of QPAI (X’s $0 DPGR- X’s $1,000 depreciation deduction). Because Xis deemed to have negative QPAI, also pursuant toparagraph (d)(5) of this section, X’s QPAI is treatedas zero. Y has $4,600 of QPAI (Y’s $7,500 DPGR- Y’s $1,400 CGS allocable to such receipts - Y’s$1,500 of rental expense). Accordingly, X is allo-cated $0/($0 + $4,600) of the consolidated group’ssection 199 deduction and Y is allocated $4,600/($0+ $4,600) of the consolidated group’s section 199deduction.

Example 3. Corporations P and S are membersof the same EAG but are not members of a consoli-dated group. P and S each use the section 861 methodfor allocating and apportioning their deductions andare both calendar year taxpayers. In 2007, P incurs$1,000 in research and development expenses in cre-ating an intangible asset and deducts these expensesin 2007. P anticipates that it will license the intan-gible asset to S. On January 1, 2008, P licenses theintangible asset to S for $2,500. S uses the intangible

asset in manufacturing QPP within the United States.S incurs $2,000 of additional costs in manufacturingthe QPP. On December 31, 2008, S sells the QPP tounrelated persons for $10,000. Because on December31, 2007, P anticipates that it will license the intan-gible asset to S, a related person, and also becausethe intangible asset is not QPP, P’s license receiptsfrom S will be non-DPGR. Accordingly, P’s researchand development expenses in 2007 are not attribut-able to DPGR. In 2008, S has $5,500 of QPAI (S’s$10,000 DPGR received from unrelated persons - S’s$2,000 additional costs in manufacturing the QPP -S’s $2,500 of license expense), P has $0 of QPAI, andthe EAG has $5,500 of QPAI.

Example 4. (i) Determination of consolidatedgroup’s QPAI. The facts are the same as in Example3 except that P and S are members of the same con-solidated group. Pursuant to section 199(c)(7) and§1.199–3(b), and also because the intangible asset isnot QPP, P’s license income ordinarily would not beDPGR (and its related costs would not be allocableto DPGR). However, because P and S are membersof the same consolidated group, §1.1502–13(c)(1)(i)provides that the separate entity attributes of P’s inter-company items or S’s corresponding items, or both,may be redetermined in order to produce the same ef-fect as if P and S were divisions of a single corpora-tion. If P and S were divisions of a single corporation,in 2007 the single corporation would have $1,000 ofexpenses allocable to the anticipated DPGR from thesale of the QPP to unrelated persons, resulting in anegative QPAI (from this individual item) of $1,000.In 2008, the single corporation would have QPAI of$8,000 ($10,000 DPGR received from unrelated per-sons - $2,000 additional costs in manufacturing theQPP). To obtain this same result for the consolidatedgroup, P’s license income from S is redetermined asDPGR. P’s research and development expenses areallocable to DPGR. This results in the consolidatedgroup having negative QPAI in 2007 (from the re-search and development expense) of $1,000. In 2008,the consolidated group has $12,500 of DPGR (thesum of S’s DPGR of $10,000 + P’s DPGR of $2,500)and $4,500 of costs allocable to DPGR (the sum ofS’s $2,000 additional costs + S’s $2,500 license ex-pense), resulting in $8,000 of QPAI in 2008.

(ii) Allocation of deduction. Since the consoli-dated group has no QPAI in 2007, there is no section199 deduction to be allocated between P and S in2007. In 2008, the consolidated group has $8,000of QPAI and, assuming that the group has positivetaxable income and W–2 wages, the consolidatedgroup will have a section 199 deduction. For pur-poses of determining how much of the consolidatedgroup’s section 199 deduction is allocated to P andS, pursuant to paragraph (d)(5) of this section, the re-determination of P’s license income as DPGR under§1.1502–13(c)(1)(i) is not taken into account. Ac-cordingly, for purposes of allocating the consolidatedgroup’s section 199 deduction between P and S, P isdeemed to have $0 DPGR and $0 QPAI in 2008. Shas $5,500 of QPAI (S’s $10,000 DPGR - S’s $2,000in additional costs allocable to such receipts - S’s$2,500 of license expense). Accordingly, P is allo-cated $0/($0 + $5,500) of the consolidated group’ssection 199 deduction in 2008 and S is allocated$5,500/($0 + $5,500) of the consolidated group’ssection 199 deduction.

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Example 5. (i) Facts. Corporations A and Bare the only two members of an EAG but are notmembers of a consolidated group. A and B each fileFederal income tax returns on a calendar year basis.The average annual gross receipts of the EAG are lessthan or equal to $100,000,000 and A and B each usethe simplified deduction method under §1.199–4(e).In 2007, A MPGE televisions within the UnitedStates. A has $10,000,000 of DPGR from sales oftelevisions to unrelated persons and $2,000,000 ofDPGR from sales of televisions to B. In addition,A has gross receipts from computer consulting ser-vices with unrelated persons of $3,000,000. A hasCGS of $6,000,000. A is able to determine from itsbooks and records that $4,500,000 of its CGS areattributable to televisions sold to unrelated personsand $1,500,000 are attributable to televisions sold toB (see §1.199–4(b)(2)). A has other deductions of$4,000,000. A has no other items of income, gain,or deductions. In 2007, B sells the televisions it pur-chased from A to unrelated persons for $4,100,000.B also pays $100,000 for administrative servicesperformed in 2007. B has no other items of income,gain, or deductions.

(ii) QPAI. (A) A’s QPAI. In order to determineA’s QPAI, A subtracts its $6,000,000 CGS from its$12,000,000 DPGR. Under the simplified deductionmethod, A then apportions its remaining $4,000,000of deductions to DPGR in proportion to the ratioof its DPGR to total gross receipts. Thus, of A’s$4,000,000 of deductions, $3,200,000 is apportionedto DPGR ($4,000,000 x $12,000,000/$15,000,000).Accordingly, A’s QPAI is $2,800,000 ($12,000,000DPGR - $6,000,000 CGS - $3,200,000 deductionsapportioned to its DPGR).

(B) B’s QPAI. Although B did not MPGE thetelevisions it sold, pursuant to paragraph (a)(3) ofthis section, B is treated as conducting A’s MPGE ofthe televisions in determining whether B’s gross re-ceipts are DPGR. Thus, B has $4,100,000 of DPGR.In order to determine B’s QPAI, B subtracts its$2,000,000 CGS from its $4,100,000 DPGR. Underthe simplified deduction method, B then apportionsits remaining $100,000 of deductions to DPGR inproportion to the ratio of its DPGR to total grossreceipts. Thus, because B has no other gross receipts,all of B’s $100,000 of deductions is apportionedto DPGR ($100,000 x $4,100,000/$4,100,000).Accordingly, B’s QPAI is $2,000,000 ($4,100,000DPGR - $2,000,000 CGS - $100,000 deductionsapportioned to its DPGR).

Example 6. (i) Facts. The facts are the sameas in Example 5 except that A and B are membersof the same consolidated group, B does not sell thetelevisions purchased from A until 2008, and B’s$100,000 paid for administrative services are paidin 2008 for services performed in 2008. In addition,in 2008, A has $3,000,000 in gross receipts fromcomputer consulting services with unrelated personsand $1,000,000 in related deductions.

(ii) Consolidated group’s 2007 QPAI. The con-solidated group’s DPGR and total gross receiptsin 2007 are $10,000,000 and $13,000,000, respec-tively, because, pursuant to paragraph (d)(1) of thissection and §1.1502–13, the sale of the televisionsfrom A to B is not taken into account in 2007. Inorder to determine the consolidated group’s QPAI,the consolidated group subtracts its $4,500,000CGS from the televisions sold to unrelated persons

from its $10,000,000 DPGR. Under the simplifieddeduction method, the consolidated group appor-tions its remaining $4,000,000 of deductions toDPGR in proportion to the ratio of its DPGR tototal gross receipts. Thus, $3,076,923 ($4,000,000 x$10,000,000/$13,000,000) is allocated to DPGR. Ac-cordingly, the consolidated group’s QPAI for 2007 is$2,423,077 ($10,000,000 DPGR - $4,500,000 CGS -$3,076,923 deductions apportioned to its DPGR).

(iii) Allocation of consolidated group’s 2007 sec-tion 199 deduction to its members. Because B’s onlyactivity during 2007 is the purchase of televisionsfrom A, B has no DPGR or deductions and thus, noQPAI, in 2007. Accordingly, the entire section 199deduction in 2007 for the consolidated group will beallocated to A.

(iv) Consolidated group’s 2008 QPAI. Pursuant toparagraph (d)(1) of this section and §1.1502–13(c),A’s sale of televisions to B in 2007 is taken intoaccount in 2008 when B sells the televisions to unre-lated persons. However, because A and B are mem-bers of a consolidated group, §1.1502–13(c)(1)(i)provides that the separate entity attributes of A’sintercompany items or B’s corresponding items, orboth, may be redetermined in order to produce thesame effect as if A and B were divisions of a singlecorporation. Accordingly, A’s $2,000,000 of grossreceipts are redetermined to be non-DPGR and as notbeing gross receipts for purposes of allocating costsbetween DPGR and non-DPGR, and B’s $2,000,000CGS are redetermined to be not allocable to DPGR.Notwithstanding that A’s receipts are redeterminedto be non-DPGR and as not being gross receiptsfor purposes of allocating costs between DPGRand non-DPGR, A’s CGS are still considered to beallocable to DPGR because they are allocable tothe consolidated group deriving DPGR. Accord-ingly, the consolidated group’s DPGR in 2008 is$4,100,000 from B’s sales of televisions, and itstotal receipts are $7,100,000 ($4,100,000 DPGRplus $3,000,000 non-DPGR from A’s computerconsulting services). To determine the consolidatedgroup’s QPAI, the consolidated group subtracts A’s$1,500,000 CGS from the televisions sold to B fromits $4,100,000 DPGR. Under the simplified deduc-tion method, the consolidated group apportions itsremaining $1,100,000 of deductions ($1,000,000from A and $100,000 from B) to DPGR in propor-tion to the consolidated group’s ratio of its DPGR tototal gross receipts. Thus, $635,211 ($1,100,000 x$4,100,000/$7,100,000) is allocated to DPGR. Ac-cordingly, the consolidated group’s QPAI for 2008is $1,964,789 ($4,100,000 DPGR - $1,500,000 CGS- $635,211 deductions apportioned to its DPGR),the same QPAI that would result if A and B weredivisions of a single corporation.

(v) Allocation of consolidated group’s 2008 sec-tion 199 deduction to its members. (A) A’s QPAI.For purposes of allocating the consolidated group’ssection 199 deduction to its members, pursuant toparagraph (d)(5) of this section, the redeterminationof A’s $2,000,000 in receipts is disregarded. Accord-ingly, for this purpose, A’s DPGR are $2,000,000(receipts from the sale of televisions to B taken intoaccount in 2008) and its total receipts are $5,000,000($2,000,000 DPGR + $3,000,000 non-DPGR fromits computer consulting services). In determining A’sQPAI, A subtracts its $1,500,000 CGS from the tele-visions sold to B from its $2,000,000 DPGR. Under

the simplified deduction method, A apportions itsremaining $1,000,000 of deductions in proportionto the ratio of its DPGR to total receipts. Thus,$400,000 ($1,000,000 x $2,000,000/$5,000,000) isallocated to DPGR. Thus, A’s QPAI is $100,000($2,000,000 DPGR - $1,500,000 CGS - $400,000deductions allocated to its DPGR).

(B) B’s QPAI. B’s DPGR and its total grossreceipts are each $4,100,000. For purposes ofallocating the consolidated group’s section 199 de-duction to its members, pursuant to paragraph (d)(5)of this section, the redetermination of B’s $2,000,000CGS as not allocable to DPGR is disregarded. Indetermining B’s QPAI, B subtracts its $2,000,000CGS from the televisions purchased from A fromits $4,100,000 DPGR. Under the simplified deduc-tion method, B apportions its remaining $100,000deductions in proportion to the ratio of its DPGRto total receipts. Thus, all $100,000 ($100,000x $4,100,000/$4,100,000) is allocated to DPGR.Thus, B’s QPAI is $2,000,000 ($4,100,000 DPGR -$2,000,000 CGS - $100,000 deductions allocated toits DPGR).

(C) Allocation to A and B. Pursuant to para-graph (d)(5) of this section, the consolidatedgroup’s section 199 deduction for 2008 is allo-cated $100,000/($100,000 + $2,000,000) to A and$2,000,000/($100,000 + $2,000,000) to B.

Example 7. Corporations S and B are members ofthe same consolidated group that files its Federal in-come tax returns on a calendar year basis. In 2007, Smanufactures office furniture for B to use in B’s cor-porate headquarters and S sells the office furniture toB. S and B have no other activities in the taxable year.If S and B were not members of a consolidated group,S’s gross receipts from the sale of the office furnitureto B would be DPGR (assuming all the other require-ments of §1.199–3 are met) and S’s CGS or other de-ductions, expenses, or losses from the sale to B wouldbe allocable to S’s DPGR. However, because S andB are members of a consolidated group, the separateentity attributes of S’s intercompany items or B’s cor-responding items, or both, may be redetermined un-der §1.1502–13(c)(1)(i) or (c)(4) in order to producethe same effect as if S and B were divisions of a sin-gle corporation. If S and B were divisions of a singlecorporation, there would be no DPGR with respect tothe office furniture because there would be no lease,rental, license, sale, exchange, or other disposition ofthe furniture by the single corporation (and no CGS orother deductions allocable to DPGR). Thus, in orderto produce the same effect as if S and B were divisionsof a single corporation, S’s gross receipts are redeter-mined as non-DPGR. Accordingly, the consolidatedgroup has no DPGR (and no CGS or other deductionsallocated or apportioned to DPGR) and receives nosection 199 deduction in 2007.

Example 8. (i) Facts. A and B are members of thesame consolidated group that files its Federal incometax returns on a calendar year basis. On January 1,2007, A MPGE QPP which is 10-year recovery prop-erty for $100 and depreciates it under the straight-linemethod. On January 1, 2009, A sells the property toB for $130. Under section 168(i)(7), B is treated asA for purposes of section 168 to the extent B’s $130basis does not exceed A’s adjusted basis at the time ofthe sale. B’s additional basis is treated as new 10-yearrecovery property for which B elects the straight-line

June 19, 2006 1116 2006–25 I.R.B.

method of recovery. (To simplify the example, thehalf-year convention is disregarded.)

(ii) Depreciation; intercompany gain. A claims$10 of depreciation for each taxable year 2007 and2008 and has an $80 basis at the time of the sale toB. Thus, A has a $50 intercompany gain from its saleto B. For each taxable year 2009 through 2016, B has$10 of depreciation with respect to $80 of its basis(the portion of its $130 basis not exceeding A’s ad-justed basis) and $5 of depreciation with respect tothe $50 of its additional basis that exceeds A’s ad-justed basis. For each taxable year 2017 and 2018, Bhas $5 of depreciation with respect to the $50 of itsadditional basis that exceeds A’s adjusted basis.

(iii) Timing. A’s $50 gain is taken into accountto reflect the difference for each consolidated returnyear between B’s depreciation taken into accountwith respect to the property and the depreciation thatwould have been taken into account if A and B weredivisions of a single corporation. For each taxableyear 2009 through 2016, B takes into account $15of depreciation rather than the $10 of depreciationthat would have been taken into account if A andB were divisions of a single corporation. For eachtaxable year 2017 and 2018, B takes into account$5 of depreciation rather than the $0 of depreciationthat would have been taken into account if A andB were divisions of a single corporation (the QPPwould have been fully depreciated after the 2016taxable year if A and B were divisions of a singlecorporation). Thus, A takes $5 of gain into accountin each of the 2009 through 2018 taxable years (10%of its $50 gain). Pursuant to §1.199–7(d)(1), A takesits sale to B into account in computing the section199 deduction at the same time and in the sameproportion as A takes into account the income, gain,deduction, or loss from the intercompany transactionunder §1.1502–13. Thus, in each taxable year 2009through 2018, A takes into account $13 of grossreceipts (10% of its $130 gross receipts) from thesale to B. The group’s income in each taxable year2009 through 2016 is a $10 loss ($5 gain - $15 de-preciation), the same net amount it would have beenif A and B were divisions of a single corporation.The group’s income in each taxable year 2017 and2018 is $0 ($5 gain - $5 depreciation), the same netamount it would have been if A and B were divisionsof a single corporation.

(iv) Attributes. If A and B were not membersof a consolidated group, A’s gross receipts on thesale of the QPP to B would be DPGR (assuming allthe other requirements of §1.199–3 are met). How-ever, because A and B are members of a consolidatedgroup, the separate entity attributes of A’s DPGR maybe redetermined under §1.1502–13(c)(1)(i) or (c)(4)in order to produce the same effect as if A and Bwere divisions of a single corporation. If A and Bwere divisions of a single corporation, there wouldbe no DPGR with respect to the QPP because therewould be no lease, rental, license, sale, exchange, orother disposition of the QPP by the single corporation(and no CGS or other deductions allocable to DPGR).Thus, in order to produce the same effect as if A andB were divisions of a single corporation, A’s $13 ofgross receipts taken into account in each year is re-determined as non-DPGR. Accordingly, the consoli-dated group has no DPGR (and no CGS or other de-ductions allocable or apportioned to DPGR) and re-ceives no section 199 deduction.

Example 9. Corporations X, Y, and Z are mem-bers of the same EAG but are not members of a con-solidated group. X, Y, and Z each files Federal in-come tax returns on a calendar year basis. Assumethat the EAG has W–2 wages in excess of the sec-tion 199(b) wage limitation. Prior to 2007, X hadno taxable income or loss. In 2007, X has $0 oftaxable income and $2,000 of QPAI, Y has $4,000of taxable income and $3,000 of QPAI, and Z has$4,000 of taxable income and $5,000 of QPAI. Ac-cordingly, the EAG has taxable income of $8,000,the sum of X’s taxable income of $0, Y’s taxable in-come of $4,000, and Z’s taxable income of $4,000.The EAG has QPAI of $10,000, the sum of X’s QPAIof $2,000, Y’s QPAI of $3,000, and Z’s QPAI of$5,000. Because X’s, Y’s, and Z’s taxable years allbegan in 2007, the transition percentage under sec-tion 199(a)(2) is 6%. Thus, the EAG’s section 199deduction for 2007 is $480 (6% of the lesser of theEAG’s taxable income of $8,000 or the EAG’s QPAIof $10,000). Pursuant to paragraph (c)(1) of this sec-tion, the $480 section 199 deduction is allocated to X,Y, and Z in proportion to their respective amounts ofQPAI, that is $96 to X ($480 x $2,000/$10,000), $144to Y ($480 x $3,000/$10,000), and $240 to Z ($480x $5,000/$10,000). Although X’s taxable income for2007 determined prior to allocation of a portion of theEAG’s section 199 deduction to it was $0, pursuant toparagraph (c)(2) of this section X will have an NOLfor 2007 equal to $96. Because X’s NOL for 2007cannot be carried back to a previous taxable year, X’sNOL carryover to 2008 will be $96.

Example 10. (i) Facts. Corporation P owns allof the stock of Corporations S and T, and P, S, andT file a consolidated Federal income tax return on acalendar year basis. In 2007, P MPGE QPP in theUnited States at a cost of $1,000. On November 30,2007, P sells the QPP to S for $2,500. On February28, 2008, P disposes of 60% of the stock of S. OnJune 30, 2008, S sells the QPP to an unrelated personfor $3,000.

(ii) Analysis. Because P and S are membersof a consolidated group in 2007, pursuant to§1.199–7(d)(1) and §1.1502–13, neither P’s $1,500of gain on the sale of QPP to S nor P’s $2,500 grossreceipts from the sale are taken into account in 2007.Under §1.1502–13(d), P takes the intercompanytransaction into account immediately before S be-comes a non-member of the consolidated group. Inorder to produce the same effect as if P and S weredivisions of a single corporation, P’s gross receiptsfrom the sale of the QPP to S are redetermined under§1.1502–13(c)(1)(i) as non-DPGR. Further, becauseP and S are not members of the same EAG when Ssells the QPP to the unrelated person, and becauseP’s transfer of the QPP to S did not take place in atransaction to which section 381(a) applies, S is nottreated as conducting the activities conducted by P indetermining if S’s receipts are DPGR, notwithstand-ing that P and S were members of the same EAGwhen P MPGE the QPP and when P sold the QPP toS. Accordingly, neither the P consolidated group norS will have DPGR with respect to the QPP.

Example 11. Corporation X is the common parentof a consolidated group, consisting of X and Y, whichhas filed a consolidated Federal income tax return formany years. Corporation P is the common parent ofa consolidated group, consisting of P and S, whichhas filed a consolidated Federal income tax return for

many years. The X and P consolidated groups eachfile their consolidated Federal income tax returns ona calendar year basis. X, Y, P and S are membersof the same EAG in 2008. In 2007, the X consoli-dated group incurred a consolidated net operating loss(CNOL) of $25,000, none of which was carried backand used to offset taxable income of prior taxableyears. Neither P nor S (nor the P consolidated group)has ever incurred an NOL. In 2008, the X consoli-dated group has (prior to the deduction under section172) taxable income of $8,000 and the P consolidatedgroup has taxable income of $20,000. The X consol-idated group uses $8,000 of its CNOL from 2007 tooffset the X consolidated group’s taxable income in2008. None of the X consolidated group’s remainingCNOL may be used to offset taxable income of theP consolidated group under paragraph (b)(3) of thissection. Accordingly, for purposes of determining theEAG’s section 199 deduction, the EAG has taxableincome of $20,000 (the X consolidated group’s tax-able income (after the deduction under section 172)of $0 plus the P consolidated group’s taxable incomeof $20,000).

(f) Allocation of income and loss by acorporation that is a member of the ex-panded affiliated group for only a portionof the year—(1) In general. A corporationthat becomes or ceases to be a member ofan EAG during its taxable year must allo-cate its taxable income or loss, QPAI, andW–2 wages between the portion of the tax-able year that it is a member of the EAGand the portion of the taxable year that it isnot a member of the EAG. In general, thisallocation of items is made by using the prorata allocation method described in para-graph (f)(1)(i) of this section. However,a corporation may elect to use the section199 closing of the books method describedin paragraph (f)(1)(ii) of this section. Nei-ther the pro rata allocation method nor thesection 199 closing of the books method isa method of accounting.

(i) Pro rata allocation method. Underthe pro rata allocation method, an equalportion of a corporation’s taxable incomeor loss, QPAI, and W–2 wages for the tax-able year is assigned to each day of the cor-poration’s taxable year. Those items as-signed to those days that the corporationwas a member of the EAG are then aggre-gated.

(ii) Section 199 closing of the booksmethod. Under the section 199 closingof the books method, a corporation’s tax-able income or loss, QPAI, and W–2 wagesfor the period during which the corpora-tion was a member of an EAG are com-puted by treating the corporation’s taxableyear as two separate taxable years, the firstof which ends at the close of the day on

2006–25 I.R.B. 1117 June 19, 2006

which the corporation’s status as a mem-ber of the EAG changes and the second ofwhich begins at the beginning of the dayafter the corporation’s status as a memberof the EAG changes.

(iii) Making the section 199 closing ofthe books election. A corporation makesthe section 199 closing of the books elec-tion by making the following statement:“The section 199 closing of the bookselection is hereby made with respect to[insert name of corporation and its em-ployer identification number] with respectto the following periods [insert dates ofthe two periods between which items areallocated pursuant to the closing of thebooks method].” The statement must befiled with the corporation’s timely filed(including extensions) Federal income taxreturn for the taxable year that includesthe periods that are subject to the election.Once made, a section 199 closing of thebooks election is irrevocable.

(2) Coordination with rules relat-ing to the allocation of income under§1.1502–76(b). If §1.1502–76(b) (relatingto items included in a consolidated return)applies to a corporation that is a memberof an EAG, then any allocation of itemsrequired under this paragraph (f) is madeonly after the allocation of the corpora-tion’s items pursuant to §1.1502–76(b).

(g) Total section 199 deduction for acorporation that is a member of an ex-panded affiliated group for some or all ofits taxable year—(1) Member of the sameexpanded affiliated group for the entiretaxable year. If a corporation is a mem-ber of the same EAG for its entire taxableyear, the corporation’s section 199 deduc-tion for the taxable year is the amount ofthe section 199 deduction allocated to thecorporation by the EAG under paragraph(c)(1) of this section.

(2) Member of the expanded affiliatedgroup for a portion of the taxable year. Ifa corporation is a member of an EAG onlyfor a portion of its taxable year and is eithernot a member of any EAG or is a memberof another EAG, or both, for another por-tion of the taxable year, the corporation’ssection 199 deduction for the taxable yearis the sum of its section 199 deductions foreach portion of the taxable year.

(3) Example. The following exampleillustrates the application of paragraphs (f)and (g) of this section:

Example. Corporations X and Y, calendar yearcorporations, are members of the same EAG for theentire 2007 taxable year. Corporation Z, also a cal-endar year corporation, is a member of the EAG ofwhich X and Y are members for the first half of 2007and not a member of any EAG for the second half of2007. During the 2007 taxable year, Z does not joinin the filing of a consolidated return. Z makes a sec-tion 199 closing of the books election. As a result,Z has $80 of taxable income and $100 of QPAI thatis allocated to the first half of 2007 and a $150 tax-able loss and ($200) of QPAI that is allocated to thesecond half of 2007. Taking into account Z’s taxableincome, QPAI, and W–2 wages allocated to the firsthalf of 2007 pursuant to the section 199 closing ofthe books election, the EAG has positive taxable in-come and QPAI for 2007 and W–2 wages in excess ofthe section 199(b) wage limitation. Because the EAGhas both positive taxable income and QPAI and suf-ficient W–2 wages, and because Z has positive QPAIfor the first half of 2007, a portion of the EAG’s sec-tion 199 deduction is allocated to Z. Because Z hasnegative QPAI for the second half of 2007, Z is al-lowed no section 199 deduction for the second half of2007. Thus, despite the fact that Z has a $70 taxableloss and ($100) of QPAI for the entire 2007 taxableyear, Z is entitled to a section 199 deduction for 2007equal to the section 199 deduction allocated to Z as amember of the EAG.

(h) Computation of section 199 deduc-tion for members of an expanded affiliatedgroup with different taxable years—(1) Ingeneral. If members of an EAG have dif-ferent taxable years, in determining thesection 199 deduction of a member (thecomputing member), the computing mem-ber is required to take into account the tax-able income or loss, determined withoutregard to the section 199 deduction, QPAI,and W–2 wages of each other group mem-ber that are both—

(i) Attributable to the period that eachother member of the EAG and the comput-ing member are members of the EAG; and

(ii) Taken into account in a taxable yearthat begins after the effective date of sec-tion 199 and such taxable year ends withor within the taxable year of the computingmember with respect to which the section199 deduction is computed.

(2) Example. The following exampleillustrates the application of this paragraph(h):

Example. (i) Corporations X, Y, and Z are mem-bers of the same EAG. Neither X, Y, nor Z is a mem-ber of a consolidated group. X and Y are calendaryear taxpayers and Z is a June 30 fiscal year taxpayer.Z came into existence on July 1, 2007. Each corpo-ration has taxable income that exceeds its QPAI andhas sufficient W–2 wages to avoid the limitation un-der section 199(b). For the taxable year ending De-cember 31, 2007, X’s QPAI is $8,000 and Y’s QPAIis ($6,000). For its taxable year ending June 30, 2008,Z’s QPAI is $2,000.

(ii) In computing X’s and Y’s respective sec-tion 199 deductions for their taxable years endingDecember 31, 2007, X’s and Y’s taxable income,QPAI, and W–2 wages from their respective taxableyears ending December 31, 2007, are aggregated.The EAG’s QPAI for this purpose is $2,000 (X’sQPAI of $8,000 + Y’s QPAI of ($6,000)). Becausethe taxable years of the computing members, X andY, began in 2007, the transition percentage undersection 199(a)(2) is 6%. Accordingly, the EAG’ssection 199 deduction is $120 ($2,000 x .06). The$120 deduction is allocated to each of X and Y inproportion to their respective QPAI as a percentageof the QPAI of each member of the EAG that wastaken into account in computing the EAG’s section199 deduction. Pursuant to paragraph (c)(1) ofthis section, in allocating the section 199 deductionbetween X and Y, because Y’s QPAI is negative, Y’sQPAI is treated as being $0. Accordingly, X’s section199 deduction for its taxable year ending December31, 2007, is $120 ($120 x $8,000/($8,000 + $0)).Y’s section 199 deduction for its taxable year endingDecember 31, 2007, is $0 ($120 x $0/($8,000 + $0)).

(iii) In computing Z’s section 199 deduction forits taxable year ending June 30, 2008, X’s and Y’sitems from their respective taxable years ending De-cember 31, 2007, are taken into account. Therefore,X’s and Y’s taxable income or loss, determined with-out regard to the section 199 deduction, QPAI, andW–2 wages from their taxable years ending Decem-ber 31, 2007, are aggregated with Z’s taxable in-come or loss, QPAI, and W–2 wages from its tax-able year ending June 30, 2008. The EAG’s QPAI is$4,000 (X’s QPAI of $8,000 + Y’s QPAI of ($6,000)+ Z’s QPAI of $2,000). Because the taxable year ofthe computing member, Z, began in 2007, the transi-tion percentage under section 199(a)(2) is 6%. Ac-cordingly, the EAG’s section 199 deduction is $240($4,000 x .06). A portion of the $240 deduction isallocated to Z in proportion to its QPAI as a percent-age of the QPAI of each member of the EAG that wastaken into account in computing the EAG’s section199 deduction. Pursuant to paragraph (c)(1) of thissection, in allocating a portion of the $240 deduc-tion to Z, because Y’s QPAI is negative, Y’s QPAIis treated as being $0. Z’s section 199 deduction forits taxable year ending June 30, 2008, is $48 ($240 x$2,000/($8,000 + $0 + $2,000)).

§1.199–8 Other rules.

(a) In general. The provisions of thissection apply solely for purposes of sec-tion 199 of the Internal Revenue Code(Code). When calculating the deductionunder §1.199–1(a) (section 199 deduc-tion), taxpayers are required to makenumerous allocations under §§1.199–1through 1.199–9. In making these alloca-tions, taxpayers may use any reasonablemethod that is satisfactory to the Secretarybased on all of the facts and circumstances,unless the regulations under §§1.199–1through 1.199–9 specify a method. Achange in a taxpayer’s method of allocat-ing or apportioning gross receipts, cost of

June 19, 2006 1118 2006–25 I.R.B.

goods sold (CGS), expenses, losses, or de-ductions (deductions) does not constitute achange in method of accounting to whichthe provisions of sections 446 and 481 andthe regulations thereunder apply.

(b) Individuals. In the case of an in-dividual, the section 199 deduction isequal to the applicable percentage of thelesser of the taxpayer’s qualified produc-tion activities income (QPAI) (as definedin §1.199–1(c)) for the taxable year, oradjusted gross income (AGI) for the tax-able year determined after applying sec-tions 86, 135, 137, 219, 221, 222, and 469,and without regard to section 199.

(c) Trade or business requirement—(1)In general. Sections 1.199–1 through1.199–9 are applied by taking into accountonly items that are attributable to the ac-tual conduct of a trade or business.

(2) Individuals. An individual engagedin the actual conduct of a trade or businessmust apply §§1.199–1 through 1.199–9by taking into account in computing QPAIonly items that are attributable to thattrade or business (or trades or businesses)and any items allocated from a pass-thruentity engaged in a trade or business.Compensation received by an individualemployee for services performed as anemployee is not considered gross receiptsfor purposes of computing QPAI under§§1.199–1 through 1.199–9. Similarly,any costs or expenses paid or incurred byan individual employee with respect tothose services performed as an employeeare not considered CGS or deductions ofthat employee for purposes of computingQPAI under §§1.199–1 through 1.199–9.

(3) Trusts and estates. For purposes ofthis paragraph (c), a trust or estate is treatedas an individual.

(d) Coordination with alternative min-imum tax. For purposes of determin-ing alternative minimum taxable income(AMTI) under section 55, a taxpayer thatis not a corporation must deduct an amountequal to 9 percent (3 percent in the case oftaxable years beginning in 2005 or 2006,and 6 percent in the case of taxable yearsbeginning in 2007, 2008, or 2009) of thelesser of the taxpayer’s QPAI for the tax-able year, or the taxpayer’s taxable incomefor the taxable year, determined withoutregard to the section 199 deduction (or inthe case of an individual, AGI). For pur-poses of determining AMTI in the case ofa corporation (including a corporation sub-

ject to tax under section 511(a)), a taxpayermust deduct an amount equal to 9 percent(3 percent in the case of taxable yearsbeginning in 2005 or 2006, and 6 percentin the case of taxable years beginning in2007, 2008, or 2009) of the lesser of thetaxpayer’s QPAI for the taxable year, orthe taxpayer’s AMTI for the taxable year,determined without regard to the section199 deduction. For purposes of comput-ing AMTI, QPAI is determined withoutregard to any adjustments under sections56 through 59. In the case of an individ-ual or a non-grantor trust or estate, AGIand taxable income are also determinedwithout regard to any adjustments undersections 56 through 59. The amount of thededuction allowable under this paragraph(d) for any taxable year cannot exceed 50percent of the W–2 wages of the employerfor the taxable year (as determined under§1.199–2). The section 199 deduction isnot taken into account in determining theamount of the alternative tax net operatingloss deduction (ATNOL) allowed undersection 56(a)(4). For example, assume thatfor the calendar year 2007, a corporationhas both AMTI (before the NOL deductionand before the section 199 deduction) andQPAI of $1,000,000, and has an ATNOLcarryover to 2007 of $5,000,000. Assumethat the taxpayer has W–2 wages in ex-cess of the section 199(b) wage limitation.Under section 56(d), the ATNOL deduc-tion for 2007 is $900,000 (90 percent of$1,000,000), reducing AMTI to $100,000.The taxpayer must then further reducethe AMTI by the section 199 deductionof $6,000 (six percent of the lesser of$1,000,000 or $100,000) to $94,000. TheATNOL carryover to 2008 is $4,100,000.

(e) Nonrecognition transactions—(1)In general—(i) Sections 351, 721, and731. Except as provided for an EAGpartnership (as defined in §1.199–9(j))and an expanded affiliated group (EAG)(as defined in §1.199–7), if property istransferred by the taxpayer to an entityin a transaction to which section 351 or721 applies, then whether the gross re-ceipts derived by the entity are domesticproduction gross receipts (DPGR) (as de-fined in §1.199–3) shall be determinedbased solely on the activities performedby the entity without regard to the ac-tivities performed by the taxpayer priorto the contribution of the property to theentity. Except as provided for a quali-

fying in-kind partnership (as defined in§1.199–9(i)) and an EAG partnership, ifproperty is transferred by a partnership toa partner in a transaction to which section731 applies, then whether gross receiptsderived by the partner are DPGR shall bedetermined based on the activities per-formed by the partner without regard tothe activities performed by the partnershipbefore the distribution of the property tothe partner.

(ii) Exceptions—(A) Section 708(b)(1)(B). If property is deemed to be con-tributed by a partnership (transferor part-nership) to another partnership (transfereepartnership) as a result of a termina-tion under section 708(b)(1)(B), then thetransferee partnership shall be treated asperforming those activities performed bythe transferor partnership with respect tothe transferred property of the transferorpartnership.

(B) Transfers by reason of death. Ifproperty is transferred upon or by reasonof the death of an individual (decedent),then the decedent’s successor(s) in interestshall be treated as having performed thoseactivities performed by or deemed to havebeen performed (pursuant to §1.199–9(i))by the decedent with respect to the trans-ferred property. For this purpose, a transfershall include without limitation the passingof the property by bequest, contractual pro-vision, beneficiary designation, or opera-tion of law, and successor in interest shallinclude without limitation the decedent’sheirs or legatees, the decedent’s estate ortrust, or the beneficiary or beneficiaries ofthe decedent’s estate or trust.

(2) Section 1031 exchanges. If a tax-payer exchanges property for replacementproperty in a transaction to which section1031 applies, then whether the gross re-ceipts derived from the lease, rental, li-cense, sale, exchange, or other disposi-tion of the replacement property are DPGRshall be determined based solely on the ac-tivities performed by the taxpayer with re-spect to the replacement property.

(3) Section 381 transactions. If acorporation (the acquiring corporation)acquires the assets of another corporation(the target corporation) in a transactionto which section 381(a) applies, then theacquiring corporation shall be treated asperforming those activities of the targetcorporation with respect to the acquiredassets of the target corporation. Therefore,

2006–25 I.R.B. 1119 June 19, 2006

to the extent that the acquired assets ofthe target corporation would have givenrise to DPGR if leased, rented, licensed,sold, exchanged, or otherwise disposedof by the target corporation, such assetswill give rise to DPGR if leased, rented,licensed, sold, exchanged, or otherwisedisposed of by the acquiring corporation(assuming all the other requirements of§1.199–3 are met).

(f) Taxpayers with a 52–53 week tax-able year. For purposes of applying§1.441–2(c)(1) in the case of a taxpayerusing a 52–53 week taxable year, any ref-erence in section 199(a)(2) (the phase-inrule), §§1.199–1 through 1.199–9 to ataxable year beginning after a particularcalendar year means a taxable year be-ginning after December 31st of that year.Similarly, any reference to a taxable yearbeginning in a particular calendar yearmeans a taxable year beginning after De-cember 31st of the preceding calendaryear. For example, a 52–53 week taxableyear that begins on December 26, 2006, isdeemed to begin on January 1, 2007, andthe transition percentage for that taxableyear is 6 percent.

(g) Section 481(a) adjustments. Forpurposes of determining QPAI, a section481(a) adjustment, whether positive ornegative, taken into account by a taxpayerduring the taxable year that is solely at-tributable to either the taxpayer’s grossreceipts, CGS, or deductions must be al-located or apportioned between DPGRand non-DPGR using the methods used bya taxpayer to allocate or apportion grossreceipts, CGS, and deductions betweenDPGR and non-DPGR for the current tax-able year. See §§1.199–1 and 1.199–4for rules related to the allocation and ap-portionment of gross receipts, CGS, anddeductions, respectively. For example,if a taxpayer changes its method of ac-counting for inventories from the last-in,first-out (LIFO) method to the first-in,first-out (FIFO) method and the taxpayeruses the small business simplified over-all method to apportion CGS betweenDPGR and non-DPGR, the taxpayer isrequired to apportion the resulting section481(a) adjustment, whether positive ornegative, between DPGR and non-DPGRusing the small business simplified overallmethod. If a section 481(a) adjustment isnot solely attributable to either gross re-ceipts, CGS, or deductions (for example,

the taxpayer changes its overall methodof accounting from an accrual method tothe cash method) and the section 481(a)adjustment cannot be specifically identi-fied with either gross receipts, CGS, ordeductions, then the section 481(a) ad-justment, whether positive or negative,must be attributed to, or among, grossreceipts, CGS, or deductions using anyreasonable method that is satisfactory tothe Secretary based on all of the facts andcircumstances, and then allocated or ap-portioned between DPGR and non-DPGRusing the same methods the taxpayer usesto allocate or apportion gross receipts,CGS, or deductions between DPGR andnon-DPGR for the taxable year or taxableyears that the section 481(a) adjustmentis taken into account. Factors taken intoconsideration in determining whether themethod is reasonable include whether thetaxpayer uses the most accurate informa-tion available; the relationship betweenthe section 481(a) adjustment and the ap-portionment base chosen; the accuracy ofthe method chosen as compared with otherpossible methods; and the time, burden,and cost of using alternative methods.If a section 481(a) adjustment is spreadover more than one taxable year, then ataxpayer must attribute the section 481(a)adjustment among gross receipts, CGS,or deductions, as applicable, in the sameamount for each taxable year within thespread period. For example, if a taxpayer,using a reasonable method that is satisfac-tory to the Secretary based on all of thefacts and circumstances, determines that asection 481(a) adjustment that is requiredto be spread over four taxable years shouldbe attributed half to gross receipts and halfto deductions, then the taxpayer must at-tribute the section 481(a) adjustment halfto gross receipts and half to deductionsin each of the four taxable years of thespread period. Further, if such taxpayeruses the simplified deduction method toapportion deductions between DPGR andnon-DPGR in the first taxable year of thespread period, then the taxpayer must usethe simplified deduction method to ap-portion half the section 481(a) adjustmentfor that taxable year between DPGR andnon-DPGR for that taxable year. Simi-larly, if in the second taxable year of thespread period the taxpayer uses the section861 method to apportion and allocate costsbetween DPGR and non-DPGR, then the

taxpayer must use the section 861 methodto allocate and apportion half the section481(a) adjustment for that taxable yearbetween DPGR and non-DPGR for thattaxable year.

(h) Disallowed losses or deduc-tions. Except as provided by publica-tion in the Internal Revenue Bulletin (see§601.601(d)(2)(ii)(b) of this chapter),losses or deductions of a taxpayer thatotherwise would be taken into accountin computing the taxpayer’s section 199deduction are taken into account only ifand to the extent the deductions are notdisallowed by section 465 or 469, or anyother provision of the Code. If only a por-tion of the taxpayer’s share of the losses ordeductions is allowed for a taxable year,the proportionate share of those allowablelosses or deductions that are allocated tothe taxpayer’s qualified production activ-ities, determined in a manner consistentwith sections 465 and 469, and any otherapplicable provision of the Code, is takeninto account in computing QPAI for pur-poses of the section 199 deduction for thattaxable year. To the extent that any ofthe disallowed losses or deductions are al-lowed in a later taxable year, the taxpayertakes into account a proportionate shareof those losses or deductions in comput-ing its QPAI for that later taxable year.Losses or deductions of the taxpayer thatare disallowed for taxable years beginningon or before December 31, 2004, are nottaken into account in a later taxable yearfor purposes of computing the taxpayer’sQPAI and the wage limitation of sec-tion 199(d)(1)(A)(iii) under §1.199–9 forthat taxable year, regardless of whether thelosses or deductions are allowed for otherpurposes. For taxpayers that are partnersin partnerships, see §1.199–9(b)(2). Fortaxpayers that are shareholders in S corpo-rations, see §1.199–9(c)(2).

(i) Effective dates—(1) In general. Sec-tion 199 applies to taxable years begin-ning after December 31, 2004. Sections1.199–1 through 1.199–8 are applicablefor taxable years beginning on or afterJune 1, 2006. For a taxable year be-ginning on or before May 17, 2006, theenactment date of the Tax Increase Pre-vention and Reconciliation Act of 2005(Public Law 109–222, 120 Stat. 345), ataxpayer may apply §§1.199–1 through1.199–9 provided that the taxpayer ap-plies all provisions in §§1.199–1 through

June 19, 2006 1120 2006–25 I.R.B.

1.199–9 to the taxable year. For a taxableyear beginning after May 17, 2006, andbefore June 1, 2006, a taxpayer may ap-ply §§1.199–1 through 1.199–8 providedthat the taxpayer applies all provisionsin §§1.199–1 through 1.199–8 to the tax-able year. For a taxpayer who choosesnot to rely on these final regulations fora taxable year beginning before June 1,2006, the guidance under section 199 thatapplies to such taxable year is containedin Notice 2005–14, 2005–1 C.B. 498 (see§601.601(d)(2) of this chapter). In ad-dition, a taxpayer also may rely on theprovisions of REG–105847–05, 2005–47I.R.B. 987 (see §601.601(d)(2) of thischapter), for a taxable year beginningbefore June 1, 2006. If Notice 2005–14and REG–105847–05 include differentrules for the same particular issue, then ataxpayer may rely on either the rule setforth in Notice 2005–14 or the rule setforth in REG–105847–05. However, ifREG–105847–05 includes a rule that wasnot included in Notice 2005–14, then ataxpayer is not permitted to rely on theabsence of a rule in Notice 2005–14 toapply a rule contrary to REG–105847–05.For taxable years beginning after May17, 2006, and before June 1, 2006, a tax-payer may not apply Notice 2005–14,REG–105847–05, or any other guidanceunder section 199 in a manner inconsistentwith amendments made to section 199 bysection 514 of the Tax Increase Preventionand Reconciliation Act of 2005.

(2) Pass-thru entities. In determiningthe deduction under section 199, itemsarising from a taxable year of a part-nership, S corporation, estate, or trustbeginning before January 1, 2005, shallnot be taken into account for purposes ofsection 199(d)(1).

(3) Non-consolidated EAG members. Amember of an EAG that is not a memberof a consolidated group may apply para-graph (i)(1) of this section without regardto how other members of the EAG applyparagraph (i)(1) of this section.

(4) Computer software provided to cus-tomers over the Internet. [Reserved]. Forfurther guidance, see §1.199–8T(i)(4).

§1.199–9 Application of section 199to pass-thru entities for taxable yearsbeginning on or before May 17, 2006,the enactment date of the Tax Increase

Prevention and Reconciliation Act of2005.

(a) In general. The provisions of thissection apply solely for purposes of section199 of the Internal Revenue Code (Code).

(b) Partnerships—(1) In general—(i)Determination at partner level. The de-duction with respect to the qualified pro-duction activities of the partnership allow-able under §1.199–1(a) (section 199 de-duction) is determined at the partner level.As a result, each partner must compute itsdeduction separately. The section 199 de-duction has no effect on the adjusted ba-sis of the partner’s interest in the part-nership. Except as provided by publi-cation pursuant to paragraph (b)(1)(ii) ofthis section, for purposes of this section,each partner is allocated, in accordancewith sections 702 and 704, its share ofpartnership items (including items of in-come, gain, loss, and deduction), cost ofgoods sold (CGS) allocated to such itemsof income, and gross receipts that are in-cluded in such items of income, even if thepartner’s share of CGS and other deduc-tions and losses exceeds domestic produc-tion gross receipts (DPGR) (as defined in§1.199–3(a)) and regardless of the amountof the partner’s share of W–2 wages (asdefined in §1.199–2(e)) of the partnershipfor the taxable year. A partnership mayspecially allocate items of income, gain,loss, or deduction to its partners, subjectto the rules of section 704(b) and the sup-porting regulations. Guaranteed paymentsunder section 707(c) are not considered al-locations of partnership income for pur-poses of this section. Guaranteed pay-ments under section 707(c) are deductionsby the partnership that must be taken intoaccount under the rules of §1.199–4. See§1.199–3(p) and paragraph (b)(6) Example5 of this section. Except as provided inparagraph (b)(1)(ii) of this section, to de-termine its section 199 deduction for thetaxable year, a partner aggregates its dis-tributive share of such items, to the extentthey are not otherwise disallowed by theCode, with those items it incurs outside thepartnership (whether directly or indirectly)for purposes of allocating and apportion-ing deductions to DPGR and computingits qualified production activities income(QPAI) (as defined in §1.199–1(c)).

(ii) Determination at entity level.The Secretary may, by publication

in the Internal Revenue Bulletin (see§601.601(d)(2)(ii)(b) of this chapter), per-mit a partnership to calculate a partner’sshare of QPAI at the entity level, insteadof allocating, in accordance with sections702 and 704, the partner’s share of part-nership items (including items of income,gain, loss, and deduction). If a partnershipdoes calculate QPAI at the entity level—

(A) The partner is allocated its shareof QPAI and W–2 wages (as defined in§1.199–2(e)), which (subject to the lim-itations of paragraph (b)(2) of this sec-tion and section 199(d)(1)(A)(iii), respec-tively) are combined with the partner’sQPAI and W–2 wages from other sources;

(B) For purposes of computing QPAIunder §§1.199–1 through 1.199–9, a part-ner does not take into account the itemsfrom such a partnership (for example, apartner does not take into account itemsfrom such a partnership in determiningwhether a threshold or de minimis rule ap-plies or when the partner allocates and ap-portions deductions in calculating its QPAIfrom other sources);

(C) A partner generally does not recom-pute its share of QPAI from the partnershipusing another method; however, the part-ner might have to adjust its share of QPAIfrom the partnership to take into accountcertain disallowed losses or deductions, orthe allowance of suspended losses or de-ductions; and

(D) A partner’s distributive share ofQPAI from a partnership may be less thanzero.

(2) Disallowed losses or deduc-tions. Except as provided by publica-tion in the Internal Revenue Bulletin (see§601.601(d)(2)(ii)(b) of this chapter),losses or deductions of a partnership thatotherwise would be taken into account incomputing the partner’s section 199 de-duction for a taxable year are taken intoaccount in that year only if and to theextent the partner’s distributive share ofthose losses or deductions from all of thepartnership’s activities is not disallowedby section 465, 469, or 704(d), or anyother provision of the Code. If only aportion of the partner’s distributive shareof the losses or deductions is allowed fora taxable year, a proportionate share ofthose allowable losses or deductions thatare allocated to the partnership’s quali-fied production activities, determined ina manner consistent with sections 465,

2006–25 I.R.B. 1121 June 19, 2006

469, and 704(d), and any other applicableprovision of the Code, is taken into ac-count in computing QPAI and the wagelimitation of section 199(d)(1)(A)(iii) forthat taxable year. To the extent that anyof the disallowed losses or deductions areallowed in a later taxable year, the partnertakes into account a proportionate shareof those losses or deductions in comput-ing its QPAI for that later taxable year.Losses or deductions of the partnershipthat are disallowed for taxable years be-ginning on or before December 31, 2004,are not taken into account in a later tax-able year for purposes of computing thepartner’s QPAI or the wage limitation ofsection 199(d)(1)(A)(iii) for that taxableyear, regardless of whether the losses ordeductions are allowed for other purposes.

(3) Partner’s share of W–2 wages.Under section 199(d)(1)(A)(iii), a part-ner’s share of W–2 wages of a partnershipfor purposes of determining the part-ner’s section 199(b) wage limitation isthe lesser of the partner’s allocable shareof those wages (without regard to sec-tion 199(d)(1)(A)(iii)), or 2 times 3 per-cent of the QPAI computed by taking intoaccount only the items of the partnershipallocated to the partner for the taxable yearof the partnership. Except as provided bypublication in the Internal Revenue Bul-letin (see §601.601(d)(2)(ii)(b) of thischapter), this QPAI calculation is per-formed by the partner using the same costallocation method that the partner usesin calculating the partner’s section 199deduction. The partnership must allocateW–2 wages (prior to the application ofthe wage limitation) among the partners

in the same manner as wage expense. Thepartner must add the partner’s share ofthe W–2 wages from the partnership, aslimited by section 199(d)(1)(A)(iii), to thepartner’s W–2 wages from other sources,if any. If QPAI, computed by taking intoaccount only the items of the partnershipallocated to the partner for the taxableyear (as required by the wage limitationof section 199(d)(1)(A)(iii)) is not greaterthan zero, then the partner may not takeinto account any W–2 wages of the part-nership in applying the wage limitationof §1.199–2 (but the partner will, never-theless, aggregate its distributive share ofpartnership items including wage expensewith those items not from the partnershipin computing its QPAI when determiningits section 199 deduction). See §1.199–2for the computation of W–2 wages, andparagraph (g) of this section for rulesregarding pass-thru entities in a tieredstructure.

(4) Transition percentage rule for W–2wages. With regard to partnerships, forpurposes of section 199(d)(1)(A)(iii)(II)the transition percentages determined un-der section 199(a)(2) shall be determinedby reference to the partnership’s taxableyear. Thus, if a partner uses a calendaryear taxable year, and owns an interestin a partnership that has a taxable yearending on April 30, the partner’s section199(d)(1)(A)(iii) wage limitation for thepartnership’s taxable year beginning onMay 1, 2006, would be calculated using 3percent, even though the partner includesthe partner’s distributive share of partner-ship items from that taxable year on thepartner’s 2007 Federal income tax return.

(5) Partnerships electing out of sub-chapter K. For purposes of §§1.199–1through 1.199–9, the rules of paragraph(b) of this section shall apply to all partner-ships, including those partnerships elect-ing under section 761(a) to be excluded,in whole or in part, from the application ofsubchapter K of chapter 1 of the Code.

(6) Examples. The following examplesillustrate the application of this paragraph(b). Assume that each partner has suf-ficient adjusted gross income or taxableincome so that the section 199 deductionis not limited under section 199(a)(1)(B);that the partnership and each of its partners(whether individual or corporate) are cal-endar year taxpayers; and that the amountof the partnership’s W–2 wages equalswage expense for each taxable year. Theexamples are as follows:

Example 1. Section 861 method with interest ex-pense. (i) Partnership Federal income tax items. Xand Y, unrelated United States corporations, are each50% partners in PRS, a partnership that engages inproduction activities that generate both DPGR andnon-DPGR. X and Y share all items of income, gain,loss, deduction, and credit 50% each. Both X and Yare engaged in a trade or business. PRS is not ableto specifically identify CGS allocable to DPGR andnon-DPGR. In this case, because CGS is definitely re-lated under the facts and circumstances to all of PRS’sgross income, apportionment of CGS between DPGRand non-DPGR based on gross receipts is appropriate.For 2006, the adjusted basis of PRS’s business as-sets is $5,000, $4,000 of which generate gross incomeattributable to DPGR and $1,000 of which generategross income attributable to non-DPGR. For 2006,PRS has the following Federal income tax items:

DPGR. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3,000Non-DPGR. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3,000CGS (includes $200 of W–2 wages) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3,240Section 162 selling expenses (includes $300 of W–2 wages) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,200Interest expense (not included in CGS) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $300

(ii) Allocation of PRS’s items of income, gain,loss, deduction, or credit. X and Y each receive

the following distributive share of PRS’s items of in- come, gain, loss, deduction or credit, as determinedunder the principles of §1.704–1(b)(1)(vii):

Gross income attributable to DPGR

($1,500 (DPGR) - $810 (allocable CGS,includes $50 of W–2 wages)) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $690

Gross income attributable to non-DPGR

($1,500 (non-DPGR) - $810 (allocable CGS,includes $50 of W–2 wages)) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $690

Section 162 selling expenses (includes $150 of W–2 wages) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $600Interest expense (not included in CGS) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $150

June 19, 2006 1122 2006–25 I.R.B.

(iii) Determination of QPAI. (A) X’s QPAI. Be-cause the section 199 deduction is determined at thepartner level, X determines its QPAI by aggregating,to the extent necessary, its distributive share of PRS’sFederal income tax items with all other such itemsfrom all other, non-PRS-related activities. For 2006,X does not have any other such items. For 2006, theadjusted basis of X’s non-PRS assets, all of which

are investment assets, is $10,000. X’s only gross re-ceipts for 2006 are those attributable to the allocationof gross income from PRS. X allocates and apportionsits deductible items to gross income attributable toDPGR under the section 861 method of §1.199–4(d).In this case, the section 162 selling expenses (includ-ing W–2 wages) are definitely related to all of PRS’sgross receipts. Based on the facts and circumstances

of this specific case, apportionment of those expensesbetween DPGR and non-DPGR on the basis of PRS’sgross receipts is appropriate. X elects to apportionits distributive share of interest expense under the taxbook value method of §1.861–9T(g). X’s QPAI for2006 is $366, as shown below:

DPGR. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,500CGS allocable to DPGR (includes $50 of W–2 wages) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($810)Section 162 selling expenses (includes $75 of W–2 wages)

($600 x $1,500/$3,000) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($300)Interest expense (not included in CGS)

($150 x $2,000 (X’s share of PRS’s DPGR assets)/$12,500 (X’s non-PRS assets ($10,000) and X’s shareof PRS assets ($2,500))) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($24)

X’s QPAI . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $366

(B) Y’s QPAI. (1) For 2006, in addition to the ac-tivities of PRS, Y engages in production activitiesthat generate both DPGR and non-DPGR. Y is ableto specifically identify CGS allocable to DPGR and

to non-DPGR. For 2006, the adjusted basis of Y’snon-PRS assets attributable to its production activi-ties that generate DPGR is $8,000 and to other pro-duction activities that generate non-DPGR is $2,000.

Y has no other assets. Y has the following Federalincome tax items relating to its non-PRS activities:

Gross income attributable to DPGR

($1,500 (DPGR) - $900 (allocable CGS,includes $70 of W–2 wages)) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $600

Gross income attributable to non-DPGR

($3,000 (other gross receipts) - $1,620(allocable CGS, includes $150 of W–2 wages)) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,380

Section 162 selling expenses (includes $30 of W–2 wages) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $540Interest expense (not included in CGS) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $90

(2) Y determines its QPAI in the same generalmanner as X. However, because Y has other tradeor business activities outside of PRS, Y must aggre-gate its distributive share of PRS’s Federal incometax items with its own such items. Y allocates andapportions its deductible items to gross income at-tributable to DPGR under the section 861 method of§1.199–4(d). In this case, Y’s distributive share of

PRS’s section 162 selling expenses (including W–2wages), as well as those selling expenses from Y’snon-PRS activities, are definitely related to all of itsgross income. Based on the facts and circumstancesof this specific case, apportionment of those expensesbetween DPGR and non-DPGR on the basis of Y’sgross receipts is appropriate. Y elects to apportionits distributive share of interest expense under the tax

book value method of §1.861–9T(g). Y has $1,290of gross income attributable to DPGR ($3,000 DPGR($1,500 from PRS and $1,500 from non-PRS activi-ties) - $1,710 CGS ($810 from PRS and $900 fromnon-PRS activities)). Y’s QPAI for 2006 is $642, asshown below:

DPGR ($1,500 from PRS and $1,500 fromnon-PRS activities) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3,000

CGS allocable to DPGR ($810 from PRS and $900 fromnon-PRS activities) (includes $120 of W–2 wages) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($1,710)

Section 162 selling expenses (includes $180 of W–2 wages)($1,140 ($600 from PRS and $540 from non-PRSactivities) x ($1,500 PRS DPGR + $1,500 non-PRSDPGR)/($3,000 PRS total gross receipts + $4,500non-PRS total gross receipts)) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($456)

Interest expense (not included in CGS)

($240 ($150 from PRS and $90 from non-PRSactivities) x $10,000 (Y’s non-PRS DPGR assets($8,000) and Y’s share of PRS DPGR assets($2,000))/$12,500 (Y’s non-PRS assets ($10,000) andY’s share of PRS assets ($2,500))) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($192)

Y’s QPAI . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $642

(iv) PRS W–2 wages allocated to X and Y un-der section 199(d)(1)(A)(iii). Solely for purposes ofcalculating the PRS W–2 wages that are allocated to

them under section 199(d)(1)(A)(iii) for purposes ofthe wage limitation of section 199(b), X and Y mustseparately determine QPAI taking into account only

the items of PRS allocated to them. X and Y must usethe same methods of allocation and apportionmentthat they use to determine their QPAI in paragraphs

2006–25 I.R.B. 1123 June 19, 2006

(iii)(A) and (B) of this Example 1, respectively. Ac-cordingly, X and Y must apportion deductible section162 selling expenses that include W–2 wage expenseon the basis of gross receipts, and must apportion in-

terest expense according to the tax book value methodof §1.861–9T(g).

(A) QPAI of X and Y, solely for this purpose, isdetermined by allocating and apportioning each part-ner’s share of PRS expenses to each partner’s share

of PRS gross income of $690 attributable to DPGR($1,500 DPGR - $810 CGS, apportioned based ongross receipts). Thus, QPAI of X and Y solely forthis purpose is $270, as shown below:

DPGR. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,500CGS allocable to DPGR . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($810)Section 162 selling expenses (including W–2 wages)

($600 x ($1,500/$3,000)) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($300)Interest expense (not included in CGS)

($150 x $2,000 (partner’s share of adjusted basis ofPRS’s DPGR assets)/$2,500 (partner’s share ofadjusted basis of total PRS assets)) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($120)

QPAI. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $270

(B) X’s and Y’s shares of PRS’s W–2 wages de-termined under section 199(d)(1)(A)(iii) for purposesof the wage limitation of section 199(b) are $16, thelesser of $250 (partner’s allocable share of PRS’sW–2 wages ($100 included in total CGS, and $150included in selling expenses) and $16 (2 x ($270 x.03)).

(v) Section 199 deduction determination. (A) X’stentative section 199 deduction is $11 (.03 x $366(that is, QPAI determined at partner level)) subject tothe wage limitation of $8 (50% x $16). Accordingly,X’s section 199 deduction for 2006 is $8.

(B) Y’s tentative section 199 deduction is $19 (.03x $642 (that is, QPAI determined at the partner level)subject to the wage limitation of $133 (50% x ($16

from PRS and $250 from non-PRS activities)). Ac-cordingly, Y’s section 199 deduction for 2006 is $19.

Example 2. Section 861 method with R&E ex-pense. (i) Partnership items of income, gain, loss,deduction or credit. X and Y, unrelated United Statescorporations each of which is engaged in a tradeor business, are partners in PRS, a partnership thatengages in production activities that generate bothDPGR and non-DPGR. Neither X nor Y is a memberof an affiliated group. X and Y share all items of in-come, gain, loss, deduction, and credit 50% each. Allof PRS’s domestic production activities that generateDPGR are within Standard Industrial Classification(SIC) Industry Group AAA (SIC AAA). All of PRS’sproduction activities that generate non-DPGR arewithin SIC Industry Group BBB (SIC BBB). PRS

is not able to specifically identify CGS allocable toDPGR and to non-DPGR and, therefore, apportionsCGS to DPGR and non-DPGR based on its grossreceipts. PRS incurs $900 of research and experi-mentation expenses (R&E) that are deductible undersection 174, $300 of which are performed with re-spect to SIC AAA and $600 of which are performedwith respect to SIC BBB. None of the R&E is legallymandated R&E as described in §1.861–17(a)(4) andnone is included in CGS. PRS incurs section 162selling expenses (that include W–2 wage expense)that are not includible in CGS and are definitelyrelated to all of PRS’s gross income. For 2006, PRShas the following Federal income tax items:

DPGR (all from sales of products within SIC AAA) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3,000Non-DPGR (all from sales of products within SIC BBB). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3,000CGS (includes $200 of W–2 wages) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,400Section 162 selling expenses (includes $100 of W–2 wages) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $840Section 174 R&E-SIC AAA . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $300Section 174 R&E-SIC BBB. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $600

(ii) Allocation of PRS’s items of income, gain,loss, deduction, or credit. X and Y each receive

the following distributive share of PRS’s items of in- come, gain, loss, deduction, or credit, as determinedunder the principles of §1.704–1(b)(1)(vii):

Gross income attributable to DPGR

($1,500 (DPGR) - $600 (CGS, includes$50 of W–2 wages)). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $900

Gross income attributable to non-DPGR

($1,500 (other gross receipts) - $600 (CGS,includes $50 of W–2 wages)) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $900

Section 162 selling expenses (includes $50 of W–2 wages) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $420Section 174 R&E-SIC AAA . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $150Section 174 R&E-SIC BBB. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $300

(iii) Determination of QPAI. (A) X’s QPAI. Be-cause the section 199 deduction is determined at thepartner level, X determines its QPAI by aggregat-ing, to the extent necessary, its distributive shares ofPRS’s Federal income tax items with all other suchitems from all other, non-PRS-related activities. For2006, X does not have any other such tax items. X’sonly gross receipts for 2006 are those attributable tothe allocation of gross income from PRS. As stated,all of PRS’s domestic production activities that gen-

erate DPGR are within SIC AAA. X allocates andapportions its deductible items to gross income at-tributable to DPGR under the section 861 method of§1.199–4(d). In this case, the section 162 selling ex-penses (including W–2 wages) are definitely relatedto all of PRS’s gross income. Based on the facts andcircumstances of this specific case, apportionment ofthose expenses between DPGR and non-DPGR onthe basis of PRS’s gross receipts is appropriate. Forpurposes of apportioning R&E, X elects to use the

sales method as described in §1.861–17(c). BecauseX has no direct sales of products, and because allof PRS’s SIC AAA sales attributable to X’s shareof PRS’s gross income generate DPGR, all of X’sshare of PRS’s section 174 R&E attributable to SICAAA is taken into account for purposes of determin-ing X’s QPAI. Thus, X’s total QPAI for 2006 is $540,as shown below:

June 19, 2006 1124 2006–25 I.R.B.

DPGR (all from sales of products within SIC AAA) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,500CGS (includes $50 of W–2 wages) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($600)Section 162 selling expenses (including W–2 wages)

($420 x ($1,500 DPGR/$3,000 total gross receipts)) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($210)Section 174 R&E-SIC AAA . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($150)

X’s QPAI . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $540

(B) Y’s QPAI. (1) For 2006, in addition to the ac-tivities of PRS, Y engages in domestic productionactivities that generate both DPGR and non-DPGR.With respect to those non-PRS activities, Y is not ableto specifically identify CGS allocable to DPGR and

to non-DPGR. In this case, because CGS is definitelyrelated under the facts and circumstances to all of Y’snon-PRS gross receipts, apportionment of CGS be-tween DPGR and non-DPGR based on Y’s non-PRS

gross receipts is appropriate. For 2006, Y has the fol-lowing non-PRS Federal income tax items:

DPGR (from sales of products within SIC AAA) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,500DPGR (from sales of products within SIC BBB) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,500Non-DPGR (from sales of products within SIC BBB) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3,000CGS (allocated to DPGR within SIC AAA)

(includes $56 of W–2 wages) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $750CGS (allocated to DPGR within SIC BBB)

(includes $56 of W–2 wages) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $750CGS (allocated to non-DPGR within SIC BBB)

(includes $113 of W–2 wages). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,500Section 162 selling expenses (includes $30 of W–2 wages) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $540Section 174 R&E-SIC AAA . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $300Section 174 R&E-SIC BBB. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $450

(2) Because Y has DPGR as a result of activi-ties outside PRS, Y must aggregate its distributiveshare of PRS’s Federal income tax items with suchitems from all its other, non-PRS-related activities.Y allocates and apportions its deductible items togross income attributable to DPGR under the section861 method of §1.199–4(d). In this case, the section162 selling expenses (including W–2 wages) aredefinitely related to all of Y’s gross income. Basedon the facts and circumstances of the specific case,

apportionment of such expenses between DPGRand non-DPGR on the basis of Y’s gross receiptsis appropriate. For purposes of apportioning R&E,Y elects to use the sales method as described in§1.861–17(c).

(3) With respect to sales that generate DPGR, Yhas gross income of $2,400 ($4,500 DPGR ($1,500from PRS and $3,000 from non-PRS activities) -$2,100 CGS ($600 from sales of products by PRSand $1,500 from non-PRS activities)). Because all

of the sales in SIC AAA generate DPGR, all of Y’sshare of PRS’s section 174 R&E attributable to SICAAA and the section 174 R&E attributable to SICAAA that Y incurs in its non-PRS activities are takeninto account for purposes of determining Y’s QPAI.Because only a portion of the sales within SIC BBBgenerate DPGR, only a portion of the section 174R&E attributable to SIC BBB is taken into accountin determining Y’s QPAI. Thus, Y’s QPAI for 2006is $1,282, as shown below:

DPGR ($4,500 DPGR ($1,500 from PRS and $3,000from non-PRS activities)) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $4,500

CGS ($600 from sales of products by PRS and $1,500from non-PRS activities) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($2,100)

Section 162 selling expenses (including W–2 wages)

($420 from PRS + $540 from non-PRS activities) x($4,500 DPGR/$9,000 total gross receipts) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($480)

Section 174 R&E-SIC AAA ($150 from PRS and $300from non-PRS activities) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($450)

Section 174 R&E-SIC BBB ($300 from PRS + $450from non-PRS activities) x ($1,500 DPGR/$6,000total gross receipts allocated to SIC BBB ($1,500from PRS and $4,500 from non-PRS activities)) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($188)

Y’s QPAI . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,282

(iv) PRS W–2 wages allocated to X and Y undersection 199(d)(1)(A)(iii). Solely for purposes of cal-culating the PRS W–2 wages that are allocated to Xand Y under section 199(d)(1)(A)(iii) for purposes ofthe wage limitation of section 199(b), X and Y mustseparately determine QPAI taking into account onlythe items of PRS allocated to them. X and Y mustuse the same methods of allocation and apportion-ment that they use to determine their QPAI in para-graphs (iii)(A) and (B) of this Example 2, respec-

tively. Accordingly, X and Y must apportion sec-tion 162 selling expenses that include W–2 wage ex-pense on the basis of gross receipts, and apportionsection 174 R&E expense under the sales method asdescribed in §1.861–17(c).

(A) QPAI of X and Y, solely for this purpose, isdetermined by allocating and apportioning each part-ner’s share of PRS expenses to each partner’s shareof PRS gross income of $900 attributable to DPGR($1,500 DPGR - $600 CGS, allocated based on PRS’s

gross receipts). Because all of PRS’s SIC AAA salesgenerate DPGR, all of X’s and Y’s shares of PRS’ssection 174 R&E attributable to SIC AAA is takeninto account for purposes of determining X’s and Y’sQPAI. None of PRS’s section 174 R&E attributableto SIC BBB is taken into account because PRS hasno DPGR within SIC BBB. Thus, X and Y each hasQPAI, solely for this purpose, of $540, as shown be-low:

2006–25 I.R.B. 1125 June 19, 2006

DPGR (all from sales of products within SIC AAA) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,500CGS (includes $50 of W–2 wages) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($600)Section 162 selling expenses (including W–2 wages)

($420 x $1,500/$3,000) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($210)Section 174 R&E-SIC AAA . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ($150)

QPAI. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $540

(B) X’s and Y’s shares of PRS’s W–2 wages de-termined under section 199(d)(1)(A)(iii) for purposesof the wage limitation of section 199(b) are $32, thelesser of $150 (partner’s allocable share of PRS’sW–2 wages ($100 included in CGS, and $50 includedin selling expenses)) and $32 (2 x ($540 x .03)).

(v) Section 199 deduction determination. (A) X’stentative section 199 deduction is $16 (.03 x $540(QPAI determined at partner level)) subject to thewage limitation of $16 (50% x $32). Accordingly,X’s section 199 deduction for 2006 is $16.

(B) Y’s tentative section 199 deduction is $38 (.03x $1,282 (QPAI determined at partner level) subjectto the wage limitation of $144 (50% x $287 ($32 fromPRS + $255 from non-PRS activities)). Accordingly,Y’s section 199 deduction for 2006 is $38.

Example 3. Partnership with special allocations.(i) In general. X and Y are unrelated corporate part-ners in PRS and each is engaged in a trade or busi-ness. PRS is a partnership that engages in a domesticproduction activity and other activities. In general,X and Y share all partnership items of income, gain,loss, deduction, and credit equally, except that 80%of the wage expense of PRS and 20% of PRS’s otherexpenses are specially allocated to X (substantial eco-nomic effect under section 704(b) is presumed). Inthe 2006 taxable year, PRS’s only wage expense is$2,000 for marketing, which is not included in CGS.PRS has $8,000 of gross receipts ($6,000 of whichis DPGR), $4,000 of CGS ($3,500 of which is al-locable to DPGR), and $3,000 of deductions (com-prised of $2,000 of wages for marketing and $1,000of other expenses). X qualifies for and uses the sim-plified deduction method under §1.199–4(e). Y doesnot qualify to use that method and, therefore, mustuse the section 861 method under §1.199–4(d). In the2006 taxable year, X has gross receipts attributable tonon-partnership trade or business activities of $1,000and wages of $200. None of X’s non-PRS gross re-ceipts is DPGR.

(ii) Allocation and apportionment of costs. Un-der the partnership agreement, X’s distributive shareof the items of PRS is $1,250 of gross incomeattributable to DPGR ($3,000 DPGR - $1,750 al-locable CGS), $750 of gross income attributableto non-DPGR ($1,000 non-DPGR - $250 alloca-ble CGS), and $1,800 of deductions (comprised ofX’s special allocations of $1,600 of wage expense($2,000 x 80%) for marketing and $200 of otherexpenses ($1,000 x 20%)). Under the simplifieddeduction method, X apportions $1,200 of otherdeductions to DPGR ($2,000 ($1,800 from the part-nership and $200 from non-partnership activities) x($3,000 DPGR/$5,000 total gross receipts)). Accord-ingly, X’s QPAI is $50 ($3,000 DPGR - $1,750 CGS- $1,200 of deductions). However, in determiningthe section 199(d)(1)(A)(iii) wage limitation, QPAIis computed taking into account only the items ofPRS allocated to X for the taxable year of PRS.Thus, X apportions $1,350 of deductions to DPGR

($1,800 x ($3,000 DPGR/$4,000 total gross receiptsfrom PRS)). Accordingly, X’s QPAI for purposesof the section 199(d)(1)(A)(iii) wage limitation is$0 ($3,000 DPGR - $1,750 CGS - $1,350 of deduc-tions). X’s share of PRS’s W–2 wages is $0, thelesser of $1,600 (X’s 80% allocable share of $2,000of wage expense for marketing) and $0 (2 x ($0 QPAIx .03)). X’s tentative deduction is $2 ($50 QPAI x.03), subject to the section 199(b)(1) wage limitationof $100 (50% x $200 ($0 of PRS-related W–2 wages+ $200 of non-PRS W–2 wages)). Accordingly, X’ssection 199 deduction for the 2006 taxable year is $2.

Example 4. Partnership with no W–2 wages. (i)Facts. A, an individual, and B, an individual, arepartners in PRS. PRS is a partnership that engagesin manufacturing activities that generate both DPGRand non-DPGR. A and B share all items of income,gain, loss, deduction, and credit equally. In the 2006taxable year, PRS has total gross receipts of $2,000($1,000 of which is DPGR), CGS of $400 and deduc-tions of $800. PRS has no W–2 wages. A and B eachuse the small business simplified overall method un-der §1.199–4(f). A has trade or business activitiesoutside of PRS. With respect to those activities, Ahas total gross receipts of $1,000 ($500 of which isDPGR), CGS of $400 (including $50 of W–2 wages)and deductions of $200 for the 2006 taxable year. Bhas no trade or business activities outside of PRS andpays $0 of W–2 wages directly for the 2006 taxableyear. A’s distributive share of the items of the part-nership is $500 DPGR, $500 non-DPGR, $200 CGS,and $400 of deductions.

(ii) Section 199(d)(1)(A)(iii) wage limitation. A’sCGS and deductions apportioned to DPGR from PRSequal $300 (($200 CGS + $400 of other deductions)x ($500 DPGR/$1,000 total gross receipts)). Accord-ingly, for purposes of the wage limitation of section199(d)(1)(A)(iii), A’s QPAI is $200 ($500 DPGR -$300 CGS and other deductions). A’s share of part-nership W–2 wages after application of the section199(d)(1)(A)(iii) limitation is $0, the lesser of $0 (A’s50% allocable share of PRS’s $0 of W–2 wages) or$12 (2 x ($200 QPAI x .03)). B’s share of PRS’s W–2wages also is $0.

(iii) Section 199 deduction computation. A’s to-tal CGS and deductions apportioned to DPGR equal$600 (($200 PRS CGS + $400 outside trade or busi-ness CGS + $400 PRS deductions + $200 outsidetrade or business deductions) x ($1,000 total DPGR($500 from PRS + $500 from outside trade or busi-ness)/$2,000 total gross receipts ($1,000 from PRS +$1,000 from outside trade or business)). Accordingly,A’s QPAI is $400 ($1,000 DPGR - $600 CGS and de-ductions). A’s tentative deduction is $12 ($400 QPAIx .03), subject to the section 199(b)(1) wage limita-tion of $25 (50% x $50 total W–2 wages). A’s section199 deduction for the 2006 taxable year is $12. B’stotal section 199 deduction for the 2006 taxable yearis $0 because B has no W–2 wages for the 2006 tax-able year.

Example 5. Guaranteed payment. (i) Facts. Thefacts are the same as Example 4 except that in 2006PRS also makes a guaranteed payment of $200 to Afor services, and PRS pays $200 of W–2 wages toPRS employees, which is included within the $400of CGS. See section 707(c). This guaranteed pay-ment is taxable to A as ordinary income and is prop-erly deducted by PRS under section 162. Pursuantto §1.199–3(p), A may not treat any part of this pay-ment as DPGR. Accordingly, PRS has total gross re-ceipts of $2,000 ($1,000 of which is DPGR), CGSof $400 (including $200 of W–2 wages) and deduc-tions of $1,000 (including the $200 guaranteed pay-ment) for the 2006 taxable year. A’s distributive shareof the items of the partnership is $500 DPGR, $500non-DPGR, $200 CGS, and $500 of deductions.

(ii) Section 199(d)(1)(A)(iii) wage limitation. A’sCGS and deductions apportioned to DPGR fromPRS equal $350 (($200 CGS + $500 of other deduc-tions) x ($500 DPGR/$1,000 total gross receipts)).Accordingly, for purposes of the wage limitation ofsection 199(d)(1)(A)(iii), A’s QPAI is $150 ($500DPGR - $350 CGS and other deductions). A’s shareof partnership W–2 wages after application of thesection 199(d)(1)(A)(iii) limitation is $9, the lesserof $100 (A’s 50% allocable share of PRS’s $200 ofW–2 wages) or $9 (2 x ($150 QPAI x .03)). B’s shareof PRS’s W–2 wages after application of section199(d)(1)(A)(iii) also is $9.

(iii) A’s section 199 deduction computation. A’stotal CGS and deductions apportioned to DPGR equal$591 (($200 PRS CGS + $400 outside trade or busi-ness CGS + $500 PRS deductions + $200 outsidetrade or business deductions) x ($1,000 total DPGR($500 from PRS + $500 from outside trade or busi-ness)/$2,200 total gross receipts ($1,000 from PRS+ $200 guaranteed payment + $1,000 from outsidetrade or business)). Accordingly, A’s QPAI is $409($1,000 DPGR - $591 CGS and other deductions).A’s tentative deduction is $12 ($409 QPAI x .03), sub-ject to the section 199(b)(1) wage limitation of $30(50% x $59 ($9 PRS W–2 wages + $50 W–2 wagesfrom A’s trade or business activities outside of PRS)).A’s section 199 deduction for the 2006 taxable yearis $12.

(iv) B’s section 199 deduction computation. B’sQPAI is $150 ($500 DPGR - $350 CGS and other de-ductions). B’s tentative deduction is $5 ($150 QPAIx .03), subject to the section 199(b)(1) wage limita-tion of $5 (50% x $9). Assuming that B engages inno other activities generating DPGR, B’s section 199deduction for the 2006 taxable year is $5.

(c) S corporations—(1) In gen-eral—(i) Determination at shareholderlevel. The section 199 deduction withrespect to the qualified production activ-ities of an S corporation is determined atthe shareholder level. As a result, eachshareholder must compute its deduction

June 19, 2006 1126 2006–25 I.R.B.

separately. The section 199 deduction willhave no effect on the basis of a share-holder’s stock in an S corporation. Ex-cept as provided by publication pursuantto paragraph (c)(1)(ii) of this section,for purposes of this section, each share-holder is allocated, in accordance withsection 1366, its pro rata share of S corpo-ration items (including items of income,gain, loss, and deduction), CGS allocatedto such items of income, and gross re-ceipts included in such items of income,even if the shareholder’s share of CGSand other deductions and losses exceedsDPGR, and regardless of the amount ofthe shareholder’s share of the W–2 wagesof the S corporation for the taxable year.Except as provided by publication underparagraph (c)(1)(ii) of this section, to de-termine its section 199 deduction for thetaxable year, the shareholder aggregatesits pro rata share of such items, to the ex-tent they are not otherwise disallowed bythe Code, with those items it incurs out-side the S corporation (whether directlyor indirectly) for purposes of allocatingand apportioning deductions to DPGR andcomputing its QPAI.

(ii) Determination at entity level.The Secretary may, by publicationin the Internal Revenue Bulletin (see§601.601(d)(2)(ii)(b) of this chapter), per-mit an S corporation to calculate a share-holder’s share of QPAI at the entity level,instead of allocating, in accordance withsection 1366, the shareholder’s pro ratashare of S corporation items (includingitems of income, gain, loss, and deduc-tion). If an S corporation does calculateQPAI at the entity level—

(A) Each shareholder is allocated itsshare of QPAI and W–2 wages, which(subject to the limitations under para-graph (c)(2) of this section and section199(d)(1)(A)(iii), respectively) are com-bined with the shareholder’s QPAI andW–2 wages from other sources;

(B) For purposes of computing QPAIunder §§1.199–1 through 1.199–9, a share-holder does not take into account the itemsfrom such an S corporation (for example,a shareholder does not take into accountitems from such an S corporation in deter-mining whether a threshold or de minimisrule applies or when the shareholder allo-cates and apportions deductions in calcu-lating its QPAI from other sources);

(C) A shareholder generally does notrecompute its share of QPAI from theS corporation using another method; how-ever, the shareholder might have to adjustits share of QPAI from the S corporationto take into account certain disallowedlosses or deductions, or the allowance ofsuspended losses or deductions; and

(D) A shareholder’s share of QPAI froman S corporation may be less than zero.

(2) Disallowed losses or deduc-tions. Except as provided by publica-tion in the Internal Revenue Bulletin (see§601.601(d)(2)(ii)(b) of this chapter),losses or deductions of the S corpora-tion that otherwise would be taken intoaccount in computing the shareholder’ssection 199 deduction for a taxable yearare taken into account in that year only ifand to the extent the shareholder’s pro ratashare of the losses or deductions from allof the S corporation’s activities is not dis-allowed by section 465, 469, or 1366(d),or any other provision of the Code. Ifonly a portion of the shareholder’s shareof the losses or deductions is allowed fora taxable year, a proportionate share ofthose allowable losses or deductions thatare allocated to the S corporation’s quali-fied production activities, determined in amanner consistent with sections 465, 469,and 1366(d), and any other applicable pro-vision of the Code, is taken into accountin computing the QPAI and the wage lim-itation of section 199(d)(1)(A)(iii) for thattaxable year. To the extent that any ofthe disallowed losses or deductions areallowed in a later taxable year, the share-holder takes into account a proportionateshare of those losses or deductions in com-puting its QPAI for that later taxable year.Losses or deductions of the S corporationthat are disallowed for taxable years be-ginning on or before December 31, 2004,are not taken into account in a later taxableyear for purposes of computing the share-holder’s QPAI or the wage limitation ofsection 199(d)(1)(A)(iii) for that taxableyear, regardless of whether the losses ordeductions are allowed for other purposes.

(3) Shareholder’s share of W–2 wages.Under section 199(d)(1)(A)(iii), anS corporation shareholder’s share ofthe W–2 wages of the S corporationfor purposes of determining the share-holder’s section 199(b) limitation is thelesser of the shareholder’s allocable shareof those wages (without regard to sec-

tion 199(d)(1)(A)(iii)), or 2 times 3 per-cent of the QPAI computed by taking intoaccount only the items of the S corporationallocated to the shareholder for the taxableyear of the S corporation. Except as pro-vided by publication in the Internal Rev-enue Bulletin (see §601.601(d)(2)(ii)(b) ofthis chapter), this QPAI calculation is per-formed by the shareholder using the samecost allocation method that the shareholderuses in calculating the shareholder’s sec-tion 199 deduction. The S corporationmust allocate W–2 wages (prior to theapplication of the wage limitation) amongthe shareholders in the same manner aswage expense. The shareholder must addthe shareholder’s share of W–2 wagesfrom the S corporation, as limited by sec-tion 199(d)(1)(A)(iii), to the shareholder’sW–2 wages from other sources, if any. IfQPAI, computed by taking into accountonly the items of the S corporation allo-cated to the shareholder for the taxableyear (as required by the wage limitationof section 199(d)(1)(A)(iii)), is not greaterthan zero, then the shareholder may nottake into account any W–2 wages of theS corporation in applying the wage lim-itation of §1.199–2 (but the shareholderwill, nevertheless, aggregate its distribu-tive share of S corporation items includingwage expense with those items not fromthe S corporation in computing its QPAIwhen determining its section 199 deduc-tion). See §1.199–2 for the computationof W–2 wages, and paragraph (g) of thissection for rules regarding pass-thru enti-ties in a tiered structure.

(4) Transition percentage rule for W–2wages. With regard to S corporations, forpurposes of section 199(d)(1)(A)(iii)(II)the transition percentages determined un-der section 199(a)(2) shall be determinedby reference to the S corporation’s taxableyear. Thus, if an S corporation share-holder uses a calendar year taxable year,and owns stock in an S corporation thathas a taxable year ending on April 30,the shareholder’s section 199(d)(1)(A)(iii)wage limitation for the S corporation’staxable year beginning on May 1, 2006,would be calculated using 3 percent, eventhough the shareholder includes the share-holder’s pro rata share of S corporationitems from that taxable year on the share-holder’s 2007 Federal income tax return.

(d) Grantor trusts. To the extent thatthe grantor or another person is treated as

2006–25 I.R.B. 1127 June 19, 2006

owning all or part (the owned portion) of atrust under sections 671 through 679, suchperson (owner) computes its QPAI with re-spect to the owned portion of the trust asif that QPAI had been generated by activi-ties performed directly by the owner. Sim-ilarly, for purposes of the section 199(b)wage limitation, the owner of the trusttakes into account the owner’s share of theW–2 wages of the trust that are attribut-able to the owned portion of the trust. Thesection 199(d)(1)(A)(iii) wage limitationis not applicable to the owned portion ofthe trust. The provisions of paragraph (e)of this section do not apply to the ownedportion of a trust.

(e) Non-grantor trusts and estates—(1)Allocation of costs. The trust or estatecalculates each beneficiary’s share (aswell as the trust’s or estate’s own share,if any) of QPAI and W–2 wages from thetrust or estate at the trust or estate level.The beneficiary of a trust or estate is notpermitted to use another cost allocationmethod to recompute its share of QPAIfrom the trust or estate or to reallocatethe costs of the trust or estate. Except asprovided in paragraph (d) of this section,the QPAI of a trust or estate must be com-puted by allocating expenses describedin section 199(d)(5) in one of two ways,depending on the classification of thoseexpenses under §1.652(b)–3. Specifically,directly attributable expenses within themeaning of §1.652(b)–3 are allocated pur-suant to §1.652(b)–3, and expenses notdirectly attributable within the meaning of§1.652(b)–3 (other expenses) are allocatedunder the simplified deduction method of§1.199–4(e) (unless the trust or estate doesnot qualify to use the simplified deduc-tion method, in which case it must usethe section 861 method of §1.199–4(d)with respect to such other expenses). Forthis purpose, depletion and depreciationdeductions described in section 642(e) andamortization deductions described in sec-tion 642(f) are treated as other expensesdescribed in section 199(d)(5). Also forthis purpose, the trust’s or estate’s share ofother expenses from a lower-tier pass-thru

entity is not directly attributable to anyclass of income (whether or not thoseother expenses are directly attributable tothe aggregate pass-thru gross income as aclass for purposes other than section 199).A trust or estate may not use the smallbusiness simplified overall method forcomputing its QPAI. See §1.199–4(f)(5).

(2) Allocation among trust or estate andbeneficiaries—(i) In general. The QPAIof a trust or estate (which will be lessthan zero if the CGS and deductions allo-cated and apportioned to DPGR exceed thetrust’s or estate’s DPGR) and W–2 wagesof the trust or estate are allocated to eachbeneficiary and to the trust or estate basedon the relative proportion of the trust’s orestate’s distributable net income (DNI), asdefined by section 643(a), for the taxableyear that is distributed or required to bedistributed to the beneficiary or is retainedby the trust or estate. To the extent thatthe trust or estate has no DNI for the tax-able year, any QPAI and W–2 wages areallocated entirely to the trust or estate. Atrust or estate is allowed the section 199deduction in computing its taxable incometo the extent that QPAI and W–2 wagesare allocated to the trust or estate. A ben-eficiary of a trust or estate is allowed thesection 199 deduction in computing its tax-able income based on its share of QPAI andW–2 wages from the trust or estate, which(subject to the wage limitation as describedin paragraph (e)(3) of this section) are ag-gregated with the beneficiary’s QPAI andW–2 wages from other sources.

(ii) Treatment of items from a trust orestate reporting qualified production ac-tivities income. When, pursuant to thisparagraph (e), a taxpayer must combineQPAI and W–2 wages from a trust or es-tate with the taxpayer’s total QPAI andW–2 wages from other sources, the tax-payer, when applying §§1.199–1 through1.199–9 to determine the taxpayer’s to-tal QPAI and W–2 wages from such othersources, does not take into account theitems from such trust or estate. Thus, forexample, a beneficiary of an estate that re-ceives QPAI from the estate does not take

into account the beneficiary’s distributiveshare of the estate’s gross receipts, grossincome, or deductions when the benefi-ciary determines whether a threshold or deminimis rule applies or when the benefi-ciary allocates and apportions deductionsin calculating its QPAI from other sources.

(3) Beneficiary’s share of W–2 wages.The trust or estate must compute eachbeneficiary’s share of W–2 wages fromthe trust or estate in accordance with sec-tion 199(d)(1)(A)(iii), as if the beneficiarywere a partner in a partnership. The ap-plication of section 199(d)(1)(A)(iii) toeach trust and estate therefore means thatif QPAI, computed by taking into accountonly the items of the trust or estate allo-cated to the beneficiary for the taxableyear, is not greater than zero, then thebeneficiary may not take into account anyW–2 wages of the trust or estate in ap-plying the wage limitation of §1.199–2(but the beneficiary will, nevertheless,aggregate its QPAI from the trust or estatewith its QPAI from other sources whendetermining the beneficiary’s section 199deduction). See paragraph (g) of thissection for rules applicable to pass-thruentities in a tiered structure.

(4) Transition percentage rule forW–2 wages. With regard to trustsand estates, for purposes of section199(d)(1)(A)(iii)(II), the transition per-centages determined under section199(a)(2) shall be determined by refer-ence to the taxable year of the trust orestate.

(5) Example. The following exampleillustrates the application of this para-graph (e) and paragraph (g) of this section.Assume that the partnership, trust, andtrust beneficiary all are calendar year tax-payers.

Example. (i) Computation of DNI and inclusionand deduction amounts. (A) Trust’s distributiveshare of partnership items. Trust, a complex trust,is a partner in PRS, a partnership that engages inactivities that generate DPGR and non-DPGR. In2006, PRS distributes $10,000 cash to Trust. Trust’sdistributive share of PRS items, which are properlyincluded in Trust’s DNI, is as follows:

June 19, 2006 1128 2006–25 I.R.B.

Gross income attributable to DPGR

($15,000 DPGR - $5,000 CGS(including W–2 wages of $1,000)) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $10,000

Gross income attributable to non-DPGR

($5,000 other gross receipts - $0 CGS) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $5,000Selling expenses (includes W–2 wages of $2,000) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3,000Other expenses (includes W–2 wages of $1,000) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,000

(B) Trust’s direct activities. In addition to its cashdistribution in 2006 from PRS, Trust also directly has

the following items which are properly included inTrust’s DNI:

Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $10,000Tax-exempt interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $10,000Rents from commercial real property operated by Trust

as a business. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $10,000Real estate taxes. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,000Trustee commissions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3,000State income and personal property taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $5,000W–2 wages for rental business . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,000Other business expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,000

(C) Allocation of deductions under §1.652(b)–3.(1) Directly attributable expenses. In computingTrust’s DNI for the taxable year, the distributiveshare of expenses of PRS are directly attributableunder §1.652(b)–3(a) to the distributive share ofincome of PRS. Accordingly, the $5,000 of CGS,$3,000 of selling expenses, and $2,000 of other ex-penses are subtracted from the gross receipts fromPRS ($20,000), resulting in net income from PRS of$10,000. With respect to the Trust’s direct expenses,$1,000 of the trustee commissions, the $1,000 of realestate taxes, and the $2,000 of W–2 wages are di-rectly attributable under §1.652(b)–3(a) to the rentalincome.

(2) Non-directly attributable expenses. Under§1.652(b)–3(b), the trustee must allocate a portionof the sum of the balance of the trustee commissions($2,000), state income and personal property taxes($5,000), and the other business expenses ($1,000) tothe $10,000 of tax-exempt interest. The portion to beattributed to tax-exempt interest is $2,222 ($8,000 x($10,000 tax-exempt interest/$36,000 gross receiptsnet of direct expenses)), resulting in $7,778 ($10,000- $2,222) of net tax-exempt interest. Pursuant toits authority recognized under §1.652(b)–3(b), thetrustee allocates the entire amount of the remaining$5,778 of trustee commissions, state income andpersonal property taxes, and other business expensesto the $6,000 of net rental income, resulting in $222($6,000 - $5,778) of net rental income.

(D) Amounts included in taxable income. For2006, Trust has DNI of $28,000 (net dividend in-come of $10,000 + net PRS income of $10,000 + netrental income of $222 + net tax-exempt income of$7,778). Pursuant to Trust’s governing instrument,Trustee distributes 50%, or $14,000, of that DNI toB, an individual who is a discretionary beneficiary ofTrust. Assume that there are no separate shares underTrust, and no distributions are made to any other ben-eficiary that year. Consequently, with respect to the$14,000 distribution B receives from Trust, B prop-erly includes in B’s gross income $5,000 of incomefrom PRS, $111 of rents, and $5,000 of dividends,and properly excludes from B’s gross income $3,889

of tax-exempt interest. Trust includes $20,222 in itsadjusted total income and deducts $10,111 under sec-tion 661(a) in computing its taxable income.

(ii) Section 199 deduction. (A) Simplified de-duction method. For purposes of computing thesection 199 deduction for the taxable year, assumeTrust qualifies for the simplified deduction methodunder §1.199–4(e). The determination of Trust’sQPAI under the simplified deduction method re-quires multiple steps to allocate costs. First, theTrust’s expenses directly attributable to DPGR un-der §1.652(b)–3(a) are subtracted from the Trust’sDPGR. In this step, the directly attributable $5,000of CGS and selling expenses of $3,000 are subtractedfrom the $15,000 of DPGR from PRS. Next, Trustmust identify its other trade or business expensesdirectly related to non-DPGR trade or business in-come. In this example, the portion of the trusteecommissions not directly attributable to the rentaloperation ($2,000), as well as the portion of thestate income and personal property taxes not directlyattributable to either the PRS interests or the rentaloperation, are not trade or business expenses and,thus, are ignored in computing QPAI. The portionof the state income and personal property taxesthat is treated as other trade or business expensesis $3,000 ($5,000 x $30,000 total trade or businessgross receipts/$50,000 total gross receipts). Trustthen allocates its other trade or business expenses onthe basis of its total gross receipts from the conductof a trade or business ($20,000 from PRS + $10,000rental income). Trust then combines its non-di-rectly attributable (other) business expenses ($2,000from PRS + $4,000 ($1,000 of other expenses +$3,000 of income and property taxes) from its ownactivities) and then apportions this total betweenDPGR and other receipts on the basis of Trust’s totaltrade or business gross receipts ($6,000 x $15,000DPGR/$30,000 total trade or business gross receipts= $3,000). Thus, for purposes of computing Trust’sand B’s section 199 deduction, Trust’s QPAI is$4,000 ($7,000 - $3,000). Because the distributionof Trust’s DNI to B equals one-half of Trust’s DNI,

Trust and B each has QPAI from PRS for purposesof the section 199 deduction of $2,000.

(B) Section 199(d)(1)(A)(iii) wage limitation.The wage limitation under section 199(d)(1)(A)(iii)must be applied both at the Trust level and at B’slevel. After applying this limitation to the Trust’sshare of PRS’s W–2 wages, Trust is allocated $330of W–2 wages from PRS (the lesser of Trust’sallocable share of PRS’s W–2 wages ($4,000)or 2 x 3% of Trust’s QPAI from PRS ($5,500)).Trust’s QPAI from PRS for purposes of the section199(d)(1)(A)(iii) limitation is determined by takinginto account only the items of PRS allocated to Trust($15,000 DPGR - ($5,000 of CGS + $3,000 sellingexpenses + $1,500 of other expenses)). For thispurpose, the $1,500 of other expenses is determinedby multiplying $2,000 of other expenses from PRSby $15,000 of DPGR from PRS, divided by $20,000of total gross receipts from PRS. Trust adds this $330of W–2 wages to Trust’s own $2,000 of W–2 wages(thus, $2,330). Because the $14,000 Trust distribu-tion to B equals one-half of Trust’s DNI, Trust andB each has W–2 wages of $1,165. After applyingthe section 199(d)(1)(A)(iii) wage limitation to B’sshare of the W–2 wages allocated from Trust, B hasW–2 wages of $120 from Trust (lesser of $1,165(allocable share of W–2 wages) or 2 x .03 x $2,000(B’s share of Trust’s QPAI)). B has W–2 wages of$100 from non-Trust activities for a total of $220 ofW–2 wages.

(C) Section 199 deduction computation. (1) B’scomputation. B is eligible to use the small businesssimplified overall method. Assume that B has suf-ficient adjusted gross income so that the section 199deduction is not limited under section 199(a)(1)(B).B has $1,000 of QPAI from non-Trust activities thatis added to the $2,000 QPAI from Trust for a total of$3,000 of QPAI. B’s tentative deduction is $90 (.03 x$3,000), but it is limited under section 199(b) to $110(50% x $220 W–2 wages). Accordingly, B’s section199 deduction for 2006 is $90.

(2) Trust’s computation. Trust has sufficient ad-justed gross income so that the section 199 deductionis not limited under section 199(a)(1)(B). Trust’s ten-

2006–25 I.R.B. 1129 June 19, 2006

tative deduction is $60 (.03 x $2,000 QPAI), but it islimited under section 199(b) to $583 (50% x $1,165W–2 wages). Accordingly, Trust’s section 199 de-duction for 2006 is $60.

(f) Gain or loss from the disposition ofan interest in a pass-thru entity. DPGRgenerally does not include gain or loss rec-ognized on the sale, exchange, or other dis-position of an interest in a pass-thru entity.However, with respect to a partnership, ifsection 751(a) or (b) applies, then gain orloss attributable to assets of the partnershipgiving rise to ordinary income under sec-tion 751(a) or (b), the sale, exchange, orother disposition of which would give riseto DPGR, is taken into account in com-puting the partner’s section 199 deduc-tion. Accordingly, to the extent that cashor property received by a partner in a saleor exchange for all or part of its partner-ship interest is attributable to unrealizedreceivables or inventory items within themeaning of section 751(c) or (d), respec-tively, and the sale or exchange of the unre-alized receivable or inventory items wouldgive rise to DPGR if sold, exchanged, orotherwise disposed of by the partnership,the cash or property received by the part-ner is taken into account by the partnerin determining its DPGR for the taxableyear. Likewise, to the extent that a dis-tribution of property to a partner is treatedunder section 751(b) as a sale or exchangeof property between the partnership andthe distributee partner, and any propertydeemed sold or exchanged would give riseto DPGR if sold, exchanged, or otherwisedisposed of by the partnership, the deemedsale or exchange of the property must betaken into account in determining the part-nership’s and distributee partner’s DPGRto the extent not taken into account underthe qualifying in-kind partnership rules.See §1.751–1(b) and paragraph (i) of thissection.

(g) Section 199(d)(1)(A)(iii) wage lim-itation and tiered structures—(1) In gen-eral. If a pass-thru entity owns an interest,directly or indirectly, in one or more pass-thru entities, then the wage limitation ofsection 199(d)(1)(A)(iii) must be appliedat each tier (that is, separately for eachentity). For purposes of this wage limi-tation, references to pass-thru entities in-cludes partnerships, S corporations, trusts(to the extent not described in paragraph(d) of this section) and estates. Thus, ateach tier, the owner of a pass-thru en-

tity (or the entity on behalf of the owner)calculates the amounts described in sec-tions 199(d)(1)(A)(iii)(I) (owner’s alloca-ble share) and 199(d)(1)(A)(iii)(II) (twicethe applicable percentage of the owner’sQPAI from that entity) separately with re-gard to its interest in that pass-thru entity.

(2) Share of W–2 wages. For purposesof section 199(d)(1)(A)(iii) and section199(b), the W–2 wages of the owner ofan interest in a pass-thru entity (upper-tierentity) that owns an interest in one ormore pass-thru entities (lower-tier enti-ties) are equal to the sum of the owner’sallocable share of W–2 wages of the up-per-tier entity, as limited in accordancewith section 199(d)(1)(A)(iii), and theowner’s own W–2 wages. The upper-tierentity’s W–2 wages are equal to the sumof the upper-tier entity’s allocable shareof W–2 wages of the next lower-tier en-tity, as limited in accordance with section199(d)(1)(A)(iii), and the upper-tier en-tity’s own W–2 wages. The W–2 wages ofeach lower-tier entity in a tiered structure,in turn, is computed as described in thepreceding sentence. Except as providedby publication in the Internal RevenueBulletin (see §601.601(d)(2)(ii)(b) of thischapter)—

(i) An upper-tier entity may compute itsshare of QPAI attributable to items froma lower-tier entity solely for purposes ofsection 199(d)(1)(A)(iii)(II) by applyingeither the section 861 method describedin §1.199–4(d) or the simplified deduc-tion method described in §1.199–4(e), pro-vided the upper tier entity would otherwisequalify to use such method.

(ii) Alternatively, the upper-tier entity(other than a trust or estate described inparagraph (e) of this section) may com-pute its share of QPAI attributable to itemsfrom a lower-tier entity solely for pur-poses of section 199(d)(1)(A)(iii)(II) byapplying the small business simplifiedoverall method described in §1.199–4(f),regardless of whether such upper-tier en-tity would otherwise qualify to use thesmall business simplified overall method.

(3) Example. The following exampleillustrates the application of this para-graph (g). Assume that each partnershipand each partner (whether or not an indi-vidual) is a calendar year taxpayer.

Example. (i) In 2006, A, an individual, owns a50% interest in a partnership, UTP, which in turnowns a 50% interest in another partnership, LTP.

All partnership items are allocated in proportion tothese ownership percentages. LTP has $900 DPGR,$450 CGS (which includes W–2 wages of $100), and$50 other deductions. Before taking into account itsshare of items from LTP, UTP has $500 DPGR, $500CGS (which includes W–2 wages of $200), and $500other deductions. UTP chooses to compute its shareof QPAI attributable to items from LTP for purposesof section 199(d)(1)(A)(iii)(II) by applying the smallbusiness simplified overall method described in§1.199–4(f). For purposes of the wage limitation ofsection 199(d)(1)(A)(iii), UTP’s distributive share ofLTP’s QPAI is $200 ($450 DPGR - $250 CGS andother deductions).

(ii) UTP’s share of LTP’s W–2 wages for pur-poses of the section 199(d)(1)(A)(iii) limitation is$12, the lesser of $50 (UTP’s 50% allocable shareof LTP’s $100 of W–2 wages) or $12 (2 x ($200QPAI x .03)). After taking into account its share ofitems from LTP, UTP has $950 DPGR, $725 CGS,and $525 other deductions. A is eligible for anduses the simplified deduction method described in§1.199–4(e). For purposes of the wage limitation ofsection 199(d)(1)(A)(iii), A’s distributive share ofUTP’s QPAI is ($151) ($475 DPGR - $363 CGS -$263 other deductions). A’s wage limitation undersection 199(d)(1)(A)(iii) with respect to A’s interestin UTP is $0, the lesser of $106 (A’s 50% allocableshare of UTP’s $212 of W–2 wages) or $0 (becauseA’s share of UTP’s QPAI ($151), is less than zero).

(h) No attribution of qualified activ-ities. Except as provided in paragraph(i) of this section regarding qualifyingin-kind partnerships and paragraph (j)of this section regarding EAG partner-ships, an owner of a pass-thru entity isnot treated as conducting the qualifiedproduction activities of the pass-thru en-tity, and vice versa. For example, if apartnership MPGE QPP within the UnitedStates, or produces a qualified film orproduces utilities in the United States, anddistributes or leases, rents, licenses, sells,exchanges, or otherwise disposes of suchproperty to a partner who then, withoutperforming its own qualifying MPGE orother production, leases, rents, licenses,sells, exchanges, or otherwise disposesof such property, then the partner’s grossreceipts from this latter lease, rental, li-cense, sale, exchange, or other dispositionare treated as non-DPGR. In addition, ifa partner MPGE QPP within the UnitedStates, or produces a qualified film orproduces utilities in the United States, andcontributes or leases, rents, licenses, sells,exchanges, or otherwise disposes of suchproperty to a partnership which then, with-out performing its own qualifying MPGEor other production, leases, rents, licenses,sells, exchanges, or otherwise disposes ofsuch property, then the partnership’s gross

June 19, 2006 1130 2006–25 I.R.B.

receipts from this latter disposition aretreated as non-DPGR.

(i) Qualifying in-kind partnership—(1)In general. If a partnership is a qualifyingin-kind partnership described in paragraph(i)(2) of this section, then each partner istreated as MPGE or producing the prop-erty MPGE or produced by the partnershipthat is distributed to that partner. If a part-ner of a qualifying in-kind partnership de-rives gross receipts from the lease, rental,license, sale, exchange, or other disposi-tion of the property that was MPGE or pro-duced by the qualifying in-kind partner-ship, then, provided such partner is a part-ner of the qualifying in-kind partnership atthe time the partner disposes of the prop-erty, the partner is treated as conductingthe MPGE or production activities previ-ously conducted by the qualifying in-kindpartnership with respect to that property.With respect to a lease, rental, or license,the partner is treated as having disposed ofthe property on the date or dates on whichit takes into account its gross receipts de-rived from the lease, rental, or license un-der its methods of accounting. With re-spect to a sale, exchange, or other dispo-sition, the partner is treated as having dis-posed of the property on the date on whichit ceases to own the property for Federal in-come tax purposes, even if no gain or lossis taken into account.

(2) Definition of qualifying in-kindpartnership. For purposes of this para-graph (i), a qualifying in-kind partnershipis a partnership engaged solely in—

(i) The extraction, refining, or process-ing of oil, natural gas (as described in§1.199–3(l)(2)), petrochemicals, or prod-ucts derived from oil, natural gas, or petro-chemicals in whole or in significant partwithin the United States;

(ii) The production or generation ofelectricity in the United States; or

(iii) An activity or industry desig-nated by the Secretary by publicationin the Internal Revenue Bulletin (see§601.601(d)(2)(ii)(b) of this chapter).

(3) Special rules for distributions. If aqualifying in-kind partnership distributesproperty to a partner, then, solely for pur-poses of section 199(d)(1)(A)(iii)(II), thepartnership is treated as having gross re-ceipts in the taxable year of the distribu-tion equal to the fair market value of thedistributed property at the time of distribu-tion to the partner and the deemed gross

receipts are allocated to that partner, pro-vided that the partner derives gross re-ceipts from the distributed property (andtakes into account such receipts under itsmethod of accounting) during the taxableyear of the partner with or within whichthe partnership’s taxable year (in whichthe distribution occurs) ends. For rulesfor taking costs into account (such as costsincluded in the adjusted basis of the dis-tributed property), see §1.199–4.

(4) Other rules. Except as providedin this paragraph (i), a qualifying in-kindpartnership is treated the same as otherpartnerships for purposes of section 199.Accordingly, a qualifying in-kind partner-ship is subject to the rules of this sectionregarding the application of section 199to pass-thru entities, including applicationof the section 199(d)(1)(A)(iii) wage lim-itation under paragraph (b)(3) of this sec-tion. In determining whether a qualifyingin-kind partnership or its partners MPGEQPP in whole or in significant part withinthe United States, see §1.199–3(g)(2) and(3).

(5) Example. The following exampleillustrates the application of this paragraph(i). Assume that PRS and X are calendaryear taxpayers.

Example. X, Y and Z are partners in PRS, a qual-ifying in-kind partnership described in paragraph(i)(2) of this section. X, Y, and Z are corporations. In2006, PRS distributes oil to X that PRS derived fromits oil extraction. PRS incurred $600 of CGS, includ-ing $500 of W–2 wages (as defined in §1.199–2(e)),extracting the oil distributed to X, and X’s adjustedbasis in the distributed oil is $600. The fair marketvalue of the oil at the time of the distribution to Xis $1,000. X incurs $200 of CGS, including $100of W–2 wages, in refining the oil within the UnitedStates. In 2006, X, while it is a partner in PRS, sellsthe oil to a customer for $1,500, taking the gross re-ceipts into account under its method of accounting inthe same taxable year. Under paragraph (i)(1) of thissection, X is treated as having extracted the oil. Theextraction and refining of the oil qualify as an MPGEactivity under §1.199–3(e)(1). Therefore, X’s $1,500of gross receipts qualify as DPGR. X subtracts fromthe $1,500 of DPGR the $600 of CGS incurredby PRS and the $200 of refining costs incurred byX. Thus, X’s QPAI is $700 for 2006. In addition,PRS is treated as having $1,000 of DPGR solely forpurposes of applying the wage limitation in section199(d)(1)(A)(iii) based on the applicable percentageof QPAI. Accordingly, X’s share of PRS’s W–2wages determined under section 199(d)(1)(A)(iii) is$24, the lesser of $500 (X’s allocable share of PRS’sW–2 wages included in CGS) and $24 (2 x ($400($1,000 deemed DPGR less $600 of CGS) x .03)).X adds the $24 of PRS W–2 wages to its $100 ofW–2 wages incurred in refining the oil for purposesof section 199(b).

(j) Partnerships owned by members ofa single expanded affiliated group—(1) Ingeneral. For purposes of this section, if allof the interests in the capital and profits ofa partnership are owned by members of asingle EAG at all times during the taxableyear of the partnership (EAG partnership),then the EAG partnership and all membersof that EAG are treated as a single taxpayerfor purposes of section 199(c)(4) duringthat taxable year.

(2) Attribution of activities—(i) In gen-eral. If a member of an EAG (dispos-ing member) derives gross receipts fromthe lease, rental, license, sale, exchange,or other disposition of property that wasMPGE or produced by an EAG partner-ship, all the partners of which are mem-bers of the same EAG to which the dis-posing member belongs at the time thatthe disposing member disposes of suchproperty, then the disposing member istreated as conducting the MPGE or pro-duction activities previously conducted bythe EAG partnership with respect to thatproperty. The previous sentence appliesonly for those taxable years in which thedisposing member is a member of the EAGof which all the partners of the EAG part-nership are members for the entire taxableyear of the EAG partnership. With re-spect to a lease, rental, or license, the dis-posing member is treated as having dis-posed of the property on the date or dateson which it takes into account its gross re-ceipts from the lease, rental, or license un-der its methods of accounting. With re-spect to a sale, exchange, or other dis-position, the disposing member is treatedas having disposed of the property on thedate on which it ceases to own the prop-erty for Federal income tax purposes, evenif no gain or loss is taken into account.Likewise, if an EAG partnership derivesgross receipts from the lease, rental, li-cense, sale, exchange, or other dispositionof property that was MPGE or produced bya member (or members) of the same EAG(the producing member) to which all thepartners of the EAG partnership belong atthe time that the EAG partnership disposesof such property, then the EAG partner-ship is treated as conducting the MPGE orproduction activities previously conductedby the producing member with respect tothat property. The previous sentence ap-plies only for those taxable years in whichthe producing member is a member of the

2006–25 I.R.B. 1131 June 19, 2006

EAG of which all the partners of the EAGpartnership are members for the entire tax-able year of the EAG partnership. With re-spect to a lease, rental, or license, the EAGpartnership is treated as having disposed ofthe property on the date or dates on whichit takes into account its gross receipts de-rived from the lease, rental, or license un-der its methods of accounting. With re-spect to a sale, exchange, or other dispo-sition, the EAG partnership is treated ashaving disposed of the property on the dateon which it ceases to own the property forFederal income tax purposes, even if nogain or loss is taken into account. See para-graph (j)(5) Example 3 of this section.

(ii) Attribution between EAG partner-ships. If an EAG partnership (disposingpartnership) derives gross receipts fromthe lease, rental, license, sale, exchange,or other disposition of property that wasMPGE or produced by another EAG part-nership (producing partnership), then thedisposing partnership is treated as con-ducting the MPGE or production activitiespreviously conducted by the producingpartnership with respect to that property,provided that the producing partnershipand the disposing partnership are ownedby members of the same EAG for theentire taxable year of the respective part-nership in which the disposing partnershipdisposes of such property. With respectto a lease, rental, or license, the disposingpartnership is treated as having disposed ofthe property on the date or dates on whichit takes into account its gross receiptsfrom the lease, rental, or license under itsmethods of accounting. With respect to asale, exchange, or other disposition, thedisposing partnership is treated as havingdisposed of the property on the date onwhich it ceases to own the property forFederal income tax purposes, even if nogain or loss is taken into account.

(iii) Exceptions to attribution. Attri-bution of activities does not apply forpurposes of the construction of real prop-erty under §1.199–3(m)(1) and the per-formance of engineering and architecturalservices under §1.199–3(n)(2) and (3),respectively.

(3) Special rules for distributions. If anEAG partnership distributes property to apartner, then, solely for purposes of sec-tion 199(d)(1)(A)(iii)(II), the EAG part-nership is treated as having gross receiptsin the taxable year of the distribution equal

to the fair market value of the propertyat the time of distribution to the partnerand the deemed gross receipts are allo-cated to that partner, provided that the part-ner derives gross receipts from the dis-tributed property (and takes such receiptsinto account under its methods of account-ing) during the taxable year of the part-ner with or within which the partnership’staxable year (in which the distribution oc-curs) ends. For rules for taking costs intoaccount (such as costs included in the ad-justed basis of the distributed property),see §1.199–4.

(4) Other rules. Except as provided inthis paragraph (j), an EAG partnership istreated the same as other partnerships forpurposes of section 199. Accordingly, anEAG partnership is subject to the rules ofthis section regarding the application ofsection 199 to pass-thru entities, includingapplication of the section 199(d)(1)(A)(iii)wage limitation under paragraph (b)(3) ofthis section. In determining whether amember of an EAG or an EAG partner-ship MPGE QPP in whole or in significantpart within the United States or produced aqualified film or produced utilities withinthe United States, see §1.199–3(g)(2) and(3) and Example 5 of paragraph (j)(5) ofthis section.

(5) Examples. The following examplesillustrate the rules of this paragraph (j).Assume that PRS, X, Y, and Z all are cal-endar year taxpayers.

Example 1. Contribution. X and Y are the onlypartners in PRS, a partnership, for PRS’s entire 2006taxable year. X and Y are both members of a singleEAG for the entire 2006 year. In 2006, X MPGE QPPwithin the United States and contributes the propertyto PRS. In 2006, PRS sells the QPP for $1,000. Un-der this paragraph (j), PRS is treated as having MPGEthe QPP within the United States, and PRS’s $1,000gross receipts constitute DPGR. PRS, X, and Y mustapply the rules of this section regarding the applica-tion of section 199 to pass-thru entities with respectto the activity of PRS, including application of thesection 199(d)(1)(A)(iii) wage limitation under para-graph (b)(3) of this section.

Example 2. Sale. X, Y, and Z are the only mem-bers of a single EAG for the entire 2006 year. X andY each own 50% of the capital and profits interestsin PRS, a partnership, for PRS’s entire 2006 taxableyear. In 2006, PRS MPGE QPP within the UnitedStates and then sells the property to X for $6,000, itsfair market value at the time of the sale. PRS’s grossreceipts of $6,000 qualify as DPGR. In 2006, X sellsthe QPP to customers for $10,000, incurring sellingexpenses of $2,000. Under this paragraph (j), X istreated as having MPGE the QPP within the UnitedStates, and X’s $10,000 of gross receipts qualify asDPGR. PRS, X and Y must apply the rules of this

section regarding the application of section 199 topass-thru entities with respect to the activity of PRS,including application of the section 199(d)(1)(A)(iii)wage limitation under paragraph (b)(3) of this sec-tion. The results would be the same if PRS sold theproperty to Z rather than to X.

Example 3. Lease. X, Y, and Z are the only mem-bers of a single EAG for the entire 2005 year. X andY each own 50% of the capital and profits interestsin PRS, a partnership, for PRS’s entire 2005 taxableyear. In 2005, PRS MPGE QPP within the UnitedStates and then sells the property to X for $6,000,its fair market value at the time of the sale. PRS’sgross receipts of $6,000 qualify as DPGR. In 2005,X rents the QPP it acquired from PRS to customersunrelated to X. X takes the gross receipts attributableto the rental of the QPP into account under its meth-ods of accounting in 2005 and 2006. On July 1, 2006,X ceases to be a member of the same EAG to whichY, the other partner in PRS, belongs. For 2005, X istreated as having MPGE the QPP in the United States,and its gross receipts derived from the rental of theQPP qualify as DPGR. For 2006, however, becauseX and Y, partners in PRS, are no longer members ofthe same EAG for the entire year, the gross rental re-ceipts X takes into account in 2006 do not qualify asDPGR.

Example 4. Distribution. X and Y are the onlypartners in PRS, a partnership, for PRS’s entire 2006taxable year. X and Y are both members of a sin-gle EAG for the entire 2006 year. In 2006, PRSMPGE QPP within the United States, incurring $600of CGS, including $500 of W–2 wages (as definedin §1.199–2(e)), and then distributes the QPP to X.X’s adjusted basis in the QPP is $600. At the timeof the distribution, the fair market value of the QPPis $1,000. X incurs $200 of directly allocable costs,including $100 of W–2 wages, to further MPGE theQPP within the United States. In 2006, X sells theQPP for $1,500 to an unrelated customer and takesthe gross receipts into account under its method ofaccounting in the same taxable year. Under para-graph (j)(1) of this section, X is treated as havingMPGE the QPP within the United States, and X’s$1,500 of gross receipts qualify as DPGR. In addition,PRS is treated as having DPGR of $1,000 solely forpurposes of applying the wage limitation in section199(d)(1)(A)(iii) based on the applicable percentageof QPAI.

Example 5. Multiple sales. (i) Facts. X and Y arethe only partners in PRS, a partnership, for PRS’s en-tire 2006 taxable year. X and Y are both non-consol-idated members of a single EAG for the entire 2006year. PRS produces in bulk form in the United Statesthe active ingredient for a pharmaceutical product.Assume that PRS’s own MPGE activity with respectto the active ingredient is not substantial in nature,taking into account all of the facts and circumstances,and PRS’s direct labor and overhead to MPGE the ac-tive ingredient within the United States are $15 andaccount for 15% of PRS’s $100 CGS of the activeingredient. In 2006, PRS sells the active ingredientin bulk form to X. X uses the active ingredient toproduce the finished dosage form drug. Assume thatX’s own MPGE activity with respect to the drug isnot substantial in nature, taking into account all ofthe facts and circumstances, and X’s direct labor andoverhead to MPGE the drug within the United Statesare $12 and account for 10% of X’s $120 CGS of the

June 19, 2006 1132 2006–25 I.R.B.

drug. In 2006, X sells the drug in finished dosageto Y and Y sells the drug to customers. Assume thatY’s own MPGE activity with respect to the drug isnot substantial in nature, taking into account all ofthe facts and circumstances, and Y incurs $2 of directlabor and overhead and Y’s CGS in selling the drugto customers is $130.

(ii) Analysis. PRS’s gross receipts from the saleof the active ingredient to X are non-DPGR becausePRS’s MPGE activity is not substantial in nature andPRS does not satisfy the safe harbor described in§1.199–3(g)(3) because PRS’s direct labor and over-head account for less than 20% of PRS’s CGS of theactive ingredient. X’s gross receipts from the saleof the drug to Y are DPGR because X is consid-ered to have MPGE the drug in significant part in theUnited States pursuant to the safe harbor described in§1.199–3(g)(3) because the $27 ($15 + $12) of directlabor and overhead incurred by PRS and X equals orexceeds 20% of X’s total CGS ($120) of the drug atthe time X disposes of the drug to Y. Similarly, Y’sgross receipts from the sale of the drug to customersare DPGR because Y is considered to have MPGEthe drug in significant part in the United States pur-suant to the safe harbor described in §1.199–3(g)(3)because the $29 ($15 + $12 + $2) of direct labor andoverhead incurred by PRS, X, and Y equals or ex-ceeds 20% of Y’s total CGS ($130) of the drug at thetime Y disposes of the drug to Y’s customers.

(k) Effective dates. Section 199 appliesto taxable years beginning after December31, 2004. In determining the deductionunder section 199, items arising from a tax-able year of a partnership, S corporation,estate, or trust beginning before January 1,2005, shall not be taken into accountfor purposes of section 199(d)(1). Section

1.199–9 does not apply to taxable years be-ginning after May 17, 2006, the enactmentdate of the Tax Increase Prevention andReconciliation Act of 2005 (Public Law109–222, 120 Stat. 345). For taxable yearsbeginning on or before May 17, 2006, ataxpayer must apply §1.199–9 if the tax-payer applies §§1.199–1 through 1.199–8to that taxable year. Notwithstanding thepreceding sentence, a partnership or S cor-poration that is a qualifying small taxpayerunder §1.199–4(f) of REG–105847–05,2005–47 I.R.B. 987 (see §601.601(d)(2)of this chapter) may use the small businesssimplified overall method to apportionCGS and deductions between DPGRand non-DPGR at the entity level under§1.199–4(f) of REG–105847–05 for tax-able years beginning on or before May 17,2006. If a taxpayer chooses not to rely on§§1.199–1 through 1.199–9 (as providedin §1.199–8(i)) for a taxable year begin-ning before June 1, 2006, the guidanceunder section 199 that applies to taxableyears beginning before June 1, 2006, iscontained in Notice 2005–14, 2005–1 C.B.498 (see §601.601(d)(2) of this chapter).In addition, a taxpayer also may rely on theprovisions of REG–105847–05 for taxableyears beginning before June 1, 2006. IfNotice 2005–14 and REG–105847–05 in-clude different rules for the same particular

issue, then a taxpayer may rely on eitherthe rule set forth in Notice 2005–14 or therule set forth in REG–105847–05. How-ever, if REG–105847–05 includes a rulethat was not included in Notice 2005–14,then a taxpayer is not permitted to rely onthe absence of a rule in Notice 2005–14 toapply a rule contrary to REG–105847–05.For taxable years beginning after May17, 2006, and before June 1, 2006, a tax-payer may not apply Notice 2005–14,REG–105847–05, or any other guidanceunder section 199 in a manner inconsistentwith amendments made to section 199 bysection 514 of the Tax Increase Preventionand Reconciliation Act of 2005.

PART 602—OMB CONTROLNUMBERS UNDER THE PAPERWORKREDUCTION ACT

Par. 3. The authority citation for part602 continues to read as follows:

Authority: 26 U.S.C. 7805.Par. 4. In §602.101, paragraph (b) is

amended by adding an entry to the table innumerical order to read, in part, as follows:

§602.101 OMB Control numbers.

* * * * *(b) * * *

CFR part or section whereidentified and described

Current OMBcontrol No.

* * * * *

1.199–6 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1545–1966* * * * *

Mark E. Matthews,Deputy Commissioner forServices and Enforcement.

Approved May 2, 2006.

Eric Solomon,Acting Deputy Assistant Secretary

of the Treasury.

(Filed by the Office of the Federal Register on May 24, 2006,11:47 a.m., and published in the issue of the Federal Registerfor June 1, 2006, 71 F.R. 31267)

Section 851.—Definition ofRegulated InvestmentCompany26 CFR 1.851–2: Limitations.(Also Sections 7704, 7805; 301.7805–1.)

Regulated investment company(RIC). This ruling modifies Rev. Rul.2006–1 to extend until September 30,2006, the transition period provided bythat ruling, and clarifies that Rev. Rul.2006–1 was not intended to preclude aconclusion that income from certain in-struments (such as structured notes) thatcreate a commodity exposure for theholder is qualifying income under section

851(b)(2) of the Code. Rev. Rul. 2006–1modified and clarified.

Rev. Rul. 2006–31

Rev. Rul. 2006–1, 2006–2 I.R.B. 261,discusses derivative contracts with respectto a commodity index (“Derivatives”) thata regulated investment company (R) entersinto under Master Agreements with vari-ous counterparties. Under the Derivatives,R will pay an amount equal to the 3-monthU.S. Treasury bill rate plus a spread andwill receive (or pay) an amount based onthe total return gain (or loss) on a com-modity index. The payment obligation oneach Derivative is settled monthly by the

2006–25 I.R.B. 1133 June 19, 2006

receipt (in the event of a gain) or pay-ment (in the event of a loss) of cash, inthe net amount under the contract, andeach monthly measuring period constitutesa separate derivative contract under theMaster Agreements.

Rev. Rul. 2006–1 holds that a deriva-tive contract with respect to a commod-ity index is not a security for purposes ofsection 851(b)(2) of the Internal RevenueCode and that, under the facts stated inthe ruling, R’s income from the contract isnot qualifying income for purposes of sec-tion 851(b)(2), because the income fromthe contract is not derived with respect toR’s business of investing in stocks, secu-rities, or currencies. Rev. Rul. 2006–1further provides that under the authority ofsection 7805(b)(8), the holding of the rev-enue ruling will not be applied adverselywith respect to amounts of income that ataxpayer recognizes on or before June 30,2006.

It has come to the attention of the Ser-vice that some taxpayers are questioningwhether the holding of the revenue rul-ing applies to investments by regulated in-vestment companies (RICs) in all deriva-tive contracts with respect to a commod-ity index, including for example structurednotes, rather than just to the Derivativesdescribed in the revenue ruling.

The ruling was not intended to precludea conclusion that the income from cer-tain instruments (such as certain structurednotes) that create a commodity exposurefor the holder is qualifying income undersection 851(b)(2). Accordingly, to clar-ify the holding of Rev. Rul. 2006–1, theHOLDING section is revised to read:

A Derivative is not a security for pur-poses of section 851(b)(2). Under thefacts above, R’s income from a Deriva-tive is not qualifying income for pur-poses of section 851(b)(2), because theincome from the contract is not derivedwith respect to R’s business of invest-ing in stocks, securities, or currencies.

In addition, some taxpayers have ques-tioned whether the prospective applicationof the ruling is limited to the Derivativesdescribed in the revenue ruling or includesall derivative contracts with respect to acommodity index or an individual com-modity, including, for example, commod-ity futures contracts. The Service has also

been informed that, due to temporary de-mand/supply imbalances, some RICs thathad previously invested in derivative con-tracts similar to the Derivatives describedin Rev. Rul. 2006–1 are having difficultyin acquiring alternative commodity-linkedinvestments that result in qualifying in-come for purposes of section 851(b)(2).

The prospective application of the rul-ing was intended to apply to all derivativecontracts with respect to a commodityindex or an individual commodity. Ac-cordingly, to alleviate temporary sup-ply/demand pressure and to clarify thescope of the PROSPECTIVE APPLICA-TION section of Rev. Rul. 2006–1, thatsection is revised to read:

Under the authority of section7805(b)(8), the holding of this revenueruling will not be applied adverselywith respect to amounts of incomethat a taxpayer recognizes on or beforeSeptember 30, 2006, from a Deriva-tive. Neither will the Service apply theprinciples set forth in this revenue rul-ing adversely with respect to amountsof income recognized on or beforeSeptember 30, 2006, by a taxpayerfrom a derivative contract (includingan option, futures or forward contract)on a commodity index or an individualcommodity.

EFFECT ON OTHER DOCUMENTS

Rev. Rul. 2006–1 is modified and clar-ified.

DRAFTING INFORMATION

The principal author of this revenueruling is Dale S. Collinson of the Officeof the Associate Chief Counsel (Finan-cial Institutions & Products). For furtherinformation regarding this revenue rul-ing, contact him at (202) 622–3900 orSusan Thompson Baker at (202) 622–3930(not toll-free calls).

Section 6621.—Determina-tion of Rate of Interest26 CFR 301.6621–1: Interest rate.

Interest rates; underpayments andoverpayments. The rate of interest de-termined under section 6621 of the Code

for the calendar quarter beginning July 1,2006, will be 8 percent for overpayments(7 percent in the case of a corporation), 8percent for underpayments, and 10 percentfor large corporate underpayments. Therate of interest paid on the portion of acorporate overpayment exceeding $10,000will be 5.5 percent.

Rev. Rul. 2006–30

Section 6621 of the Internal RevenueCode establishes the rates for intereston tax overpayments and tax underpay-ments. Under section 6621(a)(1), theoverpayment rate is the sum of the federalshort-term rate plus 3 percentage points (2percentage points in the case of a corpo-ration), except the rate for the portion ofa corporate overpayment of tax exceeding$10,000 for a taxable period is the sum ofthe federal short-term rate plus 0.5 of apercentage point for interest computationsmade after December 31, 1994. Undersection 6621(a)(2), the underpayment rateis the sum of the federal short-term rateplus 3 percentage points.

Section 6621(c) provides that for pur-poses of interest payable under section6601 on any large corporate underpay-ment, the underpayment rate under section6621(a)(2) is determined by substituting“5 percentage points” for “3 percentagepoints.” See section 6621(c) and section301.6621–3 of the Regulations on Proce-dure and Administration for the definitionof a large corporate underpayment andfor the rules for determining the appli-cable date. Section 6621(c) and section301.6621–3 are generally effective forperiods after December 31, 1990.

Section 6621(b)(1) provides that theSecretary will determine the federalshort-term rate for the first month in eachcalendar quarter.

Section 6621(b)(2)(A) provides that thefederal short-term rate determined undersection 6621(b)(1) for any month appliesduring the first calendar quarter beginningafter such month.

Section 6621(b)(3) provides that thefederal short-term rate for any month isthe federal short-term rate determinedduring such month by the Secretary inaccordance with § 1274(d), rounded to thenearest full percent (or, if a multiple of 1/2

of 1 percent, the rate is increased to thenext highest full percent).

June 19, 2006 1134 2006–25 I.R.B.

Notice 88–59, 1988–1 C.B. 546, an-nounced that, in determining the quarterlyinterest rates to be used for overpaymentsand underpayments of tax under section6621, the Internal Revenue Service willuse the federal short-term rate based ondaily compounding because that rate ismost consistent with section 6621 which,pursuant to section 6622, is subject to dailycompounding.

Rounded to the nearest full percent, thefederal short-term rate based on daily com-pounding determined during the month ofApril 2006 is 5 percent. Accordingly, anoverpayment rate of 8 percent (7 percentin the case of a corporation) and an under-

payment rate of 8 percent are establishedfor the calendar quarter beginning July 1,2006. The overpayment rate for the por-tion of a corporate overpayment exceeding$10,000 for the calendar quarter beginningJuly 1, 2006, is 5.5 percent. The under-payment rate for large corporate underpay-ments for the calendar quarter beginningJuly 1, 2006, is 10 percent. These rates ap-ply to amounts bearing interest during thatcalendar quarter.

Interest factors for daily compound in-terest for annual rates of 5.5 percent, 7 per-cent, 8 percent, and 10 percent are pub-lished in Tables 16, 19, 21, and 25 of Rev.

Proc. 95–17, 1995–1 C.B. 556, 570, 573,575, and 579.

Annual interest rates to be compoundeddaily pursuant to section 6622 that applyfor prior periods are set forth in the tablesaccompanying this revenue ruling.

DRAFTING INFORMATION

The principal author of this revenue rul-ing is Crystal Foster of the Office of Asso-ciate Chief Counsel (Procedure & Admin-istration). For further information regard-ing this revenue ruling, contact Ms. Fosterat (202) 622–7198 (not a toll-free call).

TABLE OF INTEREST RATES

PERIODS BEFORE JUL. 1, 1975 — PERIODS ENDING DEC. 31, 1986

OVERPAYMENTS AND UNDERPAYMENTS

PERIOD RATEIn 1995–1 C.B.

DAILY RATE TABLE

Before Jul. 1, 1975 6% Table 2, pg. 557Jul. 1, 1975—Jan. 31, 1976 9% Table 4, pg. 559Feb. 1, 1976—Jan. 31, 1978 7% Table 3, pg. 558Feb. 1, 1978—Jan. 31, 1980 6% Table 2, pg. 557Feb. 1, 1980—Jan. 31, 1982 12% Table 5, pg. 560Feb. 1, 1982—Dec. 31, 1982 20% Table 6, pg. 560Jan. 1, 1983—Jun. 30, 1983 16% Table 37, pg. 591Jul. 1, 1983—Dec. 31, 1983 11% Table 27, pg. 581Jan. 1, 1984—Jun. 30, 1984 11% Table 75, pg. 629Jul. 1, 1984—Dec. 31, 1984 11% Table 75, pg. 629Jan. 1, 1985—Jun. 30, 1985 13% Table 31, pg. 585Jul. 1, 1985—Dec. 31, 1985 11% Table 27, pg. 581Jan. 1, 1986—Jun. 30, 1986 10% Table 25, pg. 579Jul. 1, 1986—Dec. 31, 1986 9% Table 23, pg. 577

TABLE OF INTEREST RATES

FROM JAN. 1, 1987 — DEC. 31, 1998

OVERPAYMENTS UNDERPAYMENTS

1995–1 C.B. 1995–1 C.B.RATE TABLE PG RATE TABLE PG

Jan. 1, 1987—Mar. 31, 1987 8% 21 575 9% 23 577Apr. 1, 1987—Jun. 30, 1987 8% 21 575 9% 23 577Jul. 1, 1987—Sep. 30, 1987 8% 21 575 9% 23 577Oct. 1, 1987—Dec. 31, 1987 9% 23 577 10% 25 579Jan. 1, 1988—Mar. 31, 1988 10% 73 627 11% 75 629Apr. 1, 1988—Jun. 30, 1988 9% 71 625 10% 73 627Jul. 1, 1988—Sep. 30, 1988 9% 71 625 10% 73 627Oct. 1, 1988—Dec. 31, 1988 10% 73 627 11% 75 629Jan. 1, 1989—Mar. 31, 1989 10% 25 579 11% 27 581Apr. 1, 1989—Jun. 30, 1989 11% 27 581 12% 29 583Jul. 1, 1989—Sep. 30, 1989 11% 27 581 12% 29 583Oct. 1, 1989—Dec. 31, 1989 10% 25 579 11% 27 581

2006–25 I.R.B. 1135 June 19, 2006

TABLE OF INTEREST RATES

FROM JAN. 1, 1987 — DEC. 31, 1998 – Continued

OVERPAYMENTS UNDERPAYMENTS

1995–1 C.B. 1995–1 C.B.RATE TABLE PG RATE TABLE PG

Jan. 1, 1990—Mar. 31, 1990 10% 25 579 11% 27 581Apr. 1, 1990—Jun. 30, 1990 10% 25 579 11% 27 581Jul. 1, 1990—Sep. 30, 1990 10% 25 579 11% 27 581Oct. 1, 1990—Dec. 31, 1990 10% 25 579 11% 27 581Jan. 1, 1991—Mar. 31, 1991 10% 25 579 11% 27 581Apr. 1, 1991—Jun. 30, 1991 9% 23 577 10% 25 579Jul. 1, 1991—Sep. 30, 1991 9% 23 577 10% 25 579Oct. 1, 1991—Dec. 31, 1991 9% 23 577 10% 25 579Jan. 1, 1992—Mar. 31, 1992 8% 69 623 9% 71 625Apr. 1, 1992—Jun. 30, 1992 7% 67 621 8% 69 623Jul. 1, 1992—Sep. 30, 1992 7% 67 621 8% 69 623Oct. 1, 1992—Dec. 31, 1992 6% 65 619 7% 67 621Jan. 1, 1993—Mar. 31, 1993 6% 17 571 7% 19 573Apr. 1, 1993—Jun. 30, 1993 6% 17 571 7% 19 573Jul. 1, 1993—Sep. 30, 1993 6% 17 571 7% 19 573Oct. 1, 1993—Dec. 31, 1993 6% 17 571 7% 19 573Jan. 1, 1994—Mar. 31, 1994 6% 17 571 7% 19 573Apr. 1, 1994—Jun. 30, 1994 6% 17 571 7% 19 573Jul. 1, 1994—Sep. 30, 1994 7% 19 573 8% 21 575Oct. 1, 1994—Dec. 31, 1994 8% 21 575 9% 23 577Jan. 1, 1995—Mar. 31, 1995 8% 21 575 9% 23 577Apr. 1, 1995—Jun. 30, 1995 9% 23 577 10% 25 579Jul. 1, 1995—Sep. 30, 1995 8% 21 575 9% 23 577Oct. 1, 1995—Dec. 31, 1995 8% 21 575 9% 23 577Jan. 1, 1996—Mar. 31, 1996 8% 69 623 9% 71 625Apr. 1, 1996—Jun. 30, 1996 7% 67 621 8% 69 623Jul. 1, 1996—Sep. 30, 1996 8% 69 623 9% 71 625Oct. 1, 1996—Dec. 31, 1996 8% 69 623 9% 71 625Jan. 1, 1997—Mar. 31, 1997 8% 21 575 9% 23 577Apr. 1, 1997—Jun. 30, 1997 8% 21 575 9% 23 577Jul. 1, 1997—Sep. 30, 1997 8% 21 575 9% 23 577Oct. 1, 1997—Dec. 31, 1997 8% 21 575 9% 23 577Jan. 1, 1998—Mar. 31, 1998 8% 21 575 9% 23 577Apr. 1, 1998—Jun. 30, 1998 7% 19 573 8% 21 575Jul. 1, 1998—Sep. 30, 1998 7% 19 573 8% 21 575Oct. 1, 1998—Dec. 31, 1998 7% 19 573 8% 21 575

TABLE OF INTEREST RATES

FROM JANUARY 1, 1999 — PRESENT

NONCORPORATE OVERPAYMENTS AND UNDERPAYMENTS

1995–1 C.B.RATE TABLE PG

Jan. 1, 1999—Mar. 31, 1999 7% 19 573Apr. 1, 1999—Jun. 30, 1999 8% 21 575Jul. 1, 1999—Sep. 30, 1999 8% 21 575Oct. 1, 1999—Dec. 31, 1999 8% 21 575Jan. 1, 2000—Mar. 31, 2000 8% 69 623Apr. 1, 2000—Jun. 30, 2000 9% 71 625Jul. 1, 2000—Sep. 30, 2000 9% 71 625Oct. 1, 2000—Dec. 31, 2000 9% 71 625Jan. 1, 2001—Mar. 31, 2001 9% 23 577Apr. 1, 2001—Jun. 30, 2001 8% 21 575

June 19, 2006 1136 2006–25 I.R.B.

TABLE OF INTEREST RATES

FROM JANUARY 1, 1999 — PRESENT – Continued

NONCORPORATE OVERPAYMENTS AND UNDERPAYMENTS

1995–1 C.B.RATE TABLE PG

Jul. 1, 2001—Sep. 30, 2001 7% 19 573Oct. 1, 2001—Dec. 31, 2001 7% 19 573Jan. 1, 2002—Mar. 31, 2002 6% 17 571Apr. 1, 2002—Jun. 30, 2002 6% 17 571Jul. 1, 2002—Sep. 30, 2002 6% 17 571Oct. 1, 2002—Dec. 31, 2002 6% 17 571Jan. 1, 2003—Mar. 31, 2003 5% 15 569Apr. 1, 2003—Jun. 30, 2003 5% 15 569Jul. 1, 2003—Sep. 30, 2003 5% 15 569Oct. 1, 2003—Dec. 31, 2003 4% 13 567Jan. 1, 2004—Mar. 31, 2004 4% 61 615Apr. 1, 2004—Jun. 30, 2004 5% 63 617Jul. 1, 2004—Sep. 30, 2004 4% 61 615Oct. 1, 2004—Dec. 31, 2004 5% 63 617Jan. 1, 2005—Mar. 31, 2005 5% 15 569Apr. 1, 2005—Jun. 30, 2005 6% 17 571Jul. 1, 2005—Sep. 30, 2005 6% 17 571Oct. 1, 2005—Dec. 31, 2005 7% 19 573Jan. 1, 2006—Mar. 31, 2006 7% 19 573Apr. 1, 2006—Jun. 30, 2006 7% 19 573Jul. 1, 2006—Sep. 30, 2006 8% 21 575

TABLE OF INTEREST RATES

FROM JANUARY 1, 1999 — PRESENT

CORPORATE OVERPAYMENTS AND UNDERPAYMENTS

OVERPAYMENTS UNDERPAYMENTS

1995–1 C.B. 1995–1 C.B.RATE TABLE PG RATE TABLE PG

Jan. 1, 1999—Mar. 31, 1999 6% 17 571 7% 19 573Apr. 1, 1999—Jun. 30, 1999 7% 19 573 8% 21 575Jul. 1, 1999—Sep. 30, 1999 7% 19 573 8% 21 575Oct. 1, 1999—Dec. 31, 1999 7% 19 573 8% 21 575Jan. 1, 2000—Mar. 31, 2000 7% 67 621 8% 69 623Apr. 1, 2000—Jun. 30, 2000 8% 69 623 9% 71 625Jul. 1, 2000—Sep. 30, 2000 8% 69 623 9% 71 625Oct. 1, 2000—Dec. 31, 2000 8% 69 623 9% 71 625Jan. 1, 2001—Mar. 31, 2001 8% 21 575 9% 23 577Apr. 1, 2001—Jun. 30, 2001 7% 19 573 8% 21 575Jul. 1, 2001—Sep. 30, 2001 6% 17 571 7% 19 573Oct. 1, 2001—Dec. 31, 2001 6% 17 571 7% 19 573Jan. 1, 2002—Mar. 31, 2002 5% 15 569 6% 17 571Apr. 1, 2002—Jun. 30, 2002 5% 15 569 6% 17 571Jul. 1, 2002—Sep. 30, 2002 5% 15 569 6% 17 571Oct. 1, 2002—Dec. 31, 2002 5% 15 569 6% 17 571Jan. 1, 2003—Mar. 31, 2003 4% 13 567 5% 15 569Apr. 1, 2003—Jun. 30, 2003 4% 13 567 5% 15 569Jul. 1, 2003—Sep. 30, 2003 4% 13 567 5% 15 569Oct. 1, 2003—Dec. 31, 2003 3% 11 565 4% 13 567Jan. 1, 2004—Mar. 31, 2004 3% 59 613 4% 61 615Apr. 1, 2004—Jun. 30, 2004 4% 61 615 5% 63 617Jul. 1, 2004—Sep. 30, 2004 3% 59 613 4% 61 615

2006–25 I.R.B. 1137 June 19, 2006

TABLE OF INTEREST RATES

FROM JANUARY 1, 1999 — PRESENT – Continued

CORPORATE OVERPAYMENTS AND UNDERPAYMENTS

OVERPAYMENTS UNDERPAYMENTS

1995–1 C.B. 1995–1 C.B.RATE TABLE PG RATE TABLE PG

Oct. 1, 2004—Dec. 31, 2004 4% 61 615 5% 63 617Jan. 1, 2005—Mar. 31, 2005 4% 13 567 5% 15 569Apr. 1, 2005—Jun. 30, 2005 5% 15 569 6% 17 571Jul. 1, 2005—Sep. 30, 2005 5% 15 569 6% 17 571Oct. 1, 2005—Dec. 31, 2005 6% 17 571 7% 19 573Jan. 1, 2006—Mar. 31, 2006 6% 17 571 7% 19 573Apr. 1, 2006—Jun. 30, 2006 6% 17 571 7% 19 573Jul. 1, 2006—Sep. 30, 2006 7% 19 573 8% 21 575

TABLE OF INTEREST RATES FORLARGE CORPORATE UNDERPAYMENTS

FROM JANUARY 1, 1991 — PRESENT

1995–1 C.B.RATE TABLE PG

Jan. 1, 1991—Mar. 31, 1991 13% 31 585Apr. 1, 1991—Jun. 30, 1991 12% 29 583Jul. 1, 1991—Sep. 30, 1991 12% 29 583Oct. 1, 1991—Dec. 31, 1991 12% 29 583Jan. 1, 1992—Mar. 31, 1992 11% 75 629Apr. 1, 1992—Jun. 30, 1992 10% 73 627Jul. 1, 1992—Sep. 30, 1992 10% 73 627Oct. 1, 1992—Dec. 31, 1992 9% 71 625Jan. 1, 1993—Mar. 31, 1993 9% 23 577Apr. 1, 1993—Jun. 30, 1993 9% 23 577Jul. 1, 1993—Sep. 30, 1993 9% 23 577Oct. 1, 1993—Dec. 31, 1993 9% 23 577Jan. 1, 1994—Mar. 31, 1994 9% 23 577Apr. 1, 1994—Jun. 30, 1994 9% 23 577Jul. 1, 1994—Sep. 30, 1994 10% 25 579Oct. 1, 1994—Dec. 31, 1994 11% 27 581Jan. 1, 1995—Mar. 31, 1995 11% 27 581Apr. 1, 1995—Jun. 30, 1995 12% 29 583Jul. 1, 1995—Sep. 30, 1995 11% 27 581Oct. 1, 1995—Dec. 31, 1995 11% 27 581Jan. 1, 1996—Mar. 31, 1996 11% 75 629Apr. 1, 1996—Jun. 30, 1996 10% 73 627Jul. 1, 1996—Sep. 30, 1996 11% 75 629Oct. 1, 1996—Dec. 31, 1996 11% 75 629Jan. 1, 1997—Mar. 31, 1997 11% 27 581Apr. 1, 1997—Jun. 30, 1997 11% 27 581Jul. 1, 1997—Sep. 30, 1997 11% 27 581Oct. 1, 1997—Dec. 31, 1997 11% 27 581Jan. 1, 1998—Mar. 31, 1998 11% 27 581Apr. 1, 1998—Jun. 30, 1998 10% 25 579Jul. 1, 1998—Sep. 30, 1998 10% 25 579Oct. 1, 1998—Dec. 31, 1998 10% 25 579Jan. 1, 1999—Mar. 31, 1999 9% 23 577Apr. 1, 1999—Jun. 30, 1999 10% 25 579Jul. 1, 1999—Sep. 30, 1999 10% 25 579Oct. 1, 1999—Dec. 31, 1999 10% 25 579Jan. 1, 2000—Mar. 31, 2000 10% 73 627

June 19, 2006 1138 2006–25 I.R.B.

TABLE OF INTEREST RATES FORLARGE CORPORATE UNDERPAYMENTS

FROM JANUARY 1, 1991 — PRESENT – Continued

1995–1 C.B.RATE TABLE PG

Apr. 1, 2000—Jun. 30, 2000 11% 75 629Jul. 1, 2000—Sep. 30, 2000 11% 75 629Oct. 1, 2000—Dec. 31, 2000 11% 75 629Jan. 1, 2001—Mar. 31, 2001 11% 27 581Apr. 1, 2001—Jun. 30, 2001 10% 25 579Jul. 1, 2001—Sep. 30, 2001 9% 23 577Oct. 1, 2001—Dec. 31, 2001 9% 23 577Jan. 1, 2002—Mar. 31, 2002 8% 21 575Apr. 1, 2002—Jun. 30, 2002 8% 21 575Jul. 1, 2002—Sep. 30, 2002 8% 21 575Oct. 1, 2002—Dec. 30, 2002 8% 21 575Jan. 1, 2003—Mar. 31, 2003 7% 19 573Apr. 1, 2003—Jun. 30, 2003 7% 19 573Jul. 1, 2003—Sep. 30, 2003 7% 19 573Oct. 1, 2003—Dec. 31, 2003 6% 17 571Jan. 1, 2004—Mar. 31, 2004 6% 65 619Apr. 1, 2004—Jun. 30, 2004 7% 67 621Jul. 1, 2004—Sep. 30, 2004 6% 65 619Oct. 1, 2004—Dec. 31, 2004 7% 67 621Jan. 1, 2005—Mar. 31, 2005 7% 19 573Apr. 1, 2005—Jun. 30, 2005 8% 21 575Jul. 1, 2005—Sep. 30, 2005 8% 21 575Oct. 1, 2005—Dec. 31, 2005 9% 23 577Jan. 1, 2006—Mar. 31, 2006 9% 23 577Apr. 1, 2006—Jun. 30, 2006 9% 23 577Jul. 1, 2006—Sep. 30, 2006 10% 25 579

TABLE OF INTEREST RATES FOR CORPORATEOVERPAYMENTS EXCEEDING $10,000

FROM JANUARY 1, 1995 — PRESENT

1995–1 C.B.RATE TABLE PG

Jan. 1, 1995—Mar. 31, 1995 6.5% 18 572Apr. 1, 1995—Jun. 30, 1995 7.5% 20 574Jul. 1, 1995—Sep. 30, 1995 6.5% 18 572Oct. 1, 1995—Dec. 31, 1995 6.5% 18 572Jan. 1, 1996—Mar. 31, 1996 6.5% 66 620Apr. 1, 1996—Jun. 30, 1996 5.5% 64 618Jul. 1, 1996—Sep. 30, 1996 6.5% 66 620Oct. 1, 1996—Dec. 31, 1996 6.5% 66 620Jan. 1, 1997—Mar. 31, 1997 6.5% 18 572Apr. 1, 1997—Jun. 30, 1997 6.5% 18 572Jul. 1, 1997—Sep. 30, 1997 6.5% 18 572Oct. 1, 1997—Dec. 31, 1997 6.5% 18 572Jan. 1, 1998—Mar. 31, 1998 6.5% 18 572Apr. 1, 1998—Jun. 30, 1998 5.5% 16 570Jul. 1, 1998—Sep. 30, 1998 5.5% 16 570Oct. 1, 1998—Dec. 31, 1998 5.5% 16 570Jan. 1, 1999—Mar. 31, 1999 4.5% 14 568Apr. 1, 1999—Jun. 30, 1999 5.5% 16 570Jul. 1, 1999—Sep. 30, 1999 5.5% 16 570Oct. 1, 1999—Dec. 31, 1999 5.5% 16 570

2006–25 I.R.B. 1139 June 19, 2006

TABLE OF INTEREST RATES FOR CORPORATEOVERPAYMENTS EXCEEDING $10,000

FROM JANUARY 1, 1995 — PRESENT – Continued

1995–1 C.B.RATE TABLE PG

Jan. 1, 2000—Mar. 31, 2000 5.5% 64 618Apr. 1, 2000—Jun. 30, 2000 6.5% 66 620Jul. 1, 2000—Sep. 30, 2000 6.5% 66 620Oct. 1, 2000—Dec. 31, 2000 6.5% 66 620Jan. 1, 2001—Mar. 31, 2001 6.5% 18 572Apr. 1, 2001—Jun. 30, 2001 5.5% 16 570Jul. 1, 2001—Sep. 30, 2001 4.5% 14 568Oct. 1, 2001—Dec. 31, 2001 4.5% 14 568Jan. 1, 2002—Mar. 31, 2002 3.5% 12 566Apr. 1, 2002—Jun. 30, 2002 3.5% 12 566Jul. 1, 2002—Sep. 30, 2002 3.5% 12 566Oct. 1, 2002—Dec. 31, 2002 3.5% 12 566Jan. 1, 2003—Mar. 31, 2003 2.5% 10 564Apr. 1, 2003—Jun. 30, 2003 2.5% 10 564Jul. 1, 2003—Sep. 30, 2003 2.5% 10 564Oct. 1, 2003—Dec. 31, 2003 1.5% 8 562Jan. 1, 2004—Mar. 31, 2004 1.5% 56 610Apr. 1, 2004—Jun. 30, 2004 2.5% 58 612Jul. 1, 2004—Sep. 30, 2004 1.5% 56 610Oct. 1, 2004—Dec. 31, 2004 2.5% 58 612Jan. 1, 2005—Mar. 31, 2005 2.5% 10 564Apr. 1, 2005—Jun. 30, 2005 3.5% 12 566Jul. 1, 2005—Sep. 30, 2005 3.5% 12 566Oct. 1, 2005—Dec. 31, 2005 4.5% 14 568Jan. 1, 2006—Mar. 31, 2006 4.5% 14 568Apr. 1, 2006—Jun. 30, 2006 4.5% 14 568Jul. 1, 2006—Sep. 30, 2006 5.5% 16 570

June 19, 2006 1140 2006–25 I.R.B.

Part III. Administrative, Procedural, and MiscellaneousCommunications Excise Tax;Toll Telephone Service

Notice 2006–50

SECTION 1. PURPOSE

(a) In general. As further described inthis notice, the Internal Revenue Servicewill follow the holdings of Am. BankersIns. Group v. United States, 408 F.3d1328 (11th Cir. 2005) (ABIG); OfficeMax,Inc. v. United States, 428 F.3d 583 (6thCir. 2005); Nat’l R.R. Passenger Corp.v. United States, 431 F.3d 374 (D.C. Cir.2005) (Amtrak); Fortis v. United States,2006 U.S. App. LEXIS 10749 (2d Cir.Apr. 27, 2006); and Reese Bros. v. UnitedStates, 2006 U.S. App. LEXIS 11468 (3dCir. May 9, 2006). These cases hold that atelephonic communication for which thereis a toll charge that varies with elapsedtransmission time and not distance (time-only service) is not taxable toll telephoneservice as defined in § 4252(b)(1) of the In-ternal Revenue Code. As a result, amountspaid for time-only service are not subjectto the tax imposed by § 4251. Accordingly,the government will no longer litigate thisissue and Notice 2005–79, 2005–46 I.R.B.952, which states otherwise, is revoked.

(b) Credits and refunds. Taxpayers maybe entitled to request credit or refund ofthe excise taxes paid for the services cov-ered by this notice. This notice providesguidance regarding these requests. In ad-dition, the Commissioner will authorizethe scheduling of an overassessment un-der § 6407 to keep the period of limitationsopen for these requests. This overassess-ment will apply to all taxpayers and to alltaxes paid for the services covered by thisnotice beginning with the tax paid on ser-vices that were billed to customers afterFebruary 28, 2003.

SECTION 2. BACKGROUND

(a) In general—(1) Tax imposed. Sec-tion 4251(a)(1) imposes a tax on amountspaid for communications services.

(2) Payment of tax. Section 4251(a)(2)provides that the tax imposed shall bepaid by the person paying for the service(taxpayer). Section 4251(b)(2) providesthat the applicable percentage is 3 percent

of amounts paid for communications ser-vices.

(3) Collection of tax. Section 4291 pro-vides that the tax is collected by the personreceiving the payment (collector). In mostcases, the collector, which is also respon-sible for paying over the tax to the govern-ment, is the telecommunications companythat provides the communications servicesto the taxpayer.

(b) Definitions—(1) Communicationsservices. Section 4251(b)(1) providesthat the term communications servicesmeans (A) local telephone service; (B) tolltelephone service; and (C) teletypewriterexchange service. This notice does notaddress teletypewriter exchange service.

(2) Local telephone service. Section4252(a) provides that local telephone ser-vice means (1) the access to a local tele-phone system, and the privilege of tele-phonic quality communication with sub-stantially all persons having telephone orradio telephone stations constituting a partof such local telephone system; and (2)any facility or service provided in connec-tion with such a service. Local telephoneservice does not include any service thatis a toll telephone service as defined in§ 4252(b) or a private communications ser-vice as defined in § 4252(d). This noticedoes not address private communicationsservice.

(3) Toll telephone service—(i) Time anddistance. Section 4252(b)(1) provides thattoll telephone service includes a telephonicquality communication for which there isa toll charge that varies in amount withthe distance and elapsed transmission timeof each individual communication and forwhich the charge is paid within the UnitedStates.

(ii) Periodic charge for a specifiedarea. Section 4252(b)(2) provides thattoll telephone service also includes a ser-vice which entitles the subscriber, uponpayment of a periodic charge (determinedas a flat amount or upon the basis of totalelapsed transmission time), to the privilegeof an unlimited number of telephonic com-munications to or from all or a substantialportion of the persons having telephoneor radio telephone stations in a specifiedarea which is outside the local telephone

system area in which the station providedwith this service is located.

(c) Rev. Rul. 79–404. Rev. Rul.79–404, 1979–2 C.B. 382, concludes thata long distance telephone call for whichthe charge varies with elapsed transmis-sion time but not with distance is toll tele-phone service described in § 4252(b)(1).

(d) Notice of proposed rulemaking.In a notice of proposed rulemaking(REG–141097–02, 2003–1 C.B. 807 [68FR 15690]; April 1, 2003), the Serviceproposed an amendment to the Facilitiesand Services Excise Taxes Regulationsto provide that toll telephone service de-scribed in section 4252(b)(1) may includea communication service for which thecharge does not vary with the distance ofeach individual communication.

(e) Recent litigation. ABIG, OfficeMax,Amtrak, and Reese Bros. hold time-onlyservice is not toll telephone service asdefined in § 4252(b)(1). Further, ABIG,OfficeMax, and Reese Bros. hold that thecommunications service provided was nota service described in § 4252(b)(2) be-cause the end result was not a “periodiccharge” based on total elapsed time butrather a monthly bill based on a summationof toll charges for individual communica-tions. (In Amtrak, toll telephone servicedescribed in § 4252(b)(2) would have beenexempt from tax under the common carrierexception in § 4253(f).) ABIG, OfficeMax,Amtrak, and Reese Bros. also hold that thecommunications services provided werenot local service, notwithstanding the ac-cess the services provided to the localtelephone system. (Fortis affirms, in a percuriam opinion, a district court decisionreaching the same results.)

(f) Notice 2005–79. Notice 2005–79,2005–46 I.R.B. 952, states that the Servicewill continue to assess and collect the taximposed by § 4251 on all taxable commu-nications services, including those similarto the services in ABIG.

SECTION 3. TERMS DEFINED

The following terms are defined solelyfor purposes of this notice:

(a) Bundled service. Bundled serviceis local and long distance service pro-vided under a plan that does not separatelystate the charge for the local telephone

2006–25 I.R.B. 1141 June 19, 2006

service. Bundled service includes, forexample, Voice over Internet Protocol ser-vice, prepaid telephone cards, and plansthat provide both local and long distanceservice for either a flat monthly fee or acharge that varies with the elapsed trans-mission time for which the service is used.Telecommunications companies providebundled service for both landline andwireless (cellular) service.

(b) Local-only service. Local-only ser-vice is local telephone service, as definedin § 4252(a), provided under a plan thatdoes not include long distance telephoneservice or that separately states the chargefor local service on its bill to customers.The term also includes services and facil-ities provided in connection with servicedescribed in the preceding sentence eventhough these services and facilities mayalso be used with long distance service.See, for example, Rev. Rul. 72–537,1972–2 C.B. 574 (telephone amplifier);Rev. Rul. 73–171, 1973–1 C.B. 445 (au-tomatic call distributing equipment); andRev. Rul. 73–269, 1973–1 C.B. 444 (spe-cial telephone).

(c) Long distance service. Long dis-tance service is telephonic quality com-munication with persons whose telephonesare outside the local telephone system ofthe caller.

(d) Nontaxable service. Nontaxableservice means bundled service and longdistance service.

SECTION 4. EFFECT OF ABIG,OFFICEMAX, AMTRAK, FORTIS, ANDREESE BROS.

(a) Tax treatment of communicationsservice after ABIG, OfficeMax, Amtrak,Fortis, and Reese Bros. The Service willfollow ABIG, OfficeMax, Amtrak, Fortis,and Reese Bros. Accordingly, taxpayersare no longer required to pay tax under§ 4251 for nontaxable service. In addition,collectors or taxpayers may request a re-fund of tax paid under § 4251 on nontax-able service that was billed to the taxpayersduring the period after February 28, 2003,and before August 1, 2006 (the relevant pe-riod).

(b) Tax on local-only service. Collec-tors should continue to collect and payover the § 4251 tax on amounts paid forlocal-only service. As noted in section3(b) of this notice, local-only service in-

cludes amounts paid for facilities or ser-vices provided in connection with localtelephone service. Thus, for example, taxwill continue to be imposed on amountspaid by a taxpayer for renting an ampli-fier phone provided in connection with lo-cal telephone service that is subject to tax.

(c) Effect on collectors. Collectors aredirected to cease collecting and payingover tax under § 4251 on nontaxable ser-vice that is billed after July 31, 2006, andare not required to report to the IRS anyrefusal by their customers to pay any taxon nontaxable service that is billed afterMay 25, 2006. Collectors should not payover to the IRS any tax on nontaxableservice that is billed after July 31, 2006.The form will require collectors to cer-tify that for the third quarter of 2006 the§ 4251 tax reported on the Form 720 doesnot include any tax on nontaxable servicethat was billed after July 31, 2006. Con-sequently, the IRS will deny all taxpayerrequests for refund of tax on nontaxableservice that was billed after July 31, 2006.All such requests should be directed tothe collector. In addition, collectors mayrepay to taxpayers the tax on nontaxableservice that was billed before August 1,2006, but are not required to repay suchtax. Collectors may also request a refundor make an adjustment to their separateaccounts, as appropriate, subject to theprovisions of § 6415 and section 5(d)(4)of this notice. Collectors must continue tocollect and pay over tax under § 4251 onamounts paid for local only service.

SECTION 5. REQUESTS FOR CREDITOR REFUND

(a) In general—(1) Request must followthis notice. The Commissioner agrees tocredit or refund the amounts paid for non-taxable service if the taxpayer requests thecredit or refund in the manner prescribedin this notice.

(2) Form of request. Taxpayers may re-quest a credit or refund of tax on nontax-able service that was billed after February28, 2003, and before August 1, 2006, onlyon their 2006 Federal income tax returns.For this purpose, the 2006 income tax re-turn is the income tax return for calendaryear 2006 or for the first taxable year in-cluding December 31, 2006. Forms 1040(series), 1041, 1065, 1120 (series), and990–T will include a line for requesting the

overpayment amount. Persons that are nototherwise required to file a federal incometax return must nevertheless file a returnto obtain the credit or refund. Except asprovided in section 5(d)(4) of this notice,a request for this credit or refund on anyother form (such as a Form 720, 843, or8849) will not be processed by the Service.Taxpayers will be permitted to request thesafe harbor amount under paragraph (c) ofthis section only if they have paid all taxesbilled by their service provider after Febru-ary 28, 2003, and before August 1, 2006.

(3) Guidance on the form. The instruc-tions to the respective federal income taxreturn forms will provide additional guid-ance. The forms and instructions will re-quire taxpayers to certify that (1) the tax-payer has not received from the collector acredit or refund of the tax paid on nontax-able service billed during the relevant pe-riod and (2) the taxpayer will not ask thecollector for a credit or refund of that taxand has withdrawn any such request thatwas previously submitted. The instruc-tions will also require that taxpayers, ex-cept for those individuals using the safeharbor amount, retain records that substan-tiate the request. These records should in-clude bills from the collector that show theamount of tax charged for nontaxable ser-vice for each month during the relevant pe-riod and receipts, canceled checks, or otherevidence that the amount requested wasactually paid.

(b) Period of request. The Commis-sioner will authorize the scheduling of anoverassessment under § 6407 to preservethe period of limitations during which tax-payers may request refunds of the tax onnontaxable service that was billed to cus-tomers after February 28, 2003, and beforeAugust 1, 2006. Therefore, requests maybe made for credits or refunds of tax paidfor nontaxable service billed after Febru-ary 28, 2003, and before August 1, 2006.

(c) Amount of the request—(1) Re-quests by individual taxpayers—(i) Safeharbor amount. Individual taxpayers mayrequest a safe harbor amount. No docu-mentation will be required to be submittedor kept to support the safe harbor request.However, taxpayers will be permitted torequest the safe harbor amount only ifthey have paid all taxes billed by theirservice provider after February 28, 2003,and before August 1, 2006; have not re-ceived a credit or refund of these taxes

June 19, 2006 1142 2006–25 I.R.B.

from the service provider, and either havenot requested such a credit or refund fromthe service provider or have withdrawnany such request. The amount of this safeharbor is still under consideration and willbe announced in later guidance.

(ii) Actual amount. Taxpayers that donot request the safe harbor amount mayrequest a credit or refund of the actualamount of tax they paid.

(d) How to file—(1) Requests by in-dividual taxpayers. Individual taxpayersmay request a credit or refund of federalexcise taxes paid on nontaxable serviceonly on their 2006 Form 1040, 1040A,or 1040–EZ, U.S. Individual Income TaxReturn. Individuals who are not otherwiserequired to file a federal income tax returnmust nevertheless file Form 1040EZ–Tto request the credit or refund. Individualtaxpayers, including Schedule C filers,may request either the safe harbor amountor the actual amount of tax paid for non-taxable service.

(2) Requests by taxpayers other than in-dividual taxpayers. Taxpayers other thanindividual taxpayers (entities) may requestonly the actual amount of tax paid on non-taxable service billed during the relevantperiod. No safe harbor amount is allowedfor entities.

(3) Requests by entities—(i) In general.Entities may request a credit or refund offederal excise taxes paid on nontaxableservice only on their 2006 income tax re-turns. Any part of the credit or refund at-tributable to tax payments that were de-ducted as an ordinary and necessary busi-ness expense (including in the determina-tion of unrelated business taxable income)must be included in income for the tax-able year in which the refund is receivedor accrued to the extent that the tax pay-ments reduced the amount of federal in-come tax (or unrelated business incometax) imposed.

(ii) Partnerships. A partnership, as de-fined in § 7701(a)(2), may request a creditor refund of federal excise taxes paid onnontaxable service only on its 2006 Form1065, U.S. Return of Partnership Income.Any amount of the credit or refund in-cluded in partnership income and any in-terest on the credit or refund must be re-ported on the partnership’s return for thetaxable year in which received or accruedand must be allocated to its partners on theSchedule K–1, Partner’s Share of Income,

Deductions, Credits, etc., for that taxableyear.

(iii) S Corporations. An S Corpora-tion, as defined in § 1361, may requesta credit or refund of federal excise taxespaid on nontaxable service only on its 2006Form 1120S, U.S. Income Tax Return foran S Corporation. Any amount of thecredit or refund included in S Corpora-tion income and any interest on the creditor refund must be reported on the S Cor-poration’s return for the taxable year inwhich received or accrued and must be al-located to its shareholders on the Sched-ule K–1, Shareholder’s Share of Income,Deductions, Credits, etc., for that taxableyear.

(iv) Estates and trusts. An estate ora trust, as defined in § 301.7701–4(a) ofthe Procedure and Administration Regula-tions, may request a credit or refund of fed-eral excise taxes paid on nontaxable ser-vice only on its 2006 Form 1041, U.S. In-come Tax Return for Estates and Trusts.Any amount of the credit or refund in-cluded in the estate’s or trust’s income andany interest on the credit or refund mustbe reported on the estate’s or trust’s Form1041, U.S. Income Tax Return for Estatesand Trusts, for the taxable year in whichreceived or accrued. However, for a trustthat is treated as owned by the grantor orother person under subpart E (§ 671 andfollowing), part I, subchapter J, chapter1 of the Internal Revenue Code (grantortrust), the owner of the trust may requesta credit or refund of federal excise taxestreated as paid by the owner for nontaxableservice only on its applicable 2006 federaltax return.

(v) Tax exempt organizations. An or-ganization that is described in § 501(a)may request a credit or refund of federalexcise taxes paid on nontaxable serviceonly on its 2006 Form 990–T, Exempt Or-ganization Business Income Tax Return.Tax exempt organizations that are not oth-erwise required to file a federal incometax return must nevertheless file Form990–T to request the credit or refund. Anyamount of the credit or refund includedin the organization’s unrelated businesstaxable income must be reported on theorganization’s Form 990–T, Exempt Or-ganization Business Income Tax Return,for the taxable year in which received oraccrued. An organization that is subject totax on its interest income must also report

any interest on the credit or refund on itsForm 990–T, Exempt Organization Busi-ness Income Tax Return, for the taxableyear in which received or accrued.

(vi) Corporations. A corporation, asdefined in § 7701(a)(3), that is not de-scribed in section 5(d)(3)(iii) of this noticemay request a credit or refund of federalexcise taxes paid on nontaxable serviceonly on its 2006 Form 1120 (series) in-come tax return (generally, Form 1120,U.S. Corporation Income Tax Return).Any amount of the credit or refund in-cluded in the corporation’s income andany interest on the credit or refund mustbe reported on the corporation’s incometax return for the taxable year in whichreceived or accrued. Corporations thatare not otherwise required to file a federalincome tax return must nevertheless fileForm 1120 (series) to request the credit orrefund.

(vii) Other nonfiling entities. Entitiesthat are not otherwise required to file afederal income tax return must file Form990–T to request the credit or refund.

(4) Requests and adjustments by col-lectors—(i) Section 6415 conditions to al-lowance. The conditions to allowance de-scribed in § 6415 apply to all requests andadjustments by collectors, as defined bysection 2(a)(3) of this notice. Thus, a re-quest by a collector is allowed only if theperson that paid over the tax establishesthat it has repaid the amount of the tax tothe person from whom the tax was col-lected, or obtains the written consent ofsuch person to the allowance of the creditor refund.

(ii) Requests for regular method collec-tors—(A) In general. A person that col-lected the tax imposed by § 4251 on non-taxable service and paid it over to the gov-ernment based on amounts actually col-lected under § 40.6302(c)–1(a)(2)(i) of theExcise Tax Procedural Regulations (regu-lar method collectors) may request a creditor refund.

(B) Form of the request. Regularmethod collectors may use Form 720X,Amended Quarterly Federal Excise TaxReturn, line 1, IRS No. 22, for credit orrefund of amounts collected and repaid totaxpayers.

(iii) Account adjustments for alter-native method collectors. A person thatcollected the tax imposed by § 4251 onnontaxable service and paid it over to the

2006–25 I.R.B. 1143 June 19, 2006

government based on amounts consideredas collected under § 40.6302(c)–1(a)(2)(ii)(alternative method collectors) may adjustthe separate account for the amount of anoverpayment. The required adjustmentto the separate account is described in§ 40.6302(c)–3(b)(2)(ii)(C). The adjust-ment is reflected on Form 720, ScheduleA, line 2, but may not reduce tax liabilityon Form 720 below zero.

(e) Interest on the credit or refund in-cluded in income. If a taxpayer requests acredit or refund of the actual amount of taxpaid, interest on the credit or refund of thetax paid for nontaxable service must be in-cluded as income on the taxpayer’s incometax return for the taxable year in which theinterest is received or accrued. Thus, indi-viduals are generally required to report theinterest on their 2007 income tax returns.

(f) Estimated tax effects. Although thecredit or refund allowed to a taxpayer un-der this notice will be requested on the tax-payer’s income tax return, it is not a creditagainst tax for purposes of §§ 6654 and6655. Accordingly, the taxpayer may nottake the credit or refund into account in de-termining the amount of the required in-stallments of estimated tax for 2006. Indetermining the amount of the required in-stallments of estimated tax for 2007, the in-come attributable to the credit or refund istaken into account on the date the incomeis paid or credited in the case of a cashmethod taxpayer and on the date the returnmaking the request is filed in the case of anaccrual method taxpayer.

(g) Requests that do not follow the pro-visions of this notice. Requests that donot follow the provisions of this notice(whether filed before or after its publica-tion)—

(1) Will not be processed to the extentthey relate to the tax paid on nontaxableservice that was billed after February 28,2003; and

(2) Will be processed normally to theextent they relate to the tax paid on nontax-able service that was billed before March1, 2003.

SECTION 6. EFFECT ON OTHERDOCUMENTS

Notice 2005–79, 2005–46 I.R.B. 952,is revoked. Rev. Rul. 79–404, 1979–2C.B. 382, will be revoked in a later revenueruling.

SECTION 7. DRAFTINGINFORMATION

The principal author of this notice isTaylor Cortright of the Office of the As-sociate Chief Counsel (Passthroughs andSpecial Industries). For further informa-tion regarding this notice, contact (202)622–3130 (not a toll-free call).

Renewable ElectricityProduction Credit andRefined Coal ProductionCredit, Publication of InflationAdjustment Factor andReference Prices for CalendarYear 2006

Notice 2006–51

This notice publishes the inflation ad-justment factor and reference prices forcalendar year 2006 for the renewable elec-tricity production credit and the refinedcoal production credit under § 45 of theInternal Revenue Code. The 2006 infla-tion adjustment factor and reference pricesare used in determining the availability ofthe credits. The 2006 inflation adjustmentfactor and reference prices apply to calen-dar year 2006 sales of kilowatt-hours ofelectricity produced in the United States ora possession thereof from qualified energyresources and to calendar year 2006 salesof refined coal produced in the UnitedStates or a possession thereof.

BACKGROUND

Section 45(a) provides that the renew-able electricity production credit for anytax year is an amount equal to the prod-uct of 1.5 cents multiplied by the kilowatthours of specified electricity produced bythe taxpayer and sold to an unrelated per-son during the tax year. This electricitymust be produced from qualified energyresources and at a qualified facility duringthe 10-year period beginning on the datethe facility was originally placed in ser-vice.

Section 45(b)(1) provides that theamount of the credit determined under§ 45(a) is reduced by an amount whichbears the same ratio to the amount of thecredit as (A) the amount by which the

reference price for the calendar year inwhich the sale occurs exceeds 8 cents,bears to (B) 3 cents. Under § 45(b)(2),the 1.5 cent amount in § 45(a), the 8 centamount in § 45(b)(1), the $4.375 amount in§ 45(e)(8)(A), and in § 45(e)(8)(B)(i) thereference price of fuel used as feedstock(within the meaning of § 45(c)(7)(A)) in2002 are each adjusted by multiplying theamount by the inflation adjustment factorfor the calendar year in which the saleoccurs. If any amount as increased underthe preceding sentence is not a multipleof 0.1 cent, the amount is rounded to thenearest multiple of 0.1 cent.

Section 45(c)(1) defines qualifiedenergy resources as wind, closed-loopbiomass, open-loop biomass, geother-mal energy, solar energy, small irrigationpower, municipal solid waste, and quali-fied hydropower production.

Section 45(d)(1) defines a qualified fa-cility using wind to produce electricity asany facility owned by the taxpayer that isoriginally placed in service after Decem-ber 31, 1993, and before January 1, 2008.See § 45(e)(7) for rules relating to the in-applicability of the credit to electricity soldto utilities under certain contracts.

Section 45(d)(2)(A) defines a qualifiedfacility using closed-loop biomass to pro-duce electricity as any facility (i) ownedby the taxpayer that is originally placed inservice after December 31, 1992, and be-fore January 1, 2008, or (ii) owned by thetaxpayer which before January 1, 2008, isoriginally placed in service and modifiedto use closed-loop biomass to co-fire withcoal, with other biomass, or with both,but only if the modification is approvedunder the Biomass Power for Rural De-velopment Programs or is part of a pilotproject of the Commodity Credit Corpora-tion as described in 65 Fed. Reg. 63052.Section 45(d)(2)(B) provides that in thecase of a qualified facility described in§ 45(d)(2)(A)(ii), (i) the 10-year period re-ferred to in § 45(a) is treated as begin-ning no earlier than the date of enactmentof § 45(d)(2)(B)(i); (ii) the amount of thecredit determined under § 45(a) with re-spect to the facility is an amount equalto the amount determined without regardto § 45(d)(2)(B)(ii) multiplied by the ratioof the thermal content of the closed-loopbiomass used in the facility to the thermalcontent of all fuels used in the facility; and(iii) if the owner of the facility is not the

June 19, 2006 1144 2006–25 I.R.B.

producer of the electricity, the person eli-gible for the credit allowable under § 45(a)is the lessee or the operator of the facility.

Section 45(d)(3)(A) defines a qualifiedfacility using open-loop biomass to pro-duce electricity as any facility owned bythe taxpayer which (i) in the case of a facil-ity using agricultural livestock waste nutri-ents, (I) is originally placed in service afterthe date of enactment of § 45(d)(3)(A)(i)(I)and before January 1, 2008, and (II) thenameplate capacity rating of which is notless than 150 kilowatts; and (ii) in the caseof any other facility, is originally placed inservice before January 1, 2008. In the caseof any facility described in § 45(d)(3)(A),if the owner of the facility is not the pro-ducer of the electricity, § 45(d)(3)(B) pro-vides that the person eligible for the creditallowable under § 45(a) is the lessee or theoperator of the facility.

Section 45(d)(4) defines a qualified fa-cility using geothermal or solar energy toproduce electricity as any facility ownedby the taxpayer which is originally placedin service after the date of enactment of§ 45(d)(4) and before January 1, 2008 (Jan-uary 1, 2006, in the case of a facility us-ing solar energy). A qualified facility us-ing geothermal or solar energy does not in-clude any property described in § 48(a)(3)the basis of which is taken into account bythe taxpayer for purposes of determiningthe energy credit under § 48.

Section 45(d)(5) defines a qualifiedfacility using small irrigation power toproduce electricity as any facility ownedby the taxpayer which is originally placedin service after the date of enactment of§ 45(d)(5) and before January 1, 2008.

Section 45(d)(6) defines a qualified fa-cility using gas derived from the biodegra-dation of municipal solid waste to produceelectricity as any facility owned by the tax-payer which is originally placed in serviceafter the date of enactment of § 45(d)(6)and before January 1, 2008.

Section 45(d)(7) defines a qualified fa-cility that burns municipal solid waste toproduce electricity as any facility ownedby the taxpayer which is originally placedin service after the date of enactment of§ 45(d)(7) and before January 1, 2008. Aqualified facility burning municipal solidwaste includes a new unit placed in servicein connection with a facility placed in ser-vice on or before the date of enactment of§ 45(d)(7), but only to the extent of the in-

creased amount of electricity produced atthe facility by reason of such new unit.

Section 45(d)(8) provides in the caseof a facility that produces refined coal,the term “refined coal production facility”means a facility which is placed in serviceafter the date of enactment of § 45(d)(8)and before January 1, 2009.

Section 45(d)(9) defines a qualifiedfacility producing qualified hydroelec-tric production described in § 45(c)(8) as(A) any facility producing incrementalhydropower production, but only to theextent of its incremental hydropower pro-duction attributable to efficiency improve-ments or additions to capacity describedin § 45(c)(8)(B) placed in service after thedate of enactment of § 45(d)(9) and beforeJanuary 1, 2008, and (B) any other facilityplaced in service after the date of enact-ment of § 45(d)(9) and before January 1,2008. Section 45(d)(9)(C) provides that inthe case of a qualified facility described in§ 45(d)(9)(A), the 10-year period referredto in § 45(a) is treated as beginning onthe date the efficiency improvements oradditions to capacity are placed in service.

Section 45(e)(8)(A) provides that therefined coal production credit is an amountequal to $4.375 per ton of qualified re-fined coal (i) produced by the taxpayerat a refined coal production facility dur-ing the 10-year period beginning on thedate the facility was originally placed inservice, and (ii) sold by the taxpayer (I)to an unrelated person and (II) during the10-year period and the tax year. Section45(e)(8)(B) provides that the amount ofcredit determined under § 45(e)(8)(A) isreduced by an amount which bears thesame ratio to the amount of the increaseas (i) the amount by which the referenceprice of fuel used as feedstock (within themeaning of § 45(c)(7)(A)) for the calendaryear in which the sale occurs exceeds anamount equal to 1.7 multiplied by the ref-erence price for such fuel in 2002, bears to(ii) $8.75.

Section 45(e)(2)(A) requires the Secre-tary to determine and publish in the Fed-eral Register each calendar year the infla-tion adjustment factor and the referenceprices for the calendar year. The inflationadjustment factor and the reference pricesfor the 2006 calendar year were publishedin the Federal Register on March 31, 2006(71 Fed. Reg. 16420), and corrected onMay 9, 2006 (71 Fed. Reg. 27038).

Section 45(e)(2)(B) defines the infla-tion adjustment factor for a calendar yearas the fraction the numerator of which isthe GDP implicit price deflator for the pre-ceding calendar year and the denominatorof which is the GDP implicit price defla-tor for the calendar year 1992. The term“GDP implicit price deflator” means themost recent revision of the implicit pricedeflator for the gross domestic product ascomputed and published by the Depart-ment of Commerce before March 15 of thecalendar year.

Section 45(e)(2)(C) provides that thereference price is the Secretary’s determi-nation of the annual average contract priceper kilowatt hour of electricity generatedfrom the same qualified energy resourceand sold in the previous year in the UnitedStates. Only contracts entered into af-ter December 31, 1989, are taken into ac-count.

Under § 45(e)(8)(C), the determinationof the reference price for fuel used as feed-stock within the meaning of § 45(c)(7)(A)is made according to rules similar to therules under § 45(e)(2)(C).

INFLATION ADJUSTMENT FACTORAND REFERENCE PRICES

The inflation adjustment factor forcalendar year 2006 is 1.2981. The ref-erence price for calendar year 2006 forfacilities producing electricity from windbased upon information provided by theDepartment of Energy is 2.89 cents perkilowatt hour. The reference prices forfuel used as feedstock within the mean-ing of § 45(c)(7)(A), relating to refinedcoal production (based upon informationprovided by the Department of Energy)are $31.90 per ton for calendar year 2002and $42.78 per ton for calendar year2006. The reference prices for facilitiesproducing electricity from closed-loopbiomass, open-loop biomass, geother-mal energy, solar energy, small irrigationpower, municipal solid waste, and quali-fied hydropower production have not beendetermined for calendar year 2006. TheIRS is exploring methods of determiningthose reference prices for calendar year2007.

PHASE-OUT CALCULATION

Because the 2006 reference price forelectricity produced from wind does not

2006–25 I.R.B. 1145 June 19, 2006

exceed 8 cents multiplied by the infla-tion adjustment factor, the phaseout ofthe credit provided in § 45(b)(1) doesnot apply to such electricity sold duringcalendar year 2006. Because the 2006 ref-erence price of fuel used as feedstock forrefined coal does not exceed the $31.90reference price of such fuel in 2002 mul-tiplied by the inflation adjustment factorand 1.7, the phaseout of credit providedin § 45(e)(8)(B) does not apply to re-fined coal sold during calendar year 2006.Further, for electricity produced fromclosed-loop biomass, open-loop biomass,geothermal energy, solar energy, smallirrigation power, municipal solid waste,and qualified hydropower production, thephaseout of credit provided in § 45(b)(1)does not apply to such electricity sold dur-ing calendar year 2006.

CREDIT AMOUNT BY QUALIFIEDENERGY RESOURCE AND FACILITYAND REFINED COAL

As required by § 45(b)(2), the 1.5 centamount in § 45(a)(1), the 8 cent amountin § 45(b)(1), and the $4.375 amount in§ 45(e)(8)(A) are each adjusted by mul-tiplying such amount by the inflationadjustment factor for the calendar yearin which the sale occurs. If any amountas increased under the preceding sen-tence is not a multiple of 0.1 cent, suchamount is rounded to the nearest multi-ple of 0.1 cent. In the case of electricityproduced in open-loop biomass facilities,small irrigation power facilities, landfillgas facilities, trash combustion facili-ties, and qualified hydropower facilities,§ 45(b)(4)(A) requires the amount in ef-fect under § 45(a)(1) (before roundingto the nearest 0.1 cent) to be reduced by

one-half. Under the calculation requiredby § 45(b)(2), the credit for renewableelectricity production for calendar year2006 under § 45(a) is 1.9 cents per kilo-watt hour on the sale of electricity pro-duced from the qualified energy resourcesof wind, closed-loop biomass, geothermalenergy, and solar energy, and 1.0 cent perkilowatt hour on the sale of electricityproduced in open-loop biomass facilities,small irrigation power facilities, landfillgas facilities, trash combustion facilities,and qualified hydropower facilities. Underthe calculation required by § 45(b)(2), thecredit for refined coal production for cal-endar year 2006 under section 45(e)(8)(A)is $5.679 per ton on the sale of qualifiedrefined coal.

DRAFTING AND CONTACTINFORMATION

The principal author of this notice isDavid A. Selig of the Office of AssociateChief Counsel (Passthroughs and SpecialIndustries). For further information re-garding this notice, contact Mr. Selig at(202) 622–3040 (not a toll-free call).

Weighted Average InterestRate Update

Notice 2006–55

Sections 412(b)(5)(B) and 412(l)(7)(C)(i) of the Internal Revenue Code gen-erally provide that the interest rates usedto calculate current liability for purposesof determining the full funding limitationunder § 412(c)(7) and the required con-tribution under § 412(l) must be withina permissible range around the weighted

average of the rates of interest on 30-yearTreasury securities during the four-yearperiod ending on the last day before thebeginning of the plan year.

Notice 88–73, 1988–2 C.B. 383, pro-vides guidelines for determining theweighted average interest rate and theresulting permissible range of interestrates used to calculate current liability forthe purpose of the full funding limitationof § 412(c)(7) of the Code.

Section 417(e)(3)(A)(ii)(II) definesthe applicable interest rate, which mustbe used for purposes of determining theminimum present value of a participant’sbenefit under § 417(e)(1) and (2), as theannual rate of interest on 30-year Treasurysecurities for the month before the dateof distribution or such other time as theSecretary may by regulations prescribe.Section 1.417(e)–1(d)(3) of the IncomeTax Regulations provides that the applica-ble interest rate for a month is the annualinterest rate on 30-year Treasury securi-ties as specified by the Commissioner forthat month in revenue rulings, notices orother guidance published in the InternalRevenue Bulletin.

The rate of interest on 30-year Treasurysecurities for May 2006 is 5.20 percent.The Service has determined this rate as themonthly average of the daily determina-tion of yield on the 30-year Treasury bondmaturing in February 2036.

The following 30-year Treasury rateswere determined for the plan years begin-ning in the month shown below.

For Plan Years30-YearTreasury 90% to 105% 90% to 110%

Beginning in: Weighted Permissible PermissibleMonth Year Average Range Range

June 2006 4.82 4.34 to 5.06 4.34 to 5.31

Drafting Information

The principal authors of this notice arePaul Stern and Tony Montanaro of the Em-ployee Plans, Tax Exempt and Govern-ment Entities Division. For further infor-

mation regarding this notice, please con-tact the Employee Plans’ taxpayer assis-tance telephone service at 877–829–5500(a toll-free number), between the hours of8:30 a.m. and 4:30 p.m. Eastern time,Monday through Friday. Mr. Stern may be

reached at 202–283–9703. Mr. Montanaromay be reached at 202–283–9714. Thetelephone numbers in the preceding sen-tences are not toll-free.

June 19, 2006 1146 2006–25 I.R.B.

26 CFR 601.105: Examination of returns and claimsfor refund, credit, or abatement; determination ofcorrect tax liability.(Also: Part I, § 911, 1.911–1.)

Rev. Proc. 2006–28

SECTION 1. PURPOSE

.01 This revenue procedure providesinformation to any individual who failedto meet the eligibility requirements of§ 911(d)(1) of the Internal Revenue Codebecause adverse conditions in a foreigncountry precluded the individual frommeeting those requirements for taxableyear 2005.

.02 This revenue procedure lists thecountry, for which the eligibility require-ments of § 911(d)(1) are waived for taxableyear 2005.

SECTION 2. BACKGROUND

.01 Section 911(a) of the Code allowsa “qualified individual,” as defined in

§ 911(d)(1), to exclude foreign earnedincome and housing cost amounts fromgross income. Section 911(c)(3) of theCode allows a qualified individual todeduct housing cost amounts from grossincome.

.02 Section 911(d)(1) of the Code de-fines the term “qualified individual” as anindividual whose tax home is in a foreigncountry and who is (A) a citizen of theUnited States and establishes to the satis-faction of the Secretary of the Treasury thatthe individual has been a bona fide residentof a foreign country or countries for an un-interrupted period that includes an entiretaxable year, or (B) a citizen or resident ofthe United States who, during any periodof 12 consecutive months, is present in aforeign country or countries during at least330 full days.

.03 Section 911(d)(4) of the Code pro-vides an exception to the eligibility re-quirements of § 911(d)(1). An individ-ual will be treated as a qualified individ-ual with respect to a period in which theindividual was a bona fide resident of, or

was present in, a foreign country, if the in-dividual left the country during a periodfor which the Secretary of the Treasury, af-ter consultation with the Secretary of State,determines that individuals were requiredto leave because of war, civil unrest, orsimilar adverse conditions that precludedthe normal conduct of business. An in-dividual must establish that but for thoseconditions the individual could reasonablyhave been expected to meet the eligibilityrequirements.

.04 For 2005, the Secretary of the Trea-sury, in consultation with the Secretaryof State, has determined that war, civilunrest, or similar adverse conditions pre-cluded the normal conduct of business inthe following country beginning on thespecified date:

CountryDate of Departure

On or after

Haiti May 26, 2005

.05 Accordingly, for purposes of § 911of the Code, an individual who left Haition or after May 26, 2005, shall be treatedas a qualified individual with respect to theperiod during which that individual waspresent in, or was a bona fide resident of,Haiti, if the individual establishes a reason-able expectation of meeting the require-ments of § 911(d) but for those conditions.

.06 To qualify for relief under§ 911(d)(4) of the Code, an individualmust have established residency, or havebeen physically present, in the foreigncountry on or prior to the date that theSecretary of the Treasury determines thatindividuals were required to leave the for-eign country. Individuals who establish

residency, or are first physically present, inthe foreign country after the date that theSecretary prescribes shall not be treatedas qualified individuals under § 911(d)(4)of the Code. Therefore, individuals whoare first physically present or establishresidency in Haiti after May 26, 2005, arenot eligible to qualify for the exceptionprovided in § 911(d)(4) of the Code fortaxable year 2005.

SECTION 3. INQUIRIES

A taxpayer who needs assistance onhow to claim this exclusion, or on how tofile an amended return, should contact a lo-cal IRS Office or, for a taxpayer residing

or traveling outside the United States, thenearest overseas IRS office.

SECTION 4. DRAFTINGINFORMATION

The principal author of this revenueprocedure is Kate Y. Hwa of the Office ofAssociate Chief Counsel (International).For further information regarding this rev-enue procedure, contact Kate Y. Hwa at(202) 622–3840 (not a toll-free call).

2006–25 I.R.B. 1147 June 19, 2006

Definition of TermsRevenue rulings and revenue procedures(hereinafter referred to as “rulings”) thathave an effect on previous rulings use thefollowing defined terms to describe the ef-fect:

Amplified describes a situation whereno change is being made in a prior pub-lished position, but the prior position is be-ing extended to apply to a variation of thefact situation set forth therein. Thus, ifan earlier ruling held that a principle ap-plied to A, and the new ruling holds that thesame principle also applies to B, the earlierruling is amplified. (Compare with modi-fied, below).

Clarified is used in those instanceswhere the language in a prior ruling is be-ing made clear because the language hascaused, or may cause, some confusion.It is not used where a position in a priorruling is being changed.

Distinguished describes a situationwhere a ruling mentions a previously pub-lished ruling and points out an essentialdifference between them.

Modified is used where the substanceof a previously published position is beingchanged. Thus, if a prior ruling held that aprinciple applied to A but not to B, and thenew ruling holds that it applies to both A

and B, the prior ruling is modified becauseit corrects a published position. (Comparewith amplified and clarified, above).

Obsoleted describes a previously pub-lished ruling that is not considered deter-minative with respect to future transac-tions. This term is most commonly used ina ruling that lists previously published rul-ings that are obsoleted because of changesin laws or regulations. A ruling may alsobe obsoleted because the substance hasbeen included in regulations subsequentlyadopted.

Revoked describes situations where theposition in the previously published rulingis not correct and the correct position isbeing stated in a new ruling.

Superseded describes a situation wherethe new ruling does nothing more than re-state the substance and situation of a previ-ously published ruling (or rulings). Thus,the term is used to republish under the1986 Code and regulations the same po-sition published under the 1939 Code andregulations. The term is also used whenit is desired to republish in a single rul-ing a series of situations, names, etc., thatwere previously published over a period oftime in separate rulings. If the new rul-ing does more than restate the substance

of a prior ruling, a combination of termsis used. For example, modified and su-perseded describes a situation where thesubstance of a previously published rulingis being changed in part and is continuedwithout change in part and it is desired torestate the valid portion of the previouslypublished ruling in a new ruling that is selfcontained. In this case, the previously pub-lished ruling is first modified and then, asmodified, is superseded.

Supplemented is used in situations inwhich a list, such as a list of the names ofcountries, is published in a ruling and thatlist is expanded by adding further names insubsequent rulings. After the original rul-ing has been supplemented several times, anew ruling may be published that includesthe list in the original ruling and the ad-ditions, and supersedes all prior rulings inthe series.

Suspended is used in rare situationsto show that the previous published rul-ings will not be applied pending somefuture action such as the issuance of newor amended regulations, the outcome ofcases in litigation, or the outcome of aService study.

AbbreviationsThe following abbreviations in current useand formerly used will appear in materialpublished in the Bulletin.

A—Individual.Acq.—Acquiescence.B—Individual.BE—Beneficiary.BK—Bank.B.T.A.—Board of Tax Appeals.C—Individual.C.B.—Cumulative Bulletin.CFR—Code of Federal Regulations.CI—City.COOP—Cooperative.Ct.D.—Court Decision.CY—County.D—Decedent.DC—Dummy Corporation.DE—Donee.Del. Order—Delegation Order.DISC—Domestic International Sales Corporation.DR—Donor.E—Estate.EE—Employee.E.O.—Executive Order.

ER—Employer.ERISA—Employee Retirement Income Security Act.EX—Executor.F—Fiduciary.FC—Foreign Country.FICA—Federal Insurance Contributions Act.FISC—Foreign International Sales Company.FPH—Foreign Personal Holding Company.F.R.—Federal Register.FUTA—Federal Unemployment Tax Act.FX—Foreign corporation.G.C.M.—Chief Counsel’s Memorandum.GE—Grantee.GP—General Partner.GR—Grantor.IC—Insurance Company.I.R.B.—Internal Revenue Bulletin.LE—Lessee.LP—Limited Partner.LR—Lessor.M—Minor.Nonacq.—Nonacquiescence.O—Organization.P—Parent Corporation.PHC—Personal Holding Company.PO—Possession of the U.S.PR—Partner.

PRS—Partnership.PTE—Prohibited Transaction Exemption.Pub. L.—Public Law.REIT—Real Estate Investment Trust.Rev. Proc.—Revenue Procedure.Rev. Rul.—Revenue Ruling.S—Subsidiary.S.P.R.—Statement of Procedural Rules.Stat.—Statutes at Large.T—Target Corporation.T.C.—Tax Court.T.D. —Treasury Decision.TFE—Transferee.TFR—Transferor.T.I.R.—Technical Information Release.TP—Taxpayer.TR—Trust.TT—Trustee.U.S.C.—United States Code.X—Corporation.Y—Corporation.Z —Corporation.

June 19, 2006 i 2006–25 I.R.B.

Numerical Finding List1

Bulletin 2006–1 through 2006–25

Announcements:

2006-1, 2006-1 I.R.B. 260

2006-2, 2006-2 I.R.B. 300

2006-3, 2006-3 I.R.B. 327

2006-4, 2006-3 I.R.B. 328

2006-5, 2006-4 I.R.B. 378

2006-6, 2006-4 I.R.B. 340

2006-7, 2006-4 I.R.B. 342

2006-8, 2006-4 I.R.B. 344

2006-9, 2006-5 I.R.B. 392

2006-10, 2006-5 I.R.B. 393

2006-11, 2006-6 I.R.B. 420

2006-12, 2006-6 I.R.B. 421

2006-13, 2006-7 I.R.B. 462

2006-14, 2006-8 I.R.B. 516

2006-15, 2006-11 I.R.B. 632

2006-16, 2006-12 I.R.B. 653

2006-17, 2006-12 I.R.B. 653

2006-18, 2006-12 I.R.B. 654

2006-19, 2006-13 I.R.B. 674

2006-20, 2006-13 I.R.B. 675

2006-21, 2006-14 I.R.B. 703

2006-22, 2006-16 I.R.B. 779

2006-23, 2006-14 I.R.B. 729

2006-24, 2006-16 I.R.B. 820

2006-25, 2006-18 I.R.B. 871

2006-26, 2006-18 I.R.B. 871

2006-27, 2006-18 I.R.B. 871

2006-28, 2006-18 I.R.B. 873

2006-29, 2006-19 I.R.B. 879

2006-30, 2006-19 I.R.B. 879

2006-31, 2006-20 I.R.B. 912

2006-32, 2006-20 I.R.B. 913

2006-33, 2006-20 I.R.B. 914

2006-34, 2006-21 I.R.B. 937

2006-35, 2006-24 I.R.B. 1061

2006-36, 2006-23 I.R.B. 1038

2006-37, 2006-23 I.R.B. 1039

2006-38, 2006-24 I.R.B. 1062

Court Decisions:

2081, 2006-13 I.R.B. 656

2082, 2006-14 I.R.B. 697

Notices:

2006-1, 2006-4 I.R.B. 347

2006-2, 2006-2 I.R.B. 278

2006-3, 2006-3 I.R.B. 306

2006-4, 2006-3 I.R.B. 307

2006-5, 2006-4 I.R.B. 348

2006-6, 2006-5 I.R.B. 385

2006-7, 2006-10 I.R.B. 559

Notices— Continued:

2006-8, 2006-5 I.R.B. 386

2006-9, 2006-6 I.R.B. 413

2006-10, 2006-5 I.R.B. 386

2006-11, 2006-7 I.R.B. 457

2006-12, 2006-7 I.R.B. 458

2006-13, 2006-8 I.R.B. 496

2006-14, 2006-8 I.R.B. 498

2006-15, 2006-8 I.R.B. 501

2006-16, 2006-9 I.R.B. 538

2006-17, 2006-10 I.R.B. 559

2006-18, 2006-8 I.R.B. 502

2006-19, 2006-9 I.R.B. 539

2006-20, 2006-10 I.R.B. 560

2006-21, 2006-12 I.R.B. 643

2006-22, 2006-11 I.R.B. 593

2006-23, 2006-11 I.R.B. 594

2006-24, 2006-11 I.R.B. 595

2006-25, 2006-11 I.R.B. 609

2006-26, 2006-11 I.R.B. 622

2006-27, 2006-11 I.R.B. 626

2006-28, 2006-11 I.R.B. 628

2006-29, 2006-12 I.R.B. 644

2006-30, 2006-24 I.R.B. 1044

2006-31, 2006-15 I.R.B. 751

2006-32, 2006-13 I.R.B. 677

2006-33, 2006-15 I.R.B. 754

2006-34, 2006-14 I.R.B. 705

2006-35, 2006-14 I.R.B. 708

2006-36, 2006-15 I.R.B. 756

2006-37, 2006-18 I.R.B. 855

2006-38, 2006-16 I.R.B. 777

2006-39, 2006-17 I.R.B. 841

2006-40, 2006-18 I.R.B. 855

2006-41, 2006-18 I.R.B. 857

2006-42, 2006-19 I.R.B. 878

2006-43, 2006-21 I.R.B. 921

2006-44, 2006-20 I.R.B. 889

2006-45, 2006-20 I.R.B. 891

2006-46, 2006-24 I.R.B. 1044

2006-47, 2006-20 I.R.B. 892

2006-48, 2006-21 I.R.B. 922

2006-49, 2006-22 I.R.B. 943

2006-50, 2006-25 I.R.B. 1141

2006-51, 2006-25 I.R.B. 1144

2006-55, 2006-25 I.R.B. 1146

Proposed Regulations:

REG-107722-00, 2006-4 I.R.B. 354

REG-104385-01, 2006-5 I.R.B. 389

REG-122380-02, 2006-10 I.R.B. 563

REG-137243-02, 2006-3 I.R.B. 317

REG-139059-02, 2006-24 I.R.B. 1052

REG-144784-02, 2006-23 I.R.B. 1036

REG-133446-03, 2006-2 I.R.B. 299

REG-113365-04, 2006-10 I.R.B. 580

Proposed Regulations— Continued:

REG-148568-04, 2006-6 I.R.B. 417

REG-106418-05, 2006-7 I.R.B. 461

REG-133036-05, 2006-20 I.R.B. 911

REG-138879-05, 2006-8 I.R.B. 503

REG-143244-05, 2006-6 I.R.B. 419

REG-146384-05, 2006-17 I.R.B. 843

REG-146459-05, 2006-8 I.R.B. 504

REG-157271-05, 2006-12 I.R.B. 652

REG-164247-05, 2006-15 I.R.B. 758

REG-111578-06, 2006-24 I.R.B. 1060

Revenue Procedures:

2006-1, 2006-1 I.R.B. 1

2006-2, 2006-1 I.R.B. 89

2006-3, 2006-1 I.R.B. 122

2006-4, 2006-1 I.R.B. 132

2006-5, 2006-1 I.R.B. 174

2006-6, 2006-1 I.R.B. 204

2006-7, 2006-1 I.R.B. 242

2006-8, 2006-1 I.R.B. 245

2006-9, 2006-2 I.R.B. 278

2006-10, 2006-2 I.R.B. 293

2006-11, 2006-3 I.R.B. 309

2006-12, 2006-3 I.R.B. 310

2006-13, 2006-3 I.R.B. 315

2006-14, 2006-4 I.R.B. 350

2006-15, 2006-5 I.R.B. 387

2006-16, 2006-9 I.R.B. 539

2006-17, 2006-14 I.R.B. 709

2006-18, 2006-12 I.R.B. 645

2006-19, 2006-13 I.R.B. 677

2006-20, 2006-17 I.R.B. 841

2006-21, 2006-24 I.R.B. 1050

2006-22, 2006-23 I.R.B. 1033

2006-23, 2006-20 I.R.B. 900

2006-24, 2006-22 I.R.B. 943

2006-25, 2006-21 I.R.B. 926

2006-26, 2006-21 I.R.B. 936

2006-27, 2006-22 I.R.B. 945

2006-28, 2006-25 I.R.B. 1147

Revenue Rulings:

2006-1, 2006-2 I.R.B. 261

2006-2, 2006-2 I.R.B. 261

2006-3, 2006-2 I.R.B. 276

2006-4, 2006-2 I.R.B. 264

2006-5, 2006-3 I.R.B. 302

2006-6, 2006-5 I.R.B. 381

2006-7, 2006-6 I.R.B. 399

2006-8, 2006-9 I.R.B. 520

2006-9, 2006-9 I.R.B. 519

2006-10, 2006-10 I.R.B. 557

2006-11, 2006-12 I.R.B. 635

2006-12, 2006-12 I.R.B. 637

2006-13, 2006-13 I.R.B. 656

1 A cumulative list of all revenue rulings, revenue procedures, Treasury decisions, etc., published in Internal Revenue Bulletins 2005–27 through 2005–52 is in Internal Revenue Bulletin2005–52, dated December 27, 2005.

2006–25 I.R.B. ii June 19, 2006

Revenue Rulings— Continued:

2006-14, 2006-15 I.R.B. 740

2006-15, 2006-13 I.R.B. 661

2006-16, 2006-14 I.R.B. 694

2006-17, 2006-15 I.R.B. 748

2006-18, 2006-15 I.R.B. 743

2006-19, 2006-15 I.R.B. 749

2006-20, 2006-15 I.R.B. 746

2006-21, 2006-15 I.R.B. 745

2006-22, 2006-14 I.R.B. 687

2006-23, 2006-17 I.R.B. 839

2006-24, 2006-19 I.R.B. 875

2006-25, 2006-20 I.R.B. 882

2006-26, 2006-22 I.R.B. 939

2006-27, 2006-21 I.R.B. 915

2006-28, 2006-22 I.R.B. 938

2006-29, 2006-23 I.R.B. 1031

2006-30, 2006-25 I.R.B. 1134

2006-31, 2006-25 I.R.B. 1133

Tax Conventions:

2006-6, 2006-4 I.R.B. 340

2006-7, 2006-4 I.R.B. 342

2006-8, 2006-4 I.R.B. 344

2006-19, 2006-13 I.R.B. 674

2006-20, 2006-13 I.R.B. 675

2006-21, 2006-14 I.R.B. 703

Treasury Decisions:

9231, 2006-2 I.R.B. 272

9232, 2006-2 I.R.B. 266

9233, 2006-3 I.R.B. 303

9234, 2006-4 I.R.B. 329

9235, 2006-4 I.R.B. 338

9236, 2006-5 I.R.B. 382

9237, 2006-6 I.R.B. 394

9238, 2006-6 I.R.B. 408

9239, 2006-6 I.R.B. 401

9240, 2006-7 I.R.B. 454

9241, 2006-7 I.R.B. 427

9242, 2006-7 I.R.B. 422

9243, 2006-8 I.R.B. 475

9244, 2006-8 I.R.B. 463

9245, 2006-14 I.R.B. 696

9246, 2006-9 I.R.B. 534

9247, 2006-9 I.R.B. 521

9248, 2006-9 I.R.B. 524

9249, 2006-10 I.R.B. 546

9250, 2006-11 I.R.B. 588

9251, 2006-11 I.R.B. 590

9252, 2006-12 I.R.B. 633

9253, 2006-14 I.R.B. 689

9254, 2006-13 I.R.B. 662

9255, 2006-15 I.R.B. 741

9256, 2006-16 I.R.B. 770

9257, 2006-17 I.R.B. 821

9258, 2006-20 I.R.B. 886

9259, 2006-19 I.R.B. 874

Treasury Decisions— Continued:

9260, 2006-23 I.R.B. 1001

9261, 2006-21 I.R.B. 919

9262, 2006-24 I.R.B. 1040

9263, 2006-25 I.R.B. 1063

June 19, 2006 iii 2006–25 I.R.B.

Finding List of Current Actions onPreviously Published Items1

Bulletin 2006–1 through 2006–25

Announcements:

2000-48

Modified by

Notice 2006-35, 2006-14 I.R.B. 708

Notices:

89-85

Amplified by

Notice 2006-46, 2006-24 I.R.B. 1044

2001-4

Sections (V)(C), (D), and (E) superseded by

T.D. 9253, 2006-14 I.R.B. 689

2001-11

Superseded by

T.D. 9253, 2006-14 I.R.B. 689

2001-43

Modified by

Notice 2006-35, 2006-14 I.R.B. 708

Sections 2 and 3 superseded by

T.D. 9253, 2006-14 I.R.B. 689

2002-35

Clarified and modified by

Notice 2006-16, 2006-9 I.R.B. 538

2005-14

Obsoleted for taxable years beginning on or after

June 1, 2006, by

T.D. 9263, 2006-25 I.R.B. 1063

2005-30

Modified and superseded by

Notice 2006-31, 2006-15 I.R.B. 751

2005-44

Supplemented by

Notice 2006-1, 2006-4 I.R.B. 347

2005-66

Supplemented by

Notice 2006-20, 2006-10 I.R.B. 560

2005-73

Supplemented by

Notice 2006-20, 2006-10 I.R.B. 560

2005-79

Revoked by

Notice 2006-50, 2006-25 I.R.B. 1141

2005-81

Supplemented by

Notice 2006-20, 2006-10 I.R.B. 560

Notices— Continued:

2005-98

Supplemented by

Notice 2006-7, 2006-10 I.R.B. 559

Proposed Regulations:

REG-103829-99

Withdrawn by

Ann. 2006-16, 2006-12 I.R.B. 653

REG-150313-01

Withdrawn by

Ann. 2006-30, 2006-19 I.R.B. 879

REG-131739-03

Corrected by

Ann. 2006-10, 2006-5 I.R.B. 393

REG-131264-04

Withdrawn by

Ann. 2006-34, 2006-21 I.R.B. 937

REG-138647-04

Corrected by

Ann. 2006-4, 2006-3 I.R.B. 328

REG-158080-04

Corrected by

Ann. 2006-11, 2006-6 I.R.B. 420

Revenue Procedures:

81-17

Obsoleted by

Rev. Proc. 2006-24, 2006-22 I.R.B. 943

89-8

Superseded by

Rev. Proc. 2006-23, 2006-20 I.R.B. 900

89-56

Modified by

Rev. Proc. 2006-21, 2006-24 I.R.B. 1050

90-39

Modified by

Rev. Proc. 2006-21, 2006-24 I.R.B. 1050

96-52

Superseded by

Rev. Proc. 2006-10, 2006-2 I.R.B. 293

97-27

Modified by

Rev. Proc. 2006-11, 2006-3 I.R.B. 309

Modified and amplified by

Rev. Proc. 2006-12, 2006-3 I.R.B. 310

Revenue Procedures— Continued:

2002-9

Modified by

Rev. Proc. 2006-11, 2006-3 I.R.B. 309

Modified and amplified by

Notice 2006-47, 2006-20 I.R.B. 892Rev. Proc. 2006-12, 2006-3 I.R.B. 310Rev. Proc. 2006-14, 2006-4 I.R.B. 350Rev. Proc. 2006-16, 2006-9 I.R.B. 539

2002-17

Modified by

Rev. Proc. 2006-14, 2006-4 I.R.B. 350

2002-32

Modified by

Rev. Proc. 2006-21, 2006-24 I.R.B. 1050

2002-52

Modified by

Rev. Proc. 2006-26, 2006-21 I.R.B. 936

2003-31

Superseded by

Rev. Proc. 2006-19, 2006-13 I.R.B. 677

2003-38

Modified by

Rev. Proc. 2006-16, 2006-9 I.R.B. 539

2003-44

Modified and superseded by

Rev. Proc. 2006-27, 2006-22 I.R.B. 945

2004-23

Superseded for certain taxable years by

Rev. Proc. 2006-12, 2006-3 I.R.B. 310

2004-40

Superseded by

Rev. Proc. 2006-9, 2006-2 I.R.B. 278

2005-1

Superseded by

Rev. Proc. 2006-1, 2006-1 I.R.B. 1

2005-2

Superseded by

Rev. Proc. 2006-2, 2006-1 I.R.B. 89

2005-3

Superseded by

Rev. Proc. 2006-3, 2006-1 I.R.B. 122

2005-4

Superseded by

Rev. Proc. 2006-4, 2006-1 I.R.B. 132

2005-5

Superseded by

Rev. Proc. 2006-5, 2006-1 I.R.B. 174

2005-6

Superseded by

Rev. Proc. 2006-6, 2006-1 I.R.B. 204

1 A cumulative list of current actions on previously published items in Internal Revenue Bulletins 2005–27 through 2005–52 is in Internal Revenue Bulletin 2005–52, dated December 27,2005.

2006–25 I.R.B. iv June 19, 2006

Revenue Procedures— Continued:

2005-7

Superseded by

Rev. Proc. 2006-7, 2006-1 I.R.B. 242

2005-8

Superseded by

Rev. Proc. 2006-8, 2006-1 I.R.B. 245

2005-9

Superseded for certain taxable years by

Rev. Proc. 2006-12, 2006-3 I.R.B. 310

2005-12

Section 10 modified and superseded by

Rev. Proc. 2006-1, 2006-1 I.R.B. 1

2005-15

Obsoleted in part by

Rev. Proc. 2006-17, 2006-14 I.R.B. 709

2005-21

Superseded by

Rev. Proc. 2006-25, 2006-21 I.R.B. 926

2005-22

Obsoleted by

Rev. Proc. 2006-20, 2006-17 I.R.B. 841

2005-24

Modified by

Notice 2006-15, 2006-8 I.R.B. 501

2005-61

Superseded by

Rev. Proc. 2006-3, 2006-1 I.R.B. 122

2005-68

Superseded by

Rev. Proc. 2006-1, 2006-1 I.R.B. 1Rev. Proc. 2006-3, 2006-1 I.R.B. 122

Revenue Rulings:

55-355

Obsoleted by

T.D. 9244, 2006-8 I.R.B. 463

74-503

Revoked by

Rev. Rul. 2006-2, 2006-2 I.R.B. 261

77-230

Obsoleted by

T.D. 9249, 2006-10 I.R.B. 546

91-5

Modified by

T.D. 9250, 2006-11 I.R.B. 588

92-19

Supplemented in part by

Rev. Rul. 2006-25, 2006-20 I.R.B. 882

92-86

Modified by

T.D. 9250, 2006-11 I.R.B. 588

Revenue Rulings— Continued:

2000-2

Modified and superseded by

Rev. Rul. 2006-26, 2006-22 I.R.B. 939

2006-1

Modified and clarified by

Rev. Rul. 2006-31, 2006-25 I.R.B. 1133

2006-25

Corrected by

Ann. 2006-35, 2006-24 I.R.B. 1061

Treasury Decisions:

9191

Corrected by

Ann. 2006-26, 2006-18 I.R.B. 871

9192

Corrected by

Ann. 2006-15, 2006-11 I.R.B. 632

9203

Corrected by

Ann. 2006-12, 2006-6 I.R.B. 421

9243

Corrected by

Ann. 2006-38, 2006-24 I.R.B. 1062

9244

Corrected by

Ann. 2006-31, 2006-20 I.R.B. 912

9248

Corrected by

Ann. 2006-32, 2006-20 I.R.B. 913

June 19, 2006 v 2006–25 I.R.B. U.S. GPO: 2006—320–797/20063