SECTION 199 DOMESTIC PRODUCTION ACTIVITY …...The proposed regulations provide that oil-related...
Transcript of SECTION 199 DOMESTIC PRODUCTION ACTIVITY …...The proposed regulations provide that oil-related...
SECTION 199 DOMESTIC PRODUCTION ACTIVITY REGULATIONS
SPECIAL REPORT
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Special Report on §199 Domestic Production Activity Regulations August 31, 2015
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On August 26, 2015, the IRS released a long-anticipated proposed regulation package addressing
the §199 domestic production activities deduction. The proposed rules have been in the works
for several years, and develop about a dozen technical aspects of the domestic production
activities deduction, including issues relevant to contract manufacturing, oil and gas extraction
and production, and film production. The proposed regulations contains several provisions that
taxpayers will welcome, according to practitioners contacted by Bloomberg BNA.
The Core §199 Deduction Calculation
The §199 deduction formula allows a deduction for a percentage (typically 9%, except for oil-
related production activities) of the smaller of a taxpayer’s qualified production activities
income and the taxpayer’s taxable income determined without regard to the §199 deduction.
Qualified production activities income is the excess of domestic production gross receipts
over the sum of:
(1) The cost of goods sold allocable to such receipts;
(2) Other deductions, expenses, or losses directly allocable to such receipts; and
(3) A ratable portion of deductions, expenses and losses not directly allocable to such receipts or
another class of income.
Domestic production gross receipts generally include gross receipts derived from the lease,
rental, license, sale, exchange or other disposition of qualified production property. Domestic
production gross receipts also include gross receipts derived from qualified construction,
engineering and architectural services. Additionally, qualified production property must be
manufactured, produced, grown or extracted by the taxpayer in whole, or in significant part,
within the United States.
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Scope of the New Guidance
The §199 regulation package provides guidance to taxpayers on:
• Contract manufacturing;
• Hedging transactions;
• Allocations of wages to short tax years;
• Oil-related qualified production activities income;
• Filmmaking;
• Manufacturing activities in Puerto Rico;
• Domestic production gross receipts determinations;
• The scope of qualified production property that is manufactured, produced, grown, or
extracted in the U.S.;
• Construction activities;
• Cost of goods sold allocations; and
• The application of §199 to agricultural and horticultural cooperatives.
REG-136459-09, 80 Fed. Reg. 51,978 (Aug. 27, 2015).
On August 26th, the IRS also released final and temporary regulations clarifying how taxpayers
calculate W-2 wages for purposes of the §199 wage limitation in the case of a tax year or a short
tax year in which a taxpayer acquires, or disposes of, the major portion of a trade or business, or
the major portion of a separate unit of a trade or business. These regulations also clarify how to
allocate W-2 wages paid by two or more taxpayers that employ the same employees of the
acquired, or disposed-of, trade or business during a calendar year. T.D. 9731, 80 Fed. Reg.
51,939 (Aug. 27, 2015).
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Contract Manufacturing
One notable clarification offered in the proposed regulations is that contract manufacturers hired
to perform qualifying activities to produce products can take a domestic production deduction
under the proposed regulations. The proposed regulations effectively resolve a long-standing
debate between principals and contract manufacturers about which party can take the domestic
production deduction under §199 based on who has the benefits and burden of ownership of the
products being produced.
The IRS Large Business and International Division (LB&I) noted that the IRS had adopted the
§199 benefits-and-burdens test to prevent more than one taxpayer from claiming the §199
deduction in contract manufacturing arrangements. LB&I has addressed this issue in three
directives discussing determinations of which taxpayer has the benefits and burdens of
ownership under a contract manufacturing arrangement, with the most recent directive calling on
parties to execute a certification to clarify which entity will claim the §199 deduction. IRS LB&I
Directive LB&I-04-1013-008 on Guidance for Examiners on Section 199 Benefits, Burdens of
Ownership Analysis in Contract Manufacturing Arrangements (Oct. 29, 2013).
The proposed regulations remove the rule under §199 treating a taxpayer in a contract
manufacturing arrangement as engaging in the qualifying activity only if the taxpayer has the
benefits and burdens of ownership during the period in which the qualifying activity occurs. In
place of the benefits-and-burdens-of-ownership rule, the proposed rules provide a more practical
approach: if a qualifying activity is performed under a contract, then the party that performs the
activity is deemed to be the taxpayer.
The proposed regulations “disregard[] the statutory requirements of ownership,” according to
Mr. George Manousos, a partner at PricewaterhouseCoopers LLP, comparing the rules to saying
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that a tailor owns the suit he is altering. 166 DTR G-2 (Aug. 27, 2015). “[The contract
manufacturers] are completely following instructions and just providing a service.”
The proposed regulations express an intention to be “consistent with §199, [to] reduce the burden
on taxpayers and the IRS in evaluating factors related to the benefits and burdens of ownership,
and [to] prevent more than one taxpayer from being allowed a deduction.”
Ceding the deduction to the contract manufacturer is a “scorched earth” approach, Mr. Manousos
said. The Treasury Department and the IRS requested comments on whether there should be a
limited exception allowing the party that is not performing the qualifying activity to be the
taxpayer entitled to the deduction if it provides all of the raw materials, labor, and overhead costs
related to fulfilling the contract. Mr. Manousos indicated that if the proposed new provision were
to be finalized, manufacturing companies may choose to bring more of their production in-house,
or move their production activity overseas. “They could just say, if the U.S. isn’t going to give
me the benefit, I’m going to take it overseas … We still have a lot of runway. This is one of the
biggest controversial areas, and there are so many issues to figure out.” 166 DTR G-2 (Aug. 27,
2015).
Wage Deductions for Short Tax Years
T.D. 9731 addresses manufacturers’ uncertainty about allocating wages to certain short tax years
for purposes of the §199 deduction. “This has been an issue for many, many years,” Mr. Tom
Windram, a partner at McGladrey LLP, said. “It’s really a result of a drafting error in the
regulations.” 166 DTR G-2 (Aug. 27, 2015). The IRS issued the temporary regulations as
proposed regulations also.
Acquisitions or dispositions of businesses often result in short tax years. Under the proposed and
temporary rules, Form W-2 wages paid during a calendar year to employees of an acquired, or
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disposed-of, business are prorated (i.e., allocated between each business based on the time each
company employed them) for §199 purposes. The proposed and temporary rules provide that
wages paid during a short tax year that does not include December 31 are treated as W-2 wages
for that short tax year, clarifying an apparent regulatory mistake that precluded some companies
from taking the deduction. “Let’s say a company is acquired on June 30 and it has a fiscal year
that ends September 30. Then there would be short period return for the three months beginning
July 1 and ending September 30,” Mr. Windram said. “Since that short period did not include
December 31, the W-2 wage limitation would be zero, meaning they would get no §199
deduction for the short [tax] year.” This unfortunate outcome is resolved by the proposed and
temporary rule.
To effect this fix, the final regulations remove the current language of Reg. §1.199-2(c) and
replace it with a cross-reference to new temporary and proposed regulations addressing
calculations of W-2 wages for purposes of the wage limitation in the cases of:
• Short tax years; or
• Acquisitions or dispositions of a trade or business, the major portion of a trade or business, or
the major portion of a separate unit of a trade or business.
Specifically, the proposed and temporary regulations provide that W-2 wages paid during the
calendar year to employees of the acquired, or disposed-of, trade or business are allocated
between each taxpayer based on the period during which the employees of the acquired, or the
disposed-of, trade or business were employed by the taxpayer. The proposed and temporary
regulations also provide a rule to apply in the case of a short tax year not including December 31.
Wages paid by a taxpayer during the short tax year to employees for employment by such
taxpayer are treated as W-2 wages for such short tax year for purposes of §199(b)(1). The
proposed and temporary regulations also explicitly address the types of transactions that are
considered either an acquisition or disposition for purposes of §199(b)(3), including an
incorporation, a formation, a liquidation, a reorganization, or a purchase or sale of assets. The
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proposed and temporary regulations also note that wages qualifying as W-2 wages of one
taxpayer cannot be treated as W-2 wages of another taxpayer.
Oil-Related Qualified Production Activities Income and Deductions
The proposed regulations provide several technical rules applicable to the oil and gas industry.
The proposed regulations define oil-related qualified production activities income as an
amount equal to the excess (if any) of the taxpayer's domestic production gross receipts from
the production, refining, or processing of oil, gas, or similar primary products (oil-related
domestic production gross receipts) over the sum of the cost of goods sold that is allocable to
such receipts and other expenses, losses, or deductions that are properly allocable to such
receipts. The proposed regulations provide that oil-related domestic production gross receipts
do not include gross receipts derived from the transportation or distribution of oil, gas, or any
primary product thereof, except if the de minimis rule under Reg. §1.199-1(d)(3)(i) applies, or an
exception for embedded services under Reg. §1.199-3(i)(4)(i)(B) applies.
The proposed regulations further provide that, to the extent a taxpayer treats gross receipts
derived from the transportation or distribution of oil, gas, or any primary product thereof, as
domestic production gross receipts under Reg. §1.199-1(d)(3)(i) or §1.199-3(i)(4)(i)(B), the
taxpayer must include those gross receipts in oil-related domestic production gross receipts.
The proposed regulations provide guidance on how a taxpayer should allocate and apportion
costs under the §861 method, the simplified deduction method, and the small business simplified
overall method when determining oil-related qualified production activities income. Under the
§861 method, a taxpayer allocates and apportions its deductions using the allocation and
apportionment rules provided under the §861 regulations (i.e., rules provided by Reg. §1.861-8
through §1.861-17 and §1.861-8T through §1.861-14T, with certain exceptions and
modifications). Prop. Reg. §1.199-1(f)(2).
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The proposed regulations require taxpayers to use the same cost allocation method to allocate
and apportion costs to oil-related domestic production gross receipts as the taxpayer uses to
allocate and apportion costs to domestic production gross receipts.
Filmmaking Businesses
The proposed regulations amend the definition of qualified film in Reg. §1.199-3(k)(1) to
include copyrights, trademarks, or other intangibles with respect to films. The proposed
regulations provide a special rule for disposition of promotional films to address concerns of the
Treasury Department and the IRS that the inclusion of intangibles in the definition of qualified
film could be interpreted too broadly. The proposed regulations explicitly include compensation
for services performed in the U.S. by actors, production personnel, directors, and producers
within the definition of W-2 wages.
The proposed regulations also address an amendment to §199(c)(6) that provides that the
methods and means of distributing a qualified film won't affect the availability of the §199
deduction.
The proposed regulations clarify that production activities don't include activities related to the
transmission or distribution of films. Prior legislation added an attribution rule for a qualified
film for taxpayers who are partnerships or S corporations, or partners or shareholders of those
entities under §199(d)(1)(A)(iv). The proposed regulations describe the application of
§199(d)(1)(A)(iv) to those entities and individuals for tax years beginning after 2007, and clarify
how a taxpayer producing live or delayed television programs should apply the qualified film
safe harbor.
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Filmmaking industry taxpayers may object to a proposed rule that would exclude from overhead
licensing fees for films produced by third parties.
Scope of Manufactured, Produced, Grown, or Extracted Property and Minor Assembly
The current §199 regulations provide that manufactured, produced, grown, or extracted
property includes property derived from manufacturing, producing, growing, extracting,
installing, developing, improving, and creating qualified production property; making
qualified production property out of scrap, salvage, or junk material, as well as from new or
raw material, by processing, manipulating, refining, or changing the form of an article, or by
combining or assembling two or more articles; and includes cultivating soil, raising livestock,
fishing, and mining minerals.
The preamble to the proposed regulations notes that the IRS recognizes that an example in Reg.
§1.199-3(e)(5) has been interpreted as suggesting that testing activities qualify as
manufacturing, production, growth, or extraction activities even if the taxpayer engages in no
other manufacturing, production, growth, or extraction activity; however, the IRS disagrees
with this position. Accordingly, the proposed regulations would add a sentence to Example 5 in
Reg. §1.199-3(e)(5) to establish that testing activities are not treated as manufacturing,
production, growth, or extraction activities unless performed as part of the manufacture,
production, growth, or extraction of qualified production property.
Under both the current and the proposed §199 regulations, a taxpayer's packaging, repackaging,
labeling, or minor assembly of qualifying production property does not qualify as
manufacturing, production, growth, or extraction activity for that property, assuming that the
taxpayer engages in no other manufacturing, production, growth, or extraction activity
regarding that property.
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An example in the proposed regulations states that assembling products purchased from
unrelated third parties into gift baskets, by itself, is not manufacturing, production, growth, or
extraction activity that would qualify for the §199 deduction. This example relates the decision
in United States v. Dean, 945 F.Supp.2d 1110 (C.D. Cal. 2013), in which the IRS unsuccessfully
challenged a business’s §199 deductions for the assembly of gift baskets and gift towers through
both wholesale and retail channels. The preamble to the proposed regulations notes that the IRS
disagrees with the interpretation of Reg. §1.199-3(e)(2) adopted by the court in Dean, and the
proposed regulations add an example (Example 9) that illustrates the appropriate application of
this rule in a situation in which the taxpayer is engaged in no other manufacturing, production,
growth, or extraction activities with respect to the qualified production property other than
those described in Reg. §1.199-3(e)(2). The proposed regulations request comments on how the
term minor assembly should be defined.
Hedging
In many industries, businesses commonly engage in hedging transactions to manage the risk
associated with price fluctuations of inputs into a production process. The current §199
regulations provide special gain or loss treatment rules concerning hedges of inventory and
supplies consumed in activities giving rise to domestic production gross receipts where:
1. The risk being hedged relates to qualified production property described in §1221(a)(1)
(i.e., inventory of the business), or relates to property described in §1221(a)(8) (i.e., supplies
regularly consumed in the ordinary course of a trade or business), in an activity giving rise to
domestic production gross receipts;
2. The transaction is a hedging transaction; and
3. The transaction is properly identified as a hedging transaction.
In hedging scenarios meeting these three conditions:
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• For hedges of purchases of property described in §1221(a)(1), gain or loss on the hedging
transaction must be taken into account in determining cost of goods sold;
• For hedges of sales of property described in §1221(a)(1), gain or loss on the hedging
transaction must be taken into account in determining domestic production gross receipts;
and
• For hedges of purchases of property described in §1221(a)(8), gain or loss on the hedging
transaction must be taken into account in determining domestic production gross receipts.
The proposed regulations broaden the definition of a hedging transaction to include transactions
in which the risk being hedged relates to property described in §1221(a)(1) giving rise to
domestic production gross receipts, whereas the current regulations require the risk being
hedged to relate to qualified production property described in §1221(a)(1).
Allowing hedges to qualify where the risk being hedged relates to property giving rise to
domestic production gross receipts is a positive change, according to Mr. Mel Schwarz, a
partner in Grant Thornton LLP’s National Tax Office. This provision closes a gap in the existing
regulations that disqualified income or loss on a hedge of intermediate items that are not
qualified production property themselves. Mr. Schwarz notes this rule should facilitate the
hedging of risks using surrogate items and indices where there is not an adequate way to hedge
the end product itself.
The proposed revisions to the hedging rules facilitate §199 deductions for hedging activities by
utility companies, according to Mr. Manousos. 166 DTR G-2 (Aug. 27, 2015).
The proposed regulations also provide that the consequence of an abusive identification or
nonidentification is that deduction or loss, but not income or gain, is taken into account in
calculating domestic production gross receipts.
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Concluding Observations Adoption of return positions in compliance with the proposed regulations may provide taxpayers
protection against the imposition of §6662 penalties. Section 6662 imposes a penalty for
negligent disregard of rules or regulations, exception for positions that have a “reasonable basis.”
Section 6662 also imposes a penalty for a substantial underpayment, except for underpayments
related to positions that have a “reasonable basis” and are adequately disclosed, or that have
“substantial authority,” even if not disclosed. In determining whether a position has a
“reasonable basis,” is supported by “substantial authority,” or both, proposed regulations are
almost certainly relevant. Proposed regulations may also be relevant to a determination that a
taxpayer acted with reasonable cause and in good faith, and, while subject to change, and often
changed, are reasonable indicators of how the IRS interprets the law.
The temporary regulations were effective on August 27th, their date of publication in the Federal
Register. Comments on the proposed regulations are due November 25th. A public hearing on
the proposed regulations is scheduled for December 16th.