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

1 Copyright 2015, The Bureau of National Affairs, Inc.

Reproduction or redistribution, in whole or in part, and in any form, without express written permission, is prohibited except as permitted by the BNA Copyright Policy.

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.




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).




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




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




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




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).




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.




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.




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:




• 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.




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.

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