In-Depth: IRS Issues Proposed and Temporary Regs on Domestic Production Activities.

(Parker Tax Publishing September 8, 2015)

The IRS has issued proposed regulations on the domestic production activities deduction under Code Sec. 199 to reflect amendments made in 2008 to rules relating to oil-related qualified production activities income and qualified films. The proposed regs also remove the "benefits and burdens" test and clarify several other rules. Temporary regulations issued simultaneously address the calculation of W-2 wages in a short tax year. REG-136459-09 (8/27/15); T.D. 9731 (8/27/15).

The proposed regulations are effective when finalized, and the temporary regulations are effective as of August 27, 2015.

Background

Under Code Sec. 199, taxpayers can take a deduction for a percentage of their income attributable to certain production activities that take place within the United States (i.e., domestic production activities).

For 2010 and later years, the domestic production activities deduction is equal to 9 percent of the lesser of the taxpayer's qualified production activities income (QPAI) or its taxable income. Code Sec. 199(b)(1) limits this deduction to 50 percent of the W-2 wages paid by the taxpayer that are properly allocable to its domestic production gross receipts (DPGR).

Pursuant to Reg. Sec. 1.199-1(c), the QPAI of a taxpayer is equal to its domestic production gross receipts (DPGR) less certain expenses, losses, or deductions allocable to that DPGR. The amounts subtracted from DPGR include the cost of goods sold allocable to DPGR and any other expenses, losses, or deductions that are properly allocable to DPGR.

The term DPGR means the taxpayer's gross receipts that are derived from any lease, rental, license, sale, exchange, or other disposition of:

(1) qualifying production property (QPP) that was manufactured, produced, grown, or extracted (MPGE) by the taxpayer in whole or in significant part within the United States;

(2) any qualified film produced by the taxpayer; or

(3) electricity, natural gas, or potable water (utilities) produced by the taxpayer in the United States.

Proposed regulations issued in REG-136459-09 (8/27/15) provide guidance to taxpayers on the amendments made to Code Sec. 199 by the Energy Improvement and Extension Act of 2008 and the Tax Extenders and Alternative Minimum Tax Relief Act of 2008, involving oil related qualified production activities income and qualified films. The proposed regs also amend and clarify sever other rules under Code Sec. 199.

Regulations issued simultaneously in T.D. 9731 (8/27/15) provide guidance on the allocation of W-2 wages paid by two or more taxpayers that are employers of the same employees during a calendar year and the determination of W-2 wages if the taxpayer has a short tax year. To provide immediate effect, the IRS is issuing these regulations as temporary regulations.

TEMPORARY REGULATIONS

Allocation of W-2 Wages Following Acquisition or Disposition or a During Short Tax Year

Reg. Sec. 1.199-2(c) currently provides that if a taxpayer (a successor) acquires a trade or business from another taxpayer (a predecessor), then, for purposes of computing the respective Code Sec. 199 deduction of the successor and of the predecessor, the W-2 wages paid for that calendar year are allocated between the successor and the predecessor based on whether the wages are for employment by the successor or for employment by the predecessor.

Rev. Proc. 2006-47 provides that the amount of W-2 wages for a taxpayer with a short tax year includes only those wages subject to income tax withholding that are reported on Form W-2, Wage and Tax Statement, for the calendar year ending with or within that short tax year.

In certain situations, a short tax year may not include a calendar year ending within such short tax year, but current Reg. Sec. 1.199-2(c) does not address these situations. The IRS has thus issued temporary regulations that provide guidance on the application of Code Sec. 199(b)(3) to a short tax year that does not include a calendar year ending within the short tax year.

The temporary regulations provide that, if one or more taxpayers may be considered the employer of the employees of the acquired or disposed of trade or business during that calendar year, the 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 disposed of trade or business were employed by that taxpayer.

In the case of a short tax year in which there is no calendar year ending within such short tax year (short-tax-year rule), the temporary regulations provide that 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 Code Sec. 199(b)(1).

The temporary regulations provide that an acquisition or disposition includes an incorporation, a formation, a liquidation, a reorganization, or a purchase or sale of assets.

The temporary regulations also contain cross references to Reg. Secs. 1.199-2(a), (b), (d), and (e), because those regulations continue to apply to taxpayers. For example, the non-duplication rule of Reg. Sec. 1.199-2(d) applies such that a taxpayer that includes wages as W-2 wages based on the temporary regulations, including by filing an amended return for a short tax year, may not treat those wages as W-2 wages for any other tax year. Also, wages qualifying as W-2 wages of one taxpayer based on the temporary regulations cannot be treated as W-2 wages of another taxpayer.

PROPOSED REGULATIONS

IRS Replaces "Benefits and Burdens" Test for Determining Taxpayer Engaged in Qualifying Activity

Current regulations provide that if one taxpayer performs a qualifying activity pursuant to a contract with another party, then only the taxpayer that has the benefits and burdens of ownership of the QPP, qualified film, or utilities is treated as engaging in the qualifying activity.

Taxpayers and the IRS have had difficulty determining which party to a contract manufacturing arrangement has the benefits and burdens of ownership of the property while the qualifying activity occurs. To resolve this confusion, the proposed regulations remove the benefits and burdens of ownership rule, and instead provide that if a qualifying activity is performed under a contract, then the party that performs the activity is the taxpayer for purposes of Code Sec. 199(c)(4)(A)(i).

Definition and Allocation of Oil Related Qualified Production Activities Income

The Energy Extension Act of 2008 added new Code Sec. 199(d)(9) which provides that, beginning in 2010, a taxpayer that has oil-related QPAI must reduce its domestic production activities deduction by 3 percent of the lesser of its oil-related QPAI, its QPAI, or its taxable income.

The proposed regulations define "oil-related QPAI" as an amount equal to the excess (if any) of the taxpayer's DPGR from the production, refining, or processing of oil, gas, or any primary product thereof (oil-related DPGR) over the sum of the cost of goods sold (CGS) 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 DPGR does not include gross receipts derived from the transportation or distribution of oil, gas, or any primary product thereof, subject to certain exceptions. To the extent a taxpayer treats gross receipts derived from the transportation or distribution of oil, gas, or any primary product thereof as DPGR, the proposed regulations require taxpayers to include those gross receipts in oil-related DPGR.

The proposed regulations provide guidance on how a taxpayer should allocate and apportion costs when determining oil-related QPAI, and require taxpayers to use the same cost allocation method to allocate and apportion costs to oil-related DPGR as the taxpayer uses to allocate and apportion costs to DPGR.

Qualified Films Include Certain Intangibles, Generally Excludes Promotional Films

Under Code Sec. 199(c)(6), gross receipts derived from the lease, rental, license, sale, exchange, or other disposition of a qualified film generally are treated as DPGR if a substantial amount of the film production activities are performed within the United States. The Tax Extenders Act of 2008 (2008 Act) amended the rules relating to qualified films, and the proposed regulations make conforming changes.

To address the changes made by the 2008 Act, the proposed regulations amend the definition of qualified film in Reg. Sec. 1.199-3(k)(1) to include copyrights, trademarks, or other intangibles with respect to such film. The proposed regulations define other intangibles with a nonexclusive list of intangibles that fall within the definition. The proposed regulations also modify the definition of W-2 wages to include compensation for services performed in the United States by actors, production personnel, directors, and producers.

Example: Xcite Co. produced a qualified film and licenses the trademark of Alfie, a character in the qualified film, to Youths Inc. for reproduction of the Alfie image onto t-shirts. Youths Inc. sells the t-shirts with Alfie's likeness to customers, and pays Xcite Co. a royalty based on sales of the t-shirts. Xcite Co.'s qualified film only includes intangibles with respect to the qualified film in tax years beginning after 2007, including the trademark of Alfie. Accordingly, any gross receipts derived from the license of the trademark of Alfie to Youths Inc. occurring in a tax year beginning before 2008 are non-DPGR, and any gross receipts derived from the license of the trademark of Alfie occurring in a tax year beginning after 2007 are DPGR (assuming all other requirements are met). The royalties Xcite Co. derives from Youths Inc. occurring in a tax year beginning before 2008 are non-DPGR because the royalties are derived from an intangible (which was not within the definition of a qualified film for tax years beginning before 2008).

The proposed regulations provide that gross receipts a taxpayer later derives from products or services promoted in a qualified film are not derived from a disposition of the qualified film (including any intangible with respect to such qualified film). The proposed regulations add an example to illustrate an exception to this rule in a situation where gross receipts from a promotional film can qualify as DPGR because the gross receipts are distinct from the disposition of the product or service.

Example: Xcite Co. produces a qualified film commercial in the United States that features the company's services (promoted services). The commercial includes the character "Alfie" developed to promote Xcite Co.'s services. Gross receipts that Xcite Co. derives from providing the promoted services are not derived from the disposition of Xcite Co.'s qualified film, including any copyrights, trademarks, or other intangibles with respect to the qualified film. Xcite Co. also licenses the right to reproduce Alfie to Youths Inc. so that Youths Inc. can produce t-shirts featuring Alfie. This license is distinct (separate and apart) from a disposition of the promoted services and the gross receipts are derived from the license of an intangible with respect to Xcite Co.'s qualified film. Thus Xcite Co.'s gross receipts derived from the license to reproduce Alfie are DPGR.

The proposed regulations amend a rule allowing a taxpayer to treat certain tangible personal property as a qualified film (for example, a DVD), to exclude tangible personal property affixed with a film intangible (such as a trademark). For example, total revenue from the sale of an imported t-shirt affixed with a film intangible should not be treated as gross receipts derived from the sale of a qualified film. The portion of the gross receipts attributable to the qualified film intangible separate from receipts attributable to the t-shirt may qualify as DPGR.

Limitations on the Attribution of the Production of a Qualified Film to Partnerships and S Corps

The 2008 Act also added an attribution rule under Code Sec. 199(d)(1)(A)(iv) for a qualified film for taxpayers who are partnerships or S corporations, or partners or shareholders of such entities. A partner of a partnership or shareholder of an S corporation who owns (directly or indirectly) at least 20 percent of the capital interests in such partnership or the stock of such S corporation is treated as having engaged directly in any film produced by such partnership or S corporation. Further, such partnership or S corporation is treated as having engaged directly in any film produced by such partner or shareholder.

The proposed regulations provide that in order for a partner or partnership to apply the attribution rule, the partnership must treat itself as a partnership for all purposes of the Code.

The proposed regulations generally prohibit attribution between partners of a partnership or shareholders of an S corporation, partnerships with a partner in common, or S corporations with a shareholder in common. Thus, when a partnership or S corporation is treated as having engaged directly in any film produced by a partner or shareholder, any other partners or shareholders who did not participate directly in the production of the film are treated as not having engaged directly in the production of the film at the partner or shareholder level.

The proposed regulations also describe the attribution period for a partner or partnership or shareholder or S corporation. A partner or shareholder is treated as having engaged directly in any qualified film produced by the partnership or S corporation, and a partnership or S corporation is treated as having engaged directly in any qualified film produced by the partner or shareholder, regardless of when the qualified film was produced, during the period in which the partner or shareholder owns (directly or indirectly) at least 20 percent of the capital interests in the partnership or the stock of the S corporation.

Example: In 2014, Studio A and Studio B form an S corporation in which each is a 50-percent shareholder to produce a qualified film. Studio A owns the rights to distribute the film domestically and Studio B owns the rights to distribute the film outside of the United States. The production activities of the S corporation are attributed to each shareholder, and thus each shareholder's revenue from the distribution of the qualified film is treated as DPGR during the attribution period because Studio A and Studio B are treated as having directly engaged in any film that was produced by the S corporation.

Testing and Minor Repackaging Activities Are Not MPGE Activities by Themselves

Generally, qualified production property (QPP) must be manufactured, produced, grown, or extracted (MPGE) in whole or in significant part by the taxpayer and in whole or in significant part within the United States to qualify for the domestic production activities deduction. The proposed regulations clarify that testing activities are not MPGE activities if they are not performed as part of the MPGE of QPP.

Current regulations provide that a taxpayer's packaging, repackaging, labeling, or minor assembly of QPP does not qualify as MPGE if the taxpayer engages in no other MPGE activities with respect to that QPP. The court in U.S. v. Dean, 945 F. Supp. 2d 1110 (C.D. Cal. 2013) concluded that the taxpayer's activity of preparing gift baskets was a manufacturing activity and not solely packaging or repackaging for purposes of Code Sec. 199.

The proposed regulations add an example based on the facts in U.S. v Dean, but reaches the opposite conclusion and illustrates that the taxpayer is not considered to have engaged in the MPGE of QPP.

Construction Activities Do Not Include Mere Approval of Payments

The proposed regulations clarify that a taxpayer must engage in construction activities that include more than the approval or authorization of payments or invoices for that taxpayer's activities to be considered as activities typically performed by a general contractor for purposes of including gross receipts from construction activity in DPGR.

The proposed regulations also revise the definition of substantial renovation to conform to the final regulations under Reg. Sec. 1.263(a)-3, which provide rules requiring capitalization of amounts paid for improvements to a unit of property owned by a taxpayer. Under the proposed regulations, in general, a substantial renovation of real property is a renovation the costs of which are required to be capitalized as an improvement.

Cost of Goods Sold Must be Allocated Between DPGR and non-DPGR

The proposed regulations provide that in the case of a long-term contract under the percentage-of-completion method (PCM) or the completed-contract method (CCM), the cost of goods sold (CGS) includes allocable contract costs.

In addition, the proposed regulations clarify that the CGS must be allocated between DPGR and non-DPGR, regardless of whether any component of the costs included in CGS can be associated with activities undertaken in an earlier taxable year.

Other Changes

In addition to the substantive changes discussed above, the proposed regulations modify the W-2 wage limitation to the extent provided by Code Sec. 199(d)(8), and modifies the term "United States" to include Puerto Rico, in order to conform to the rules involving domestic production activities in Puerto Rico made by the American Taxpayer Relief Act of 2008.

The proposed regulations also make several administrative revisions to the hedging rules in Reg. Sec. 1.199-3(i)(3), and defines a hedging transaction to include transactions in which the risk being hedged relates to property described in Code Sec. 1221(a)(1) giving rise to DPGR.

Lastly, the proposed regulations provide a new example in Reg. Sec. 1.199-6(m) illustrating how QPAI is computed when an agricultural or horticultural cooperative's payments to members for corn qualify as per-unit retain allocations paid in money under Code Sec. 1388(f).

For a discussion of the domestic production activities deduction, see Parker Tax ¶96,100. (Staff Editor Parker Tax Publishing)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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