Daily Tax Update - January 21, 2005

Treasury Issues Interim Guidance on the Domestic Manufacturing Deduction
On January 19th, Treasury and the IRS issued Notice 2005-14 to provide guidance to taxpayers on the application of section 199, which was enacted as part of the American Jobs Creation Act of 2004 (AJCA).

In general, section 199 allows U.S. manufacturers to deduct an percentage of their "qualified production activities income" ("QPAI"). QPAI is the net of a manufacturer’s domestic production gross receipts ("DPGR") over the expenses (including costs of goods sold) allocable to such receipts. DPGR are the gross receipts derived from: (a) any lease, rental, license, sale, exchange, or other disposition of (i) qualifying production property ("QPP") that was manufactured, produced, grown, or extracted ("MPGE") by the taxpayer in whole or significant part within the United States; (ii) any qualified film produced by the taxpayer; or (iii) electricity, natural gas, or potable water produced by the taxpayer in the United States; (b) construction performed in the United States; or (c) engineering or architectural services performed in the United States for construction projects in the United States. Gross receipts from the sale of food and beverages and the transmission or distribution of electricity, natural gas, or potable water are generally not DPGR. A U.S. manufacturer’s deduction under section 199 for a given year is limited to 50% of the "W-2 wages" paid by the manufacturer during the calendar year ending during the manufacturer’s taxable year.

The following summarizes some of the highlights of Notice 2005-14.

  • W-2 wages. The notice contains rules regarding how wages paid by other entities and predecessors are to be included in (or excluded from) the calculation of a taxpayer’s wage limitation. The notice also provides taxpayers with three allowable methods for calculating W-2 wages.
  • QPAI. The notice provides rules regarding how a manufacturer’s costs (including costs of goods sold) should be calculated and how such costs should be allocated to the manufacturer’s domestic production gross receipts for purposes of calculating QPAI.
  • DPGR. The notice provides that a taxpayer’s method for determining DPGR and non-DPGR must be "a reasonable method that accurately identifies the gross receipts derived from activities described in section 199(c)(4). . . ." Among the factors the Service will consider are: (i) whether the taxpayer is using the most accurate information available; (ii) the relationship between the gross receipts and the base chosen; (iii) the accuracy of the method chosen as compared with other possible methods; (iv) whether the method is used by the taxpayer for internal management or other business purposes; (iv) whether the method is used for other federal, state or foreign income tax purposes; (v) the time, burden, and cost of using various methods; and (vi) whether the taxpayer applies the method consistently from year to year. The notice also provides that gross receipts derived from the performance of services generally do not qualify as DPGR, but provides exceptions to this rule for gross receipts from certain warranties and de minimis receipts from "embedded services."
  • MPGE. The notice specifically provides that in contract manufacturing situations, only the taxpayer with the "benefits and burdens of ownership of the property" during manufacturing will be eligible to claim the deduction under section 199. In addition, the notice provides rules for determining when property partially manufactured outside the United States can qualify as QPP. The notice provides a safe harbor under which a taxpayer will be treated as manufacturing, growing, or extracting property in whole of significant part in the United States if, in connection with the property, those costs incurred in the United States with respect to the property account for 20% or more of the total costs of goods sold related to the property. Certain costs including packaging, repackaging, labeling, and minor assembly operation costs are to be disregarded.
  • QPP. The notice defines what constitutes tangible personal property, computer software, and sound recordings for purposes of section 199. Notably, "computer software" and "sound recordings" do not include the "tangible personal property" (i.e., diskettes and CDs) on which the "machine-readable coding" and sound recordings are placed.
  • Treasury and the IRS anticipate that forthcoming regulations will incorporate the rules set forth in Notice 2005-14. Accordingly, Treasury and the IRS have requested comments on the rules contained in Notice 2005-14 and "any additional guidance" that should be provided in the regulations. Written comments should be submitted on or before March 31, 2005.
  • For additional information, contact Philip R. West or Stanley Smilack.
  • The notice can be accessed here

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