According to press accounts published today, Treasury is preparing to release the long-awaited guidance governing the new domestic manufacturers deduction. The American Jobs Creation Act of 2004 added the new deduction as section 199 of the Internal Revenue Code. According to press accounts, the notice will provide interim guidance upon which taxpayers may rely until proposed regulations are issued. Although the final version of the guidance may differ in some respects from the published accounts, we believe that the notice will adhere closely to the following general concepts, and as such, are providing you with this information in advance of the notice’s official release.

For 2005, the domestic manufacturers deduction equals three percent of the lesser of (i) qualified production activities income (“QPAI”); or (ii) taxable income, for the taxable year. The deduction is limited to 50 percent of the W-2 wages paid by the taxpayer during the calendar year that ends in the taxable year. The deduction is available only if the production activity occurs in significant part within the United States.

Among the key aspects of the forthcoming notice:

• “In significant part.” Property is treated as manufactured by the taxpayer in significant part in the United States if either (i) based on all of the taxpayer’s facts and circumstances, the manufacturing, production, growth, or extraction activity performed by the taxpayer in the United States is substantial in nature; or (ii) the labor and overhead costs incurred by the taxpayer in the United States for the manufacture, production, growth, and extraction of the property are at least twenty percent of the taxpayer’s total cost of the property (excluding the costs of packaging and selling expenses).
  
  The “substantial in nature” test and the 20% safe harbor appear to be based on rules currently provided under subpart F in defining “manufacturing.” The rules found in Treas. Reg. § 1.954-3(a)(4) (particularly the examples), as well as the substantial body of authority interpreting this standard, may provide useful guidance in determining whether an item has been produced “in significant part” in the United States for purposes of section 199.
  
  Where the 20% safe harbor is not available, issues are likely to center on whether various activities are “substantial.” Packaging, repackaging, labeling, and other “minor assembly operations” will not suffice.
   
• Contract Manufacturing. Only one taxpayer will be entitled to the deduction with respect to the manufacturing activity performed with respect to an item of tangible personal property. Only the taxpayer with the benefits and burdens of ownership of the tangible personal property during the manufacturing process will be treated as the manufacturer.
   
  Presumably this proposed limitation will not apply to vendors that manufacture and sell components for use in another company’s manufactured goods. This should be the result regardless whether the components are purchased off-the-shelf or are custom manufactured to the customer’s specifications, as long as the components can be rejected by the customer if not satisfactory and where risk of loss remains with the vendor until acceptance. Instead, the proposed limitation presumably would apply only where the “contract manufacturer” is in essence providing fabrication services using the customer’s own materials, designs, intellectual property, and perhaps even the customer’s manufacturing facility, where the risk of loss and of failure rests with the customer during the fabrication process.
  
  Interestingly, Treasury did not incorporate its position on contract manufacturing in the subpart F context, as articulated in Rev. Rul. 97-48, 1997-2 C.B. 89.
   
• Design Activities. Under the proposed rules, design and developmental activities would not constitute manufacturing activities for purposes of the “in significant part” test for tangible personal property. Instead, these activities would be treated as producing only an intangible asset (the design) rather than tangible personal property.
  
  The proposed exclusion of design activities would be an unfortunate result for industries in which R&E activities (for example) are inextricably linked with the manufacture and sale of tangible property. Although a design is itself intangible property, for many companies the design activity is an inseparable part of an integrated manufacturing enterprise whose principal source of revenue is the production and sale of tangible items and who relies upon its ability to craft cutting-edge designs to make those sales. In those industries, all revenues arising in the manufacturing context including those from design activities have their ultimate source in and thus are “derived from” the sale of tangible property. Hopefully Treasury will continue to consider the vital role that design activities play in American manufacturing and will modify the proposed exclusion before issuing the next round of guidance.
   
• Construction Activities. Qualifying construction activities include construction and substantial renovation of real property, including residential and commercial buildings, as well as infrastructure such as roads, power lines, water systems, and communications facilities. Unlike the manufacture of tangible personal property, multiple taxpayers may be regarded as constructing real property with respect to the same activity and the same construction project. Revenue derived from the rental of real property constructed by the taxpayer, however, is not eligible for the manufacturers deduction.
   
• Food and Beverage. Revenue from the sale of food and beverages at a retail establishment generally does not qualify for the deduction. If a taxpayer’s facility prepares food and beverages for both wholesale and retail sale, the notice provides that as a matter of administrative grace, the food and beverage sold at wholesale will not be considered to have been prepared at a retail establishment. The taxable income related to the wholesale transaction is therefore eligible for the manufacturers deduction.
   
• Computer Software. The manufacturers deduction is available for income from a lease, rental, license, sale, exchange, or other disposition of software developed in the United States, regardless of whether the customer purchases the software off the shelf or takes delivery of the software by downloading it from the Internet. The deduction is available for video game software, but not for various other items which are viewed as being akin to a service. These excluded sources include fees for on-line use of software and on-line subscription services.
  
  The exclusion of revenues derived from on-line use of software and from on-line subscription services raises interesting technical and tax policy questions, given that the manufacturers deduction specifically is available with respect to licenses for the use of software. Arguably, all revenue derived from providing access to software produced by the taxpayer, whether through a sale or on a subscription basis, should qualify for the deduction.
   
• Application to Partnerships. The manufacturers deduction is calculated at the partner level. Individual items of production revenue and expense are allocated to the partners, who then individually compute their respective deductions under section 199.
   
• Expense Allocation. The notice provides separate rules for allocating cost of goods sold and for allocating all other production expenses. If the taxpayer cannot specifically identify the cost of goods sold, the taxpayer may use a reasonable method to determine the cost of goods sold related to the taxpayer’s qualifying production activities. In allocating all other production expenses, taxpayers having annual gross receipts of at least $25 million must follow existing rules applicable to taxpayers required to determine taxable income from within and outside the United States (e.g., sections 861 and 863(b)). Elective simplified methods are available for smaller taxpayers.
   
• W-2 Wages. W-2 wages are those paid to common law employees. This will exclude from the cap placed on the manufacturers deduction amounts paid to independent contractors or to service providers not within the same expanded affiliated group. The notice provides two methods for determining W-2 wages for purposes of section 199, including a simplified method.
   
• Calculation of QPAI. In general, the manufacturers deduction is a stated percentage of the taxpayer’s qualified production activities income (“QPAI”). QPAI in turn is the excess of production revenues over allocable production expenses. Left unanswered in the account published today is whether in offsetting production revenues with allocable expenses, all of the enterprise’s production activities must be included within a single bucket or whether this calculation instead can be made based on separate trades or businesses, separate product lines, separate activities, or separate transactions. The answer to this question can have a profound effect on highly diversified conglomerates, as well as those with start-up or experimental business activities incurring significant losses.

The media account of the forthcoming notice suggests that, not unexpectedly, it will leave a number of issues unresolved. The account also suggests that international tax concepts will play a larger role than anticipated by many. Treasury will be required to issue at least two additional rounds of guidance, including either proposed or temporary regulations, and ultimately a Treasury decision. Treasury has indicated informally they hope to issue the regulations no later than the end of 2005.

Treasury also has indicated informally that in drafting the proposed regulations, it will carefully consider all comments received from taxpayers regarding this interim notice, including proposed rules that are and those that are not yet provided. Taxpayers should not consider the approaches taken in this notice as the final word on the issues addressed.

For further information, please contact:

James Atkinson

Rocco Femia, rfemia@milchev.com, 202-626-5823

The information contained in this communication is not intended as legal advice or as an opinion on specific facts. This information is not intended to create, and receipt of it does not constitute, a lawyer-client relationship. For more information, please contact one of the senders or your existing Miller & Chevalier lawyer contact. The invitation to contact the firm and its lawyers is not to be construed as a solicitation for legal work. Any new lawyer-client relationship will be confirmed in writing.

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