Section 199 allows taxpayers to deduct a percentage of their qualified production activities income. On November 4, 2005, the Treasury Department published proposed regulations implementing section 199. Treasury received over 80 comment letters, many of which reflected a general view that the proposed regulations were overly complex and needed to be simplified to provide taxpayers with the benefits Congress intended. On May 25, 2006, Treasury issued final regulations under section 199, together with temporary and proposed regulations that address section 199 issues for software producers.

The final regulations generally follow the earlier proposed regulations. Therefore, those who sought certain changes will be disappointed. However, Treasury implemented some of the suggestions made by commentators, adding simplified rules and safe harbors. Overall, however, the regulations remain extremely complex and a number of issues remain unanswered. Below, we explain some of the significant differences between the proposed regulations and the final regulations.

In-Kind Distributions Exception Expanded

In a significant concession to the petrochemical and electric utility industries, the final regulations provide that a partner in a partnership that produces oil and gas, petrochemicals, or electricity is treated as having produced the property it receives from the partnership. Thus, when the taxpayer sells the goods it received in-kind, the gross receipts will qualify as domestic production gross receipts. Under the proposed regulations, only oil and gas partnerships qualified for this exception. Treasury expanded the exception because the other industries demonstrated that historically they have operated similarly to the oil and gas industry. Treasury may further expand the exception to other industries that demonstrate such historical practices.

New Safe-Harbor for Taxable Exchanges

In a notable win for the oil, natural gas, and petrochemical industries, the final regulations provide that a taxpayer that receives gross receipts from the sale of eligible property (oil, natural gas, petrochemicals, and their derivatives) received in a taxable exchange may treat the gross receipts (net of any adjustments for differences in the exchanged property) as the value of the property received in the exchange. Furthermore, the taxable exchange is deemed to occur on the date the taxpayer sells the eligible property. This deemed exchange date will alleviate burdensome accounting procedures that otherwise would have been necessary.

Software

The software industry had some of its issues addressed in separate temporary and proposed regulations. Under the regulations, a taxpayer that permits customers to use software online, download the software, or buy it on a disk will be treated for section 199 purposes as having disposed of the software (under the proposed regulations only the latter two situations qualified). In addition, a taxpayer that permits customers to use computer software online will be treated as having disposed of the software if a competitor sells "substantially identical software" on a disk or through a download. All computer games are "substantially identical." Treasury has requested that taxpayers submit comments on the temporary and proposed regulations by August 30, 2006.

Clarified Item-by-Item Requirement

Taxpayers must compute qualified production activities income on an item-by-item basis (rather than by division or product line). However, the final regulations provide that the item-by-item requirement applies solely for purposes of determining whether gross receipts derived from an item are domestic production gross receipts. Thus, the item-by-item requirement does not apply to cost allocation methods. Taxpayers can make the item-by-item determination using any reasonable method.

In-Whole-Or-In-Significant-Part Requirement

A taxpayer will satisfy the in-whole-or-in-significant-part requirement if the taxpayer’s direct labor and overhead to produce the qualified property within the United States accounts for 20 percent or more of the taxpayer’s cost of goods sold or, if applicable, unadjusted depreciable basis of the qualified property. The final regulations define overhead as all costs required to be capitalized under section 263A, except direct material and direct labor. For taxpayers not subject to section 263A, the taxpayer may compute overhead using any reasonable method, but may not include any cost that would not be subject to section 263A. However, in the case of computer software and sound recordings, certain additional costs are included in direct labor, overhead, and the cost of the property.

Rejecting a commentator’s suggestion, the final regulations provide that the manufacture of a key component in the U.S., standing alone does not satisfy the "substantial-in-nature" requirement. A new example in the final regulations provides that the manufacture of a computer chip that is installed in a purchased computer is insufficient, by itself, to qualify the finished computer.

Expanded Simplified Method for Allocating Deductions, but § 861 Method Continues to Apply to Most Large Taxpayers

The final regulations keep the three methods taxpayers can use to allocate deductions: the section 861 method, the simplified deduction method, and the small business simplified overall method. However, Treasury relaxed the restrictions on which taxpayers can use the simplified deduction method. Taxpayers with gross receipts of $100 million or less or assets of $10 million or less now are eligible to use the simplified deduction method.

Treasury rejected calls to allow large taxpayers to use a simplified expense allocation method instead of the burdensome section 861 method, and failed to provide rules to allow taxpayers to segregate interest expense attributable to highly leveraged financing businesses away from domestic production gross receipts. Furthermore, taxpayers must use the same section 861 methods for all purposes (that is, for section 199, the foreign tax credit, the CFC rules, etc.) As a result, Treasury intends to issue a revenue procedure that will grant automatic consent for taxpayers to change certain elections relating to the apportionment of interest expense and research and experimental expenditures under section 861 for 2005 and the first succeeding taxable year.

Rejected Simplifying Contract Manufacturing

Treasury rejected a simplifying rule that would have permitted unrelated parties to a contract manufacturing arrangement to designate which party performed the qualifying activities. However, Treasury clarified that certain subcontracts qualify for the special provision for government contracts.

W-2 Wages

The section 199 deduction generally is limited to 50 percent of W-2 wages paid by the taxpayer. Rev. Proc. 2006-22, 2006- 23 I.R.B. ___, provides the same three methods of calculating W-2 wages that were provided in Notice 2005-14, 2005-1 C.B. 498, and the proposed regulations. The rules are included in a revenue procedure so that they can be updated easily if the Form W-2 changes.

Rev. Proc. 2006-22 generally applies to taxable years that begin on or before May 17, 2006, which is the date that the Tax Increase Prevention and Reconciliation Act of 2005 ("TIPRA") was enacted. TIPRA limits W-2 wages to those allocable to domestic production gross receipts. Treasury intends to publish regulations that will implement the TIPRA change.

The TIPRA change will decrease, and could eliminate, the section 199 deduction of taxpayers using mainly independent contractors, such as construction and film companies. To be included in the computation of W-2 wages, payments by third-parties, such as professional employer organizations, must be paid to common law employees of the taxpayer for employment by the taxpayer. The preamble to the final regulations reminds taxpayers to apply the law consistently.

Clarified Subsequent Acquisition Rule

The final regulations provide that if a taxpayer acquired property that might contain a component of qualifying property that the taxpayer produced (such as a truck bought by a steel mill) but that the taxpayer cannot reasonably determine whether it did contain a component of qualifying property without undue burden and expense, the taxpayer can treat any gross receipts attributable to the component as non-qualifying. The Treasury rejected calls to provide for a broader "one-sale" rule, under which property produced by the taxpayer could not generate domestic production gross receipts following its initial disposition by the taxpayer.

New Reverse De Minimis Rule

A taxpayer can treat itself as having no domestic production gross receipts and can ignore the section 199 deduction if the taxpayer’s domestic production gross receipts are less than five percent of the taxpayer’s overall gross receipts. This rule appears to be premised on the assertions by government officials that taxpayers must always claim the section 199 deduction, even where the costs of computing the deduction outweigh the tax benefits.

Miscellaneous

The final regulations provide that if a taxpayer incurs cost of goods sold that relate to gross receipts recognized in a taxable year prior to the effective date of section 199, the taxpayer must allocate the cost of goods sold to non-qualifying gross receipts.

Treasury has provided that grading, demolition, clearing, and excavation costs are qualifying construction activities if the services are provided in connection with erecting or substantially renovating real property.

A taxpayer providing qualifying construction services is not required to allocate the gross receipts between the services and materials and supplies provided with the services.

Treasury will issue subsequent guidance on statistical sampling.

Effective Date

The final regulations generally are effective for taxable years beginning on or after June 1, 2006. However, a taxpayer generally may apply the final regulations to a taxable year beginning before June 1, 2006, but only if the taxpayer applies all the provisions of the final regulations (except for the special pass-thru entity provisions that apply only to taxable years that begin on or before May 17, 2006). Taxpayers have the option to apply either Notice 2005-14 or the proposed regulations to taxable years that begin before June 1, 2006. However, if the proposed regulations contain a rule that was not in the Notice, a taxpayer cannot rely on the absence of a rule in the Notice to apply a rule contrary to the one in the proposed regulations. In addition, a taxpayer cannot apply the Notice or the proposed regulations in a manner inconsistent with TIPRA for taxable years after May 17, 2006.

For further information, please contact any of the following lawyers:

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

Patricia Sweeney, psweeney@milchev.com, 202-626-5926

Dwight Mersereau

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