Although the domestic production activities deduction (DPAD) came into law in 2004, certain types of taxpayers eligible for the deduction often fail to claim it on their income tax returns. The types of taxpayers who do not take advantage of the deduction include contractors doing business with the federal government.
Sec. 199 generally provides a deduction for qualifying domestic production activities equal to 9% of the lesser of the taxpayer’s qualified production activities income or taxable income determined without regard to Sec. 199. One of the qualifying domestic production activities includes any lease, rental, license, sale, exchange, or other disposition of qualifying production property that was manufactured, produced, grown, or extracted by the taxpayer in whole or in significant part within the United States.
The term “qualifying production property” includes tangible personal property (other than land and real property) and computer software. Computer software for qualifying production property purposes is defined as any program or routine or any sequence of machine-readable code that is designed to cause a computer to perform a desired function and the documentation required to describe and maintain that program or routine.
Regs. Sec. 1.199-3(i)(4) specifies that gross receipts derived from the performance of services including embedded services do not qualify as domestic production gross receipts. An embedded service is one where the price of the service is not separately stated from the amount charged for the sale of qualified production property. However, there are six exceptions to the embedded service rule:
- A qualified warranty;
- A qualified delivery;
- A qualified operating manual;
- A qualified installation;
- A qualified computer software maintenance agreement; and
- A de minimis amount (5%) of gross receipts from embedded services and nonqualified property.
To qualify, all services specifically stated above must be provided in connection with qualified production property, the price for the service should not be separately stated from qualified production property, and the service should not be separately offered by the taxpayer or separately bargained for with customers.
Based on the brief overview of the Sec. 199 rules above, government contractors are faced with the following requirements in determining the applicability of DPAD to their operations.
Qualified Production Property
Typically, a government contractor’s operations are very complex and include several components such as the manufacture or production of tangible personal property, the provision of services, and the development of software that may be related or unrelated to the produced tangible personal property. A contract review should be conducted to identify which contracts are for the manufacture/production of qualified production property, the provision of services, the development of software, and any combination thereof. After the review, potentially qualifying activities will be identified, and additional requirements should be analyzed as discussed below.
By the Taxpayer
Generally, under Regs. Sec. 1.199-3(f) (1), if a taxpayer performs a qualifying activity under a contract with another party, only the taxpayer that has the ownership benefits and burdens of the qualifying production property under federal income tax principles is treated as engaged in the qualifying activity. However, a special exception to the general rule for certain government contracts under Regs. Sec. 1.199-3(f)(2) states that the taxpayer’s gross receipts from the otherwise qualifying activity will be deemed to be qualifying gross receipts if the qualifying production property is manufactured/produced by the taxpayer within the United States under a contract with the federal government, and the federal acquisition regulation requires that title or risk of loss with respect to the qualifying production property be transferred to the federal government before the manufacture of the qualifying production property is completed.
Typically, government contractors have three types of contracts: fixed price, cost plus fixed fee, and time and materials. With fixed-price contracts, the contractor often has the benefits and burdens of ownership because he or she must meet certain requirements prior to being paid by the federal government. With costplus- fixed-fee and time-and-materials contracts, the contractor should make sure that those contracts are federal government contracts for which the federal acquisition regulations require that the title or risk of loss be transferred to the federal government before the qualified production property is completed. If that is the case, these contracts will fall under the exception in Regs. Sec. 1.199-3(f)(2) to the general rule, and the contractor will meet the “by the taxpayer” test for those contracts.
In Whole or in Significant Part Within the United States
As Regs. Sec. 1.199-3(g)(1) provides, qualified production property must be manufactured/produced in whole or in significant part by the taxpayer and in whole or in significant part within the United States to qualify for the deduction. Qualified production property should be treated as manufactured/produced in significant part by the taxpayer within the United States if the manufacture/production of the qualified production property by the taxpayer within the United States is substantial in nature, taking into account all the facts and circumstances. The facts and circumstances include such measures as the relative value added by and cost of the taxpayer’s manufacturing/production activity within the United States, the nature of the qualified production property, and the nature of the manufacturing activity that the taxpayer performs in the United States.
A safe-harbor rule under Regs. Sec. 1.199-3(g)(3)(i) states that if the direct labor and overhead to manufacture/produce the qualified production property account for 20% or more of the taxpayer’s cost of qualified production property sold or, in a transaction without cost of goods sold such as a license, account for 20% or more of the taxpayer’s unadjusted depreciable basis in the qualified production property, a taxpayer will be treated as satisfying the “in whole or in significant part within the United States” requirement of the DPAD qualification test.
Computer Software Rules
Obviously, the first step in this analysis requires a careful study of the definition of “computer software.” Regs. Sec. 1.199-3(j)(3)(i) specifies that computer programs of all classes (for example, operating systems, executive systems, monitors, compilers and translators, assembly routines, utility programs, and applications programs) are included in the definition. Computer software does not include any data or information base unless the data or information base is incidental to a computer program and is in the public domain (i.e., its availability through the computer program does not contribute significantly to the cost of the program).
The way computer software is delivered to customers may also have a significant effect on the computer software qualification for DPAD. Generally, computer software can be delivered on a medium such as a computer diskette, or customers can access the computer software directly through the internet. Under Regs. Sec. 1.199-3(j)(5)(i)(A), if the otherwise qualified computer software is affixed or added to tangible personal property such as a computer diskette, the software and the tangible personal property may be treated as computer software. However, if a contractor derives gross receipts from giving customers access to the otherwise qualified computer software for the customers’ direct use while connected to the internet, such gross receipts will be treated as qualified for DPAD purposes only if:
- The contractor also derives gross receipts from
the lease, rental, license, sale, exchange, or other
disposition of computer software that:
- Has only minor or immaterial differences from the online software;
- Has been produced/developed by the contractor in whole or in significant part within the United States; and
- Has been provided to customers either affixed to a tangible medium or by allowing them to download the computer software from the internet; or
- Another person derives gross receipts from the lease, rental, license, sale, exchange, or other disposition of computer software that is provided to customers either affixed to a tangible medium or by allowing them to download the computer software from the internet.
As is evident from the discussion above, an in-depth analysis of a government contractor’s activities is necessary to determine whether these activities qualify for DPAD. This analysis can be very complex and requires a thorough knowledge of Sec. 199 as well as a thorough understanding of the business. However, the benefit of exploring DPAD eligibility can be beneficial from both a cashflow standpoint and an effective tax rate standpoint as the DPAD is treated as a permanent item and does not give rise to a deferred tax liability. This can be especially meaningful for public companies.
Greg Fairbanks is a tax manager with Grant Thornton LLP in Washington, DC.
Unless otherwise noted, contributors are members of or associated with Grant Thornton LLP.For additional information about these items, contact Mr. Fairbanks at (202) 521-1503 or email@example.com