Proposed and Temporary Sec. 199 Regulations Address a Wide Variety of Issues

Editor: Michael Dell, CPA

On Aug. 26, 2015, the Treasury Department and the IRS published proposed and temporary regulations under Sec. 199 (REG-136459-09 and T.D. 9731). The proposed and temporary regulations address a wide variety of issues and reflect guidance on statutory changes, provide clarifications of existing guidance, and address issues generating controversy between or of concern to the IRS and taxpayers.

Sec. 199 allows a taxpayer to deduct an amount equal to 9% of the lesser of the taxpayer’s qualified production activities income (QPAI) for the tax year or the taxpayer’s taxable income for the tax year. QPAI is equal to the amount of a taxpayer’s domestic production gross receipts (DPGR) over cost of goods sold (COGS) and other expenses properly allocable to those receipts. The amount of the deduction allowable, however, cannot exceed 50% of the taxpayer’s qualifying W-2 wages for the tax year.

DPGR includes the taxpayer’s gross receipts derived from the 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 produced by the taxpayer in the United States. QPP includes tangible personal property, computer software, and sound recordings.

The proposed and temporary regulations provide guidance on the following topics:

1. Contract manufacturing;

2. COGS;

3. W-2 wages for acquisitions, dispositions, and short tax years;

4. What activities are qualifying activities;

5. Defining the “item”;

6. Oil-related qualified production activities income;

7. Qualified films;

8. Treatment of activities in Puerto Rico;

9. Hedging transactions; and

10. Agricultural and horticultural cooperative payments.

Rules on W-2 wages for acquisitions, dispositions, and short tax years are the only provisions of the published rules that are temporary regulations.

Although the proposed and temporary regulations do not contain guidance on an area of ongoing controversy between the IRS and taxpayers about the definition of “minor assembly,” the preamble to the proposed and temporary regulations requests comments to assist the IRS and Treasury in providing a definition.

The proposed regulations, if finalized, will be effective for tax years beginning on or after the date they are published as final in the Federal Register. The temporary regulations, relating to W-2 wages in acquisitions, dispositions, and short tax years, apply to tax years beginning on or after Aug. 27, 2015, but taxpayers are allowed to apply the temporary regulations to certain tax years beginning before that date.

New Rules Relating to Areas Generating Controversy

The proposed and temporary regulations address several areas that have been the subject of controversy in examinations and uncertainty for taxpayers. These areas include the analysis of which taxpayer in a contract manufacturing arrangement has the benefits and burdens of the ownership of the property that is the subject of the contract, for purposes of identifying the taxpayer performing the qualifying activity (and therefore the taxpayer who has manufactured, produced, grown, or extracted the property). The proposed regulations eliminate the benefits-and-burdens analysis in favor of a bright-line test that provides that the taxpayer actually performing the activity is the party engaged in the qualified activity.

Other areas addressed by the proposed regulations include the allocation of inventory COGS between DPGR and non-DPGR and the definition of MPGE in the context of certain construction-related activities, as well as testing and assembly/packaging activities.

Finally, the temporary regulations provide guidance regarding inclusion and allocation of W-2 wages paid by two or more taxpayers that are employers of the same employees during a calendar year and for taxpayers with short tax years that do not include a Dec. 31 year end, allowing taxpayers in that situation to remain eligible under Sec. 199.

Below is a more extensive discussion of the more controversial provisions in the proposed and temporary rules.

Contract Manufacturing: Benefits-and-Burdens-of-Ownership Analysis Removed

The proposed regulations include important and long-anticipated new rules for identifying which party in a contract manufacturing arrangement is the taxpayer performing the MPGE activity. Currently, the final regulations and administrative guidance require an analysis of the facts and circumstances that would establish which party has the benefits and burdens of ownership of the produced property under federal income tax principles.

This facts-and-circumstances analysis has led to controversy in the contract manufacturing arrangement, with both parties often claiming the Sec. 199 deduction for the same qualifying activity. This result is contrary to Congress’s direction that “[t]he Secretary shall prescribe such regulations as are necessary to carry out the purposes of this section, including regulations which prevent more than 1 taxpayer from being allowed a deduction under this section with respect to any activity described in subsection (c)(4)(A)(i).” The difficulty in applying this analysis to determine the party performing the MPGE activity has led the IRS’s Large Business & International Division (LB&I) to issue several Industry Director Directives advising examination personnel to use a factor test (LB&I Control No. LB&I-4-0112-01, Directive 1) and subsequently to accept the taxpayer’s designation of the party with the benefits and burdens of ownership of the produced property (LB&I Control No. LB&I-4-0713-006 and LB&I Control No. LB&I-4-1013-008, Directives 2 and 3).

The proposed regulations attempt to resolve this long-standing controversy by abandoning the benefits-and-burdens-of-ownership test in favor of a bright-line identification of the party performing the qualified activity. The proposed regulations provide that the party actually performing the qualified activity is the taxpayer engaged in the MPGE activity. The preamble to the proposed regulations explains that:

To provide administrable rules that are consistent with section 199, reduce the burden on taxpayers and the IRS in evaluating factors related to the benefits and burdens of ownership, and prevent more than one taxpayer from being allowed a deduction under section 199 with respect to any qualifying activity, the proposed regulations remove the rule in § 1.199-3(f)(1) that treats a taxpayer in a contract manufacturing arrangement as engaging in the qualifying activity only if the taxpayer has the benefits and burdens of ownership during the period in which the qualifying activity occurs. In place of the benefits and burdens of ownership rule, these proposed regulations provide that if a qualifying activity is performed under a contract, then the party that performs the activity is the taxpayer for purposes of section 199(c)(4)(A)(i). This rule . . . reflects the conclusion that the party actually producing the property should be treated as engaging in the qualifying activity for purposes of section 199, and is therefore consistent with the statute’s goal of incentivizing domestic manufacturers and producers.

The proposed regulations are an effort to reduce controversy between the IRS and taxpayers and to more closely fulfill Congress’s intent that only one taxpayer in a contract manufacturing arrangement should be allowed a deduction for a qualifying activity. The proposed rule is similar to the intended results of Directive 3—to have one party designated as the taxpayer performing the qualifying activity—but takes the identification of that taxpayer out of the hands of the contracting parties. However, the preamble to the proposed regulations seeks comments on whether there are narrow circumstances that justify an exception to the proposed rule and requests that comments proposing an exception address the rationale for the exception, the IRS’s ability to administer the rule, and how the exception would prevent two taxpayers from claiming the deduction for the qualifying activity. The comment request specifically asks whether a limited exception to the proposed rule should be allowed for certain fully cost-plus or cost-reimbursable contracts.

Allocation of Inventory COGS Associated With Prior-Year Activities

Another area of controversy between the IRS and taxpayers that the proposed regulations address is the allocation of COGS between DPGR and non-DPGR for inventory when the COGS relates to prior-year activities, including pre-Sec. 199 enactment periods. Current regulations require the taxpayer to use a reasonable method, based on all of the facts and circumstances, and the taxpayer must base the allocation on the sale, exchange, or other disposition of inventory. The proposed regulations would require that the COGS for inventory be allocated between DPGR and non-DPGR inventory, without regard to the taxpayer’s ability to associate a COGS cost with an activity performed in a prior tax year (e.g., retiree benefit costs incurred in the tax year).

This proposed regulation reflects the government’s position in Chief Counsel Advice (CCA) 200946037, which addressed the inclusion in COGS of retiree medical benefit costs, environmental remediation, and workers’ compensation. The taxpayer had argued that certain costs related to employment in years preceding the enactment of Sec. 199, which the taxpayer accrued in 2008, should be allocated to non-DPGR because the expenses related to gross receipts received in a year prior to the effective date of Sec. 199. CCA 200946037 concluded that the 2008 expenses are included in inventory costs of property produced in the year the expense is incurred and are related to the gross receipts generated from the sale of the property (a result that conforms to rules under Sec. 263A).

W-2 Wages for Acquisitions, Dispositions, and Short Tax Years

Resolving a long-standing, unintentional gap in how the W-2 wage limitation is applied to taxpayers without a Dec. 31 year end, Congress passed a technical correction to Sec. 199(b) as part of the Tax Increase Prevention Act of 2014, P.L. 113-295. The act amended the provision under Sec. 199 that provided an exception from regular W-2 rules, which define W-2 wages with a reference to tax years ending with Dec. 31, for taxpayers engaged in acquisitions and dispositions. The original provision allowed taxpayers engaged in acquisition and disposition transactions to allocate W-2 wages to pre- and post-acquisition/disposition periods. The statutory amendment included in the act is retroactive to the date of enactment of Sec. 199 (the American Jobs Creation Act of 2004, P.L. 108-357).

The amendment allows the exception from the regular W-2 rules to apply to short tax years. The proposed and temporary regulations provide rules to apply allocations of W-2 wages between two tax periods that allow taxpayers to allocate W-2 wages for an employee on a pro rata basis. The proposed and temporary regulations state:

If a taxpayer has a short taxable year that does not contain a calendar year ending during such short taxable year, wages paid to employees for employment by such taxpayer during the short taxable year are treated as W-2 wages for such short taxable year for purposes of § 1.199-2(a)(1) (if the wages would otherwise meet the requirements to be W-2 wages under § 1.199-2 but for the requirement that a calendar year must end during the short taxable year).

The statutory amendment and proposed and temporary regulations eliminate situations in which, due to a short tax year not ending with Dec. 31, the taxpayer’s W-2 limitation results in a deduction under Sec. 199 of zero. Therefore, under the proposed and temporary regulations, a taxpayer engaged in qualifying activities, incurring W-2 wage costs and not limited by taxable income or QPAI, will not be precluded from the application of Sec. 199 due to a short tax year.

The proposed and temporary regulations also revise the language of the rules under Regs. Sec. 1.199-2(c) for acquisitions and dispositions but leave intact the basis of the allocation of W-2 wages between more than one employer (the period of employment by the employer). The proposed and temporary regulations add new definitions to clarify the meaning of “acquisition or disposition” and “trade or business,” for purposes of applying Regs. Sec. 1.199-2(c). The term “acquisition or disposition” includes incorporation, formation, liquidation, reorganization, or the purchase or sale of assets. The term “trade or business” includes a trade, a business, the major portion of a trade or business, or the major portion of a separate unit of a trade or business. The preamble to the proposed and temporary regulations does not explain why the IRS felt it needed to clarify these terms.

The temporary regulations are effective for tax years beginning on or after Aug. 27, 2015, and taxpayers may apply the temporary regulations to open tax years beginning before that date. Retroactive application of the W-2 wage short-tax-year regulations reflects Congress’s intention that the statutory amendment to Sec. 199(b) be applied as if originally enacted.

Qualifying Activities

Testing and packaging/repackaging: The definition of MPGE in the regulations is broad and encompasses many activities (including manufacturing, producing, growing, extracting, installing, developing, improving, and creating QPP; making QPP out of scrap as well as from new or raw material by processing, manipulating, refining, or changing the form of an article, or by combining or assembling two or more articles). The regulations contain an example illustrating MPGE of QPP, which includes testing of component parts. The example concludes that those testing activities are part of the MPGE of the QPP. The preamble to the proposed regulations states that taxpayers have been interpreting the example as meaning testing activities qualify as an MPGE activity even if the taxpayer engages in no other MPGE activity. The proposed regulations modify the example (Regs. Sec. 1.199-3(e)(5), Example 5) to clarify that certain activities performed alone will not be treated as MPGE activities if they are not performed as part of other activities that constitute MPGE of the QPP. Therefore, testing activities, by themselves, are not MPGE of the QPP.

Additionally, the proposed regulations add an example that is a direct challenge to the result in a recent district court case relating to the exclusion from the definition of MPGE for activities that are “packaging,” “repackaging,” “labeling,” or “minor assembly” of QPP (see Dean, 945 F. Supp. 2d 1110 (C.D. Cal. 2013) (concluding that the taxpayer’s activity of preparing gift baskets was a manufacturing activity and not solely packaging or repackaging for purposes of Sec. 199)). The preamble to the proposed regulations explains that if the taxpayer engages in no other MPGE activities for that QPP, the taxpayer will not be treated as having MPGE activities. A new example, Example 9, in the proposed regulations illustrates the IRS and Treasury’s interpretation of Regs. Sec. 1.199-3(e)(2) in a situation in which the taxpayer is engaged in no other MPGE activities for the QPP than packaging, repackaging, labeling, or minor assembly. The new example has facts that are similar to the facts in the Dean case.

Construction activities: For Sec. 199 purposes, the regulations describe qualified construction activities as those performed by, or that are typically performed by, a general contractor.The preamble to the proposed regulations comments that taxpayers have interpreted the description of activities performed by a general contractor to include approval or authorization of payments even when the taxpayer performs no other activities typically performed by a general contractor. The proposed regulations provide 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 activities typically performed by a general contractor.

The proposed regulations provide a further change that relates to the definition of “substantial renovation” for determining whether a taxpayer’s activities constitute construction activities. The current regulations define substantial renovation with reference to standards previously used to determine whether amounts paid to improve tangible property were required to be capitalized under Sec. 263(a) (a renovation of a major component or substantial structural part of real property that materially increases the value of the property, substantially prolongs the useful life of the property, or adapts the property to a new or different use). These criteria for determining whether amounts to improve tangible property, including real property, are required to be capitalized under Sec. 263(a) have been changed since the publication of the current Sec. 199 regulations (see final regulations under Sec. 263(a), T.D. 9636).

To conform the Sec. 199 regulations to the final regulations under Sec. 263(a) (part of what commonly are called the repair regulations), the proposed regulations define a substantial renovation of real property as a renovation the costs of which are required to be capitalized as an improvement under Regs. Sec. 1.263(a)-3 other than an amount described in Regs. Secs. 1.263(a)-3(k)(1)(i)-(iii) (which require capitalization of an improvement if losses on disposition are deducted or certain basis adjustments are made).

However, because the application of the Sec. 263(a) regulations is based on a defined “unit of property” and the definition of real property for purposes of the construction activity provisions under Sec. 199 does not use a unit-of-property concept, the proposed regulations provide a rule of consistency. If the property for which the Sec. 199 determination of substantial renovation is not otherwise defined under the Sec. 263(a) regulations as a unit of property, the unit of property for purposes of applying the Sec. 263(a) rules to determine whether a substantial renovation has taken place to real property under Sec. 199 is the property to which the activities relate.

Minor assembly: With respect to the definition of one of the exclusions from MPGE, activities constituting “minor assembly,” the preamble to the proposed regulations notes that it has been difficult to come up with an objective, widely applicable definition for minor assembly. Treasury and the IRS seek the public’s comments to assist them in providing a definition of minor assembly under Sec. 199. The preamble to the proposed regulations poses two possible criteria to determine whether an activity is minor assembly: (1) whether the activity is a single process that does not transform an article into a materially different QPP and (2) whether an end user could reasonably engage in the same assembly activity of the taxpayer.

Defining the “item”: Although, generally, determinations of whether gross receipts from an activity are DPGR are made on an item-by-item basis (the “item” is defined as the property the taxpayer offered to customers in the normal course of the business), the current regulations do not provide substantive guidance defining how to determine what construction activities and services or engineering or architectural services constitute an item. The preamble to the proposed regulations states that taxpayers with construction activities or performing engineering or architectural services have interpreted the current regulations relating to determining the item to allow all gross receipts from the disposition of a multiple-building project as DPGR when only one of the buildings has been substantially renovated. The proposed regulations add an example to Regs. Sec. 1.199-3(d)(4) to clarify that, in such instances, only the property that is the subject of qualifying activities constitutes the item for purposes of determining whether gross receipts from an activity are DPGR.

Furthermore, the preamble states that taxpayers may be confused as to how to apply the general “item-by-item” rule when the property offered for disposition includes embedded services. The proposed regulations add an example to Regs. Sec. 1.199-3(d)(4) that demonstrates that the determination of an item is to be made after the gross receipts related to the embedded services are removed.

Proposed Regulations Addressing Statutory Changes

The proposed regulations address several areas that reflect statutory changes to Sec. 199 since the IRS published the currently applicable regulations. These areas generally are not controversial, but the changes in the proposed regulations will provide new guidance for substantive changes to the law. Areas that reflect statutory changes (either to Sec. 199 or other statutory provisions) include new rules for oil-related QPAI (definitions, including a definition that excludes transportation and distribution activities from oil-related QPAI because those activities are not considered manufacturing of oil-related products), new rules for qualified films (including W-2 wages for qualified films, the definition of qualified films, qualified film attribution rules for partners/partnerships and owners/S corporations, and the application of the 50% compensation safe harbor and the 20% MPGE safe harbor to qualified films), and the treatment of activities in Puerto Rico.

Below is a more extensive discussion of the proposed and temporary rules addressing statutory changes.

Oil-Related QPAI

Sec. 199(d)(9) was added to the Code in 2008 and requires a reduction in the Sec. 199 deduction for oil-related activities. Specifically, Sec. 199(d)(9) states that if a taxpayer has oil-related QPAI for any tax year beginning after 2009, the amount otherwise allowable as a deduction under Sec. 199(a) must be reduced by 3% of the least of (1) the oil-related QPAI of the taxpayer for the tax year; (2) the QPAI of the taxpayer for the tax year; or (3) the taxable income of the taxpayer. The statute, as amended, defines oil-related QPAI as QPAI attributable to production, refining, processing, transportation, and distribution of oil, gas, or any primary product. However, Sec. 199(c)(4)(B) excludes from DPGR gross receipts derived from the transmission or distribution of natural gas.

Because QPAI is the excess of a taxpayer’s DPGR over allocable expenses, items that are excluded from DPGR are not QPAI; the result is that the statute eliminates transmission and distribution of natural gas from oil-related QPAI. Regs. Sec. 1.199-1(f) of the proposed regulations provides definitions for oil-related QPAI, oil, and primary products of oil for purposes of Sec. 199(d)(9). The proposed regulations provide a special rule that excludes gross receipts derived from transportation and distribution of oil, gas, or any primary product thereof from oil-related DPGR.

The Treasury and IRS decision to exclude oil-related transportation and distribution gross receipts from DPGR, as reflected in the proposed regulations, is consistent with the government’s general treatment of gross receipts derived from transportation and distribution activities—they are not considered DPGR, as they are not considered part of the MPGE activity of QPP. While not immediately apparent, this provision is taxpayer favorable. Including gross receipts from transmission and distribution in oil-related QPAI, but not regular QPAI, could result in an oversized reduction of regular QPAI by oil-related QPAI.

The proposed regulations also provide rules relating to how a taxpayer should allocate and apportion costs when determining oil-related QPAI. The proposed regulations require taxpayers to use the same cost allocation method to allocate and apportion costs to oil-related DPGR as the taxpayers use to allocate and apportion costs to regular DPGR.

Qualified Films

Section 502(c) of the Tax Extenders and Alternative Minimum Tax Relief Act of 2008, P.L. 110-343, amended the rules relating to qualified films under Sec. 199 for tax years beginning after Dec. 31, 2007. Specifically, the provision expanded the definition of W-2 wages to include compensation for services performed in the United States by actors, production personnel, directors, and producers. The statutory change also expanded the definition of qualified film to include copyrights, trademarks, or other intangibles if not less than 50% of the total compensation relating to production of the qualified film is compensation for services performed in the United States by actors, production personnel, directors, and producers. The statutory amendment also included an instructive provision that the method and means of distributing a qualified film would not affect the availability of the deduction. The amendment added an attribution rule for qualified films for taxpayers that are partnerships or S corporations, or partners or shareholders of those entities.

W–2 wages for qualified films: The proposed regulations modify the definition of W-2 wages to reflect the statutory amendment to include compensation for services performed in the United States by actors, production personnel, directors, and producers.

Definition of qualified films: The proposed regulations also reflect the statutory amendment that changed the definition of “qualified films” for tax years beginning after 2007 to include a nonexclusive list of intangible property. To reflect the amended definition of qualified films, the proposed regulations provide guidance relating to promotional films, providing that gross receipts that a taxpayer derives from the disposition of a product or service promoted in a qualified film are not gross receipts derived from the disposition of a qualified film (including an intangible), but may, in appropriate circumstances, be DPGR from the disposition of the product or service.

The preamble to the proposed regulations identified the rule for the disposition of promotional films as “a special rule . . . to address concerns of the Treasury Department and the IRS that the inclusion of intangibles in the definition of qualified film could be interpreted too broadly.” The preamble requests comments on how to determine when gross receipts can qualify as DPGR, because the gross receipts from the disposition of an intangible used in a promotional film are “distinct” from the disposition of the product or service.

Similarly, the proposed regulations provide guidance on the disposition of tangible personal property affixed with a film intangible (e.g., a trademarked character or symbol), providing that gross receipts that a taxpayer derives from the disposition of the tangible personal property affixed with a film intangible are not gross receipts derived from the disposition of a qualified film but may, in appropriate circumstances, be DPGR from the disposition of the tangible personal property.

The proposed regulations provide new examples demonstrating the application of these rules. They also remove regulations that conflict with the statutory change related to the definition of qualified films and the amendment that provides that the methods and means of distribution of a qualified film will not affect the availability of the Sec. 199 deduction. The proposed regulations also state that production activities do not include activities related to the transmission or distribution of films. The preamble to the proposed regulations states, “The Treasury Department and the IRS are aware that some taxpayers have taken the inappropriate position that these activities are part of the production of a film.”

Qualified film attribution rules for partners/partnerships and owners/S corporations: As amended, and applicable to tax years beginning after 2007, Sec. 199(d)(1)(A) provides that:

(iv) in the case of each 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 of the stock of such S corporation —

(I) such partner or shareholder shall be treated as having engaged directly in any film produced by such partnership or S corporation, and

(II) such partnership or S corporation shall be treated as having engaged directly in any film produced by such partner or shareholder.

Partnership and S corporation attribution rules under the amended provisions of Sec. 199(d)(1) are reflected in the proposed regulations. The proposed regulations require that, for a partnership or a partner to avail itself of the partnership attribution rules, the partnership must treat itself as such for all sections of the Code. The proposed regulations prevent double attribution (up and over) of activities through the partnership or through the partner/owner. However, a partner’s or owner’s activities, or a partnership’s or S corporation’s activities, can be attributed to the partnership or S corporation, or partner or owner regardless of when a film was produced as long as the ownership requirements are met. Examples in the proposed regulations demonstrate the operation of the attribution rules.

Applying the MPGE 20% safe harbor to qualified films: Under existing regulations, a film may be treated as a qualified film produced by the taxpayer if (1) at least 50% of the total compensation for services paid by the taxpayer is compensation for services performed in the United States and (2) the direct labor and overhead of the taxpayer to produce the film account for at least 20% of the taxpayer’s cost of goods sold or unadjusted depreciable basis of the film (i.e., the taxpayer can satisfy the 20% labor and overhead safe harbor in Regs. Sec. 1.199-3(g)(3)). In circumstances in which a taxpayer expenses the cost of producing the film (as in the case of live or delayed television programming), the “unadjusted depreciable basis” of the film may be zero. In that case, the taxpayer could never satisfy the 20% labor and overhead safe harbor (because the denominator of the ratio would be zero).

In recognition of the difficulty some film producers face in applying the existing regulations, the proposed regulations clarify that all costs paid or incurred in the production of a live or delayed television program, including licensing fees paid to a third party, are included in the unadjusted depreciable basis of the film for purposes of Regs. Sec. 1.199-3(g)(3)(ii). However, the proposed regulations exclude licensing fees paid to a third party from the computation of the amount of a taxpayer’s direct labor and overhead for the film production.

In essence, licensing fees paid to a third party are included in the denominator (unadjusted depreciable basis of the film) but not the numerator (labor and overhead costs) for determining whether the labor and overhead account for at least 20% of the unadjusted depreciable basis. For example, if a taxpayer producing a live television broadcast incurs $100 of total costs for the production of the broadcast ($10 for direct labor, $50 paid to a third party for a license, and $40 for property rental for the live broadcast), the taxpayer’s unadjusted depreciable basis in the film would be $100, and its direct labor and overhead costs would be $50. The taxpayer would satisfy the 20% direct labor and overhead safe harbor. However, if the taxpayer did not incur any amount for property rental for the live broadcast, the taxpayer’s unadjusted depreciable basis in the film would be $60, and its direct labor and overhead cost would be $10. The taxpayer would not satisfy the 20% direct labor and overhead safe harbor.

Treatment of Activities in Puerto Rico

Under Sec. 199(d)(8), activities in Puerto Rico are considered to be conducted in the United States, and wages paid in Puerto Rico are considered W-2 wages for Sec. 199 purposes. Although the statutory provision regarding activities performed and wages paid in Puerto Rico was set to expire by operation of the 2006 amendment to the original statute, the provision allowing Puerto Rico to be considered part of the United States has been extended several times. The proposed regulations reflect the statute and allow that the term “United States” includes Puerto Rico for the period allowed under Sec. 199(d)(8) (which was expired when the regulations were issued).

Proposed Regulations Intended to Clarify Existing Rules

The proposed regulations include provisions that are intended to clarify existing regulations including (1) rules for the application of the COGS rules to taxpayers using certain long-term contract methods of accounting, (2) a change in language to expand the application of the hedging rules and to clarify cross-references, and (3) rules relating to horticultural and agricultural cooperatives.

Taxpayers Using Long-Term Contract Accounting Methods

In addition to the COGS rules related to inventory, described above, the proposed regulations provide rules for allocable contract costs under the percentage-of-completion method (PCM) or the completed-contract method (CCM) for long-term contracts. The proposed regulations require taxpayers to treat allocable contract costs under the PCM and the CCM as COGS to determine COGS allocable between DPGR and non-DPGR. The preamble to the proposed regulations states that “[t]he Treasury Department and the IRS recognize that allocable contract costs under PCM or CCM are analogous to [COGS] and should be treated in the same manner.”

Hedging Transactions

The proposed regulations revise the current regulations’ hedging rules to address inconsistent references and unnecessary duplication of hedging rules in the Sec. 1221 regulations, and clarify the consequence of abusive identification or nonidentification. Additionally, the preamble states that the revised hedging rules under Sec. 199 reflect a taxpayer’s concern that the hedging rules are unnecessarily narrow, in that the current regulations allow Sec. 199 to apply to income, deductions, gain, or loss on hedging transactions related only to QPP giving rise to DPGR, as opposed to any property giving rise to DPGR. To reflect a broader application of the hedging rules, the proposed regulations allow the hedging rules to apply to any property giving rise to DPGR.

Agricultural and Horticultural Cooperative Payments

Sec. 199(d)(3)(A) provides that, under certain circumstances, any person who receives a qualified payment from a specified agricultural or horticultural cooperative is allowed a deduction under Sec. 199(a) equal to the portion of the deduction allowed under Sec. 199(a) to that cooperative. Regs. Sec. 1.199-6(e) defines “qualified payment” as any amount of a patronage dividend or per-unit retain allocation, as described in Sec. 1385(a)(1) or Sec. 1385(a)(3), received by a patron from a cooperative, that is attributable to the portion of the cooperative’s QPAI for which the cooperative is allowed a Sec. 199 deduction. The term “per-unit retain allocation” means, under Sec. 1388(f), any allocation to a patron with respect to products marketed for him or her, the amount of which is fixed without reference to net earnings of the organization under an agreement between the organization and the patron.

The preamble to the proposed regulations states that taxpayers have misinterpreted Example 1 in Regs. Sec. 1.199-6(m), which describes a cooperative’s payment for its members’ corn, as a conclusion that the cooperative’s payment for its members’ corn is a per-unit retain allocation paid in money as defined in Sec. 1388(f). The preamble states that the example was not intended to draw a conclusion about the character of the payment and, therefore, the proposed regulations include a new example that identifies a cooperative’s payment as a per-unit retain allocation (without otherwise characterizing the payment) and reflects how QPAI is computed when a payment is a per-unit retain allocation.

Implications

With respect to rules that interpret statutory changes, taxpayers currently enjoying tax benefits under Sec. 199 should assess whether their current application of the statute is consistent with the proposed and temporary regulations. Particularly with respect to the statutory change and temporary regulations related to short tax years, taxpayers may have an opportunity to amend prior returns to include new or additional Sec. 199 benefits if those taxpayers did not claim benefits in a tax year with qualifying activities as a result of a short tax year not ending on Dec. 31 (and, therefore, under the previous rules, they had no W-2 wages to use to compute the applicable W-2 wage limitation).

With respect to rules that address areas of controversy or clarification, taxpayers may consider how the proposed regulations will change their analysis of eligible activities, cost allocation, or the computation of DPGR. Specifically, proposed rules relating to contract manufacturing, if finalized in present form, will eliminate a taxpayer’s ability to designate which party in a contract manufacturing arrangement will benefit under Sec. 199. The proposed changes to the hedging rules may provide taxpayers additional opportunities with respect to qualified income from hedging activities.

EditorNotes

Michael Dell is a partner at Ernst & Young LLP in Washington.

For additional information about these items, contact Mr. Dell at 202-327-8788 or michael.dell@ey.com.

Unless otherwise noted, contributors are members of or associated with Ernst & Young LLP.