Sec. 199 deduction for qualified film and the IRS compliance campaign approach

By Tom Windram, CPA, Washington, and Ryan K. Carnes, J.D., LL.M., Denver

Editor: Mo Bell-Jacobs, J.D.

Sec. 199 was enacted as part of the American Jobs Creation Act of 2004, P.L. 108-357, as a special deduction intended to incentivize the creation of employment opportunities in domestic manufacturing and production activities. While the deduction applies to a wide range of activities, the IRS has taken particular interest in which activities of multichannel video programming distributors (MVPDs) and television (TV) broadcasters may be treated as qualified film production.

Due to the complex rules, conflicting guidance, and policy questions regarding what a qualified film is for Sec. 199 purposes, the IRS has created a Large Business and International (LB&I) compliance campaign that directly and significantly affects these taxpayers. Although the recent comprehensive tax reform package (P.L. 115-97, known as the Tax Cuts and Jobs Act) repealed Sec. 199 going forward, it continues to be a significant tax issue for 2017 and prior tax years that are open under the statute of limitation.


The amount of the Sec. 199 deduction is determined by applying 9% to the lesser of the taxpayer's qualified production activities income (QPAI) or taxable income (determined without regard to the Sec. 199 deduction). QPAI is equal to domestic production gross receipts (DPGR) reduced by the sum of the cost of goods sold and other expenses allocable to DPGR. DPGR consist of the taxpayer's gross receipts derived from a list of qualifying activities. Those qualifying activities include gross receipts derived from any lease, rental, license, sale, exchange, or other disposition of any qualified film produced by the taxpayer. A qualified film is any motion picture or film under Sec. 168(f)(3), or live or delayed television programming, if not less than 50% of the total compensation relating to the production is compensation for services performed in the United States by actors, production personnel, directors, and producers.

Regs. Sec. 1.199-3(d)(1) provides that a taxpayer generally determines whether gross receipts qualify as DPGR on an item-by-item basis. "Item" is defined in Regs. Sec. 1.199-3(d)(1)(i) as the property offered by the taxpayer in the normal course of the taxpayer's business for lease, rental, license, sale, exchange, or other disposition to customers, if the gross receipts from such property qualify as DPGR. Regs. Sec. 1.199-3(d)(1)(ii) provides that if the property does not qualify under Regs. Sec. 1.199-3(d)(1)(i), then any component of the property described in Regs. Sec. 1.199-3(d)(1)(i) is treated as the item, provided that the gross receipts attributable to the disposition of the component of such property qualify as DPGR.

Taxpayers that claim the Sec. 199 deduction for qualified film production face a variety of challenges, due in part to the complexity of the rules. One specific challenge is determining whether MVPDs can treat an entire program package sold to their customers as DPGR for purposes of computing the deduction. This issue arises because most MVPDs offer continuous program packages for sale. The programming content that a customer receives can vary depending on the package and the customer's geographic location and can include premium channels containing domestic and foreign films and television programs, for example. If the entire package satisfies the Sec. 199 rules, then fees received by the MVPD that are attributable to the package can qualify as DPGR. If the entire package does not qualify, then the MVPD can treat as DPGR only the portion of the fees that are attributable to the portion of the package that does qualify.

IRS guidance

On Dec. 10, 2010, the IRS Office of Chief Counsel issued Technical Advice Memorandum (TAM) 201049029 providing guidance to taxpayers facing this issue. The specific issue addressed in the TAM was whether gross receipts derived from a taxpayer's licensing of a package that included programs produced by the taxpayer, programs produced by third parties, commercial advertisements, and "interstitials" (short items appearing in between main programs) could be DPGR under Sec. 199. The IRS examination team argued that gross receipts derived from the program package could not be DPGR because the definition of "qualified film" under Sec. 199(c)(6) is limited to individual films and, therefore, the gross receipts attributable to the program package were not derived from a qualified film produced by the taxpayer. In rejecting this argument, the Chief Counsel took the position that it was permissible to test the programming package as a single qualified film (i.e., in the aggregate) for purposes of Sec. 199(c)(6) because other property that consists of multiple properties is tested as a single property for purposes of Sec. 199. This is true, the Chief Counsel argued, even though the package included multiple films, of which some were produced by the taxpayer and others by third parties.

Then, in a dramatic shift, the Chief Counsel issued Chief Counsel Advice (CCA) 201446022 on Nov. 14, 2014, in which it took a view contrary to the position it had taken in TAM 201049029. Specifically, the Chief Counsel concluded that gross receipts derived from the distribution of multiple channels of video programming through program packages did not qualify for DPGR derived from the disposition of qualified film. However, the taxpayer could apply the Regs. Sec. 1.199-3(d)(1)(ii) rules to components of the program package to determine whether the separate components individually qualified as items under Sec. 199.

On Nov. 10 and Nov. 18, 2016, the IRS issued TAM 201646004 and TAM 201647007, respectively. Both memoranda addressed the same issue as TAM 201049029 and CCA 201446022, and both were consistent with the position taken in the CCA. Specifically, the Chief Counsel, applying a strict statutory interpretation, determined that a program package could not be viewed as qualifying in the aggregate because a program package is not a qualified film. Further, a program package is not a qualified film because it is not property as described in Sec. 168(f)(3) or Regs. Sec. 1.199-3(k)(1).

The Chief Counsel supported this position by stating that the taxpayer's facts did not fulfill the legislative intent behind the Sec. 199 deduction with respect to film production, i.e., congressional concern for the decreasing number of films produced domestically. As stated in TAM 201647007, to best effectuate Congress's express desire to encourage domestic film production, the qualified film determination must be made on an individual-film basis.

More recently, on Dec. 21, 2017, the IRS issued Rev. Rul. 2018-3. Just as in the above guidance, the issue in Rev. Rul. 2018-3 was whether a package of films licensed to customers in the normal course of business may be an "item." The package in this case contained films licensed to the corporation by unrelated third parties and films produced by the corporation. In addition, the corporation paid license fees for distribution rights. However, critical to Rev. Rul. 2018-3 was Regs. Sec. 1.199-3(d)(1)(i), stating that the term "item" means the property offered by the taxpayer in the normal course of the taxpayer's business for disposition to customers if the gross receipts from the disposition of the property qualify as DPGR. The ruling applied this regulation to the above description of the corporation's activities and favorably determined that the entire package of films could be an item.

Rev. Rul. 2018-3 is potentially good news for MVPDs and TV broadcasters because, in many cases, it would eliminate both the administrative burden of allocating revenue to each individual program and determining whether there are DPGR separately for each program. Although a CCA or TAM may provide significant insight into how the IRS would likely treat a taxpayer with similar facts and circumstances, it is important to remember that it has no precedential value except to the particular taxpayer it addresses. Revenue rulings, however, apply to all affected taxpayers.

Notwithstanding the above guidance, MVPDs and TV broadcasters still face complexity in determining whether their activities qualify as the production of qualified films. That is because a qualified film will be treated as produced by the taxpayer only if the production activity is substantial in nature, taking into account all the facts and circumstances, including the relative value added by, the relative cost of, and the nature of the taxpayer's production activities within the United States. Proposed regulations (Prop. Regs. Sec. 1.199-3(k)(6), REG-136459-09) and Rev. Rul. 2018-3 both specify that production activities do not include activities related to the transmission or distribution of a film.

Taxpayers may rely on a safe harbor to determine whether a qualified film is produced by the taxpayer. Under Regs. Sec. 1.199-3(k)(7)(i), a film is treated as produced by the taxpayer if it meets two requirements:

1. Not less than 50% of the total compensation for services paid by the taxpayer is compensation for services performed in the United States; and

2. The taxpayer satisfies the safe harbor of Regs. Sec. 1.199-3(g)(3), which applies when the taxpayer's direct labor and overhead to produce a qualified film within the United States account for 20% or more of the unadjusted depreciable basis in the package of films or 20% or more of the taxpayer's cost of goods sold of the package of films.

Rev. Rul. 2018-3 specifies that direct labor and overhead do not include license fees of any licensed films (the numerator); however, license fees are included in the unadjusted depreciable basis or cost of goods sold (the denominator). Accordingly, only MVPDs and TV broadcasters that have a reasonable amount of self-produced content, such as local news or sports programs, can qualify revenue from a programming package as DPGR.

The LB&I campaign

On Jan. 31, 2017, the IRS announced the rollout of the LB&I campaign approach to examinations. A departure from issue practice groups, the campaign approach is a move toward issue-based examinations and a compliance campaign process in which LB&I determines which specific compliance issues present the highest risk to the IRS. The IRS announcement listed 13 initial campaigns, one of which deals specifically with the issue addressed herein concerning the Sec. 199 deduction for MVPDs and TV broadcasters.

According to the IRS, the decision to create the Sec. 199 campaign arose out of a concern that MVPDs and TV broadcasters often claim that a group of channels or programs is a qualified film eligible for the Sec. 199 deduction. Furthermore, taxpayers have asserted that they are the producers of a qualified film when distributing channels and program packages that often include content produced by third parties.

In addition to providing a high-level description of each of the 13 campaigns, LB&I's announcement identifies potential treatment streams, which are specific actions to take toward achieving the specific compliance goal at issue with the respective campaign. According to the announcement, these treatment streams include issue-based examinations, "soft" letters, voluntary self-correction, practitioner outreach, and published guidance.

The announcement states that "treatment streams" for the Sec. 199 campaign include issue-based examinations and the development of published guidance. With issue-based exams, taxpayers can expect narrowly focused exams that are conducted by a trained campaign issue manager and specialized agents. This signifies a move toward greater specialization in examinations generally. Given this specialization, agents conducting these exams will likely impose more scrutiny on a taxpayer's activities, due in part to the greater knowledge and specialty of the agents conducting the exam.

Answering to IRS scrutiny

Despite issuing guidance, the IRS takes the position that some taxpayers claiming the Sec. 199 deduction for qualified film production continue to incorrectly apply the rules. As a result, LB&I created the Sec. 199 campaign. The IRS also recently announced that it would apply the new guidance in Rev. Rul. 2013-3 in executing the campaign. Taxpayers that fall under the purview of the Sec. 199 campaign should anticipate being subject to issue-based exams, which could lead to greater IRS scrutiny by much more sophisticated examiners. In a step toward mitigation, these taxpayers should consider developing a preaudit plan to address potential issues before being contacted by the IRS. Taking these steps can reduce exposure in this area of high IRS scrutiny.


Mo Bell-Jacobs is a manager, Washington National Tax, for RSM US LLP.

For additional information about this item, contact the authors at or

Unless otherwise noted, contributors are members of or associated with RSM US LLP.

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