Perspectives

Research & Development and Government Incentives Developments 

Insights into the Proposed and Temporary Section 199 Regulation Amendments

Stay abreast of recent changes in the law that impact tax incentives for research and development, domestic production activities, and other areas (hiring/employment, energy sustainability, etc.) targeted for government incentives. By staying focused on the recent developments that really matter – legislative proposals, proposed regulations, revenue rulings, revenue procedures, IRS guidance, court cases, etc., released each year, this newsletter focuses on some of the few remaining permanent tax benefits and provides analysis and insights of the recent developments that could impact your organization.

Background

On August 26th, 2015 the Internal Revenue Service (IRS) released proposed regulations under Section 199.  The proposed regulations are intended to provide taxpayers guidance on a number of key technical issues related to the domestic production activities deduction.  Comments on the proposed regulations are to be submitted by November 25, 2015 and a public hearing on the proposed regulations is scheduled for December 16, 2015.  If the proposed regulations are adopted, they will be published in the Federal Register and will be applied to tax years beginning on or after the date of publication.  In the meantime, although these regulations remain in proposed form, they provide insight into the position the IRS may take with respect to the highlighted areas.

In addition, on August 26th, 2015, the IRS also released temporary regulations under Section 199 (TD 9731) that specifically address the allocation of W-2 wages in a short tax year or a tax year in which the taxpayer acquires, or disposes of, a major portion of a trade or business.  The temporary regulations are applicable for taxable years beginning on or after August 27, 2015 and are applicable to taxable years for which the limitations for assessment of tax has not expired beginning before August 27, 2015.  If the temporary regulations are not adopted permanently, their applicability will expire on August 24, 2018.

These sets of regulations will undoubtedly affect a substantial number of taxpayers that currently claim a domestic production activities deduction under section 199.  The following summary provides deeper insight into the proposed and temporary regulations.

Contract Manufacturing

The proposed regulations address which party in a contract manufacturing agreement may take the section 199 deduction for activities performed under the contract.  The IRS originally adopted the “benefits and burdens” test to ensure that when a principal has retained a contract manufacturer to perform qualifying activities, only the party with the benefits and burden of ownership of the property during the MPGE process may claim the section 199 deduction.  Due to the complexity of contract manufacturing relationships, however, both taxpayers and the IRS have had difficulty determining which party has the benefits and burdens of ownership of the property. 

In an effort to provide a rule that can be more easily and consistently applied, the proposed regulations provide that if a qualifying activity is performed under a contract, then the party that performs that activity is deemed the taxpayer for purposes of section 199.  This rule reflects the proposed regulations’ 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.”  Additionally this rule would prevent more than one taxpayer from receiving a deduction under section 199 with respect to a qualifying activity. 

Recognizing the potentially far-reaching effects of this amendment, The Treasury Department and the IRS have requested comments on whether there should be limited exceptions to the proposed rule. 

Qualified Films

The proposed regulations amend the definition of “qualified film” for section 199 purposes to include copyrights, trademarks, or other intangibles with respect to films.  In order to address concerns that the inclusion of “intangibles” within the definition of qualified film would be interpreted too broadly, the proposed regulations provide a special rule for the disposition of promotional films (i.e., films that promote a product or service) to ensure gross receipts are derived from the proper source of income.  The proposed regulations also explicitly include compensation for services performed in the U.S. by actors, production personnel, directors, and producers within the definition of W-2 wages.  

The proposed regulations also address the rules which provide the methods and means of distributing a qualified film does not affect the availability of the 199 deduction and clarify that qualified production activities do not include activities related to the transmission and distribution of films. 

In addition, the proposed regulations address the application of the attribution rules between partners and partnerships and shareholders and S corporations.  Generally under section 199, a partner of a partnership or a shareholder of an S corporation who owns at least 20 percent of the capital interests of their respective entity is treated as having engaged directly in a film produced by that entity.  Treas. Reg. § 1.199(3(i)(9)(i).  The proposed regulations, however, largely prohibit “attribution” between partners or between shareholders of their respective entity.  Thus, when a partnership or S corporation is treated as having engaged directly in a film produced by partner or shareholder, any other partners or shareholders of the respective entity who did not participate directly in the production of the film are treated as not having engaged directly in the production of the film. 

The proposed regulations also clarify the application of the section 199 safe harbor with respect to live or delayed programming and address what costs should be included in the safe harbor calculation.

Construction Activities

The proposed regulations address activities typically performed by a general contractor that constitute qualified construction activities.   Under the proposed regulations, a taxpayer merely approving or authorizing activities typically performed by a general contractor is not deemed to be engaged in construction and thus would not be entitled to the section 199 deduction. 

The proposed regulations additionally revise the definition of “substantial renovation” for purposes of section 199 to align with the final regulations under Sec 1.263(a)-3.  Section 199 generally provides that activities constituting construction are activities performed in connection with a project to erect or substantially renovate property.  Treas. Reg. §1.199-3(m)(2)(i).  Currently, section 199 defines “substantial renovation” as “the 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.”  Treas. Reg. §1.199-3(m)(5)(i).  The proposed regulations revise the definition of substantial renovation to require capitalization of amounts paid for improvements to a unit of property owned by a taxpayer.  Improvements include amounts paid for a betterment to a unit of property, amounts paid to restore a unit of property, and amounts paid to adapt a unit of property to a new or different use. 

W-2 Wages

The temporary regulations provide guidance on the allocation of W-2 wages paid by two or more employers of the same employees during a calendar year.  The temporary regulations also address situations where a short taxable year may not include a calendar year ending within the short taxable year which often precluded a section 199 deduction.

Oil-Related Qualified Production Activities Income and Deductions

The proposed regulations provide guidance on computing oil related QPAI.

Treatment of Activities in Puerto Rico

The current section 199 regulations state that for taxpayers with gross receipts in Puerto Rico, for purposes of applying the wage limitation under section 199(b) for any taxable year, the determination of W–2 wages of such taxpayer is made without regard to any exclusion under section 3401(a)(8) for remuneration paid for services performed in Puerto Rico. The proposed regulations modify the W-2 wage limitation under section 199 to the extent provided in the Tax Increase Prevention Act of 2014, which applies this limitation only to the first nine taxable years of the taxpayer beginning after December 31, 2005 and before January 1, 2015.

Determining DPGR on Item-by-Item Basis

The current regulations state that domestic production gross receipts (DPGR) must be determined on an item-by-item basis.  In the case of construction activities or engineering and architectural services, DPGR can be determined using any reasonable method.  The proposed regulations provide that if only one building has been renovated in a multi-building sale, then treating the multiple-building project as one item and treating gross receipts from the sale of a multiple-building project as DPGR, is not a reasonable method for determining the item.  In addition, the proposed regulations clarify that when property offered for disposition to customers includes embedded services, the item-by-item rule applies after excluding the gross receipts attributable to the services. 

MPGE

The proposed regulations seek to clarify that testing activities, by themselves, do not constitute qualified MPGE activities. The current section 199 regulations provide that MPGE property includes manufacturing, producing, growing, extracting, installing, developing, improving, and creating property; making property out of scrap, salvage, or junk material 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; cultivating soil, raising livestock, fishing, and mining minerals.  Treas. Reg.  §1.199-3(e)(1). The proposed regulations seek to limit the definition of MPGE to specifically exclude “testing” unless performed as part of the MPGE process.  The proposed regulations also reiterate that packaging, repackaging, labeling or minor assembly of property does not qualify as MPGE, and specifically addresses the IRS’s disapproval of the decision in United States v. Dean, 945 F.Supp.2d 1110 (C.D. Cal. 2013) (concluding that assembly of gift baskets through wholesale and retail channels was not solely packaging or repackaging for purposes of section 199). 

Hedging Transactions

The proposed regulations broaden the definition of hedging transactions to include hedging transactions of property giving rise to domestic production gross receipts.  This provision will serve to extend qualification to intermediate items beyond the qualified production property itself. 

Allocating Cost of Goods Sold

The proposed regulations recognize that allocable contract costs incurred under the percentage-of-completion method (PCM) or the completed-contract method (CCM) are analogous to cost of goods sold (CGS).  Reasonable methods must be used to allocate CGS between DPGR and non-DPGR and CGS should be allocated regardless of whether a component of the costs are associated with activities performed in an earlier tax year. 

Agricultural and Horticultural Cooperatives

The proposed regulations provide examples that clarify how QPAI is computed for persons receiving payment from a specified agricultural or horticultural cooperative. 

Conclusion

Businesses claiming the domestic production activities deduction under section 199 should be aware of the Temporary and Proposed regulations and their potential implications.  Although a majority of the changes to the regulations remain in proposed form, they provide insight into the position the IRS may take with respect to the highlighted areas.  Taxpayers should therefore review all of the amendments to the regulations in light of their own positions on qualification for the section 199 deduction and prepare accordingly.

Contacts

Questions or Comments

If you have any questions or comments, please contact any one of the partners, principals or directors in the research & development and government incentives service line.

 

Subscribe to receive Research & Development and Government Incentives Developments directly via email.

Did you find this useful?