The IRS and Treasury proposed new DPAD regulations on August 27, 2015 and discussed the following topics at the public hearing on December 16, 2015. The proposed amendments are intended to clarify how taxpayers should calculate the deduction, and provide guidance and examples to assist taxpayers in interpreting the rules. The proposed regulations would apply to tax years beginning on or after the date final regulations are published.[1]

The congressional purpose of DPAD was to reduce the tax burden on and improve the cash flow of domestic manufacturers, and make investments in domestic manufacturing facilities more attractive to create and preserve U.S. manufacturing jobs. The Domestic Production Activities Deduction (DPAD)[2] allows a deduction equal to nine percent[3] of the lesser of: (A) The qualified production activities income (QPAI) of the taxpayer for the taxable year, or (B) taxable income (determined without regard to section 199) for the taxable year (or, in the case of an individual, adjusted gross income). Qualified production activities include producing property manufactured, produced, grown, or extracted (“MPGE”) by the taxpayer in whole or in significant part within the United States. DPAD is one of the top five largest U.S business deductions.

Construction Activities

Taxpayers determine whether gross receipts qualify as domestic production gross receipts (DPGR) on an item-by-item basis. Taxpayers may use any reasonable method that is satisfactory to the Secretary based on all of the facts and circumstances to determine what construction activities and services or engineering or architectural services constitute an item[4]. Treasury and the IRS have concluded that treating gross receipts from the sale of a multiple-building project as DPGR, and the multiple-building project as one item, is not a reasonable method for the purposes of section 199 if each building in the multiple-building project was not substantially renovated[5]. Activities constituting construction are activities performed in connection with a project to erect or substantially renovate real property,[6] and 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[7].

Allocating Cost of Goods Sold

In the case of transactions accounted for under a long-term contract method of accounting (either the percentage-of-completion method (PCM) or the completed-contract method (CCM)), a taxpayer incurs allocable contract costs. Allocable contract costs under PCM or CCM are analogous to CGS and should be treated in the same manner[1]. Taxpayers have asserted that the portion of current year CGS associated with activities in earlier tax years (including pre-section 199 tax years) may be allocated to non-DPGR even if the related gross receipts are treated by the taxpayer as DPGR. The proposed regulations clarify that the CGS must be allocated between DPGR and non-DPGR[2], regardless of whether any component of the costs included in CGS can be associated with activities undertaken in an earlier taxable year[3].

Hedging Transactions

The starting point for computing DPAD is the taxpayer’s domestic production gross receipts (DPGR). In determining DPGR, gain or loss on a hedging transaction must be taken into account. The existing regulations require the risk being hedged relate to Qualifying Production Property (QPP)[4] – QPP is tangible personal property, computer software, and certain sound recordings. QPP does not include land, buildings, structural components, or utilities. This means gain or loss on a hedging transaction must be taken into account in computing DPGR either if:

  1. The transaction hedges a sale of QPP, and that property is stock in trade, inventory, or property held for sale to customers[5], or
  2. The purchase of business supplies regularly used or consumed by the taxpayer in the ordinary course of the taxpayer’s trade or business[6].

The proposed regulations broaden the qualification to include items beyond QPP, and require a hedging transaction to include transactions in which the risk being hedged relates to “property described in Code Sec. 1221(a)(1)” instead of to “QPP described in Code Sec. 1221(a)(1).” The above hedging transaction rules do not apply to require gain to be taken into account in DPGR, if the transaction is not in fact a hedging transaction within the meaning of Code Sec. 1221(b)(2)(A) and Reg § 1.1221-2(b).

Further, the consequence of an abusive identification or non-identification is that deduction or loss, but not income or gain, is taken into account in calculating DPGR.

Manufacturing and Minor Assembly

Under the current rules, minor assembly does not rise to the level of qualified manufacturing for the DPAD deduction, however Treas. Reg. §1.199-3(g) does not provide a definition of minor assembly. The proposed regulations focus on whether or not the taxpayer’s activity is only a single process that does not transform an item into materially different QPP, and whether an end use could reasonably assemble the item in a relatively brief time using tools and resources ultimately found in the end users home or place of business without the taxpayer. If so, then the taxpayer’s assembly would not be qualify.

The District court has ruled in favor of a taxpayer that claimed section 199 deductions for its assembly of gift baskets[1]. The court held the taxpayer’s process of creating gift baskets from preexisting consumer items met the threshold requirements of MPGE because the taxpayer changed the form and function of the individual items by creating distinct gifts” that had a “different demand.” The court relied, in part, on facts such as “the void fill in the gift basket is a cardboard form or Styrofoam base that is placed inside the basket; the other items are in turn placed inside. The manufacturer generally designed the cardboard forms, indicating where the cuts and folds should be made[2]. The court also found, “After the items have been placed inside the basket, a plastic wrapping is heated to shrink around the basket.” The assembly in this case was more than just minor assembly and required making a unique product. The proposed regulations attempt to make a distinction between minor assembly and manufacturing.

Contact Us
If you have questions regarding the proposed changes to the Domestic Production Activities Deduction (DPAD), please call Cheryl at 513-241-8313 or click here to contact us. We look forward to speaking with you soon!

 

[1]All section references are to the provisions of the Internal Revenue Code of 1986, as amended (the “Code”), and all regulatory references are to the regulations thereunder.

[2] Code Sec. 199 (a)(1).

[3] Three percent in the case of taxable years beginning in 2005 or 2006, and six percent in the case of taxable years beginning in 2007, 2008, or 2009.

[4] Section § 1.199-3(d)(2)(iii).

[5] Section 1.199-3(d)(4) of the proposed regulations includes an example (Example 14) illustrating the appropriate application of § 1.199-3(d)(2)(iii) to a multiple building project.

[6] Section § 1.199-3(m)(2)(i).

[7] Section 1.199-3(m)(5).

[1] United States v. Dean, 945 F. Supp. 2d 1110 (C.D. Cal. 2013).

[2] United States v. Dean,, 945 F. Supp. 2d at 1112.

[1] Section 1.199–4(b)(2)(ii).

[2] Section 1.199–4(b)(2)(iii)(A).

[3] Section 1.199–4(b)(2)(iii)(B) of the proposed regulations provides an example illustrating this rule.

[4] Described in section 1221(a)(1).

[5] Code Sec. 1221(a)(1).

[6] Code Sec. 1221(a)(8).