67220 Federal Register / Vol. 70, No. 213 / Friday, November 4, 2005 / Proposed Rules 

DEPARTMENT OF THE TREASURY 

Internal Revenue Service 

26 CFR Part 1 

[REG–105847–05] 

RIN 1545–BE33 

Income Attributable to Domestic 

Production Activities 

AGENCY: Internal Revenue Service (IRS), 

Treasury. 

ACTION: Notice of proposed rulemaking 

and notice of public hearing. 

SUMMARY: This document contains 

proposed regulations concerning the 

deduction for income attributable to 

domestic production activities under 

section 199. Section 199 was enacted as 

part of the American Jobs Creation Act 

of 2004, (the Act). The regulations will 

affect taxpayers engaged in certain 

domestic production activities. This 

document also provides a notice of a 

public hearing on these proposed 

regulations. 

DATES: Written or electronic comments 

must be received by January 3, 2006. 

Outlines of topics to be discussed at the 

public hearing scheduled for 

Wednesday, January 11, 2006, must be 

received by December 21, 2005. 

ADDRESSES: Send submissions to: 

CC:PA:LPD:PR (REG–105847–05), room 

5203, Internal Revenue Service, POB 

7604, Ben Franklin Station, Washington, 

DC 20044. Submissions may be hand 

delivered Monday through Friday 

between the hours of 8 a.m. and 4 p.m. 

to: CC:PA:LPD:PR (REG–105847–05), 

Courier’s Desk, Internal Revenue 

Service, 1111 Constitution Avenue, 

NW., Washington, DC, or sent 

electronically, via the IRS Internet site 

at http://www.irs.gov/regs or via the 

Federal eRulemaking Portal at http:// 

www.regulations.gov (IRS–REG– 

105847–05). The public hearing will be 

held in the IRS Auditorium, Internal 

Revenue Building, 1111 Constitution 

Avenue, NW., Washington, DC. 

FOR FURTHER INFORMATION CONTACT: 

Concerning §§ 1.199–1, 1.199–3, 1.199– 

6, and 1.199–8, Paul Handleman or 

Lauren Ross Taylor, (202) 622–3040; 

concerning § 1.199–2, Alfred Kelley, 

(202) 622–6040; concerning § 1.199–4(c) 

and (d), Richard Chewning, (202) 622– 

3850; concerning all other provisions of 

§ 1.199–4, Scott Rabinowitz, (202) 622– 

4970; concerning § 1.199–5, Martin 

Schaffer, (202) 622–3080; concerning 

§ 1.199–7, Ken Cohen, (202) 622–7790; 

concerning submission of comments, 

the hearing, and/or to be placed on the 

building access list to attend the 

hearing, LaNita Van Dyke, (202) 622– 

7180 (not toll-free numbers). 

SUPPLEMENTARY INFORMATION: 

Paperwork Reduction Act 

The collections of information 

contained in this notice of proposed 

rulemaking have been submitted to the 

Office of Management and Budget for 

review in accordance with the 

Paperwork Reduction Act of 1995 (44 

U.S.C. 3507(d)). Comments on the 

collections of information should be 

sent to the Office of Management and 

Budget, Attn: Desk Officer for the 

Department of the Treasury, Office of 

Information and Regulatory Affairs, 

Washington, DC 20503, with copies to 

the Internal Revenue Service, Attn: IRS 

Reports Clearance Officer, 

SE:W:CAR:MP:T:T:SP, Washington, DC 

20224. Comments on the collection of 

information should be received by 

January 3, 2006. 

Comments are specifically requested 

concerning: 

Whether the proposed collection of 

information is necessary for the proper 

performance of the functions of the IRS, 

including whether the information will 

have practical utility; 

The accuracy of the estimated burden 

associated with the proposed collection 

of information; 

How the quality, utility, and clarity of 

the information to be collected may be 

enhanced; 

How the burden of complying with 

the proposed collections of information 

may be minimized, including through 

the application of automated collection 

techniques or other forms of information 

technology; and 

Estimates of capital or start-up costs 

and costs of operation, maintenance, 

and purchase of service to provide 

information. 

The collection of information in these 

proposed regulations is in § 1.199–6(b) 

involving patrons of agricultural and 

horticultural cooperatives. This 

information is required so that patrons 

of agricultural and horticultural 

cooperatives may claim the section 199 

deduction. The collections of 

information is mandatory. The likely 

respondents are business or other forprofit institutions. 

Estimated total annual reporting 

burden: 9,000 hours. 

Estimated average annual burden 

hours per respondent: 3 hours. 

Estimated number of respondents: 

3,000. 

Estimated annual frequency of 

responses: annually. 

An agency may not conduct or 

sponsor, and a person is not required to 

respond to, a collection of information 

unless it displays a valid control 

number assigned by the Office of 

Management and Budget. 

Books or records relating to a 

collection of information must be 

retained as long as their contents may 

become material in the administration 

of any internal revenue law. Generally, 

tax returns and tax return information 

are confidential, as required by 26 

U.S.C. 6103. 

Background 

This document contains proposed 

regulations relating to the deduction for 

income attributable to domestic 

production activities under section 199 

of the Internal Revenue Code (Code). 

Section 199 was added to the Code by 

section 102 of the Act (Public Law 108– 

357, 118 Stat. 1418). On January 19, 

2005, the IRS and Treasury Department 

issued Notice 2005–14 (2005–7 I.R.B. 

498) providing interim guidance on 

section 199 and inviting comments on 

issues arising under section 199. 

Written and electronic comments 

responding to Notice 2005–14 were 

received. The IRS and Treasury 

Department have reviewed and 

considered all the comments in the 

process of preparing these proposed 

regulations. This preamble to the 

proposed regulations describes many of 

the more significant comments received 

by the IRS and Treasury Department. 

Because of the large volume of 

comments received, however, the IRS 

and Treasury Department are not able to 

address all of the comments in this 

preamble. 

General Overview 

Section 199(a)(1) allows a deduction 

equal to 9 percent (3 percent in the case 

of taxable years beginning in 2005 or 

2006, and 6 percent in the case of 

taxable years beginning in 2007, 2008, 

or 2009) 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 

(AGI)). 

Section 199(b)(1) limits the deduction 

for a taxable year to 50 percent of the 

W–2 wages paid by the taxpayer during 

the calendar year that ends in such 

taxable year. For this purpose, section 

199(b)(2) defines the term W–2 wages to 

mean the sum of the aggregate amounts 

the taxpayer is required under section 

6051(a)(3) and (8) to include on the 

Forms W–2, ‘‘Wage and Tax Statement,’’ 

of the taxpayer’s employees during the 

calendar year ending during the 

Federal Register / Vol. 70, No. 213 / Friday, November 4, 2005 / Proposed Rules 67221 

taxpayer’s taxable year. Section 

199(b)(3) provides that the Secretary 

shall prescribe rules for the application 

of section 199(b) in the case of an 

acquisition or disposition of a major 

portion of either a trade or business or 

a separate unit of a trade or business 

during the taxable year. 

Qualified Production Activities Income 

Under section 199(c)(1), QPAI is the 

excess of domestic production gross 

receipts (DPGR) over the sum of: (a) The 

cost of goods sold (CGS) allocable to 

such receipts; (b) other deductions, 

expenses, or losses directly allocable to 

such receipts; and (c) a ratable portion 

of deductions, expenses, and losses not 

directly allocable to such receipts or 

another class of income. 

Section 199(c)(2) provides that the 

Secretary shall prescribe rules for the 

proper allocation of items of income, 

deduction, expense, and loss for 

purposes of determining QPAI. 

Section 199(c)(3) provides special 

rules for determining costs in 

computing QPAI. Under these special 

rules, any item or service imported into 

the United States without an arm’s 

length transfer price shall be treated as 

acquired by purchase, and its cost shall 

be treated as not less than its value 

immediately after it enters the United 

States. A similar rule applies in 

determining the adjusted basis of leased 

or rented property when the lease or 

rental gives rise to DPGR. If the property 

has been exported by the taxpayer for 

further manufacture, the increase in cost 

or adjusted basis must not exceed the 

difference between the value of the 

property when exported and its value 

when imported back into the United 

States after further manufacture. 

Section 199(c)(4)(A) defines DPGR to 

mean the taxpayer’s gross receipts that 

are derived from: (i) Any lease, rental, 

license, sale, exchange, or other 

disposition of (I) 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; (II) any qualified film produced 

by the taxpayer; or (III) electricity, 

natural gas, or potable water 

(collectively, utilities) produced by the 

taxpayer in the United States; (ii) 

construction performed in the United 

States; or (iii) engineering or 

architectural services performed in the 

United States for construction projects 

in the United States. 

Section 199(c)(4)(B) excepts from 

DPGR gross receipts of the taxpayer that 

are derived from: (i) The sale of food 

and beverages prepared by the taxpayer 

at a retail establishment; and (ii) the 

transmission or distribution of 

electricity, natural gas, or potable water. 

Section 199(c)(5) defines QPP to 

mean: (A) Tangible personal property; 

(B) any computer software; and (C) any 

property described in section 168(f)(4) 

(certain sound recordings). 

Section 199(c)(6) defines a qualified 

film to mean any property described in 

section 168(f)(3) if not less than 50 

percent of the total compensation 

relating to production of the property is 

compensation for services performed in 

the United States by actors, production 

personnel, directors, and producers. The 

term does not include property with 

respect to which records are required to 

be maintained under 18 U.S.C. 2257 

(generally, films, videotapes, or other 

matter that depict actual sexually 

explicit conduct and are produced in 

whole or in part with materials that 

have been mailed or shipped in 

interstate or foreign commerce, or are 

shipped or transported or are intended 

for shipment or transportation in 

interstate or foreign commerce). 

Section 199(c)(7) provides that DPGR 

does not include any gross receipts of 

the taxpayer derived from property 

leased, licensed, or rented by the 

taxpayer for use by any related person. 

A person is treated as related to another 

person if both persons are treated as a 

single employer under either section 

52(a) or (b) (without regard to section 

1563(b)), or section 414(m) or (o). 

Pass-Thru Entities 

Section 199(d)(1) provides that, in the 

case of an S corporation, partnership, 

estate or trust, or other pass-thru entity, 

section 199 generally is applied at the 

shareholder, partner, or similar level, 

except as otherwise provided in rules 

applicable to patrons of cooperatives. 

Section 199(d)(1) further provides that 

the Secretary shall prescribe rules for 

the application of section 199, including 

rules relating to: (a) Restrictions on the 

allocation of the deduction to taxpayers 

at the partner or similar level; and (b) 

additional reporting requirements. 

The general rule is that section 199 is 

applied at the shareholder, partner, or 

similar level. However, section 

199(d)(1)(B) limits the amount of W–2 

wages from a pass-thru entity that may 

be used by each shareholder, partner, or 

similar person to compute the section 

199 deduction. Specifically, section 

199(d)(1)(B) provides that such person 

is treated as having been allocated W–

2 wages from such entity in an amount 

equal to the lesser of: (i) Such person’s 

allocable share of such wages (without 

regard to this rule) from such entity as 

determined under regulations 

prescribed by the Secretary; or (ii) 2 

times 9 percent (3 percent in the case of 

taxable years beginning in 2005 or 2006, 

and 6 percent in the case of taxable 

years beginning in 2007, 2008, or 2009) 

of the QPAI of that entity allocated to 

such person for the taxable year. 

Individuals 

In the case of an individual, section 

199(d)(2) provides that the deduction is 

equal to the applicable percentage of the 

lesser of the taxpayer’s: (a) QPAI for the 

taxable year; or (b) AGI for the taxable 

year determined after applying sections 

86, 135, 137, 219, 221, 222, and 469, 

and without regard to section 199. 

Patrons of Certain Cooperatives 

Section 199(d)(3) provides special 

rules under which a taxpayer receiving 

certain patronage dividends or certain 

qualified per-unit retain allocations 

from a cooperative (to which subchapter 

T applies) engaged in the MPGE, in 

whole or in significant part, or in the 

marketing of any agricultural or 

horticultural product is allowed a 

section 199 deduction with respect to 

the amount of the patronage dividends 

or qualified per-unit retain allocations 

that are: (a) Allocable to the portion of 

the cooperative’s QPAI that would be 

deductible by the cooperative; and (b) 

designated as such by the cooperative in 

a written notice mailed to its patrons 

during the payment period described in 

section 1382. Such an amount, however, 

does not reduce the taxable income of 

the cooperative under section 1382. 

In determining the portion of the 

cooperative’s QPAI that would be 

deductible by the cooperative, the 

cooperative’s taxable income is 

computed without taking into account 

any deduction allowable under section 

1382(b) or (c) (relating to patronage 

dividends, per-unit retain allocations, 

and nonpatronage distributions) and, in 

the case of a cooperative engaged in 

marketing agricultural and horticultural 

products, the cooperative is treated as 

having MPGE, in whole or in significant 

part, any agricultural and horticultural 

products marketed by the cooperative 

that its patrons have MPGE. 

Expanded Affiliated Groups 

Section 199(d)(4)(A) provides that all 

members of an expanded affiliated 

group (EAG) are treated as a single 

corporation for purposes of section 199. 

Taking into account the provisions of 

the Congressional Letter, as described 

elsewhere, section 199(d)(4)(B) provides 

that an EAG is an affiliated group as 

defined in section 1504(a), determined 

by substituting ‘‘more than 50 percent’’

for ‘‘at least 80 percent’’ each place it 

67222 Federal Register / Vol. 70, No. 213 / Friday, November 4, 2005 / Proposed Rules 

appears and without regard to section 

1504(b)(2) and (4). 

Section 199(d)(4)(C) provides that, 

except as provided in regulations, the 

section 199 deduction is allocated 

among the members of the EAG in 

proportion to each member’s respective 

amount (if any) of QPAI. 

Trade or Business Requirement 

Section 199(d)(5) provides that 

section 199 is applied by taking into 

account only items that are attributable 

to the actual conduct of a trade or 

business. 

Alternative Minimum Tax 

Section 199(d)(6) provides rules to 

coordinate the deduction allowed under 

section 199 with the alternative 

minimum tax (AMT) imposed by 

section 55. Taking into account the 

provisions of the Congressional Letter, 

as described elsewhere, section 

199(d)(6) provides that for purposes of 

determining alternative minimum 

taxable income (AMTI) under section 

55, the section 199 deduction shall be 

determined without regard to any 

adjustments under sections 56 through 

59, except that in the case of a 

corporation (including a corporation 

subject to tax under section 511), the 

taxable income limitation is the 

corporation’s AMTI. 

Authority To Prescribe Regulations 

Section 199(d)(7) authorizes the 

Secretary to prescribe such regulations 

as are necessary to carry out the 

purposes of section 199. 

Congressional Letter 

On July 21, 2005, the Chairman and 

Ranking Member of the Senate Finance 

Committee and the Chairman of the 

House Ways and Means Committee 

introduced the Tax Technical 

Corrections Act of 2005, H.R. 3376 and 

S. 1447, 109th Cong. (2005). In a letter 

on the same date to the Treasury 

Department (the Congressional Letter), 

they provided clarification for several 

issues so that appropriate regulatory 

guidance may be issued reflecting their 

intention. These proposed regulations 

reflect the intent expressed in the 

Congressional Letter with respect to 

section 199. 

Summary of Comments 

Qualified Production Activities Income 

One commentator requested that the 

proposed regulations clarify the 

treatment of advance payments, and the 

costs related to those payments, for 

purposes of computing QPAI. Section 

4.03(3) of Notice 2005–14 provides that, 

in the case of advance payments (for 

goods, services, and use of property) 

that are recognized under the taxpayer’s 

method of accounting in a taxable year 

earlier than that in which the property 

or services are delivered, performed, 

and provided, the taxpayer must 

accurately identify, based on a 

reasonable method, whether the receipts 

(and the corresponding expenses) 

qualify as DPGR. If a taxpayer 

recognizes an advance payment in Year 

1, and the CGS in Year 2, the 

commentator asks whether CGS must be 

applied to reduce DPGR in Year 2, even 

though the DPGR and CGS are 

recognized in different taxable years. 

The proposed regulations clarify that, 

in the example the commentator cites 

involving advance payments, as well as 

other circumstances (such as taxpayers 

that use the cash receipts and 

disbursements method) where gross 

receipts and corresponding expenses are 

recognized in different taxable years, 

taxpayers must take the receipts and 

expenses into account for purposes of 

section 199 in the taxable year such 

items are recognized under their 

methods of accounting for Federal 

income tax purposes. The IRS and 

Treasury Department believe it would 

be unduly burdensome and complicated 

to create a separate set of timing rules 

for purposes of section 199. Thus, gross 

receipts and costs are taken into account 

for purposes of computing QPAI in the 

taxable year they are recognized for 

Federal income tax purposes under the 

taxpayer’s methods of accounting, even 

if the related gross receipts or costs, as 

applicable, are taken into account in 

different taxable years. If the gross 

receipts are recognized in an 

intercompany transaction within the 

meaning of § 1.1502–13, see also 

§ 1.199–7(d). 

A commentator requested clarification 

of how the advance payment rules 

would apply in the following scenario. 

In Year 1, a taxpayer sells for $100 a 

one-year software maintenance 

agreement that provides for software 

updates (that the taxpayer would MPGE 

in whole or in significant part within 

the United States) and customer support 

services. At the end of Year 1, the 

taxpayer uses a reasonable method to 

allocate 60 percent of the gross receipts 

($60) to the software updates and 40 

percent ($40) to the customer support 

services. The taxpayer treats the $60 as 

DPGR in Year 1. In Year 2, no software 

updates are provided. The commentator 

asks whether the taxpayer in this 

scenario would be required to amend its 

Year 1 return and reduce its DPGR by 

$60, reduce DPGR by $60 in Year 2, or 

make no adjustment for Year 1 or Year 

2. 

Consistent with the application of the 

rules relating to advance payments, 

which require that the taxpayer follow 

its methods of accounting for Federal 

income tax purposes, the taxpayer 

should make no adjustment in Year 1 

(by amended return) or in Year 2 for the 

$60 that was appropriately treated as 

DPGR in Year 1, even though no 

software updates were provided in Year 

2. 

A commentator suggested that the 

proposed regulations clarify how a 

taxpayer that uses a long-term contract 

method determines the portion of the 

percentage of completion revenue 

reported for each contract for the taxable 

year that is allocated to DPGR. The 

proposed regulations provide that 

taxpayers using a long-term contract 

method (for example, under section 460) 

may use any reasonable method of 

allocating gross receipts under such a 

contract between DPGR and non-DPGR. 

A number of comments were received 

regarding the rule in section 4.03(1) of 

Notice 2005–14 that requires that 

section 199 be applied on an item-byitem basis. Some commentators stated 

that applying section 199 on an item-byitem basis is unduly burdensome, and 

that the proposed regulations should 

permit taxpayers to determine QPAI on 

a division or product-line basis instead. 

The IRS and Treasury Department, 

however, continue to believe that 

applying section 199 on a basis other 

than item-by-item would allow 

taxpayers to receive the benefits of 

section 199 with respect to gross 

receipts that should not qualify as 

DPGR. Accordingly, the proposed 

regulations retain the requirement that 

section 199 be applied on an item-byitem basis. 

Many commentators requested 

clarification of what constitutes an item. 

Commentators asked whether an item is 

a final product or whether one or more 

component parts of the final product 

may qualify as an item. For example, if 

a final product does not meet the in 

whole or in significant part requirement 

(so that gross receipts from the sale of 

the final product are non-DPGR), 

commentators inquired whether they 

could allocate gross receipts to a 

component of the product that did meet 

all of the requirements of section 199(c), 

and thereby treat that portion of the 

gross receipts as DPGR. 

H.R. Conf. Rep. No. 755, 108th Cong., 

2d Sess. 272 n. 27 (2004) (the 

Conference Report) indicates that a 

component may be treated as qualifying 

property in the case of food and 

beverages. Footnote 27 of the 

Conference Report explains that, in the 

context of food and beverages prepared 

Federal Register / Vol. 70, No. 213 / Friday, November 4, 2005 / Proposed Rules 67223 

at a retail establishment, although a cup 

of coffee prepared at a retail 

establishment does not qualify under 

section 199(c), a portion of the cup of 

coffee, that is, the coffee beans (roasted 

at a facility separate from the retail 

establishment) that meet the 

requirements under section 199(c), does 

qualify under section 199. The Joint 

Committee on Taxation Staff, General 

Explanation of Tax Legislation Enacted 

in the 108th Congress, 109th Cong., 1st 

Sess. 172 (2005) (the Blue Book), 

indicates Congressional intent that this 

treatment is not limited to food and 

beverages, but rather, is permitted with 

respect to section 199 in general. 

Accordingly, in the case of QPP, 

qualified films, and utilities, the 

proposed regulations define an item as 

the property offered for sale to 

customers that meets all of the 

requirements under section 199(c). If the 

property offered for sale does not meet 

all of the requirements under section 

199(c), a taxpayer must treat as the item 

any portion of the property offered for 

sale that meets all of these requirements. 

However, in no case shall the portion of 

the property offered for sale that is 

treated as the item exclude any other 

portion that meets all of the 

requirements under section 199(c). For 

example, assume that the taxpayer 

MPGE software entirely within the 

United States, attaches the software to a 

router that it MPGE entirely outside the 

United States, and then sells the 

combined property. Assume further that 

if the combined property is treated as 

the item, the gross receipts from the sale 

will not qualify as DPGR because the 

combined property does not satisfy the 

in whole or in significant part 

requirement. The proposed regulations 

require the taxpayer to treat the software 

as an item; separate from the router, 

because the software meets all of the 

requirements of section 199(c) (that is, 

it is computer software that is MPGE by 

the taxpayer in whole or in significant 

part within the United States). This is 

the case even if the software is not 

offered for sale to customers separately 

from the router. Accordingly, the gross 

receipts from the software qualify as 

DPGR, but the gross receipts from the 

router do not qualify as DPGR. 

Alternatively, assume that the 

taxpayer MPGE only software but that 

some of the content is MPGE within the 

United States and some content is 

MPGE outside the United States. 

Assuming that the software does not 

meet the requirements of section 199(c), 

that portion of the software that is 

MPGE within the United States must be 

treated as the item. Accordingly, gross 

receipts from the sale of the software 

must be allocated (using any reasonable 

method) between that portion that is 

MPGE within the United States (which 

is DPGR if all other requirements of 

section 199(c) are met) and that portion 

that is MPGE outside the United States 

(which is non-DPGR). 

In the case of construction and 

architectural and engineering services, 

commentators asked that the proposed 

regulations clarify whether the item is 

the construction project itself, or 

whether the item can constitute a task 

or sub-task that is performed as part of 

the construction project. The IRS and 

Treasury Department believe that the 

determination of what constitutes the 

item for purposes of construction and 

architectural or engineering services 

should be made on a case-by-case basis 

taking into account all of the facts and 

circumstances. Taxpayers may use any 

reasonable method of determining the 

item for this purpose. 

A commentator requested that the 

proposed regulations clarify how the 

rules for determining DPGR apply in the 

case of a taxpayer that repairs or 

rebuilds property for a customer. The 

commentator suggested the IRS and 

Treasury Department distinguish 

between ‘‘repair’’ activities and 

‘‘rebuild’’ activities. In the case of a 

repair contract where the customer 

retains the benefits and burdens of the 

property while it is being repaired, the 

commentator suggests that the 

contractor should be permitted to treat 

as DPGR the gross receipts attributable 

to parts that the contractor MPGE in 

whole or in significant part within the 

United States, as well as the gross 

receipts attributable to the installation 

of those parts. Gross receipts 

attributable to the parts MPGE by the 

taxpayer in whole or in significant part 

within the United States are DPGR 

(assuming all the other requirements of 

section 199(c) are met). Consistent with 

the general rule for installation 

(discussed below), the installation 

activity will be considered an MPGE 

activity only if the contractor retains the 

benefits and burdens of ownership with 

respect to the parts while the parts are 

being installed. In addition, the gross 

receipts attributable to the installation 

of parts that the contractor MPGE may 

qualify as DPGR if the exception for 

embedded installation described in 

§ 1.199–3(h)(4)(ii)(D) of the proposed 

regulations applies. The contractor is 

not permitted to treat as DPGR gross 

receipts attributable to purchased parts, 

or the installation of purchased parts. 

The commentator suggested that the 

proposed regulations provide a special 

rule for ‘‘rebuild’’ contracts, which the 

commentator suggested be defined as 

any contract where the value of the 

rebuild work performed exceeds 25 

percent of the value of the preexisting 

property immediately before the 

rebuild. The commentator further 

suggested that if more than 50 percent 

of the contractor’s costs of performing 

the rebuild is attributable to the cost of 

parts that the contractor MPGE, the 

contractor should not be required to 

allocate its gross receipts between parts 

that it MPGE and any parts that it 

purchased. The commentator’s 

suggested rule would effectively create 

for rebuild contracts a separate de 

minimis exception to the general 

allocation requirement. The IRS and 

Treasury Department believe that the de 

minimis exceptions provided in the 

proposed regulations (for example, the 5 

percent de minimis exception discussed 

later generally applicable to embedded 

services and embedded nonqualifying 

property) are appropriate. Accordingly, 

the proposed regulations do not adopt 

this suggestion. 

Section 4.03(2) of Notice 2005–14 

provides that, if the amount of the 

taxpayer’s gross receipts that do not 

qualify as DPGR equals or exceeds 5 

percent of the total gross receipts, the 

taxpayer is required to allocate all gross 

receipts between DPGR and non-DPGR. 

For purposes of this 5 percent de 

minimis rule, the proposed regulations 

in § 1.199–1(d)(2) provide that, in the 

case of an S corporation, partnership, 

estate, trust, or other pass-thru entity, 

the determination of whether less than 

5 percent of the pass-thru entity’s total 

gross receipts are non-DPGR is made at 

the pass-thru entity level. In the case of 

an owner of a pass-thru entity, the 

determination of whether less than 5 

percent of the owner’s total gross 

receipts are non-DPGR is made at the 

owner level, taking into account the 

owner’s share of any of the pass-thru 

entity’s gross receipts as well as all 

other gross receipts of the owner. In 

addition, the 5 percent de minimis 

exception in § 1.199–3(h)(4)(ii)(E) 

applies at the entity level to each item 

that qualifies. 

Commentators also observed that, in 

determining whether the taxpayer’s 

method of allocating gross receipts and 

CGS between DPGR and non-DPGR is 

reasonable, the list of factors cited in 

section 4.03(2) of Notice 2005–14 with 

respect to gross receipts is inconsistent 

with the list of factors cited in section 

4.05(2)(b) of the notice with respect to 

CGS. The list of factors was intended to 

be as consistent as possible for both 

gross receipts and CGS, and appropriate 

changes to the lists have been 

67224 Federal Register / Vol. 70, No. 213 / Friday, November 4, 2005 / Proposed Rules 

incorporated into the proposed 

regulations as necessary. 

Taxable Income 

In the Congressional Letter, the 

Treasury Department was advised that 

unrelated business taxable income, 

rather than taxable income, applies for 

purposes of section 199(a)(1) in 

computing the unrelated business 

income tax under section 511. 

Accordingly, the proposed regulations 

in § 1.199–1(b) provide that, for 

purposes of determining the tax 

imposed by section 511, section 

199(a)(1)(B) is applied using unrelated 

business taxable income. 

The Congressional Letter also 

indicates that the section 199 deduction 

is not taken into account for purposes of 

computing taxable income under the 

rules relating to the carryover of a net 

operating loss (NOL). Accordingly, the 

proposed regulations provide that for 

purposes of computing the section 199 

deduction, the definition of taxable 

income under section 63 applies, but 

without regard to section 199. The 

proposed regulations also provide that 

the section 199 deduction is not taken 

into account in computing taxable 

income when determining the amount 

of the NOL carryback and carryover 

under section 172(b)(2). Thus, except as 

otherwise provided in § 1.199–7(c)(2) of 

the proposed regulations (concerning 

the portion of a section 199 deduction 

allocated to a member of an EAG), the 

section 199 deduction can neither create 

an NOL carryback or carryover nor 

increase the amount of an NOL 

carryback or carryover. 

Wage Limitation 

A commentator requested that the IRS 

and Treasury Department clarify 

whether self-employment income of 

self-employed individuals as reported 

on the individuals’ Schedule SE, ‘‘SelfEmployment Income,’’ of Form 1040 

and/or payments for nonemployee 

compensation reported by the taxpayer 

on Form 1099–MISC, ‘‘Miscellaneous 

Income,’’ are included in determining 

the amount of the W–2 wages of the 

taxpayer. A commentator also requested 

that the IRS clarify whether guaranteed 

payments to partners are included in 

W–2 wages for purposes of section 199. 

The statutory language in section 

199(b) refers to the amounts a taxpayer 

is required to report as wages on Form 

W–2 pursuant to section 6051 with 

respect to the employment of employees 

of the taxpayer. Neither selfemployment income nor guaranteed 

payments to partners are required to be 

reported under section 6051. In 

addition, section 4.02(1)(a) of Notice 

2005–14 and § 1.199–2(a)(1) of the 

proposed regulations define employees 

as including only common law 

employees of the taxpayer and officers 

of a corporate taxpayer. Consistent with 

the statutory intent, this definition does 

not include independent contractors or 

partners. Thus, payments to 

independent contractors and selfemployment income, including 

guaranteed payments made to partners, 

are not included in determining W–2 

wages. 

The proposed regulations provide for 

the same three methods of calculating 

W–2 wages as contained in Notice 

2005–14. It is anticipated that when 

final regulations are issued, these three 

methods will be published in a notice 

rather than as part of the final 

regulations. It is anticipated that this 

notice will be published at the same 

time as the final regulations. The 

methods will be included in a notice 

rather than the final regulations so that 

if changes are made to the box numbers 

on Form W–2, ‘‘Wage and Tax 

Statement,’’ a new notice can be issued 

reflecting those changes more promptly 

than an amendment to final regulations. 

The non-duplication rule in § 1.199–

2(e) continues to provide that amounts 

that are treated as W–2 wages for any 

taxable year under any method may not 

be treated as W–2 wages for any other 

taxable year. Additional language has 

been added to the non-duplication rule 

to clarify that the same W–2 wages 

cannot be claimed by more than one 

taxpayer for purposes of section 199. 

Domestic Production Gross Receipts 

DPGR includes the gross receipts of 

the taxpayer that are derived from any 

lease, rental, license, sale, exchange, or 

other disposition of property described 

in section 199(c)(4)(A)(i). Commentators 

specifically asked whether fees such as 

cotton or real estate broker’s fees are 

DPGR. These fees are non-DPGR 

because they are not derived from any 

lease, rental, license, sale, exchange, or 

other disposition of property under 

section 199(c)(4)(A)(i). 

Commentators asked for clarification 

of whether DPGR includes gross receipts 

derived by a taxpayer from the 

subsequent sale or lease of QPP MPGE 

within the United States by the 

taxpayer, sold, and then reacquired by 

the taxpayer. The proposed regulations 

in § 1.199–3(h)(2) provide an example to 

illustrate the rule that gross receipts 

from the subsequent sale or lease of QPP 

are DPGR to the taxpayer that originally 

MPGE the QPP within the United States. 

Any interest component of the lease 

payment also qualifies as DPGR because 

section 199(c)(4)(A)(i) provides that 

DPGR means gross receipts derived by 

the taxpayer from any lease. 

Commentators pointed out that the 

rule for allocating gross receipts for 

purposes of identifying DPGR under 

section 3.04(1) of Notice 2005–14 

appears to adopt a specific 

identification standard, whereas section 

4.03(2) appears to provide a reasonable 

basis standard. The proposed 

regulations provide in § 1.199–1(d)(1) 

that the taxpayer must allocate its gross 

receipts from all transactions based on 

a reasonable method that is satisfactory 

to the Secretary based on all of the facts 

and circumstances and that accurately 

identifies the gross receipts that 

constitute DPGR. If a taxpayer can, 

without undue burden or expense, 

specifically identify where an item was 

manufactured, or if the taxpayer uses a 

specific identification method for other 

purposes, then the taxpayer must use 

that specific identification method to 

determine DPGR. If a taxpayer does not 

use a specific identification method for 

other purposes and cannot, without 

undue burden or expense, use a specific 

identification method, the taxpayer is 

not required to use a specific 

identification method to determine 

DPGR. 

Related Persons 

Section 199(c)(7) provides that DPGR 

does not include any gross receipts of 

the taxpayer derived from property 

leased, licensed, or rented by the 

taxpayer for use by any related person. 

A person is treated as related to another 

person if both persons are treated as a 

single employer under either section 

52(a) or (b) (without regard to section 

1563(b)), or section 414(m) or (o). 

However, footnote 29 in the Conference 

Report indicates that this provision is 

not intended to apply to property leased 

by the taxpayer to a related person if the 

property is held for sublease or is 

subleased to an unrelated person for the 

ultimate use of such unrelated person, 

or to a license to a related person for 

reproduction and sale, exchange, lease, 

rental or sublicense to an unrelated 

person for the ultimate use of such 

unrelated person. Accordingly, the 

proposed regulations include these 

exceptions from the general rule of 

exclusion under section 199(c)(7). 

One commentator stated that if a 

television network licenses 

programming to an affiliate station, 

applying section 199(c)(7) to treat the 

royalty payment received from the 

affiliate as non-DPGR places these 

vertically integrated companies at a 

competitive disadvantage. The 

commentator therefore suggested that 

the proposed regulations provide an 

Federal Register / Vol. 70, No. 213 / Friday, November 4, 2005 / Proposed Rules 67225 

exception for networks and affiliate 

stations. The proposed regulations do 

not adopt this suggestion, which is not 

consistent with section 199(c)(7). 

Derived From a Lease, Rental, License, 

Sale, Exchange, or Other Disposition 

Commentators asked whether gains 

and losses associated with hedging 

transactions are included in DPGR. For 

example, utilities may hedge to manage 

the risk of changes in prices of ordinary 

inputs into the production process. For 

purposes of section 199 only, the 

proposed regulations include a rule in 

§ 1.199–3(h)(3) concerning hedges 

(within the meaning of section 

1221(b)(2) and § 1.1221–2(b)) of 

inventory that is QPP and supplies 

consumed in activities giving rise to 

DPGR. The proposed regulations require 

gain or loss on the hedging transaction 

to be taken into account in determining 

DPGR. The proposed rule applies to 

hedges that manage the risk of currency 

fluctuations but only to the extent that 

the hedges are not integrated with an 

underlying transaction under § 1.988–

5(b). 

Commentators suggested that the 

proposed regulations treat gross receipts 

attributable to the distribution or 

delivery of QPP as derived from the 

lease, rental, license, sale, exchange, or 

other disposition of that property. The 

commentators stated that section 

199(c)(4)(B)(ii), which specifically 

provides that DPGR does not include 

gross receipts derived from the 

transmission and distribution of 

utilities, indicates (by negative 

implication) that gross receipts 

attributable to the distribution or 

delivery of QPP is intended to be 

considered DPGR. Moreover, some 

commentators interpreted language in 

section 3.04(10)(c) of Notice 2005–14, 

stating that bottled water is treated as 

QPP and that DPGR may include gross 

receipts attributable to distribution of 

bottled water, as suggesting that gross 

receipts attributable to distribution and 

delivery of QPP are considered DPGR. 

In general, the IRS and Treasury 

Department believe that gross receipts 

attributable to distribution and delivery 

of QPP are not DPGR because 

distribution and delivery are properly 

regarded as services, regardless of 

whether the taxpayer retains the 

benefits and burdens of ownership of 

the property at the time it is delivered. 

No inference to the contrary in Notice 

2005–14 was intended. Thus, the 

proposed regulations clarify that 

taxpayers generally must allocate gross 

receipts between the lease, rental, 

license, sale, exchange, or other 

disposition of the property itself and the 

delivery component. The IRS and 

Treasury Department, however, believe 

that, because distribution and delivery 

are service components common to 

QPP, it is appropriate, as a matter of 

administrative convenience, to treat 

embedded distribution and delivery 

services similar to the qualified 

warranty exception in section 4.04(7)(b) 

of Notice 2005–14. Thus, the taxpayer 

must include in DPGR gross receipts 

attributable to the distribution and 

delivery of QPP if (1) in the normal 

course of business, the charge for the 

delivery or distribution service is 

included in the price charged for the 

sale of the QPP, and (2) the charge for 

the delivery or distribution service is 

neither separately offered nor separately 

bargained for with the customer. 

For similar reasons, the proposed 

regulations also treat embedded 

qualified operating manuals provided in 

connection with the sale or disposition 

of QPP, qualified films, and utilities 

similar to embedded qualified 

warranties. 

The proposed regulations also provide 

special rules for installation activities. 

The IRS and Treasury Department 

believe that, in some circumstances, 

installation is appropriately viewed as 

an MPGE activity, and in others it is 

appropriately viewed as a service. For 

example, installation is properly viewed 

as an MPGE activity if the taxpayer 

MPGE QPP within the United States and 

installs the QPP while the taxpayer 

retains the benefits and burdens of 

ownership of the QPP. In that case, 

gross receipts attributable to the 

installation, whether or not embedded, 

are derived from the lease, rental, 

license, sale, exchange, or other 

disposition of the QPP. If, however, the 

benefits and burdens of ownership pass 

to the customer prior to the installation 

of the QPP, the taxpayer is performing 

a service by installing the customer’s 

property. In that case, gross receipts 

attributable to installation are not 

derived from the lease, rental, license, 

sale, exchange, or other disposition of 

the property, and the taxpayer generally 

is required under the proposed 

regulations to allocate gross receipts 

between the proceeds of sale or 

disposition of the property (DPGR) and 

the installation service (non-DPGR). 

However, the IRS and Treasury 

Department believe that, because 

installation is a service component 

common to sales or dispositions of QPP, 

if the benefits and burdens of ownership 

pass to the customer prior to the 

installation, it is appropriate to treat 

embedded installation similar to an 

embedded qualified warranty, qualified 

delivery, and a qualified operating 

manual. 

A number of commentators suggested 

that the IRS and Treasury Department 

expand the exception to the allocation 

requirement for a qualified warranty to 

include all services (including training, 

technical and customer support, and 

regular maintenance of the property), as 

well as all nonqualifying property 

(including purchased spare parts), the 

charge for which is embedded in the 

contract price of the lease, rental, 

license, sale, exchange, or other 

disposition of QPP, qualified films, and 

utilities. Other commentators stated that 

the proposed regulations should adopt 

principles similar to § 1.482–2(b), so 

that services that are ancillary and 

incidental to the sale of QPP, qualified 

films, and utilities would not be treated 

as embedded services and no allocation 

of gross receipts to those services would 

be required. These commentators 

believe that footnote 27 in the 

Conference Report supports such a 

position in stating that the conferees 

intend that the Secretary provide 

guidance regarding the allocation of 

gross receipts that draws on the 

principles of section 482. Other 

commentators stated that, elsewhere in 

the Code and regulations, transactions 

are given a single characterization based 

on their predominant nature and that 

section 199 should be applied in the 

same manner. For example, if the 

predominant nature of a transaction is 

the sale of property, all gross receipts 

from the transaction should be treated 

as proceeds from the sale. Finally, some 

commentators stated that a taxpayer’s 

treatment of a transaction for financial 

reporting purposes should govern its 

characterization for section 199 

purposes. 

The IRS and Treasury Department 

infer that the commentators are referring 

to § 1.482–2(b)(8), which provides that, 

in general, no separate allocation will be 

made in connection with ancillary and 

subsidiary services provided with a 

transfer of property. Services ancillary 

and subsidiary to another transaction 

may be referred to, outside the section 

199 context, as embedded services. The 

IRS and Treasury Department do not 

intend that services defined as 

embedded services under section 199 

will be treated in the same manner 

provided in § 1.482–2(b)(8) because 

such treatment would be generally 

inconsistent with the intent and 

purpose of section 199. 

The IRS and Treasury Department 

further believe that the reference to 

section 482 principles in footnote 27 of 

the Conference Report reflects an intent 

to apply section 482 principles 

67226 Federal Register / Vol. 70, No. 213 / Friday, November 4, 2005 / Proposed Rules 

consistently with the general intent and 

purpose of section 199. The IRS and 

Treasury Department continue to 

believe that the statutory language and 

legislative history require that 

transactions be bifurcated into 

qualifying and nonqualifying elements 

and that gross receipts be allocated 

accordingly for purposes of section 199. 

The IRS and Treasury Department 

further believe that the exceptions to 

this general rule should be limited. 

Expanding the special exceptions to 

include all, or ancillary or incidental, 

embedded services and embedded 

nonqualifying property would result in 

the inclusion in DPGR of gross receipts 

that the IRS and Treasury Department 

do not believe were intended to be 

within the scope of section 199. The 

legislative history also does not support 

adopting principles applicable to other 

Code sections under which a single 

predominant nature character is 

assigned to a transaction, or 

characterizing transactions for purposes 

of section 199 according to their 

treatment for financial reporting 

purposes. Accordingly, the proposed 

regulations do not adopt these 

suggestions. 

One commentator requested that the 

proposed regulations clarify whether the 

embedded services rule is intended to 

require taxpayers to treat certain 

service-type activities that take place as 

part of the MPGE process as embedded 

services. The proposed regulations 

clarify that embedded services do not 

include service-type activities that take 

place as part of the MPGE process (that 

is, while the taxpayer is engaged in an 

MPGE activity with respect to the 

property and retains the benefits and 

burdens of ownership of the property). 

For example, with respect to QPP, 

activities such as non-construction 

engineering, materials analysis and 

selection, subcontractor inspections and 

approval, routine production 

inspections, product testing and 

documentation, and assistance with 

certain regulatory approvals, if 

undertaken in connection with a 

qualifying MPGE activity, are 

considered part of the MPGE of the QPP 

and are not considered embedded 

services. No separate allocation of gross 

receipts to such activities is required. 

Services and nonqualifying property 

are not considered embedded if they are 

either separately offered or separately 

bargained for, or a charge for the service 

or nonqualifying property is separately 

stated. Thus, for example, if a charge for 

freight or delivery is separately stated 

on an invoice for the sale of an item of 

QPP, the delivery service is not 

embedded and gross receipts 

attributable to that service are nonDPGR, even if the purchaser does not 

have the option of refusing the service. 

Further, separately stated or bargained 

for amounts will not be respected unless 

they reflect the fair market value of the 

service or nonqualifying property. For 

example, if a taxpayer offers contracts to 

customers that include a cellular phone 

priced on the invoice at $595 and three 

years of cellular telephone service 

priced on the invoice at $5, the $5 stated 

amount for the service will only be 

respected if it represents an allocation of 

gross receipts consistent with the 

principles of section 482. 

Gross receipts attributable to 

embedded services, embedded 

nonqualifying property, or any other 

embedded element (other than a 

qualified warranty, qualified delivery, 

qualified installation, and a qualified 

operating manual) may be considered 

DPGR under the 5 percent de minimis 

exception. The proposed regulations 

clarify that, with respect to the de 

minimis exception, taxpayers should 

apply the 5 percent against the total 

amount of the gross receipts derived 

from the lease, rental, license, sale, 

exchange, or other disposition of the 

item of QPP, qualified films, or utilities. 

The total amount of DPGR includes 

gross receipts attributable to a qualified 

warranty, qualified delivery, qualified 

installation, and/or a qualified operating 

manual that are treated as DPGR with 

respect to that item. In the case of a 

lease or an installment sale, the de 

minimis exception is applied by taking 

into account the total amount of gross 

receipts under the lease or installment 

sale that are attributable to the item of 

QPP, qualified films, or utilities. 

Under the proposed regulations, as 

under Notice 2005–14, applicable 

Federal income tax principles apply in 

determining whether a transaction (or 

any part of a transaction) is, in 

substance, a lease, rental, license, sale, 

exchange, or other disposition, or 

whether it is a service. For this purpose, 

section 3.04(7)(a) of Notice 2005–14 

cites Rev. Rul. 88–65 (1988–2 C.B. 32), 

and describes that revenue ruling as 

treating a short-term rental as a service. 

Many commentators asked that the 

proposed regulations clarify that not all 

short-term rentals will be regarded as 

services for purposes of section 199. 

They observed that Rev. Rul. 88–65 

involves the lease of automobiles and 

trucks on a daily basis (normally for not 

more than one week), and that the 

taxpayer performs significant services in 

connection with the vehicle, including 

maintenance and repairs, and pays all 

taxes and insurance on the vehicle. The 

IRS and Treasury Department 

acknowledge that the short-term nature 

of a transaction does not, by itself, 

render the transaction a service for 

purposes of section 199 and that many 

transactions include both service and 

property rental elements. Therefore, the 

proposed regulations clarify that, in 

such cases, taxpayers must allocate 

gross receipts between the qualifying 

rental of QPP or qualified films (DPGR) 

and the non-qualifying services (nonDPGR). The allocation must be based on 

the facts and circumstances of each 

transaction. Generally, in the case of 

short-term transactions, such as those 

described in Rev. Rul. 88–65, in which 

significant services are provided in 

connection with the property, the 

transaction will consist mostly of 

services. 

Not every transaction in which 

property is used in connection with 

providing a service to customers, 

however, constitutes a mixture of 

services and rental for which allocation 

of gross receipts is appropriate. For 

example, assume that a taxpayer 

operates a video game arcade that 

features video game machines that the 

taxpayer MPGE. The machines remain 

in the taxpayer’s possession during the 

customers’ use. Gross receipts derived 

from customers’ use of the machines at 

the taxpayer’s arcade are not derived 

from the lease, rental, license, sale, 

exchange, or other disposition of the 

machines. Rather, the machines are 

used to provide a service and, thus, the 

gross receipts are non-DPGR. 

A number of commentators objected 

to the position taken in section 

4.04(7)(d) of Notice 2005–14 that gross 

receipts from Internet access services, 

online services, customer support, 

telephone services, games played 

through a website, provider-controlled 

software online access services, and 

other services are not derived from a 

lease, rental, license, sale, exchange, or 

other disposition of the software. 

Consistent with the notice, the proposed 

regulations reflect the position that the 

use of online computer software does 

not rise to the level of a lease, rental, 

license, sale, exchange, or other 

disposition as required under section 

199 but is instead a service. This is the 

case even if the customer must agree to 

terms and conditions (which may be 

termed a license by the software 

provider) before using the software 

online, or receive enabling software to 

facilitate the customer’s use of the 

primary software on the customer’s 

hardware. 

If gross receipts attributable to the use 

of online software were permitted to 

qualify as DPGR because the same or 

similar software also is available to 

Federal Register / Vol. 70, No. 213 / Friday, November 4, 2005 / Proposed Rules 67227 

customers on disk or by download, 

different items of software available 

online would be subject to disparate 

treatment under section 199. In 

addition, if online software were 

permitted to qualify as DPGR, it would 

be difficult to distinguish this online 

software from software that is used to 

facilitate a service. The IRS and 

Treasury Department are requesting 

comments in the Request for Comments 

section on this issue. 

One commentator suggested that the 

term lease, rental, license, sale, 

exchange, or other disposition, 

especially the term other disposition, 

was intended to be interpreted broadly 

to include gross receipts from any 

means of commercialization of property, 

whether or not an actual transfer of the 

property occurs. Another commentator 

noted that section 3.04(7)(d) of Notice 

2005–14 states that gross receipts 

derived by a taxpayer from software that 

is merely offered for use to customers 

online for a fee are non-DPGR, and 

suggested that if the software is also 

offered to customers on disk or by 

download, then gross receipts for online 

use of otherwise qualifying software 

would be DPGR. The commentator also 

noted that the same section provides 

that a ‘‘service provided using computer 

software that does not involve a transfer 

of the computer software does not result 

in [DPGR],’’ and suggested that this 

language implies that if the software is 

not used in providing a service, no 

transfer is required for purposes of 

section 199. The IRS and Treasury 

Department did not intend the results 

suggested by the commentators and the 

proposed regulations have been clarified 

as necessary. 

A number of commentators requested 

clarification and expansion of the rule 

in Notice 2005–14 that treats advertising 

receipts attributable to the sale or other 

disposition of newspapers and 

magazines as DPGR. Notice 2005–14 

explains that advertising receipts in this 

context are inextricably linked to the 

gross receipts derived from the lease, 

rental, license, sale, exchange, or other 

disposition of the newspapers and 

magazines. In response to comments, 

the proposed regulations clarify that this 

rule also applies, under the same 

rationale, to advertising receipts relating 

to telephone directories and periodicals, 

whereby a taxpayer’s gross receipts 

derived from the lease, rental, license, 

sale, exchange, or other disposition of 

the telephone directories or periodicals 

that are MPGE in whole or in significant 

part within the United States includes 

advertising income from advertisements 

placed in those media, but only to the 

extent the gross receipts, if any, derived 

from the lease, rental, license, sale, 

exchange, or other disposition of the 

telephone directories or periodicals are 

DPGR. The proposed regulations clarify 

that advertising revenue for advertising 

in online newspapers and periodicals is 

non-DPGR, because any underlying 

receipts from the property itself are nonDPGR, as there is no lease, rental, 

license, sale, exchange, or other 

disposition of such property. The 

proposed regulations provide similar 

treatment for gross receipts attributable 

to product placements in a qualified 

film. The gross receipts attributable to 

product placements will be treated as 

DPGR, but (as with newspapers) only if 

the gross receipts derived from the 

lease, rental, license, sale, exchange, or 

other disposition of the qualified film 

are DPGR. Thus, for product placement 

revenue to be derived from a qualified 

film, there must be a lease, rental, 

license, sale, exchange, or other 

disposition of the qualified film. 

Section 3.04(9)(a) of Notice 2005–14 

provides that revenue from the licensing 

of film characters is not derived from 

the lease, rental, license, sale, exchange, 

or other disposition of a qualified film. 

One commentator stated that this 

treatment is inconsistent with the 

income forecast method, and that 

revenue from licensing of film-related 

intangibles is inextricably linked to (and 

therefore should be treated as derived 

from) the qualified film. The proposed 

regulations do not adopt this comment. 

Section 199(c)(4)(A)(i)(II) clearly 

requires that receipts must be derived 

from a lease, rental, license, sale, 

exchange, or other disposition of a 

qualified film to be DPGR. Receipts 

derived from the licensing of related 

intangibles, including film characters, 

trademarks, and trade names, do not 

meet this requirement. Further, the IRS 

and Treasury Department do not agree 

that receipts derived from licensing of 

film-related intangibles are inextricably 

linked to the gross receipts derived from 

a qualified film. 

Some commentators objected to the 

rule in section 4.04(7)(a) of Notice 

2005–14 that provides that if a taxpayer 

exchanges QPP MPGE by the taxpayer 

in whole or in significant part within 

the United States for other property in 

a taxable exchange, the value of the 

property received by the taxpayer is 

DPGR; whereas any gross receipts 

derived from a subsequent sale by the 

taxpayer of the acquired property are 

non-DPGR because the taxpayer did not 

MPGE the acquired property. The 

commentators noted that in their 

industry, fungible commodities held for 

sale to customers are exchanged 

routinely between producers as a 

practical means of avoiding logistical 

problems in meeting customers’ needs 

and reducing transportation and storage 

costs. The commentators noted that 

these exchanges typically are not treated 

as taxable exchanges on the parties’

financial records. The commentators 

requested that the proposed regulations 

instead provide that if the property 

relinquished in the exchange is QPP, 

qualified films, or utilities, then the 

property received in the exchange 

should be treated as QPP, qualified 

films, or utilities and gross receipts 

derived from the subsequent sale of that 

property should be treated as DPGR. 

Another commentator suggested that 

this treatment be applied only to 

nontaxable exchanges. 

The proposed regulations do not 

adopt these suggestions. The IRS and 

Treasury Department believe that the 

character of property as having been 

MPGE in whole or in significant part by 

the taxpayer within the United States is 

not an attribute of the property, like 

basis and holding periods, that may be 

substituted with the transfer of the 

property. The IRS and Department 

Treasury believe that the commentators’

interpretations are inconsistent with 

section 199(c)(4)(A)(i)(I). 

Commentators requested that the IRS 

and Treasury Department clarify 

whether gross receipts from mineral 

royalties and net profits interests are 

properly treated as DPGR. Mineral 

royalties, including net profits interests, 

are returns on passive interests in 

mineral properties, the owner of which 

makes no expenditure for operation or 

development. The courts and the IRS 

have long considered these types of 

income to be in the nature of rent (see, 

for example, Kirby Petroleum Co. v. 

Comm’r, 326 U.S. 599 (1946)). 

Accordingly, the proposed regulations 

in § 1.199–3(h)(9) provide that gross 

receipts from mineral interests and net 

profits interests other than operating or 

working interests are not treated as 

DPGR. 

Definition of Manufactured, Produced, 

Grown, or Extracted 

Section 4.04(3)(b) of Notice 2005–14 

provides that a taxpayer that MPGE QPP 

for the taxable year should treat itself as 

a producer under section 263A with 

respect to the QPP for the taxable year 

unless the taxpayer is not subject to 

section 263A. In response, 

commentators questioned whether all 

taxpayers that are subject to section 

263A are considered to have MPGE QPP 

for purposes of section 199. Taxpayers 

who do not MPGE QPP may 

nevertheless be subject to section 263A. 

For example, a taxpayer that has 

67228 Federal Register / Vol. 70, No. 213 / Friday, November 4, 2005 / Proposed Rules 

property produced for it under a 

contract is considered a producer of 

property under section 263A, but may 

not be considered as having MPGE 

property for purposes of section 199 if 

it does not have the benefits and 

burdens of ownership of the property 

while it is being produced. 

Additionally, in some circumstances a 

taxpayer that manufactures property for 

a customer pursuant to a contract may 

be considered the producer of the 

property for purposes of section 263A 

and not to have MPGE the property for 

purposes of section 199. Accordingly, 

not all taxpayers that are subject to 

section 263A are considered to have 

MPGE QPP for purposes of section 199. 

Commentators also have questioned 

whether a taxpayer that engages in 

certain production activities that are 

exempt from section 263A (for example, 

developing computer software under 

Rev. Proc. 2000–50 (2000–1 C.B. 601), 

producing property pursuant to a longterm contract under section 460, or 

farming exempt under section 263A(d)) 

must treat itself as a producer under 

section 263A if the taxpayer wants to be 

treated as MPGE QPP for purposes of 

section 199. The proposed regulations 

in § 1.199–3(d)(4) provide that a 

taxpayer that has MPGE QPP for the 

taxable year should treat itself as a 

producer under section 263A with 

respect to the QPP for the taxable year 

unless the taxpayer is not subject to 

section 263A. A taxpayer whose MPGE 

activity is exempt from section 263A is 

not required to change its method of 

accounting under section 263A to treat 

itself as engaged in the MPGE of QPP for 

purposes of section 199. 

Commentators requested clarification 

as to whether a reseller that engages in 

de minimis production activities or that 

has property produced for it under 

contract, which constitutes the MPGE of 

QPP under section 199, is precluded 

from using the simplified resale method 

provided by § 1.263A–3(d). Section 

1.263A–3(a)(4)(ii) provides that a 

reseller with de minimis production 

activities is permitted to use the 

simplified resale method. Likewise, 

§ 1.263A–3(a)(4)(iii) provides that a 

reseller otherwise permitted to use the 

simplified resale method is permitted to 

use the method if it has personal 

property produced for it under a 

contract if the contract is entered into 

incident to its resale activities and the 

property is sold to its customers. The 

section 263A consistency rule provided 

in § 1.199–3(d)(4) of the proposed 

regulations does not affect the rules 

provided in § 1.263A–3. Accordingly, a 

reseller with de minimis production or 

that has property produced for it under 

a contract that is considered the MPGE 

of QPP for purposes of section 199 is not 

precluded from using the simplified 

resale method if the taxpayer meets the 

requirements of § 1.263A–3(a)(4)(ii) or 

(iii). 

Definition of By the Taxpayer 

Section 1.199–3(e)(1) of the proposed 

regulations provides that, with the 

exception of rules that are applicable to 

an EAG, certain oil and gas partnerships 

described in § 1.199–3(h)(7), EAG 

partnerships described in § 1.199–

3(h)(8), and certain government 

contracts described in § 1.199–3(e)(2), 

only one taxpayer may claim the section 

199 deduction with respect to the MPGE 

of QPP. If one taxpayer MPGE QPP 

pursuant to a contract with another 

person, then only the taxpayer that has 

the benefits and burdens of ownership 

of the property under Federal income 

tax principles during the time the 

property is MPGE will be considered to 

have MPGE the QPP. In contrast, 

§ 1.263A–2(a)(1)(ii)(B) provides that 

property produced for the taxpayer 

under a contract is considered as 

produced by the taxpayer to the extent 

the taxpayer makes payments or 

otherwise incurs costs with respect to 

the property, even if the taxpayer is not 

the owner of the property while the 

property is being produced. 

Commentators questioned why a similar 

rule does not apply in the context of 

section 199. The rule provided by 

§ 1.263A–2(a)(1)(ii)(B) is derived from 

section 263A(g)(2). That section 

specifically provides that a taxpayer is 

treated as producing property produced 

for it under a contract to the extent that 

it has made payments or incurred costs 

with respect to the contract. In contrast, 

section 199(c)(4)(A)(i) provides that 

DPGR only includes gross receipts of the 

taxpayer that are derived from any lease, 

rental, license, sale, exchange, or other 

disposition of QPP MPGE by the 

taxpayer in whole in significant part 

within the United States. Accordingly, 

the proposed regulations do not contain 

a provision that is analogous to 

§ 1.263A–2(a)(1)(ii)(B). 

While sections 199, 263A, and 936 all 

have benefits and burdens standards, 

the standard under section 199 is not 

the same as those under sections 263A 

and 936. Commentators suggested that 

the proposed regulations adopt the 

broader standard under § 1.263A–

2(a)(1)(ii)(A) that provides that a 

taxpayer is not considered to be 

producing property unless the taxpayer 

is considered the owner of the property 

produced under Federal income tax 

principles. The determination of 

whether a taxpayer is considered an 

owner is based on all of the facts and 

circumstances, including the various 

benefits and burdens of ownership 

vested with the taxpayer. Because the 

standard under the section 263A 

regulations is broad, it has been 

interpreted to allow two taxpayers to be 

considered the producer of the same 

property. Compare, for example, Suzy’s 

Zoo v. Comm’r, 114 T.C. 1 (2000), aff’d 

273 F.3d 875 (9th Cir. 2001) and Golden 

Gate Litho v. Comm’r, T.C. Memo 

(1998–184). 

The IRS and Treasury Department 

continue to believe that the requirement 

of section 199(c)(4)(A)(i) that property 

be MPGE by the taxpayer means that 

only one taxpayer may claim the section 

199 deduction with respect to the same 

function performed with respect to the 

same property. Therefore, it would be 

inappropriate to adopt the standard 

under the section 263A regulations. In 

addition, this interpretation is 

supported by the Congressional Letter 

that states the Treasury Department has 

the authority to prescribe rules to 

prevent the section 199 deduction from 

being claimed by more than one 

taxpayer with respect to the same 

economic activity described in section 

199(c)(4)(A)(i). Thus, consistent with 

Notice 2005–14, the proposed 

regulations in § 1.199–3(e)(1) provide 

that only one taxpayer may claim the 

section 199 deduction with respect to 

any MPGE activity. 

Commentators also proposed other 

alternatives to the benefits and burdens 

standard, such as looking to the person 

that has the economic risks and benefits, 

adopting the qualified research rules 

under § 1.41–2(e)(2), providing safe 

harbors based on contract terms, treating 

the person that arranges for the 

acquisition of the property as the owner, 

and looking to the person that controls 

the process by which the property is 

MPGE. The proposed regulations do not 

adopt any of these suggestions because 

the IRS and Treasury Department 

believe that there is considerable 

variation in the types of contract 

manufacturing situations. Therefore, the 

proposed regulations contain the same 

benefits and burdens standard used in 

Notice 2005–14 because it is a standard 

that the IRS and Treasury Department 

believe covers all of the varied factual 

situations. 

Commentators requested that the 

proposed regulations provide examples 

of how to apply the benefits and 

burdens standard. The proposed 

regulations contain examples 

illustrating contract manufacturing 

situations in which the taxpayer with 

the benefits and burdens of ownership 

Federal Register / Vol. 70, No. 213 / Friday, November 4, 2005 / Proposed Rules 67229 

under Federal income tax principles is 

treated as manufacturing the QPP. 

In the Congressional Letter, the 

Treasury Department was advised that 

gross receipts derived from certain 

contracts to manufacture or produce 

property for the Federal government are 

derived from the sale of such property 

and, therefore, are DPGR. The proposed 

regulations in § 1.199–3(e)(2) provide 

that a taxpayer will be treated as 

meeting the by the taxpayer requirement 

if the QPP, qualified films, or utilities 

are MPGE or otherwise produced in the 

United States by the taxpayer pursuant 

to a contract with the Federal 

government and the Federal Acquisition 

Regulation requires that title or risk of 

loss with respect to the QPP, qualified 

films, or utilities be transferred to the 

Federal government before the MPGE or 

production of the QPP, qualified films, 

or utilities is complete. 

In Whole or In Significant Part 

Under section 199(c)(4)(A)(i)(I), QPP 

must be MPGE in whole or in significant 

part by the taxpayer within the United 

States. The proposed regulations in 

§ 1.199–3(f)(1) clarify that the in whole 

or in significant part requirement 

applies to both the by the taxpayer 

requirement and the within the United 

States requirement. 

Section 4.04(5)(b) of Notice 2005–14 

provides that QPP will be treated as 

having been MPGE in significant part by 

the taxpayer within the United States if 

the MPGE of the QPP performed within 

the United States is substantial in 

nature. Design and development costs 

do not qualify as substantial in nature 

for any QPP other than computer 

software and sound recordings. The 

proposed regulations in § 1.199–3(f)(2) 

substitute research and experimental 

expenditures under section 174 for 

design and development costs. 

Section 4.04(5)(c) of Notice 2005–14 

provides that a taxpayer will be treated 

as having MPGE property in whole or in 

significant part within the United States 

if, in connection with the property, 

conversion costs (direct labor and 

related factory burden) to MPGE the 

property are incurred by the taxpayer 

within the United States and the costs 

account for 20 percent or more of the 

total CGS of the property. The proposed 

regulations in § 1.199–3(f)(3) provide 

that, in the case of tangible personal 

property, research and experimental 

expenditures under section 174 and any 

other costs of creating intangibles may 

be excluded from total CGS for purposes 

of the safe harbor. 

A commentator suggested that a 

taxpayer’s activity within the United 

States that is critical to the functionality 

or nature of property should be 

considered to meet the in significant 

part requirement under section 

199(c)(4)(A)(i)(I) even if the activity is 

not substantial in nature. The proposed 

regulations do not adopt this suggestion 

because the IRS and Treasury 

Department do not believe that this is an 

accurate measurement of the degree of 

activity required to satisfy the in whole 

or in significant part requirement. 

Qualifying Production Property 

Commentators requested that the IRS 

and Treasury Department reconsider the 

rule under section 4.04(8)(c) and (d) of 

Notice 2005–14 which provides that, if 

the medium in which computer 

software or sound recordings are 

contained is tangible, then such 

medium is considered tangible personal 

property for purposes of section 199. 

This rule has been removed and the 

proposed regulations in § 1.199–3(i)(5) 

provide that if a taxpayer MPGE 

computer software or sound recordings 

that the taxpayer fixed on, or added to, 

tangible personal property (for example, 

a computer diskette or an appliance), 

then the tangible medium with the 

computer software or sound recordings 

may be treated by the taxpayer as 

computer software or sound recordings, 

as applicable. However, the proposed 

regulations provide that, if a taxpayer 

treats the tangible medium as computer 

software or sound recordings, any costs 

under section 174 attributable to the 

tangible medium are not considered in 

determining whether the taxpayer’s 

activity is substantial in nature under 

§ 1.199–3(f)(2) or conversion costs under 

§ 1.199–3(f)(3). In addition, because a 

taxpayer may MPGE tangible personal 

property, but not computer software or 

sound recordings that the taxpayers 

fixes on, or adds to, the tangible 

personal property MPGE by the 

taxpayer, the proposed regulations 

provide that the computer software or 

sound recordings may be treated by the 

taxpayer as tangible personal property. 

Commentators requested that the 

proposed regulations clarify whether the 

exceptions from computer software 

under section 168(i)(2)(B)(iv) apply to 

computer software under section 199. In 

response to this comment, the proposed 

regulations provide in § 1.199–3(i)(3)(i) 

that these exceptions do not apply for 

purposes of section 199 and computer 

software also includes the machinereadable code for video games and 

similar programs, for equipment that is 

an integral part of other property, and 

for typewriters, calculators, adding and 

accounting machines, copiers, 

duplicating equipment, and similar 

equipment, regardless of whether the 

code is designed to operate on a 

computer (as defined in section 

168(i)(2)(B)). Computer programs of all 

classes, for example, operating systems, 

executive systems, monitors, compilers 

and translators, assembly routines, and 

utility programs as well as application 

programs, are included. 

A commentator requested that the 

proposed regulations provide that the 

creation and licensing of copyrighted 

business information reports constitutes 

the MPGE of QPP. Formerly distributed 

in hard copy, this information is now 

generally distributed electronically. 

Customers are required to use the 

information only for their own use, and 

no copyright is transferred to them. The 

commentator contends that, while the 

activity of creating the business 

information reports provided to 

customers is not a production activity in 

the traditional sense, the definition of 

MPGE is broad enough to encompass 

this activity. The IRS and Treasury 

Department do not agree with this 

comment because creating a database of 

business information is not MPGE, the 

database is not QPP, and the business 

information reports are not QPP MPGE 

by the taxpayer. 

Qualified Films 

Similar to the rules for computer 

software, section 4.04(9)(a) of Notice 

2005–14 provides that if a medium on 

which a qualified film is fixed is 

tangible (such as a DVD), the property 

consists of both a qualified film and 

tangible personal property. The notice 

contains examples in which taxpayers 

that either produce a qualified film and 

purchase the tangible medium, or MPGE 

the tangible medium and license the 

qualified film, must allocate gross 

receipts between the tangible medium 

and the qualified film. For the reasons 

stated under the discussion of computer 

software, the proposed regulations allow 

certain taxpayers to treat such combined 

property as either tangible personal 

property or a qualified film, as 

applicable. 

One commentator requested that the 

proposed regulations clarify the 

requirement that 50 percent of the total 

compensation relating to the production 

of the film be compensation for services 

performed in the United States by 

actors, production personnel, directors, 

and producers. Specifically, the 

commentator requested that the phrase 

‘‘total compensation relating to the 

production of the film’’ be interpreted to 

mean compensation for services 

performed only by actors, production 

personnel, directors, and producers. The 

commentator further requested that the 

term ‘‘compensation’’ be interpreted to 

67230 Federal Register / Vol. 70, No. 213 / Friday, November 4, 2005 / Proposed Rules 

include all compensation (not just W–2 

wages) that is paid to these individuals 

and that is required to be capitalized by 

film producers under section 263A and 

§ 1.263A–1(e)(2) and (3). These 

suggestions have been adopted in the 

proposed regulations. 

Definition of Construction Performed in 

the United States 

Section 4.04(11)(a) of Notice 2005–14 

defines the term ‘‘construction’’ to mean 

the construction or erection of real 

property by a taxpayer that is in a trade 

or business that is considered 

construction for purposes of the North 

American Industry Classification 

System (NAICS). Commentators asked 

how a taxpayer in multiple trades or 

businesses determines if it is in a 

construction NAICS code. The proposed 

regulations clarify that in order for a 

taxpayer to be considered in a 

construction NAICS code, it must be 

engaged in a construction trade or 

business (but not necessarily its primary 

trade or business) on a regular and 

ongoing basis. The determination of 

whether an entity is in a NAICS code is 

generally tested on an entity-by-entity 

basis. Under this rule, a member of an 

EAG must perform the construction 

activity in order for its gross receipts to 

qualify as DPGR from construction. See 

§ 1.199–7(a)(3). In addition, the taxpayer 

must actually perform the construction 

activity. For example, if a taxpayer in a 

construction NAICS code hired an 

unrelated general contractor to construct 

a building, the gross receipts derived by 

the taxpayer from the sale of the 

building would not be DPGR because 

the taxpayer did not construct the 

building. The proposed regulations 

provide an example to illustrate this 

rule. 

Commentators also asked that the 

proposed regulations clarify whether 

eligible construction activities are 

limited to a specific NAICS code. 

Section 1.199–3(l)(1)(i) provides that a 

trade or business that is considered 

construction for purposes of the NAICS 

codes means a construction activity 

under the two-digit NAICS code of 23 

and any other construction activity in 

any other NAICS code relating to the 

construction of real property. For 

example, a construction activity relating 

to the construction of real property that 

is not under the two-digit NAICS code 

of 23 but which qualifies as an eligible 

construction activity would include the 

construction of oil and gas wells for 

NAICS code 213111 (drilling oil and gas 

wells) and 213112 (support activities for 

oil and gas operations). Commentators 

also asked that the proposed regulations 

include a listing of construction 

activities relating to oil and gas wells. In 

response to this request, the proposed 

regulations provide, as a matter of 

administrative grace, that qualifying 

construction activities also include 

activities relating to drilling an oil well 

and mining, and include any activities 

treated by the taxpayer as intangible 

drilling and development costs under 

section 263(c) and § 1.612–4 and 

development expenditures for a mine or 

natural deposit under section 616. 

Commentators contend that gross 

receipts attributable to the leasing or 

rental of constructed real property 

qualify as DPGR because the right to use 

constructed property represents one 

right in the bundle of rights derived 

from the construction of real property. 

The proposed regulations do not adopt 

this interpretation because gross 

receipts derived from the rental of real 

property that a taxpayer constructs are 

not derived from construction, but are 

instead compensation for the use or 

forbearance of the property. Similarly, 

gross receipts derived from renting or 

leasing equipment such as bulldozers 

and generators to contractors for use in 

the construction of real property are 

non-DPGR (assuming the rental 

companies do not manufacture the 

equipment). 

Section 4.04(11)(a) of Notice 2005–14 

contains a safe harbor rule for 

determining when tangible personal 

property that is sold as part of a 

construction project may be considered 

real property. If more than 95 percent of 

the total gross receipts derived by a 

taxpayer from a construction project are 

derived from real property (as defined 

in § 1.263A–8(c)), then the total gross 

receipts derived by the taxpayer from 

the project are DPGR from construction. 

Commentators stated that it was unclear 

what items of tangible personal property 

are included in this rule (for example, 

small or major appliances, home 

theaters, and fixtures installed by a 

builder) and whether it was intended 

that land be included for purposes of 

this safe harbor. Consequently, this rule 

has been replaced in the proposed 

regulations with a de minimis exception 

in § 1.199–3(l)(1)(ii). Accordingly, if less 

than 5 percent of the total gross receipts 

derived by a taxpayer from a 

construction project are derived from 

activities other than the construction of 

real property in the United States (for 

example, from non-construction 

activities, the sale of tangible personal 

property, or land) then the total gross 

receipts derived by the taxpayer from 

the project are DPGR from construction. 

Many commentators suggested that 

the proposed regulations treat gross 

receipts attributable to the sale or other 

disposition of land as DPGR derived 

from construction of real property. 

Commentators also suggested that 

construction begins as soon as 

production activities begin, that is, 

when land is acquired and the 

entitlement process, such as obtaining 

proper zoning and permits, commences 

in connection with construction of real 

property. The proposed regulations do 

not adopt these suggestions. The IRS 

and Treasury Department continue to 

believe that Congress intended the 

benefit under section 199 only for 

construction services performed in the 

United States. Taxpayers do not 

construct land and thus any gain 

attributable to the disposition of land 

(including zoning, planning, entitlement 

costs and other costs capitalized to the 

land such as the demolition of 

structures under section 280B) is not 

eligible for the section 199 deduction. 

Commentators also argue that the land 

exclusion creates an administrative and 

financial burden because a valuation 

will be necessary for any sale of real 

property that includes land. To address 

the administrative burden in identifying 

and valuing the gross receipts 

attributable to land in connection with 

qualifying construction activities, the 

proposed regulations provide a safe 

harbor in § 1.199–3(l)(5)(ii). Under this 

safe harbor, a taxpayer may allocate 

gross receipts between the proceeds 

from the sale, exchange, or other 

disposition of real property constructed 

by the taxpayer and the gross receipts 

attributable to the sale, exchange, or 

other disposition of land by reducing its 

costs related to DPGR in § 1.199–4 by 

costs of the land and any other costs 

capitalized to the land (collectively, 

land costs) (including land costs in any 

common improvements as defined in 

section 2.01 of Rev. Proc. 92–29 (1992–

1 C.B. 748)), and by reducing its DPGR 

from qualifying construction activities 

by those land costs plus a specified 

percentage. The percentage is based on 

the number of years that elapse between 

the date the taxpayer acquires the land, 

including the date the taxpayer enters 

into the first option to acquire all or a 

portion of the land, and ends on the 

date the taxpayer sells each item of real 

property on the land. The percentage is 

5 percent for years zero through 5; 10 

percent for years 6 through 10; and 15 

percent for years 11 through 15. Land 

held by a taxpayer for 16 or more years 

is not eligible for the safe harbor and the 

taxpayer must allocate gross receipts 

between the land and the qualifying real 

property. For example, if a taxpayer 

acquires land in 2001 and constructs 

houses that it sells in 2005, 2008, and 

Federal Register / Vol. 70, No. 213 / Friday, November 4, 2005 / Proposed Rules 67231 

2012, the houses sold in 2005 are 

subject to the 5 percent reduction; the 

houses sold in 2008 are subject to the 10 

percent reduction; and the houses sold 

in 2012 are subject to the 15 percent 

reduction. 

Commentators suggested that 

developers of raw land should be 

entitled to a section 199 deduction for 

improvements to land such as building 

roads, sidewalks, and installing utilities. 

In addition, they suggested that 

entitlements such as zoning, permits, 

and surveys that add value to the land 

should be included in DPGR similar to 

the treatment of design and 

development costs for software and 

sound recordings. The proposed 

regulations provide that a taxpayer in a 

construction NAICS code that sells 

developed land will have DPGR to the 

extent the receipts are attributable to 

real property such as infrastructure but 

not to the land and any entitlements 

attributable to the land. The proposed 

regulations provide examples in 

§ 1.199–3(l)(5)(iii) to illustrate this rule. 

Commentators suggested that the 

proposed regulations extend the 

embedded services exception for 

qualified warranties in connection with 

the sale of property to construction 

warranties. The IRS and Treasury 

Department agree with this suggestion. 

Accordingly, § 1.199–3(l)(5)(i) provides 

DPGR derived from the construction of 

real property includes gross receipts 

from any warranty that is provided in 

connection with the construction of the 

real property if, in the normal course of 

the taxpayer’s business, the charge for 

the construction warranty is included in 

the price for the construction project 

and the construction warranty is neither 

separately offered by the taxpayer nor 

separately bargained for with the 

customer (that is, the customer cannot 

purchase the constructed real property 

without the construction warranty). 

Engineering and Architectural Services 

Section 4.04(12)(a) of Notice 2005–14 

provides that DPGR includes gross 

receipts derived from engineering or 

architectural services performed in the 

United States for real property 

construction projects in the United 

States. Commentators stated that the 

definition of engineering and 

architectural services should not be 

limited to real property because this 

limitation is inconsistent with the rules 

for engineering and architectural 

services under the domestic 

international sales corporation, foreign 

sales corporation, and extraterritorial 

income exclusion provisions. The IRS 

and Treasury Department continue to 

believe that the statutory language in 

section 199(c)(4)(A)(iii) requires that 

only engineering and architectural 

services relating to real property qualify 

for the section 199 deduction and that 

the same rules relating to construction 

of real property apply for engineering or 

architectural services. In addition, the 

Blue Book at page 172 n. 292, states that 

DPGR includes gross receipts derived 

from the engineering or architectural 

services performed with respect to real 

property only. Thus, DPGR only 

includes gross receipts derived from 

engineering or architectural services 

performed in the United States for the 

construction of real property in the 

United States. In addition, the IRS and 

Treasury Department believe that, 

consistent with the rules for 

construction activities, a taxpayer 

performing engineering and 

architectural services must be in a trade 

or business described in an engineering 

or architectural NAICS code. 

Accordingly, the proposed regulations 

require that, at the time the taxpayer 

performs the engineering or 

architectural services, the taxpayer must 

be in a trade or business on a regular 

and ongoing basis (but not necessarily 

its primary trade or business) that is 

considered engineering or architectural 

services for purposes of the NAICS 

codes, for example NAICS codes 541330 

(engineering services) or 541310 

(architectural services). 

A commentator also requested 

clarification of whether a structure 

enclosing an electric generation station 

as described in Rev. Rul. 69–412 (1969–

2 C.B. 2) would be considered real 

property for purposes of section 

199(c)(4)(A)(iii). In that revenue ruling, 

the structure qualified as section 38 

property for investment credit purposes. 

The revenue ruling does not determine 

whether the property was real or 

personal property. Under section 

4.04(11)(a) of Notice 2005–14, real 

property includes residential and 

commercial buildings including items 

that are structural components of such 

buildings and inherently permanent 

structures other than tangible personal 

property in the nature of machinery. 

The proposed regulations in § 1.199–

3(l)(1)(i) retain this language. Thus, a 

structure enclosing an electric 

generation station as described in Rev. 

Rul. 69–412 is treated as real property 

for purposes of section 199(c)(4)(A)(iii). 

In addition, similar to the rules for 

construction, the determination of 

whether an entity is in an engineering 

or architectural NAICS code is made on 

an entity-by-entity basis. Under this 

rule, a member of an EAG must perform 

the engineering or architectural services 

in order for its gross receipts to qualify 

as DPGR from engineering or 

architectural services. See § 1.199–

7(a)(3). In addition, the taxpayer must 

actually perform the engineering or 

architectural services. 

One commentator pointed out that the 

requirement in section 4.04(12)(a) of 

Notice 2005–14 that a taxpayer must 

substantiate that the engineering or 

architectural services relate to a 

construction project in the United States 

is unnecessary because taxpayers are 

already required to identify and allocate 

gross receipts attributable to DPGR 

based upon a reasonable method 

satisfactory to the Secretary for purposes 

of determining QPAI. Because there was 

no intention on the part of the IRS and 

Treasury Department to create an 

additional substantiation requirement 

for engineering and architectural 

services, this additional substantiation 

requirement is not required under the 

proposed regulations. 

Commentators requested clarification 

of whether gross receipts attributable to 

feasibility studies, for example, 

planning possible road or building 

configurations for a potential real 

property development project, is a 

qualifying activity. The commentators 

state that engineering and architectural 

firms are often hired for these studies to 

determine a project’s practicability. 

Accordingly, the proposed regulations 

provide in § 1.199–3(m)(1) that DPGR 

includes gross receipts derived from 

engineering or architectural services, 

including feasibility studies for a 

construction project in the United 

States, even if the planned construction 

project is not undertaken or is not 

completed. 

Food and Beverages 

Section 199(c)(4)(B)(i) provides that 

DPGR does not include gross receipts of 

the taxpayer that are derived from the 

sale of food and beverages prepared by 

the taxpayer at a retail establishment. 

Section 4.04(13) of Notice 2005–14 

defines a ‘‘retail establishment’’ as real 

property leased, occupied, or otherwise 

used by the taxpayer in its trade or 

business of selling food or beverages to 

the public at which retail sales are 

made. One commentator stated that food 

carts and portable food stands should 

not be considered retail establishments 

because they do not constitute real 

property. The IRS and Treasury 

Department believe that the term ‘‘retail 

establishment’’ is intended to be 

interpreted broadly to include any 

facility at which the taxpayer prepares 

food or beverages and makes retail sales 

of the food or beverages to the public. 

See Conference Report at page 272 

(footnote 27) (retail establishment not 

67232 Federal Register / Vol. 70, No. 213 / Friday, November 4, 2005 / Proposed Rules 

limited to establishments at which 

customers dine on premises or to those 

engaged primarily in the dining trade). 

Accordingly, the proposed regulations 

do not adopt this suggestion, and the 

term ‘‘retail establishment’’ is clarified 

to include both real and personal 

property. In addition, a facility at which 

food and beverages are prepared solely 

for take out service or delivery is a retail 

establishment (for example, a caterer). 

Consistent with Notice 2005–14, the 

proposed regulations provide that if a 

taxpayer’s facility is a retail 

establishment, then, as a matter of 

administrative grace, a taxpayer is 

permitted to allocate its gross receipts 

between gross receipts derived from the 

wholesale sale of the food and beverages 

prepared at the retail establishment 

(which are DPGR, assuming all the other 

requirements of section 199(c) are met) 

and the gross receipts derived from the 

retail sale of the food and beverages 

prepared and sold at the retail 

establishment (which are non-DPGR). 

For this purpose, wholesale sales are 

defined as sales of food and beverages 

to be resold by the purchaser. 

One commentator requested 

clarification how the retail 

establishment exception applies in the 

case of wineries. While producers of 

distilled spirits, wines, and beer may 

conduct retail sales of their products on 

their premises, such sales do not 

transform the entire premises of the 

distilled spirits plant, bonded wine 

cellar (or bonded winery), or brewery 

into a retail establishment. Chapter 51 of 

Title 26 of the United States Code, and 

the implementing regulations found in 

27 CFR parts 19, 24, and 25, create clear 

distinctions between that portion of a 

distilled spirits plant, winery, or 

brewery devoted to production activities 

and the portion devoted to other 

activities, such as retail sales. Consistent 

with the treatment of such facilities for 

purposes of Chapter 51 of Title 26 of the 

United States Code and the regulations 

thereunder, the proposed regulations 

provide that the portion of a distilled 

spirits plant, bonded winery, or brewery 

that is restricted to production 

activities, including the processing and 

blending of distilled spirits, wine, and 

beer products, will not be treated as a 

retail establishment for purposes of 

section 199(c)(4)(B)(i). Thus, for 

example, for purposes of section 199, 

taxpaid wine sold from the taxpaid 

premises of a bonded winery is not 

considered to have been produced at a 

retail establishment because it is 

considered to have been produced on 

the bonded premises of the winery. 

Accordingly, the sales of such wine will 

be treated as DPGR for purposes of 

section 199 (assuming all the other 

requirements of section 199(c) are met). 

A similar result applies to the sale of 

taxpaid distilled spirits from the general 

(taxpaid) premises of a distilled spirits 

plant, and to the sale of taxpaid beer 

from the tavern portion of a brewery. 

A commentator suggested that the 

proposed regulations interpret the term 

food and beverages to mean only items 

prepared by the taxpayer in a single 

serving size for immediate consumption 

by the purchaser. The commentator 

believes that the Conference Report in 

footnote 27 supports this interpretation 

because these characteristics are 

common to the examples that the 

footnote provides (that is, brewed coffee 

and venison sausage prepared at a 

restaurant). The commentator further 

contends that this interpretation 

eliminates the distinction between food 

and beverages prepared off-site (gross 

receipts from the retail sale of which 

may be DPGR) and those prepared onsite (gross receipts from the retail sale of 

which are non-DPGR), a distinction that 

the commentator believes Congress did 

not intend. 

The IRS and Treasury Department do 

not believe that the statute or 

Conference Report supports the 

commentator’s interpretation. If the 

commentator’s interpretation was 

correct, then gross receipts from the 

retail sale of the roasted coffee beans in 

footnote 27 would have qualified as 

DPGR even if the taxpayer had roasted 

the beans at its retail establishment 

because the beans are not sold in single 

servings for immediate consumption. 

However, footnote 27 makes clear that 

the gross receipts attributable to the 

beans only qualify because the beans 

were roasted at a facility separate from 

the retail establishment. Thus, the 

statute and legislative history clearly 

provide different treatment for gross 

receipts attributable to the retail sale of 

food and beverages prepared at a retail 

establishment and food and beverages 

prepared elsewhere. 

The same commentator requested 

clarification of how the food and 

beverages exception applies to in-store 

bakeries. Footnote 27 of the Conference 

Report provides an example of a 

taxpayer that operates a supermarket 

that includes an in-store bakery, and 

provides that the taxpayer may allocate 

its gross receipts between DPGR and 

non-DPGR. The commentator believes 

that the example could be interpreted to 

mean that all gross receipts allocable to 

sales (both retail and wholesale) of 

items prepared in the bakery are nonDPGR. Section 4.04(13) of Notice 2005–

14 however, as a matter of 

administrative grace, permits gross 

receipts from wholesale sales of food 

and beverages produced at a retail 

establishment to qualify as DPGR (if all 

other requirements of section 199(c) are 

met), and the proposed regulations 

retain this rule. Thus, gross receipts 

from wholesale sales of items produced 

at the in-store bakery (for example, 

items sold to restaurants) may qualify as 

DPGR (if all other requirements of 

section 199(c) are met). The 

commentator further stated, consistent 

with the first comment, that gross 

receipts from retail sales of bakery 

products that require further processing 

by the consumer to be suitable for 

individual consumption (such as 

unsliced cakes and unsliced loaves of 

bread) should not be excluded from 

DPGR under section 199(c)(4)(B)(i). For 

the reasons stated above, the IRS and 

Treasury Department believe that retail 

sales of these items are subject to that 

exclusion. Receipts allocable to 

wholesale sales of these items, however, 

may qualify as DPGR under the 

administrative exception, assuming all 

the other requirements of section 199(c) 

are met. 

Determining Costs 

To determine its QPAI for the taxable 

year, a taxpayer must subtract from its 

DPGR the amount of CGS allocable to 

DPGR, the other deductions, expenses, 

and losses (deductions) directly 

allocable to DPGR, and a ratable portion 

of other deductions that are not directly 

allocable to DPGR or another class of 

income. A taxpayer’s costs must be 

determined using the taxpayer’s 

methods of accounting for Federal 

income tax purposes. 

Allocation of Cost of Goods Sold 

Notice 2005–14 provides that if a 

taxpayer can identify from its books and 

records CGS allocable to DPGR, CGS 

allocable to DPGR is that amount. The 

Notice also provides that if a taxpayer’s 

books and records do not allow it to 

identify CGS allocable to DPGR, the 

taxpayer may use a reasonable 

allocation method to allocate CGS 

between DPGR and non-DPGR. The 

Notice further provides that, if a 

taxpayer uses a method to allocate gross 

receipts between DPGR and non-DPGR, 

then the taxpayer may not use a 

different method for purposes of 

allocating CGS. 

Commentators suggested that a 

taxpayer should be permitted to allocate 

CGS using a reasonable method separate 

from the method used to allocate gross 

receipts because using the same 

allocation method for gross receipts and 

CGS may not be possible or may distort 

income. For example, a taxpayer that 

Federal Register / Vol. 70, No. 213 / Friday, November 4, 2005 / Proposed Rules 67233 

can identify from its books and records 

gross receipts allocable to DPGR may 

not be able to specifically identify CGS 

allocable to DPGR. Commentators also 

questioned whether a taxpayer that can 

identify from its books and records CGS 

allocable to DPGR must allocate CGS on 

such basis when it allocates gross 

receipts using a different method. The 

proposed regulations clarify that if a 

taxpayer does, or can without undue 

burden or expense, specifically identify 

from its books and records CGS 

allocable to DPGR, CGS allocable to 

DPGR is that amount irrespective of 

whether the taxpayer uses another 

allocation method to allocate gross 

receipts between DPGR and other gross 

receipts. The proposed regulations also 

clarify that if a taxpayer cannot, without 

undue burden or expense, use a specific 

identification method to determine CGS 

allocable to DPGR, the taxpayer is not 

required to use a specific identification 

method to determine CGS allocable to 

DPGR, but may use some other 

reasonable method. A taxpayer’s use of 

a method for purposes of allocating CGS 

between DPGR and non-DPGR that is 

different from its method for allocating 

gross receipts between DPGR and nonDPGR will ordinarily not be considered 

reasonable unless the method for 

allocating CGS is demonstrably more 

accurate than the method used to 

allocate gross receipts. 

Commentators also suggested that 

CGS allocable to DPGR may not be 

readily ascertainable when a taxpayer 

uses the last-in, first-out (LIFO) method 

to account for its inventory. Therefore, 

commentators requested that a 

simplified method be provided to 

allocate CGS between DPGR and nonDPGR when a taxpayer uses the LIFO 

method to account for its inventory. The 

proposed regulations provide that a 

taxpayer that uses the LIFO method to 

account for its inventory may use any 

reasonable method to allocate CGS 

between DPGR and non-DPGR. In 

addition, the regulations provide 

simplified methods that a taxpayer may 

use to allocate CGS when a taxpayer 

uses the LIFO method to account for its 

inventories. 

The IRS and Treasury Department 

also received comments requesting 

clarification of the types of costs that are 

required to be allocated as CGS 

allocable to DPGR. In particular, 

commentators stated that section 263A 

only requires taxpayers to capitalize 

costs with respect to inventory on hand 

at the end of the taxable year and that 

as a result taxpayers generally do not 

include indirect costs in CGS, but 

instead deduct the amount not allocated 

to ending inventory. Section 263A 

requires a taxpayer that produces 

inventory to include in inventory costs 

the direct costs of producing the 

property and the property’s properly 

allocable share of indirect costs for 

purposes of determining both ending 

inventory and CGS. Consistent with 

Notice 2005–14, the proposed 

regulations provide that, for purposes of 

determining CGS allocable to DPGR, 

CGS includes the costs that would have 

been included in ending inventory 

under the principles of sections 263A, 

471, and 472 if the goods sold during 

the taxable year were on hand at the end 

of the taxable year. However, a taxpayer 

is permitted to use any reasonable 

method to allocate indirect costs 

properly included in CGS between 

DPGR and non-DPGR if the taxpayer’s 

books and records do not, or cannot 

without undue burden or expense, 

specifically identify CGS allocable to 

DPGR. 

Comments also were received 

concerning whether a taxpayer is 

permitted to use a reasonable allocation 

method to allocate CGS if it uses the 

simplified production method or 

simplified resale method for additional 

section 263A costs. The proposed 

regulations clarify that a taxpayer that 

uses either the simplified production 

method or the simplified resale method 

for additional section 263A costs may 

use a reasonable allocation method to 

allocate both section 471 costs and 

additional section 263A costs included 

in CGS. The proposed regulations 

further provide that if a taxpayer uses 

the simplified production method or the 

simplified resale method to allocate 

additional section 263A costs to ending 

inventory, additional section 263A costs 

ordinarily should be allocated in the 

same proportion as section 471 costs are 

allocated. 

Allocation and Apportionment of 

Deductions 

Consistent with Notice 2005–14, the 

proposed regulations provide three 

methods for allocating and apportioning 

deductions. However, as described 

below, modifications have been made in 

these proposed regulations to the 

qualification requirements of the 

simplified deduction method and the 

small business simplified overall 

method. 

The first method, the ‘‘section 861 

method,’’ is required to be used by a 

taxpayer, unless the taxpayer is eligible 

and chooses to use either the simplified 

deduction method or the small business 

simplified overall method. Under the 

section 861 method, section 199 is 

treated as an operative section described 

in § 1.861–8(f). Accordingly, a taxpayer 

determines the deductions allocated and 

apportioned to DPGR by applying the 

allocation and apportionment rules 

provided by §§ 1.861–8 through 1.861–

17 and §§ 1.861–8T through 1.861–14T 

(the section 861 regulations), subject to 

certain special rules. The IRS and 

Treasury Department recognize that the 

allocation and apportionment rules of 

the section 861 method may be 

burdensome to certain taxpayers, 

particularly smaller taxpayers, that 

otherwise would not be required to use 

these rules. Accordingly, the proposed 

regulations provide two alternative 

methods, the simplified deduction 

method and the small business 

simplified overall method, with a goal 

of minimizing the need for smaller 

taxpayers to devote additional resources 

to compliance. 

Under the ‘‘simplified deduction 

method,’’ a taxpayer’s deductions are 

apportioned between DPGR and other 

receipts based on relative gross receipts. 

The simplified deduction method does 

not apply to the allocation of CGS. 

Notice 2005–14 permits only taxpayers 

with average annual gross receipts of 

$25,000,000 or less to use the simplified 

deduction method. Several 

commentators requested that the 

simplified deduction method also be 

made available to taxpayers with gross 

receipts in excess of $25,000,000. Many 

of these comments were from taxpayers 

that have not in the past been required 

to allocate and apportion deductions 

under the section 861 regulations. Some 

commentators suggested that the 

simplified deduction method be used 

for all costs, except for limited 

identified costs such as interest, for 

which the section 861 method would 

continue to apply. Still other 

commentators suggested that taxpayers 

be allowed to use other existing cost 

allocation methods, such as those under 

section 263A or under other government 

regulatory procedures. 

In response to these comments, the 

IRS and Treasury Department have 

modified the eligibility requirements for 

the simplified deduction method. Under 

the proposed regulations, a taxpayer 

may use the simplified deduction 

method if it has average annual gross 

receipts of $25,000,000 or less, or total 

assets at the end of the taxable year of 

$10,000,000 or less. However, the IRS 

and Treasury Department still believe 

that for taxpayers above this threshold 

the section 861 method is the 

appropriate method of allocating and 

apportioning deductions for purposes of 

determining QPAI. Furthermore, the 

alternative allocation methods suggested 

by commentators would each require 

additional rules and guidance to address 

67234 Federal Register / Vol. 70, No. 213 / Friday, November 4, 2005 / Proposed Rules 

the interaction of the suggested methods 

with other Federal income tax rules and 

would result in administrative 

complexity and inefficiency. The IRS 

and Treasury Department believe that 

use of the section 861 method will 

result in an appropriate cost allocation 

and apportionment for purposes of 

section 199 and will be easier 

administratively for both taxpayers and 

the IRS than any new, equally 

comprehensive cost allocation and 

apportionment rules that might be 

created. 

Section 1.199–4(f) of the proposed 

regulations provides that a qualifying 

small taxpayer may use the ‘‘small 

business simplified overall method’’ to 

apportion CGS and deductions to DPGR. 

Under Notice 2005–14, a qualifying 

small taxpayer is a taxpayer that has 

average annual gross receipts of 

$5,000,000 or less or a taxpayer that is 

eligible to use the cash method as 

provided in Rev. Proc. 2002–28 (2002–

1 C.B. 815). The IRS and Treasury 

Department are concerned that the 

$5,000,000 average annual gross receipts 

threshold without further modification 

could be used by large taxpayers to 

circumvent the requirements to allocate 

and apportion deductions using the 

section 861 method. As a result, a 

deduction limitation has been added to 

this method. In addition, commentators 

requested that the definition of 

qualifying small taxpayer for purposes 

of the small business simplified overall 

method be expanded to include farmers 

that are not required to use the accrual 

method under section 447. The 

proposed regulations incorporate this 

suggestion. Accordingly, the proposed 

regulations provide that a qualifying 

small taxpayer is a taxpayer that; (1) has 

both average annual gross receipts of 

$5,000,000 or less, and CGS and 

deductions (excluding NOL deductions 

and deductions not attributable to the 

conduct of a trade or business) for the 

current taxable year of $5,000,000 or 

less; (2) is engaged in the trade or 

business of farming that is not required 

to use the accrual method under section 

447; or (3) is eligible to use the cash 

method as provided in Rev. Proc. 2002–

28. 

Notice 2005–14 specifically requested 

comments on whether taxpayers should 

be able to change between the three cost 

allocation methods of section 199 on 

amended returns and whether there 

should be restrictions on a taxpayer’s 

ability to change from one method to 

another. Several commentators 

suggested that a taxpayer should be 

allowed to change its cost allocation 

method on an amended return and that 

a taxpayer should be able to annually 

choose to use any of the three methods. 

The IRS and Treasury Department agree 

that a taxpayer that qualifies to use a 

particular allocation and apportionment 

method should be able to change to that 

method at any time. Accordingly, the 

proposed regulations generally provide 

that a taxpayer eligible to use the 

simplified deduction method may 

choose at any time to use the simplified 

deduction method or the section 861 

method for a taxable year. A taxpayer 

eligible to use the small business 

simplified overall method may choose 

at any time to use the small business 

simplified overall method, the 

simplified deduction method, or the 

section 861 method for a taxable year. 

This rule does not affect, however, any 

restrictions or limitations that apply 

within the section 861 method. 

Pass-Thru Entities 

Section 199 applies at the owner level 

in a manner consistent with the 

economic arrangement of the owners of 

the pass-thru entity. Under the proposed 

regulations, each owner computes its 

section 199 deduction by taking into 

account its distributive or proportionate 

share of the pass-thru entity’s items 

(including items of income and gain, as 

well as items of loss and deduction not 

otherwise disallowed by the Code), CGS 

allocated to such items of income, and 

gross receipts included in such items of 

income. In response to a commentator’s 

inquiry, the proposed regulations make 

it clear that the owner of a pass-thru 

entity need not be engaged directly in 

the entity’s trade or business in order to 

claim a section 199 deduction on the 

basis of that owner’s share of the passthru entity’s items. 

Some commentators recommended 

that section 199 be applied to 

partnerships by using an aggregate 

approach in situations where the 

qualified production activities are 

conducted by the partnership, which 

distributes or sells the QPP, qualified 

films, or utilities to a partner who then 

leases, rents, licenses, sells, exchanges, 

or otherwise disposes of the property, or 

where the qualified production 

activities are conducted by a partner 

which contributes or sells the QPP, 

qualified films, or utilities to the 

partnership, which then leases, rents, 

licenses, sells, exchanges, or otherwise 

disposes of the property. The 

commentators maintained that the 

income derived by the partners and the 

partnerships from the lease, rental, 

license, sale, exchange, or other 

disposition of the property in these 

situations should be treated as QPAI 

and qualify for the section 199 

deduction. The proposed regulations do 

not follow the commentators’

recommendation because section 

199(c)(4)(A) requires that the gross 

receipts must be derived from the 

taxpayer’s own qualified production 

activities to qualify as DPGR. 

Accordingly, except for; (i) certain 

qualifying oil and gas partnerships; and 

(ii) EAG partnerships, discussed below, 

the proposed regulations provide that 

the owner of a pass-thru entity is not 

treated as directly conducting the 

qualified production activities of the 

pass-thru entity, and vice versa, with 

respect to the property transferred 

between the pass-thru entity and the 

owner. This rule applies to all 

partnerships, including partnerships 

that have elected out of subchapter K 

under section 761(a). In addition, 

attribution of activities does not apply 

for purposes of the construction of real 

property and the performance of 

engineering and architectural services. 

The proposed regulations, pursuant to 

the Congressional Letter, provide a 

limited exception for certain 

partnerships in which all of the capital 

and profits interests are owned by 

members of a single EAG at all times 

during the taxable year of the 

partnership (EAG partnership). For 

purposes of determining the DPGR of a 

partnership and its partners, an EAG 

partnership and all members of the EAG 

in which the partners of the EAG 

partnership are members are treated as 

a single taxpayer during the taxable year 

for purposes of section 199(c)(4). Thus, 

if an EAG partnership MPGE or 

produces property and distributes, 

leases, rents, licenses, sells, exchanges, 

or otherwise disposes of that property to 

a member of an EAG in which the 

partners of the EAG partnership are 

members, then the MPGE or production 

activity conducted by the EAG 

partnership will be treated as having 

been conducted by the members of the 

EAG. Similarly, if one or more members 

of an EAG in which the partners of an 

EAG partnership are members MPGE or 

produces property, and contributes, 

leases, rents, licenses, sells, exchanges, 

or otherwise disposes of that property to 

the EAG partnership, then the MPGE or 

production activity conducted by the 

EAG member (or members) will be 

treated as having been conducted by the 

EAG partnership. 

Except as otherwise provided, an EAG 

partnership is generally treated the same 

as other partnerships for purposes of 

section 199. Accordingly, the proposed 

regulations provide that an EAG 

partnership is subject to the rules of 

§ 1.199–5 regarding the application of 

section 199 to pass-thru entities, and the 

application of the section 199(d)(1)(B) 

Federal Register / Vol. 70, No. 213 / Friday, November 4, 2005 / Proposed Rules 67235 

wage limitation under § 1.199–5(a)(3). 

Under the proposed regulations, if an 

EAG partnership distributes property to 

a partner, then, solely for purposes of 

section 199(d)(1)(B)(ii), the EAG 

partnership is treated as having gross 

receipts in the taxable year of the 

distribution equal to the fair market 

value of the property at the time of 

distribution to the partner and the 

deemed gross receipts are allocated to 

that partner, provided the partner 

derives gross receipts from the 

distributed property during the taxable 

year of the partner with or within which 

the partnership’s taxable year (in which 

the distribution occurs) ends. Costs 

included in the adjusted basis of the 

distributed property and any other 

relevant deductions are taken into 

account in computing the partner’s 

QPAI. The proposed regulations provide 

that the small business simplified 

overall method is not available to EAG 

partnerships. 

Another commentator asked whether 

the owner of a pass-thru entity might 

have to perform multiple QPAI 

calculations, distinguishing between 

pass-thru and non-pass-thru production 

activities. The proposed regulations 

make it clear that, when determining its 

section 199 deduction, an owner of a 

pass-thru entity aggregates items of 

income and expense from the entity 

(including W–2 wages) with its own 

items of income and expense (including 

W–2 wages) for purposes of allocating 

and apportioning deductions to DPGR. 

As noted above, the amount of W–2 

wages of a pass-thru entity taken into 

account by an owner in applying the 

wage limitation of section 199(b) is 

determined under section 199(d)(1)(B). 

The proposed regulations provide that 

in determining an owner’s allocable 

share of wages under section 

199(d)(1)(B)(i), W–2 wages are deemed 

to be allocated in the same way as wage 

expense is allocated. In the case of a 

non-grantor trust or estate, the W–2 

wages are deemed to be allocated among 

the trust or estate and the various 

beneficiaries in the same manner as 

QPAI, as described below. Although a 

pass-thru entity’s QPAI is computed by 

deducting wages paid by the entity 

during its entire taxable year, generally 

it is the pass-thru entity’s W–2 wages (as 

shown on the Forms W–2 for the 

calendar year ending within that taxable 

year) that are used to compute the wage 

limitation under section 199(b) and an 

owner’s allocable share of wages under 

section 199(d)(1)(B)(i). If QPAI, 

computed by taking into account only 

the items of the pass-thru entity 

allocated to the owner, is not greater 

than zero, the owner may not take into 

account the W–2 wages of the entity in 

computing the section 199(b) wage 

limitation. 

A commentator requested that the 

proposed regulations clarify and 

illustrate by example how the section 

199(d)(1)(B) wage limitation applies in a 

tiered partnership structure. In 

particular, the commentator suggested 

that the W–2 wages of a lower-tier 

partnership with positive QPAI are 

properly allocable to the partner of the 

upper-tier partnership even if the QPAI 

allocated to the partner from the uppertier partnership is less than zero. The 

proposed regulations do not adopt this 

suggestion. The proposed regulations 

provide that the section 199(d)(1)(B) 

wage limitation must be applied at each 

level in a tiered structure. Thus, in a 

tiered structure, the owner of a passthru entity (including an owner that 

itself is a pass-thru entity) calculates the 

amounts described in section 

199(d)(1)(B)(i) (allocable share) and 

(d)(1)(B)(ii) (twice the applicable 

percentage of the QPAI from the entity) 

separately with regard to its interest in 

that pass-thru entity. The proposed 

regulations provide rules regarding the 

treatment of W–2 wages when a passthru entity (upper-tier entity) owns an 

interest in one or more other pass-thru 

entities (lower-tier entities). An example 

in the proposed regulations illustrates 

the application of these rules. 

The proposed regulations contain 

special rules for trusts and estates. To 

the extent that a grantor or another 

person is treated as owning all or part 

of a trust under sections 671 through 

679 (grantor trust), the owner will 

compute its QPAI with respect to the 

owned portion of the trust as if that 

QPAI had been generated by activities 

performed directly by the owner. In the 

case of a non-grantor trust or estate, the 

DPGR and expenses needed to compute 

the QPAI, as well as the W–2 wages 

relevant to the computation of the wage 

limitation, must be allocated among the 

trust or estate and its various 

beneficiaries. Each beneficiary’s share of 

the trust’s or estate’s QPAI (which will 

be less than zero if the CGS and the 

deductions allocated and apportioned to 

DPGR exceed the trust’s or estate’s 

DPGR) and W–2 wages will be 

determined based on the proportion of 

the trust’s or estate’s distributable net 

income (DNI), as defined by section 

643(a), that is deemed to be distributed 

to that beneficiary for that taxable year. 

Similarly, the proportion of the entity’s 

DNI that is not deemed distributed by 

the trust or estate will determine the 

entity’s share of the QPAI and W–2 

wages. In addition, if the trust or estate 

has no DNI in a particular taxable year, 

any QPAI and W–2 wages are allocated 

to the trust or estate, and not to any 

beneficiary. 

Section 199(d)(1)(A)(i) provides that, 

in the case of an estate or trust (or other 

pass-thru entity), section 199 shall 

apply at the beneficiary (or similar) 

level. Pursuant to this provision, as 

clarified by the Congressional Letter, the 

proposed regulations provide that a 

trust or estate may claim the section 199 

deduction to the extent that QPAI is 

allocated to it. 

Solely for purposes of determining the 

section 199 deduction for the taxable 

year, the QPAI of a trust or estate must 

be computed by allocating the expenses 

described in section 199(d)(5) under 

§ 1.652(b)–3 with respect to directly 

attributable expenses. With respect to 

other expenses described in section 

199(d)(5), a trust or estate that qualifies 

for the simplified deduction method 

described in § 1.199–4(e) must use that 

method, and any other trust or estate 

must use the section 861 method 

described in § 1.199–4(d). The small 

business simplified overall method is 

not available to a trust or estate. 

Because the sale of an interest in a 

pass-thru entity does not reflect the 

realization of DPGR by that entity, 

DPGR generally does not include gain or 

loss recognized on the sale, exchange or 

other disposition of an interest in the 

entity. However, consistent with Notice 

2005–14, if section 751(a) or (b) applies, 

then gain or loss attributable to 

partnership assets giving rise to 

ordinary income under section 751(a) or 

(b), the sale, exchange, or other 

disposition of which would give rise to 

an item of DPGR, is taken into account 

in computing the partner’s section 199 

deduction. 

Section 199 applies to taxable years 

beginning after December 31, 2004. 

Accordingly, these proposed regulations 

apply to taxable years of pass-thru 

entities that begin on or after January 1, 

2005. The IRS and Treasury Department 

recognize that a pass-thru entity will 

need to provide certain information to 

its owners to allow those persons to 

compute the section 199 deduction. No 

special provision with regard to 

information reporting is made for 

electing large partnerships (ELPs) as 

defined by section 775, which are 

subject to the same methods for 

allocating and apportioning deductions 

as are other partnerships. Thus, ELPs 

are required to provide the same 

information to their partners as other 

partnerships for purposes of computing 

the section 199 deduction. The IRS and 

the Treasury Department intend to 

provide information reporting rules for 

67236 Federal Register / Vol. 70, No. 213 / Friday, November 4, 2005 / Proposed Rules 

pass-thru entities in the relevant forms 

and instructions. 

Agricultural and Horticultural 

Cooperatives 

A commentator suggested that the 

proposed regulations provide that 

patrons cannot include patronage 

dividends and per-unit retain 

certificates in the computation of the 

QPAI from the patron’s other farming 

operations to the extent that those 

amounts were taken into account by a 

cooperative in determining the 

cooperative’s section 199 deduction. 

The commentator stated that in many 

cases, both the cooperative and its 

patrons will be engaged in qualifying 

activities. For example, gross receipts 

from crops raised by a farmer in the 

United States may be eligible for the 

section 199 deduction as well as the 

receipts the cooperative derives from 

the marketing of the crop. To avoid 

duplication of section 199 benefits, the 

proposed regulations clarify that under 

§ 1.199–6(h) patronage dividends and 

per-unit allocations a patron receives 

from a cooperative that are taken into 

account as part of the cooperative’s 

computation of QPAI may not be taken 

into account in computing the patron’s 

QPAI from its own qualifying activities. 

In addition, patronage dividends and 

per-unit retain allocations include any 

advances on patronage or per-unit 

retains paid in money made during the 

taxable year. Examples are provided to 

illustrate this rule. 

A commentator suggested that the 

proposed regulations clarify the amount 

of the section 199 deduction a 

cooperative is required to pass through 

to its patrons. Accordingly, the 

proposed regulations clarify in § 1.199–

6(d) that the cooperative may, at its 

discretion, pass through all, some, or 

none of the allowable section 199 

deduction to its patrons. 

A commentator suggested that it 

would be useful if the proposed 

regulations address whether a 

cooperative member of a federated 

cooperative may pass through to its 

patrons the section 199 deduction it 

receives as a patron cooperative. 

Accordingly, the proposed regulations 

in § 1.199–6(d) provide that a 

cooperative patron of a federated 

cooperative may pass through the 

section 199 deduction it receives to its 

member patrons. 

A commentator requested that the 

proposed regulations address the form, 

content, and timing of the patron 

notification requirements. The 

commentator stated that the notice 

should not have to accompany the 

patronage distribution. For instance, a 

cooperative should be permitted to send 

out a notice passing through an 

estimated amount of the section 199 

deduction at the time patronage 

dividends are paid and a second notice 

(when the Federal income tax return is 

completed and the section 199 

deduction is actually determined) 

covering anything that was not passed 

through by the first notice, provided the 

notice is sent during the payment period 

in section 1382(d). The proposed 

regulations provide in § 1.199–6(b) that, 

in order for a patron to qualify for the 

section 199 deduction, the cooperative 

must designate the patron’s portion of 

the section 199 deduction in a written 

notice mailed by the cooperative to its 

patrons no later than the 15th day of the 

ninth month following the close of the 

cooperative’s taxable year. The 

cooperative may use the same written 

notice, if any, that it uses to notify 

patrons of their respective allocations of 

patronage dividends, or may use a 

separate timely written notice(s) to 

comply with this section. The 

cooperative must report the amount of 

the patron’s section 199 deduction on 

Form 1099-PATR, ‘‘Taxable 

Distributions Received From 

Cooperative,’’ issued to the patron. 

A commentator suggested that the 

proposed regulations clarify that patrons 

(whether they use the cash or accrual 

method of accounting) are entitled to 

claim the section 199 deduction passed 

through from the cooperative on the 

return for the taxable year in which they 

receive written notification from the 

cooperative. The proposed regulations 

provide in § 1.199–6(d) that patrons may 

claim the section 199 deduction for the 

taxable year they receive the written 

notice informing them of the section 199 

deduction amount. 

A commentator suggested that the 

proposed regulations clarify that the 

section 199 deduction of a cooperative 

is subject to the W–2 wage limitation 

under section 199(b) at the cooperative 

level and that it is not subject to a 

second W–2 wage limitation at the 

patron level to the extent the section 

199 deduction is passed through to its 

patrons. The proposed regulations 

provide in § 1.199–6(e) that the W–2 

wage limitation shall be applied only at 

the cooperative level whether or not the 

cooperative chooses to pass through 

some or all of the section 199 deduction. 

In addition, the proposed regulations in 

§ 1.199–6(d) provide that patrons may 

claim the section 199 deduction without 

regard to the taxable income limitation. 

A commentator suggested that the 

proposed regulations address what 

happens when an audit determination 

results in a decrease in the amount of a 

cooperative’s section 199 deduction 

passed through to its patrons. The 

proposed regulations provide in 

§ 1.199–6(f) that, if an audit determines 

or an amended return reports that the 

amount of the section 199 deduction 

that was passed through to patrons 

exceeded the amount determined to be 

allowable by the audit or on the 

amended return, recapture of the audit 

adjustment amount or excess amended 

return amount will occur at the 

cooperative level. 

Expanded Affiliated Groups 

Section 199(d)(4)(A) provides that all 

members of an EAG are treated as a 

single corporation for purposes of 

section 199. 

The single corporation language in 

section 199(d)(4)(A) has created 

confusion among commentators and the 

proposed regulations clarify the 

meaning of this language. The proposed 

regulations provide that except as 

otherwise provided in the Code and 

regulations (see, for example, sections 

199(c)(7) and 267, §§ 1.199–3(b) and 

1.199–7(a)(3), and the consolidated 

return regulations), each member of an 

EAG is a separate taxpayer that 

computes its own taxable income or 

loss, QPAI, and W–2 wages, which are 

then aggregated at the EAG level. For 

example, if corporations X and Y are 

members of the same EAG, but are not 

members of the same consolidated 

group, and X sells QPP it MPGE within 

the United States to Y, the transaction 

is taken into account in determining the 

EAG’s section 199 deduction. If X and 

Y are members of the same consolidated 

group, see the section entitled 

Consolidated Groups, below. 

The IRS and Treasury Department 

believe that Congress intended that an 

EAG should be eligible for the section 

199 deduction if the activities to 

produce QPP, qualified films, and 

utilities are done by one or more 

members of the EAG other than the 

member who leases, rents, licenses, 

sells, exchanges, or otherwise disposes 

of the QPP, qualified films, and utilities. 

Accordingly, the proposed regulations 

provide generally that if a member of an 

EAG (the disposing member) derives 

gross receipts from the lease, rental, 

license, sale, exchange, or other 

disposition of QPP, qualified films, and 

utilities MPGE or otherwise produced 

by another member or members of the 

same EAG, the disposing member is 

treated as conducting the activities 

conducted by each other member of the 

EAG with respect to the QPP, qualified 

films, and utilities in determining 

whether its gross receipts are DPGR. 

However, in general, attribution of 

Federal Register / Vol. 70, No. 213 / Friday, November 4, 2005 / Proposed Rules 67237 

activities does not apply for purposes of 

the construction of real property under 

§ 1.199–3(l)(1) or the performance of 

engineering and architectural services 

under § 1.199–3(m)(1). A member of an 

EAG must engage in a construction 

activity under § 1.199–3(l)(2), provide 

engineering services under § 1.199–

3(m)(2), or provide architectural 

services under § 1.199–3(m)(3) in order 

for the member’s gross receipts to be 

derived from construction, engineering, 

or architectural services. 

Notwithstanding the above, attribution 

of activities in the construction of real 

property and the performance of 

engineering and architectural services 

does apply for members of the same 

consolidated group. For example, if X 

and Y are members of the same EAG, 

but are not members of the same 

consolidated group, and X constructs a 

commercial building and sells the 

building to Y, and Y, who performs no 

construction activities with respect to 

the building, sells the building to an 

unrelated person, Y is not attributed the 

construction activities of X and Y’s 

receipts from the sale of the building 

will not be DPGR. However, if X and Y 

are members of the same consolidated 

group, Y is attributed the construction 

activities of X and, assuming all the 

requirements of section 199(c) are met, 

Y’s receipts will be DPGR. 

Some commentators suggested that 

the proposed regulations provide a 

special rule excluding finance 

companies from an EAG. Section 

199(d)(4)(A) specifically states that all 

members of an EAG shall be treated as 

a single corporation. Neither the statute 

nor the legislative history provide any 

exceptions that would allow taxpayers 

to exclude certain types of companies, 

including finance companies, from the 

EAG. Accordingly, the commentators’

suggestion has not been adopted. 

Notwithstanding that a transaction 

between members of the same EAG (an 

intragroup transaction) generally is 

taken into account in determining the 

section 199 deduction, the IRS and 

Treasury Department recognize that 

taxpayers may engage in an intragroup 

transaction in an attempt to obtain a 

section 199 deduction when none 

should be available. Accordingly, the 

proposed regulations retain the antiavoidance rule contained in Notice 

2005–14. Thus, if a transaction between 

members of the same EAG is engaged in 

or structured with a principal purpose 

of qualifying for, or increasing the 

amount of, the section 199 deduction of 

the EAG or the portion of the section 

199 deduction allocated to one or more 

members of the EAG, adjustments must 

be made to eliminate the effect of the 

transaction on the computation of the 

section 199 deduction. 

Some commentators asked whether 

the $25,000,000 and $5,000,000 average 

annual gross receipts thresholds for 

using the simplified deduction method 

and the small business simplified 

overall method, respectively, are 

applied at the EAG level, the 

consolidated group level, or at the 

member level. If the EAG was a single 

corporation, the $25,000,000 and 

$5,000,000 average annual gross receipts 

thresholds would take into account the 

activities of all the members of the EAG. 

Accordingly, the $25,000,000 and 

$5,000,000 average annual gross receipts 

thresholds are applied at the EAG level. 

Similarly, the new $10,000,000 total 

assets threshold for using the simplified 

deduction method and the new 

$5,000,000 current year CGS and 

deductions threshold for using the small 

business simplified overall method also 

are applied at the EAG level. The 

determination of whether a taxpayer is 

engaged in the trade or business of 

farming that is not required to use the 

accrual method of accounting under 

section 447 is determined by taking into 

account the activities of all the members 

of the EAG. Similarly, the determination 

of whether a taxpayer is eligible to use 

the cash method as provided in Rev. 

Proc. 2002–28, and is thus eligible to 

use the small business simplified 

overall method, is determined by taking 

into account the activities of all the 

members of the EAG. 

Commentators requested that the rule 

in Notice 2005–14 that requires all 

members of the same EAG to use the 

same cost allocation method be changed 

to allow members to use different cost 

allocation methods. In response to the 

comments received, the IRS and 

Treasury Department agree that if an 

EAG is eligible to use the simplified 

deduction method, each member of the 

EAG may individually determine 

whether it wants to use the section 861 

method or the simplified deduction 

method, notwithstanding that another 

member of the EAG uses a different 

method. Similarly, if the EAG is eligible 

to use the small business simplified 

overall method, each member of the 

EAG may individually determine 

whether it wants to use the section 861 

method, the simplified deduction 

method, or the small business 

simplified overall method, 

notwithstanding that another member of 

the EAG uses a different method. 

However, if the EAG is not eligible to 

use either the simplified deduction 

method or the small business simplified 

overall method, then all members of the 

EAG must use the section 861 method. 

Notwithstanding that the members of an 

EAG generally are not required to use 

the same cost allocation method, each 

member of a consolidated group must 

use the same cost allocation method. 

Examples are provided to illustrate 

these provisions. 

A commentator also asked at what 

level the de minimis rule described in 

§ 1.199–1(d)(2) is tested. Section 1.199–

1(d)(2) treats all of a taxpayer’s gross 

receipts as DPGR if less than 5 percent 

of the taxpayer’s total gross receipts are 

non-DPGR. The de minimis rule is 

intended to eliminate the burden to a 

taxpayer of allocating gross receipts 

between DPGR and non-DPGR when 

less than 5 percent of its total gross 

receipts are non-DPGR. When 

considering the purpose of the de 

minimis rule, the IRS and Treasury 

Department believe that it is appropriate 

that the 5 percent threshold be 

determined at the corporation level, 

rather than at the EAG or consolidated 

group level. 

Consolidated Groups 

The section 199 deduction of a 

consolidated group (or the section 199 

deduction allocated to a consolidated 

group that is a member of an EAG) is 

allocated to the members of the 

consolidated group in proportion to 

each consolidated group member’s 

QPAI, regardless of whether the 

consolidated group member has 

separate taxable income or loss or W–2 

wages for the taxable year. Further, if 

two or more members of a consolidated 

group engage in an intercompany 

transaction, as defined in § 1.1502–

13(b)(1), the proposed regulations 

clarify that if an item of income, gain, 

deduction, or loss is not yet taken into 

account under § 1.1502–13, the 

intercompany transaction that gave rise 

to the item is not taken into account in 

computing the section 199 deduction 

until the time and in the same 

proportion that the item is taken into 

account under § 1.1502–13. For 

example, if corporations X and Y file a 

consolidated Federal income tax return 

and X sells QPP it MPGE within the 

United States to Y, the transaction is not 

taken into account until the time (and 

in the same proportion) provided in the 

matching rule of § 1.1502–13(c) or the 

acceleration rule of § 1.1502–13(d). The 

proposed regulations provide examples 

to illustrate these principles. 

Some commentators suggested that if 

X’s receipts from an intercompany 

transaction with consolidated group 

member Y are non-DPGR (for example, 

X licenses non-QPP to Y) and Y’s CGS 

and other deductions from the 

intercompany transaction are taken into 

67238 Federal Register / Vol. 70, No. 213 / Friday, November 4, 2005 / Proposed Rules 

account in determining the consolidated 

group’s QPAI, the consolidated group’s 

QPAI could be different than if X and 

Y were divisions of a single corporation, 

contrary to the general intent of 

§ 1.1502–13. The consolidated return 

regulations already prevent this result. 

Under § 1.1502–13(c)(1)(i) and (c)(4), 

X’s, Y’s, or both X’s and Y’s separate 

entity attributes must be redetermined 

to the extent necessary to treat X and Y 

as if they were divisions of a single 

corporation. Thus, X’s income may be 

redetermined to be DPGR 

(notwithstanding section 199(c)(7) or 

that the item licensed by X in the 

intercompany transaction does not 

otherwise meet the requirements of 

section 199(c)) or Y’s CGS and other 

deductions from the intercompany 

transaction may be redetermined to be 

not allocable to DPGR, whichever 

produces the effect as though X and Y 

were divisions of a single corporation. 

Similarly, if X MPGE QPP within the 

United States and sells the QPP to Y, 

but Y does not use the QPP in creating 

DPGR, in order to produce the effect as 

though X and Y were divisions of a 

single corporation, X’s gross receipts 

from the sale of the QPP may be 

redetermined to be non-DPGR or Y’s 

CGS and other deductions may be 

redetermined to be allocable to DPGR. 

In addition, if X MPGE QPP within the 

United States and sells the QPP to Y, 

and Y sells the QPP to an unrelated 

person, X’s gross receipts may be 

redetermined to be non-DPGR (and nonreceipts) and Y’s CGS and other 

deductions may be redetermined to be 

not allocable to DPGR, to the extent 

necessary to produce the effect as 

though X and Y were divisions of a 

single corporation. The proposed 

regulations provide examples to 

illustrate the situations described above. 

Some commentators asked whether 

the section 199 deduction results in a 

downward basis adjustment under 

§ 1.1502–32 if the deduction is allocated 

to a subsidiary member (S) of a 

consolidated group. Section 1.1502–

32(b)(3)(ii)(B) already addresses this 

situation. Although the section 199 

deduction is taken into account under 

the general operating rules of § 1.1502–

32(b)(3)(i), paragraph (b)(3)(ii)(B) of that 

section provides that not only is S’s 

income taken into account under the 

general operating rules of § 1.1502–

32(b)(3)(i), but an amount of S’s income 

equivalent to the section 199 deduction 

is also treated as being tax-exempt 

income under § 1.1502–32(b)(3)(ii)(A). 

The net result is that the basis that P (S’s 

parent) has in its S stock is not reduced 

on account of the section 199 deduction. 

For example, if S earns $100 and is 

entitled to a $9 section 199 deduction, 

P’s basis in S increases by $100 because 

the $100 income and the $9 deduction 

are taken into account under § 1.1502–

32(b)(3)(i) (resulting in $91 of the 

increase) and $9 of the income also is 

taken into account under § 1.1502–

32(b)(3)(ii)(A) as tax-exempt income 

(resulting in $9 of the increase). 

The proposed regulations treat a 

consolidated group as a single member 

of the EAG. For example, if A, B, C, S1, 

and S2 are members of the same EAG, 

and A, S1, and S2 are members of the 

same consolidated group (the A 

consolidated group), then the A 

consolidated group is treated as one 

member of the EAG. Thus, the EAG is 

considered to have three members, the 

A consolidated group, B, and C. 

Alternative Minimum Tax 

Section 199(d)(6), as clarified by the 

Congressional Letter, provides that for 

purposes of determining AMTI under 

section 55, the section 199 deduction 

must be computed in the same manner 

as for regular tax, except that in the case 

of a corporation, the taxable income 

limitation is the corporation’s AMTI. 

Accordingly, the proposed regulations 

provide that for purposes of determining 

AMTI under section 55, a taxpayer that 

is not a corporation may deduct an 

amount equal to 9 percent (3 percent in 

the case of taxable years beginning in 

2005 or 2006, and 6 percent in the case 

of taxable years beginning in 2007, 

2008, or 2009) of the lesser of the 

taxpayer’s QPAI for the taxable year, or 

the taxpayer’s taxable income for the 

taxable year, determined without regard 

to the section 199 deduction (or in the 

case of an individual, AGI). In the case 

of a corporation (including a 

corporation subject to tax under section 

511(a)), a taxpayer may deduct an 

amount equal to 9 percent (3 percent in 

the case of taxable years beginning in 

2005 or 2006, and 6 percent in the case 

of taxable years beginning in 2007, 

2008, or 2009) of the lesser of the 

taxpayer’s QPAI for the taxable year, or 

the taxpayer’s AMTI (as defined in 

section 55(b)(2)) for the taxable year, 

determined without regard to the 

section 199 deduction. For purposes of 

computing AMTI, QPAI is determined 

without regard to any adjustments 

under sections 56 through 59. In the 

case of an individual or a trust, AGI and 

taxable income are also determined 

without regard to any adjustments 

under sections 56 through 59. The 

amount of the deduction allowable for 

purposes of computing AMTI for any 

taxable year cannot exceed 50 percent of 

the W–2 wages of the employer for the 

taxable year (as determined under 

§ 1.199–2). 

Revocation of Election Under Section 

631(a) 

Section 102(c) of the Act allows a 

taxpayer to revoke an election under 

section 631(a) to treat the cutting of 

timber as a sale or exchange. Any 

section 631(a) election for a taxable year 

ending on or before October 22, 2004, 

may be revoked under section 102(c) of 

the Act for any taxable year ending after 

that date. In addition, any election 

under section 631(a) for a taxable year 

ending on or before October 22, 2004 

(and any revocation of the election 

under section 102(c) of the Act), is 

disregarded for purposes of determining 

whether the taxpayer is eligible to make 

a subsequent election under section 

631(a). A revocation under section 

102(c) of the Act will remain in effect 

until the first taxable year for which the 

taxpayer makes a new election under 

section 631(a). 

Commentators suggested that, if a 

taxpayer makes an election under 

section 631(a), section 199 should apply 

to any resulting section 1231 gain. A 

taxpayer that makes an election under 

section 631(a) reports the difference 

between the fair market value of the 

timber cut and its actual cost as section 

1231 gain. The proposed regulations do 

not adopt the suggestion because timber 

is real property, not tangible personal 

property, and the cutting of timber does 

not qualify under section 

199(c)(4)(A)(i)(I). In the case of a 

taxpayer who does not make an election 

under section 631(a), or a taxpayer who 

revokes an election under section 631(a) 

pursuant to section 102(c) of the Act, 

the cutting and sawing of timber 

produces lumber which qualifies as 

tangible personal property. The gross 

receipts derived by a taxpayer from the 

sale of lumber it produces qualify as 

DPGR (assuming all the other 

requirements of section 199(c) are met). 

Proposed Effective Date 

The regulations are proposed to be 

applicable to taxable years beginning 

after December 31, 2004. Section 199 

applies to taxable years of pass-thru 

entities beginning after December 31, 

2004. Accordingly, section 199 does not 

apply to taxable years of pass-thru 

entities beginning before January 1, 

2005. For example, assume a pass-thru 

entity has a taxable year beginning July 

1, 2004, and ending June 30, 2005, and 

the owners of the pass-thru entity have 

calendar taxable years. Because section 

199 first applies to the pass-thru entity 

for its taxable year beginning July 1, 

2005, the first taxable year in which an 

Federal Register / Vol. 70, No. 213 / Friday, November 4, 2005 / Proposed Rules 67239 

owner of the pass-thru entity will be 

eligible to claim a section 199 deduction 

for the owner’s allocable or pro rata 

share of items allocated or apportioned 

to the qualified production activities of 

the pass-thru entity will be the calendar 

year 2006. Conversely, assume that a 

pass-thru entity has a calendar taxable 

year beginning January 1, 2005, and has 

a short taxable year ending on June 30, 

2005, due to the termination of the 

entity. Assume the owners of that passthru entity have taxable years beginning 

July 1, 2004, and ending June 30, 2005. 

Because section 199 first applies to the 

owners for their taxable years beginning 

July 1, 2005, under § 1.199–8(g), the 

owners of the pass-thru entity will be 

ineligible to claim a section 199 

deduction for the owners’ allocable or 

pro rata share of items allocated or 

apportioned to the qualified production 

activities of the pass-thru entity for their 

taxable years ending June 30, 2005. 

Until the date final regulations are 

published in the Federal Register, the 

proposed regulations provide that 

taxpayers may rely on the rules set forth 

in the interim guidance on section 199 

as set forth in Notice 2005–14 (Notice) 

as well as the proposed regulations 

under §§ 1.199–1 through 1.199–8 

(proposed regulations). For this 

purpose, if the proposed regulations and 

the Notice include different rules for the 

same particular issue, then the taxpayer 

may rely on either the rule set forth in 

the proposed regulations or the rule set 

forth in the Notice. For example, the 

Notice and the proposed regulations 

both include the small business 

simplified overall method, however the 

eligibility requirements for the method 

under the Notice have been modified in 

the proposed regulations. Accordingly, a 

taxpayer may rely on the eligibility 

requirements for the method set forth in 

either the Notice or the proposed 

regulations. However, if the proposed 

regulations include a rule that was not 

included in the Notice, taxpayers are 

not permitted to rely on the absence of 

a rule to apply a rule contrary to the 

proposed regulations. For example, 

Notice 2005–14 does not include any 

rules regarding the treatment of hedging 

transactions whereas the proposed 

regulations include such rules. 

Accordingly, taxpayers are not 

permitted to treat hedging transactions 

contrary to the treatment provided in 

the proposed regulations. 

Request for Comments 

The IRS and Treasury Department 

invite taxpayers to submit comments on 

issues relating to section 199. The IRS 

and Treasury Department intend to 

finalize the proposed regulations as 

soon as possible so taxpayers will have 

the final regulations as they begin to 

prepare their 2005 Federal income tax 

returns. Accordingly, the IRS and 

Treasury Department encourage 

taxpayers to submit their comments by 

January 3, 2006 so they can be given 

proper consideration. In particular, the 

IRS and Treasury Department encourage 

taxpayers to submit comments on the 

following issues: 

1. Questions have arisen as to the 

applicability under section 199 of a 

Large and Mid-Size Business (LMSB) 

directive dated March 14, 2002, ‘‘Field 

Directive on the Use of Estimates from 

Probability Samples,’’ that authorizes in 

appropriate circumstances the use of 

statistical sampling by taxpayers. LMSB 

taxpayers are not precluded from 

applying the concepts of the LMSB 

directive for purposes of section 199. 

The proposed regulations do not 

provide specific rules on the use of 

statistical sampling for 199 purposes, 

however comments are requested on 

how taxpayers can apply statistical 

sampling to section 199, what specific 

areas of section 199 statistical sampling 

could be applied to, and whether 

application of statistical sampling 

should be limited to specific areas of 

section 199. 

2. Taxpayers are eligible to make 

certain elections under the section 861 

regulations. For example, § 1.861–

9T(g)(1)(ii) permits a taxpayer to elect to 

determine the value of its assets on the 

basis of either their tax book value or 

fair market value. Some of the elections 

under the section 861 regulations 

require the consent of the Commissioner 

to revoke or to change to another 

method. See §§ 1.861–8T(c)(2), 1.861–

9T(i)(2), and 1.861–17(e). Because the 

section 861 method requires certain 

taxpayers to use the rules of the section 

861 regulations in a new context, these 

taxpayers may want to reconsider 

previously made elections under those 

regulations. The IRS and Treasury 

Department intend to issue a revenue 

procedure granting taxpayers automatic 

consent to change certain elections 

under the section 861 regulations. 

Comments are requested concerning 

such an automatic consent procedure, 

including which elections should be 

included and the appropriate time 

period during which the automatic 

consent should apply. 

3. The IRS and Treasury Department 

note that there are special rules 

regarding the application of the section 

861 method in the case of affiliated 

groups. See section 864(e)(5) and (6); see 

also §§ 1.861–11(d)(7), 1.861–11T(d)(6), 

1.861–14(d) and 1.861–14T. Comments 

are requested regarding whether 

additional guidance is needed to clarify 

how the rules under §§ 1.861–11T(c) 

and (g) and 1.861–14T(c) apply under 

the section 861 method to allocate and 

apportion interest and other expenses 

such as research and experimentation 

expenses in computing QPAI of the 

members of such affiliated groups in 

which otherwise includible 

corporations are owned indirectly 

through foreign corporations and 

partnerships. 

4. Comments are requested 

concerning whether gross receipts 

derived from the provision of certain 

types of online software should qualify 

under section 199 as being derived from 

a lease, rental, license, sale, exchange, 

or other disposition of the software and, 

if so, how to distinguish between such 

types of online software. 

Special Analyses 

It has been determined that this notice 

of proposed rulemaking is not a 

significant regulatory action as defined 

in Executive Order 12866. Therefore, a 

regulatory assessment is not required. It 

has also been determined that section 

553(b) of the Administrative Procedure 

Act (5 U.S.C. chapter 5) does not apply. 

It is hereby certified that the collection 

of information in this regulation will not 

have a significant economic impact on 

a substantial number of small entities. 

This certification is based upon the fact 

that, as previously discussed, any 

burden on cooperatives is minimal. 

Accordingly, a Regulatory Flexibility 

Analysis under the Regulatory 

Flexibility Act (5 U.S.C. chapter 6) is 

not required. Pursuant to section 7805(f) 

of the Code, this notice of proposed 

rulemaking will be submitted to the 

Chief Counsel for Advocacy of the Small 

Business Administration for comment 

on their impact on small business. 

Comments and Public Hearing 

Before these proposed regulations are 

adopted as final regulations, 

consideration will be given to any 

written comments (a signed original and 

eight (8) copies) or electronic comments 

that are submitted timely to the IRS. 

Comments are requested on all aspects 

of the proposed regulations. In addition, 

the IRS and Treasury Department 

specifically request comments on the 

clarity of the proposed rules and how 

they can be made easier to understand. 

All comments will be available for 

public inspection and copying. 

A public hearing has been scheduled 

for Wednesday, January 11, 2006, at 10 

a.m. in the IRS Auditorium, Internal 

Revenue Building, 1111 Constitution 

Avenue, NW., Washington DC. Due to 

building security procedures, visitors 

67240 Federal Register / Vol. 70, No. 213 / Friday, November 4, 2005 / Proposed Rules 

must enter at the Constitution Avenue 

entrance. In addition, all visitors must 

present photo identification to enter the 

building. Because of access restrictions, 

visitors will not be admitted beyond the 

immediate entrance area more than 30 

minutes before the hearing starts. For 

information about having your name 

placed on the building access list to 

attend the hearing, see the FOR FURTHER

INFORMATION CONTACT section of this 

preamble. 

The rules of 26 CFR 601.601(a)(3) 

apply to the hearing. 

Persons who wish to present oral 

comments at the hearing must submit 

electronic or written comments and an 

outline of the topics to be discussed and 

the time to be devoted to each topic (a 

signed original and eight (8) copies) by 

December 21, 2005. A period of 10 

minutes will be allotted to each person 

for making comments. An agenda 

showing the scheduling of the speakers 

will be prepared after the deadline for 

receiving outlines has passed. Copies of 

the agenda will be available free of 

charge at the hearing. 

Drafting Information 

The principal authors of these 

regulations are Paul Handleman and 

Lauren Ross Taylor, Office of Associate 

Chief Counsel (Passthroughs and 

Special Industries), IRS. However, other 

personnel from the IRS and Treasury 

Department participated in their 

development. 

List of Subjects in 26 CFR Part 1 

Income taxes, Reporting and 

recordkeeping requirements. 

Proposed Amendments to the 

Regulations 

Accordingly, 26 CFR part 1 is 

proposed to be amended as follows: 

PART 1—INCOME TAXES 

Paragraph 1. The authority citation 

for part 1 is amended by adding entries 

in numerical order to read, in part, as 

follows: 

Authority: 26 U.S.C. 7805 * * * 

Section 1.199–1 also issued under 26 

U.S.C. 199(d). 

Section 1.199–2 also issued under 26 

U.S.C. 199(d). 

Section 1.199–3 also issued under 26 

U.S.C. 199(d). 

Section 1.199–4 also issued under 26 

U.S.C. 199(d). 

Section 1.199–5 also issued under 26 

U.S.C. 199(d). 

Section 1.199–6 also issued under 26 

U.S.C. 199(d). 

Section 1.199–7 also issued under 26 

U.S.C. 199(d). 

Section 1.199–8 also issued under 26 

U.S.C. 199(d). * * * 

Par. 2. Sections 1.199–0 through 

1.199–8 are added to read as follows: 

§ 1.199–0 Table of contents. 

This section lists the headings that 

appear in §§ 1.199–1 through 1.199–8. 

§ 1.199–1 Income attributable to domestic 

production activities. 

(a) In general. 

(b) Taxable income and adjusted gross 

income. 

(1) In general. 

(2) Examples. 

(c) Qualified production activities income. 

(1) In general. 

(2) Definition of item. 

(i) In general. 

(ii) Examples. 

(d) Allocation of gross receipts. 

(1) In general. 

(2) De minimis rule. 

(3) Examples. 

(e) Timing rules for determining QPAI. 

(1) Gross receipts and costs recognized in 

different taxable years. 

(2) Percentage of completion method. 

(3) Example. 

§ 1.199–2 Wage limitation. 

(a) Rules of application. 

(1) In general. 

(2) Wages paid by entity other than 

common law employer. 

(b) No application in determining whether 

amounts are wages for employment tax 

purposes. 

(c) Application in case of taxpayer with 

short taxable year. 

(d) Acquisition or disposition of a trade or 

business (or major portion). 

(e) Non-duplication rule. 

(f) Definition of W–2 wages. 

(1) In general. 

(2) Methods for calculating W–2 wages. 

(i) Unmodified box method. 

(ii) Modified Box 1 method. 

(iii) Tracking wages method. 

§ 1.199–3 Domestic production gross 

receipts. 

(a) In general. 

(b) Related persons. 

(1) In general. 

(2) Exceptions. 

(c) Definition of gross receipts. 

(d) Definition of manufactured, produced, 

grown, or extracted. 

(1) In general. 

(2) Packaging, repackaging, labeling, or 

minor assembly. 

(3) Installing. 

(4) Consistency with section 263A. 

(5) Examples. 

(e) Definition of by the taxpayer. 

(1) In general. 

(2) Special rule for certain government 

contracts. 

(3) Examples. 

(f) Definition of in whole or in significant 

part. 

(1) In general. 

(2) Substantial in nature. 

(3) Safe harbor. 

(4) Examples. 

(g) Definition of United States. 

(h) Definition of derived from the lease, 

rental, license, sale, exchange, or other 

disposition. 

(1) In general. 

(2) Examples. 

(3) Hedging transactions. 

(i) In general. 

(ii) Currency fluctuations. 

(iii) Other rules. 

(4) Allocation of gross receipts—embedded 

services and non-qualified property. 

(i) In general. 

(ii) Exceptions. 

(iii) Examples. 

(5) Advertising income. 

(i) Tangible personal property. 

(ii) Qualified films. 

(iii) Examples. 

(6) Computer software. 

(i) In general. 

(ii) Examples. 

(7) Exception for certain oil and gas 

partnerships. 

(i) In general. 

(ii) Example. 

(8) Partnerships owned by members of a 

single expanded affiliated group. 

(i) In general. 

(ii) Special rules for distributions from 

EAG partnerships. 

(iii) Examples. 

(9) Non-operating mineral interests. 

(i) Definition of qualifying production 

property. 

(1) In general. 

(2) Tangible personal property. 

(i) In general. 

(ii) Local law. 

(iii) Machinery. 

(iv) Intangible property. 

(3) Computer software. 

(i) In general. 

(ii) Incidental and ancillary rights. 

(iii) Exceptions. 

(4) Sound recordings. 

(i) In general. 

(ii) Exception. 

(5) Tangible personal property with 

computer software or sound recordings. 

(i) Computer software and sound 

recordings. 

(ii) Tangible personal property. 

(j) Definition of qualified film. 

(1) In general. 

(2) Tangible personal property with a film. 

(i) Film licensed by a taxpayer. 

(ii) Film produced by a taxpayer. 

(A) Qualified films. 

(B) Nonqualified films. 

(3) Derived from a qualified film. 

(4) Examples. 

(5) Compensation for services. 

(6) Determination of 50 percent. 

(7) Exception. 

(k) Electricity, natural gas, or potable 

water. 

(1) In general. 

(2) Natural gas. 

(3) Potable water. 

(4) Exceptions. 

(i) Electricity. 

(ii) Natural gas. 

(iii) Potable water. 

(iv) De minimis exception. 

(5) Example. 

Federal Register / Vol. 70, No. 213 / Friday, November 4, 2005 / Proposed Rules 67241 

(l) Definition of construction performed in 

the United States. 

(1) Construction of real property. 

(i) In general. 

(ii) De minimis exception. 

(2) Activities constituting construction. 

(3) Definition of infrastructure. 

(4) Definition of substantial renovation. 

(5) Derived from construction. 

(i) In general. 

(ii) Land safe harbor. 

(iii) Examples. 

(m) Definition of engineering and 

architectural services. 

(1) In general. 

(2) Engineering services. 

(3) Architectural services. 

(4) De minimis exception for performance 

of services in the United States. 

(n) Exception for sales of certain food and 

beverages. 

(1) In general. 

(2) Examples. 

§ 1.199–4 Costs allocable to domestic 

production gross receipts. 

(a) In general. 

(b) Cost of goods sold allocable to domestic 

production gross receipts. 

(1) In general. 

(2) Allocating cost of goods sold. 

(3) Special rules for imported items or 

services. 

(4) Rules for inventories valued at market 

or bona fide selling prices. 

(5) Rules applicable to inventories 

accounted for under the last-in, first-out 

(LIFO) inventory method. 

(i) In general. 

(ii) LIFO/FIFO ratio method. 

(iii) Change in relative base-year cost 

method. 

(6) Taxpayers using the simplified 

production method or simplified resale 

method for additional section 263A costs. 

(7) Examples. 

(c) Other deductions allocable or 

apportioned to domestic production gross 

receipts or gross income attributable to 

domestic production gross receipts. 

(1) In general. 

(2) Treatment of certain deductions. 

(i) In general. 

(ii) Net operating losses. 

(iii) Deductions not attributable to the 

conduct of a trade or business. 

(d) Section 861 method. 

(1) In general. 

(2) Deductions for charitable contributions. 

(3) Research and experimental 

expenditures. 

(4) Deductions related to gross receipts 

deemed to be domestic production gross 

receipts. 

(5) Examples. 

(e) Simplified deduction method. 

(1) In general. 

(2) Members of an expanded affiliated 

group. 

(i) In general. 

(ii) Exception. 

(iii) Examples. 

(f) Small business simplified overall 

method. 

(1) In general. 

(2) Qualifying small taxpayer. 

(3) Members of an expanded affiliated 

group. 

(i) In general. 

(ii) Exception. 

(iii) Examples. 

(4) Ineligible pass-thru entities. 

(g) Average annual gross receipts. 

(1) In general. 

(2) Members of an EAG. 

(h) Total assets. 

(1) In general. 

(2) Members of an EAG. 

(i) Total costs for the current taxable year. 

(1) In general. 

(2) Members of an EAG. 

§ 1.199–5 Application of section 199 to 

pass-thru entities. 

(a) Partnerships. 

(1) Determination at partner level. 

(2) Disallowed deductions. 

(3) Partner’s share of W–2 wages. 

(4) Examples. 

(b) S corporations. 

(1) Determination at shareholder level. 

(2) Disallowed deductions. 

(3) Shareholder’s share of W–2 wages. 

(c) Grantor trusts. 

(d) Non-grantor trusts and estates. 

(1) Computation of section 199 deduction. 

(2) Example. 

(e) Gain or loss from the disposition of an 

interest in a pass-thru entity. 

(f) Section 199(d)(1)(B) wage limitation and 

tiered structures. 

(1) In general. 

(2) Share of W–2 wages. 

(3) Example. 

(g) No attribution of qualified activities. 

§ 1.199–6 Agricultural and horticultural 

cooperatives. 

(a) In general. 

(b) Written notice to patrons. 

(c) Determining cooperative’s qualified 

production activities income. 

(d) Additional rules relating to passthrough of section 199 deduction. 

(e) W–2 wages. 

(f) Recapture of section 199 deduction. 

(g) Section is exclusive. 

(h) No double counting. 

(i) Examples. 

§ 1.199–7 Expanded affiliated groups. 

(a) In general. 

(1) Definition of expanded affiliated group. 

(2) Identification of members of an 

expanded affiliated group. 

(i) In general. 

(ii) Becoming or ceasing to be a member of 

an expanded affiliated group. 

(3) Attribution of activities. 

(4) Examples. 

(5) Anti-avoidance rule. 

(b) Computation of expanded affiliated 

group’s section 199 deduction. 

(1) In general. 

(2) Net operating loss carryovers. 

(c) Allocation of an expanded affiliated 

group’s section 199 deduction among 

members of the expanded affiliated group. 

(1) In general. 

(2) Use of section 199 deduction to create 

or increase a net operating loss. 

(d) Special rules for members of the same 

consolidated group. 

(1) Intercompany transactions. 

(2) Attribution of activities in the 

construction of real property and the 

performance of engineering and architectural 

services. 

(3) Application of the simplified deduction 

method and the small business simplified 

overall method. 

(4) Determining the section 199 deduction. 

(i) Expanded affiliated group consists of 

consolidated group and non-consolidated 

group members. 

(ii) Expanded affiliated group consists only 

of members of a single consolidated group. 

(5) Allocation of the section 199 deduction 

of a consolidated group among its members. 

(e) Examples. 

(f) Allocation of income and loss by a 

corporation that is a member of the expanded 

affiliated group for only a portion of the year. 

(1) In general. 

(i) Pro rata allocation method. 

(ii) Section 199 closing of the books 

method. 

(iii) Making the section 199 closing of the 

books election. 

(2) Coordination with rules relating to the 

allocation of income under § 1.1502–76(b). 

(g) Total section 199 deduction for a 

corporation that is a member of an expanded 

affiliated group for some or all of its taxable 

year. 

(1) Member of the same expanded affiliated 

group for the entire taxable year. 

(2) Member of the expanded affiliated 

group for a portion of the taxable year. 

(3) Example. 

(h) Computation of section 199 deduction 

for members of an expanded affiliated group 

with different taxable years. 

(1) In general. 

(2) Example. 

§ 1.199–8 Other rules. 

(a) Individuals. 

(b) Trade or business requirement. 

(c) Coordination with alternative minimum 

tax. 

(d) Nonrecognition transactions. 

(1) In general. 

(2) Section 1031 exchanges. 

(3) Section 381 transactions. 

(e) Taxpayers with a 52–53 week taxable 

year. 

(f) Section 481(a) adjustments. 

(g) Effective date. 

§ 1.199–1 Income attributable to domestic 

production activities. 

(a) In general. A taxpayer may deduct 

an amount equal to 9 percent (3 percent 

in the case of taxable years beginning in 

2005 or 2006, and 6 percent in the case 

of taxable years beginning in 2007, 

2008, or 2009) of the lesser of the 

taxpayer’s qualified production 

activities income (QPAI) (as defined in 

paragraph (c) of this section) for the 

taxable year, or the taxpayer’s taxable 

income for the taxable year (or, in the 

case of an individual, adjusted gross 

income). The amount of the deduction 

allowable under this paragraph (a) for 

any taxable year cannot exceed 50 

67242 Federal Register / Vol. 70, No. 213 / Friday, November 4, 2005 / Proposed Rules 

percent of the W–2 wages of the 

employer for the taxable year (as 

determined under § 1.199–2). 

(b) Taxable income and adjusted 

gross income—(1) In general. For 

purposes of paragraph (a) of this section, 

the definition of taxable income under 

section 63 applies and taxable income is 

determined without regard to section 

199. In the case of individuals, adjusted 

gross income for the taxable year is 

determined after applying sections 86, 

135, 137, 219, 221, 222, and 469, and 

without regard to section 199. For 

purposes of determining the tax 

imposed by section 511, paragraph (a) of 

this section is applied using unrelated 

business taxable income. For purposes 

of determining the amount of a net 

operating loss (NOL) carryback or 

carryover under section 172(b)(2), 

taxable income is determined without 

regard to the deduction allowed under 

section 199. 

(2) Examples. The following examples 

illustrate the application of this 

paragraph (b): 

Example 1. (i) Facts. X, a United States 

corporation that is not part of an expanded 

affiliated group (EAG) (as defined in § 1.199–

7), engages in production activities that 

generate QPAI and taxable income (without 

taking into account the deduction under this 

section) of $600 in 2010. During 2010, × 

incurs W–2 wages of $300. × has an NOL 

carryover to 2010 of $500. X’s deduction 

under this section for 2010 is $9 (.09 × (lesser 

of QPAI of $600 and taxable income of $100) 

subject to the wage limitation of $150 (50% 

× $300)). 

Example 2. (i) Facts. X, a United States 

corporation that is not part of an EAG, 

engages in production activities that generate 

QPAI and taxable income (without taking 

into account the deduction under this section 

and an NOL deduction) of $100 in 2010. X 

has an NOL carryover to 2010 of $500. X’s 

deduction under this section for 2010 is $0 

(.09 × (lesser of QPAI of $100 and taxable 

income of $0)). 

(ii) Carryover to 2011. X’s taxable income 

for purposes of determining its NOL 

carryover to 2011 is $100. Accordingly, X’s 

NOL carryover to 2011 is $400 ($500 NOL 

carryover to 2010—$100 NOL used in 2010). 

(c) Qualified production activities 

income—(1) In general. QPAI for any 

taxable year is an amount equal to the 

excess (if any) of the taxpayer’s 

domestic production gross receipts 

(DPGR) over the sum of the cost of 

goods sold (CGS) that is allocable to 

such receipts, other deductions, 

expenses, or losses (collectively, 

deductions) directly allocable to such 

receipts, and a ratable portion of 

deductions that are not directly 

allocable to such receipts or another 

class of income. See §§ 1.199–3 and 

1.199–4. For purposes of this paragraph 

(c), QPAI is determined on an item-byitem basis (and not, for example, on a 

division-by-division, product line-byproduct line, or transaction-bytransaction basis) and is the sum of 

QPAI derived by the taxpayer from each 

item (as defined in paragraph (c)(2) of 

this section). For purposes of this 

determination, QPAI from each item 

may be positive or negative. DPGR and 

its related CGS and deductions must be 

included in the QPAI computation 

regardless of whether, when viewed in 

isolation, the DPGR exceeds the CGS 

and deductions allocated and 

apportioned thereto. For example, if a 

taxpayer has $3 of QPAI from the sale 

of a shirt and derives ($1) of QPAI from 

the sale of a hat, the taxpayer’s QPAI is 

$2. 

(2) Definition of item—(i) In general. 

Except as otherwise provided in this 

paragraph, the term item means, for 

purposes of §§ 1.199–1 through 1.199–8, 

the property offered for sale to 

customers that meets all of the 

requirements under this section and 

§ 1.199–3. If the property offered for sale 

does not meet these requirements, a 

taxpayer must treat as the item any 

portion of the property offered for sale 

that meets these requirements. However, 

in no case shall the portion of the 

property offered for sale that is treated 

as the item exclude any other portion 

that meets these requirements. In no 

event may an item consist of two or 

more properties offered for sale that are 

not packaged and sold together as one 

item. In addition, in the case of property 

customarily sold by weight or by 

volume, the item is determined using 

the custom of the industry (for example, 

barrels of oil). In the case of 

construction (as defined in § 1.199–

3(l)(1)) or engineering and architectural 

services (as defined in § 1.199–3(m)(1)), 

a taxpayer may use any reasonable 

method, taking into account all of the 

facts and circumstances, to determine 

what construction activities and 

engineering or architectural services 

constitute an item. 

(ii) Examples. The following 

examples illustrate the application of 

paragraph (c)(2)(i) of this section: 

Example 1. X manufactures leather and 

rubber shoe soles in the United States. X 

imports shoe uppers, which are the parts of 

the shoe above the sole. X manufactures 

shoes for sale by sewing or otherwise 

attaching the soles to the imported uppers. If 

the shoes do not meet the requirements 

under this section and § 1.199–3, then under 

paragraph (c)(2)(i) of this section, X must 

treat the sole as the item if the sole meets the 

requirements under this section and § 1.199–

3. 

Example 2. The facts are the same as in 

Example 1 except that X also buys some 

finished shoes from unrelated parties and 

resells them to retail shoe stores. X sells 

shoes in individual pairs. X ships the shoes 

in boxes, each box containing 50 pairs of 

shoes, some of which X manufactured, and 

some of which X purchased. X cannot treat 

a box of 50 pairs of shoes as an item, because 

the box of shoes is not sold at retail. 

Example 3. Y manufactures toy cars in the 

United States. Y also purchases cars that 

were manufactured by unrelated parties. In 

addition to packaging some cars individually, 

Y also packages some cars in sets of three. 

Some of the cars in the sets may have been 

manufactured by Y and some may have been 

purchased. The three-car packages are sold 

by toy stores at retail. Y must treat each 

three-car package as the item. However, if the 

three-car package does not meet the 

requirements under this section and § 1.199–

3, Y must treat a toy car in the three-car 

package as the item, provided the toy car 

meets the requirements under this section 

and § 1.199–3. 

Example 4. The facts are the same as 

Example 3 except that the toy store follows 

Y’s recommended pricing arrangement for 

the individual toy cars for sale to customers 

at three for $10. Frequently, this results in 

retail customers purchasing three individual 

cars in one transaction. Y must treat each toy 

car as an item and cannot treat three 

individual toy cars as one item, because the 

individual toy cars are not packaged together 

for retail sale. 

Example 5. Z produces in bulk form in the 

United States the active ingredient for a 

pharmaceutical product. Z sells the active 

ingredient in bulk form to FX, a foreign 

corporation. This sale qualifies as DPGR 

assuming all the other requirements of this 

section and § 1.199–3 are met. FX uses the 

active ingredient to produce the finished 

dosage form drug. FX sells the drug in 

finished dosage to Z, which sells the drug to 

customers. Under paragraph (c)(2)(i) of this 

section, if the finished dosage does not meet 

the requirements under this section and 

§ 1.199–3, Z must treat the active ingredient 

portion as the item if the ingredient meets the 

requirements under this section and § 1.199–

3. 

(d) Allocation of gross receipts—(1) In 

general. A taxpayer must determine the 

portion of its gross receipts that is DPGR 

and the portion of its gross receipts that 

is non-DPGR. Applicable Federal 

income tax principles apply to 

determine whether a transaction is, in 

substance, a lease, rental, license, sale, 

exchange or other disposition, or 

whether it is a service (or some 

combination thereof). For example, if a 

taxpayer leases, rents, licenses, sells, 

exchanges, or otherwise disposes of 

qualifying production property (QPP) 

(as defined in § 1.199–3(i)(1)), the gross 

receipts of which constitute DPGR, and 

engages in transactions with respect to 

similar property, the gross receipts of 

which do not constitute DPGR, the 

taxpayer must allocate its gross receipts 

from all the transactions based on a 

reasonable method that is satisfactory to 

the Secretary based on all of the facts 

Federal Register / Vol. 70, No. 213 / Friday, November 4, 2005 / Proposed Rules 67243 

and circumstances and that accurately 

identifies the gross receipts that 

constitute DPGR. Factors taken into 

consideration in determining whether 

the method is reasonable include 

whether the taxpayer uses the most 

accurate information available; the 

relationship between the gross receipts 

and the method chosen; the accuracy of 

the method chosen as compared with 

other possible methods; whether the 

method is used by the taxpayer for 

internal management or other business 

purposes; whether the method is used 

for other Federal or state income tax 

purposes; the time, burden, and cost of 

using various methods; and whether the 

taxpayer applies the method 

consistently from year to year. Thus, if 

a taxpayer can, without undue burden 

or expense, specifically identify where 

an item was manufactured, or if the 

taxpayer uses a specific identification 

method for other purposes, then the 

taxpayer must use that specific 

identification method to determine 

DPGR. If a taxpayer does not use a 

specific identification method for other 

purposes and cannot, without undue 

burden or expense, use a specific 

identification method, then the taxpayer 

is not required to use a specific 

identification method to determine 

DPGR. 

(2) De minimis rule. All of a 

taxpayer’s gross receipts may be treated 

as DPGR if less than 5 percent of the 

taxpayer’s total gross receipts are nonDPGR (after application of exceptions 

provided in § 1.199–3(h)(4), (k)(4)(iv), 

(l)(1)(ii), (m)(4), and (n)(1) that result in 

gross receipts being treated as DPGR). If 

the amount of the taxpayer’s gross 

receipts that do not qualify as DPGR 

equals or exceeds 5 percent of the 

taxpayer’s total gross receipts, the 

taxpayer is required to allocate all gross 

receipts between DPGR and non-DPGR 

in accordance with paragraph (d)(1) of 

this section. If a corporation is a 

member of an EAG or a consolidated 

group, the determination of whether less 

than 5 percent of the taxpayer’s total 

gross receipts are non-DPGR is made at 

the corporation level rather than at the 

EAG or consolidated group level, as 

applicable. In the case of an S 

corporation, partnership, estate or trust, 

or other pass-thru entity, the 

determination of whether less than 5 

percent of the pass-thru entity’s total 

gross receipts are non-DPGR is made at 

the pass-thru entity level. In the case of 

an owner of a pass-thru entity, the 

determination of whether less than 5 

percent of the owner’s total gross 

receipts are non-DPGR is made at the 

owner level, taking into account all 

gross receipts earned by the owner from 

its activities as well as the owner’s share 

of any pass-thru entity’s gross receipts. 

(3) Examples. The following examples 

illustrate the application of this 

paragraph (d): 

Example 1. X derives its gross receipts 

from the sale of gasoline refined by X within 

the United States and the sale of refined 

gasoline that X acquired (either by purchase 

or in a taxable exchange for gasoline refined 

by X in the United States) from an unrelated 

party. X does not commingle the gasoline. X 

must allocate its gross receipts between the 

gross receipts attributable to the gasoline 

refined by X in the United States (that qualify 

as DPGR if all the other requirements of 

§ 1.199–3 are met) and X’s gross receipts 

derived from the resale of the acquired 

gasoline (that do not qualify as DPGR) if 5 

percent or more of X’s total gross receipts are 

not from the sale of gasoline refined by X 

within the United States. 

Example 2. X manufactures the same type 

of QPP at facilities within the United States 

and outside the United States which are sold 

separately. X must allocate its gross receipts 

between the receipts from the QPP 

manufactured within the United States and 

receipts from the QPP not manufactured 

within the United States if 5 percent or more 

of X’s total gross receipts are not from the 

sale of QPP manufactured by X within the 

United States. 

(e) Timing rules for determining 

QPAI—(1) Gross receipts and costs 

recognized in different taxable years. If 

a taxpayer recognizes and reports on a 

Federal income tax return gross receipts 

that the taxpayer identifies as DPGR, 

then the taxpayer must treat the CGS 

and deductions related to such receipts 

as relating to DPGR, regardless of 

whether such receipts ultimately qualify 

as DPGR. Similarly, if a taxpayer pays 

or incurs and reports on a Federal 

income tax return CGS or deductions 

and identifies such CGS or deductions 

as relating to DPGR, then the taxpayer 

must treat the gross receipts related to 

such CGS or deductions as DPGR, 

regardless of whether such receipts 

ultimately qualify as DPGR. Similar 

rules apply if the taxpayer recognizes 

and reports on a Federal income tax 

return gross receipts that the taxpayer 

identifies as non-DPGR, or pays or 

incurs and reports on a Federal income 

tax return CGS or deductions that the 

taxpayer identifies as relating to nonDPGR. The determination of whether 

gross receipts qualify as DPGR or nonDPGR, and whether CGS or deductions 

relate to DPGR or non-DPGR, must be 

made in accordance with the rules 

provided in §§ 1.199–1 through 1.199–8, 

as applicable. If the gross receipts are 

recognized in an intercompany 

transaction within the meaning of 

§ 1.1502–13, see also § 1.199–7(d). See 

§ 1.199–4 for allocation and 

apportionment of CGS and deductions. 

(2) Percentage of completion method. 

A taxpayer using the percentage of 

completion method under section 460 

must determine the ratio of DPGR and 

non-DPGR using a reasonable method 

that accurately identifies the gross 

receipts that constitute DPGR. See 

paragraph (d)(1) of this section for the 

factors taken into consideration in 

determining whether the taxpayer’s 

method is reasonable. 

(3) Example. The following example 

illustrates the application of paragraph 

(e)(1) of this section: 

Example. X, a calendar year accrual 

method taxpayer, enters into a contract with 

Y, an unrelated person, in 2005 for the sale 

of QPP. In 2005, X receives an advance 

payment from Y for the QPP. In 2006, X 

manufactures the QPP within the United 

States and delivers the QPP to Y. X’s method 

of accounting requires X to include the entire 

advance payment in its gross income for 

Federal income tax purposes in 2005. 

Assuming X can determine, using any 

reasonable method, that all the requirements 

of this section and § 1.199–3 will be met, the 

advance payment qualifies as DPGR in 2005. 

The CGS and deductions relating to the QPP 

under the contract are taken into account 

under § 1.199–4 in determining X’s QPAI in 

2006, the taxable year the CGS and 

deductions are otherwise deductible for 

Federal income tax purposes and must be 

treated as relating to DPGR in that taxable 

year. 

§ 1.199–2 Wage limitation. 

(a) Rules of application—(1) In 

general. The amount of the deduction 

allowable under § 1.199–1(a) (section 

199 deduction) to a taxpayer for any 

taxable year shall not exceed 50 percent 

of the W–2 wages of the taxpayer. For 

this purpose, except as provided in 

paragraph (c) of this section, the Forms 

W–2, ‘‘Wage and Tax Statement,’’ used 

in determining the amount of W–2 

wages are those issued for the calendar 

year ending during the taxpayer’s 

taxable year for wages paid to 

employees (or former employees) of the 

taxpayer for employment by the 

taxpayer. For purposes of this section, 

employees of the taxpayer are limited to 

employees of the taxpayer as defined in 

section 3121(d)(1) and (2) (that is, 

officers of a corporate taxpayer and 

employees of the taxpayer under the 

common law rules). For purposes of 

section 199(b)(2) and this section, the 

term taxpayer means employer. 

(2) Wages paid by entity other than 

common law employer. In determining 

W–2 wages, a taxpayer may take into 

account any wages paid by another 

entity and reported by the other entity 

on Forms W–2 with the other entity as 

67244 Federal Register / Vol. 70, No. 213 / Friday, November 4, 2005 / Proposed Rules 

the employer listed in Box c of the 

Forms W–2, provided that the wages 

were paid to employees of the taxpayer 

for employment by the taxpayer. If the 

taxpayer is treated as an employer 

described in section 3401(d)(1) because 

of control of the payment of wages (that 

is, the taxpayer is not the common law 

employer of the payee of the wages), the 

payment of wages may not be included 

in determining W–2 wages of the 

taxpayer. If the taxpayer is paying wages 

as an agent of another entity to 

individuals who are not employees of 

the taxpayer, the wages may not be 

included in determining the W–2 wages 

of the taxpayer. 

(b) No application in determining 

whether amounts are wages for 

employment tax purposes. The 

discussion of wages in this section is for 

purposes of section 199 only and has no 

application in determining whether 

amounts are wages under section 

3121(a) for purposes of the Federal 

Insurance Contributions Act (FICA), 

under section 3306(b) for purposes of 

the Federal Unemployment Tax Act 

(FUTA), under section 3401(a) for 

purposes of the Collection of Income 

Tax at Source on Wages (Federal income 

tax withholding), or any other wage 

related determination. 

(c) Application in case of taxpayer 

with short taxable year. In the case of a 

taxpayer with a short taxable year, 

subject to the rules of paragraph (a) of 

this section, the W–2 wages of the 

taxpayer for the short taxable year shall 

include those wages paid during the 

short taxable year to employees of the 

taxpayer as determined under the 

tracking wages method described in 

paragraph (f)(2)(iii) of this section. In 

applying the tracking wages method in 

the case of a short taxable year, the 

taxpayer must apply the method as 

follows—

(1) In paragraph (f)(2)(iii)(A) of this 

section, the total amount of wages 

subject to Federal income tax 

withholding and reported on Form W–

2 must include only those wages subject 

to Federal income tax withholding that 

are actually paid to employees during 

the short taxable year and reported on 

Form W–2 for the calendar year ending 

within that short taxable year; 

(2) In paragraph (f)(2)(iii)(B) of this 

section, only the supplemental 

unemployment benefits paid during the 

short taxable year that were included in 

the total in paragraph (f)(2)(iii)(A) of this 

section as modified by paragraph (c)(1) 

of this section are required to be 

deducted; and 

(3) In paragraph (f)(2)(iii)(C) of this 

section, only the portion of the amounts 

reported in Box 12, Codes D, E, F, G, 

and S, on Forms W–2, that are actually 

deferred or contributed during the short 

taxable year may be included in W–2 

wages. 

(d) Acquisition or disposition of a 

trade or business (or major portion). If 

a taxpayer (a successor) acquires a trade 

or business, the major portion of a trade 

or business, or the major portion of a 

separate unit of a trade or business from 

another taxpayer (a predecessor), then, 

for purposes of computing the 

respective section 199 deduction of the 

successor and of the predecessor, the 

W–2 wages paid for that calendar year 

shall be allocated between the successor 

and the predecessor based on whether 

the wages are for employment by the 

successor or for employment by the 

predecessor. Thus, in this situation, the 

W–2 wages are allocated based on 

whether the wages are for employment 

for a period during which the employee 

was employed by the predecessor or for 

employment for a period during which 

the employee was employed by the 

successor, regardless of which 

permissible method for Form W–2 

reporting is used. 

(e) Non-duplication rule. Amounts 

that are treated as W–2 wages for a 

taxable year under any method may not 

be treated as W–2 wages of any other 

taxable year. Also, an amount may not 

be treated as W–2 wages by more than 

one taxpayer. 

(f) Definition of W–2 wages—(1) In 

general. Section 199(b)(2) defines W–2 

wages for purposes of section 199(b)(1) 

as the sum of the amounts required to 

be included on statements under section 

6051(a)(3) and (8) with respect to 

employment of employees of the 

taxpayer for the calendar year. Thus, the 

term W–2 wages includes the total 

amount of wages as defined in section 

3401(a); the total amount of elective 

deferrals (within the meaning of section 

402(g)(3)); the compensation deferred 

under section 457; and for taxable years 

beginning after December 31, 2005, the 

amount of designated Roth 

contributions (as defined in section 

402A). Under the 2004 and 2005 Form 

W–2, the elective deferrals under 

section 402(g)(3) and the amounts 

deferred under section 457 directly 

correlate to coded items reported in Box 

12 on Form W–2. Box 12, Code D, is for 

elective deferrals to a section 401(k) 

cash or deferred arrangement; Box 12, 

Code E, is for elective deferrals under a 

section 403(b) salary reduction 

agreement; Box 12, Code F, is for 

elective deferrals under a section 

408(k)(6) salary reduction Simplified 

Employee Pension (SEP); Box 12, Code 

G, is for elective deferrals under a 

section 457(b) plan; and Box 12, Code 

S, is for employee salary reduction 

contributions under a section 408(p) 

SIMPLE (simple retirement account). 

(2) Methods for calculating W–2 

wages. For any taxable year, taxpayers 

may use one of three methods in 

calculating W–2 wages. These three 

methods are subject to the nonduplication rule provided in paragraph 

(e) of this section, and the tracking 

wages method is subject to the rule 

provided in paragraph (c) of this 

section, if applicable. 

(i) Unmodified box method. Under the 

Unmodified box method, W–2 wages are 

calculated by taking, without 

modification, the lesser of—

(A) The total entries in Box 1 of all 

Forms W–2 filed with the Social 

Security Administration (SSA) by the 

taxpayer with respect to employees of 

the taxpayer for employment by the 

taxpayer; or 

(B) The total entries in Box 5 of all 

Forms W–2 filed with the SSA by the 

taxpayer with respect to employees of 

the taxpayer for employment by the 

taxpayer. 

(ii) Modified Box 1 method. Under the 

Modified Box 1 method, the taxpayer 

makes modifications to the total entries 

in Box 1 of Forms W–2 filed with 

respect to employees of the taxpayer. 

W–2 wages under this method are 

calculated as follows—

(A) Total the amounts in Box 1 of all 

Forms W–2 filed with the SSA by the 

taxpayer with respect to employees of 

the taxpayer for employment by the 

taxpayer; 

(B) Subtract from the total in 

paragraph (f)(2)(ii)(A) of this section 

amounts included in Box 1 of Forms W–

2 that are not wages for Federal income 

tax withholding purposes and amounts 

included in Box 1 of Forms W–2 that are 

treated as wages under section 3402(o) 

(for example, supplemental 

unemployment benefits); and 

(C) Add to the amount obtained after 

paragraph (f)(2)(ii)(B) of this section 

amounts that are reported in Box 12 of 

Forms W–2 with respect to employees 

of the taxpayer for employment by the 

taxpayer and that are properly coded D, 

E, F, G, or S. 

(iii) Tracking wages method. Under 

the Tracking wages method, the 

taxpayer actually tracks total wages 

subject to Federal income tax 

withholding and makes appropriate 

modifications. W–2 wages under this 

method are calculated as follows—

(A) Total the amounts of wages 

subject to Federal income tax 

withholding that are paid to employees 

of the taxpayer for employment by the 

taxpayer and that are reported on Forms 

Federal Register / Vol. 70, No. 213 / Friday, November 4, 2005 / Proposed Rules 67245 

W–2 filed with the SSA by the taxpayer 

for the calendar year; 

(B) Subtract from the total in 

paragraph (f)(2)(iii)(A) of this section the 

supplemental unemployment 

compensation benefits (as defined in 

section 3402(o)(2)(A)) that were 

included in the total in paragraph 

(f)(2)(iii)(A) of this section; and 

(C) Add to the amount obtained after 

paragraph (f)(2)(iii)(B) of this section 

amounts that are reported in Box 12 of 

Forms W–2 with respect to employees 

of the taxpayer for employment by the 

taxpayer and that are properly coded D, 

E, F, G, or S. 

§ 1.199–3 Domestic production gross 

receipts. 

(a) In general. Domestic production 

gross receipts (DPGR) are the gross 

receipts (as defined in paragraph (c) of 

this section) of the taxpayer that are 

derived from (as defined in paragraph 

(h) of this section)—

(1) Any lease, rental, license, sale, 

exchange, or other disposition of—

(i) Qualifying production property 

(QPP) (as defined in paragraph (i)(1) of 

this section) that is manufactured, 

produced, grown, or extracted (MPGE) 

(as defined in paragraph (d) of this 

section) by the taxpayer (as defined in 

paragraph (e) of this section) in whole 

or in significant part (as defined in 

paragraph (f) of this section) within the 

United States (as defined in paragraph 

(g) of this section); 

(ii) Any qualified film (as defined in 

paragraph (j) of this section) produced 

by the taxpayer (in accordance with 

paragraph (j) of this section); or 

(iii) Electricity, natural gas, or potable 

water (as defined in paragraph (k) of this 

section) (collectively, utilities) produced 

by the taxpayer in the United States (in 

accordance with paragraph (k) of this 

section); 

(2) Construction (as defined in 

paragraph (l) of this section) performed 

in the United States (in accordance with 

paragraph (l) of this section); or 

(3) Engineering or architectural 

services (as defined in paragraph (m) of 

this section) performed in the United 

States for construction projects in the 

United States (in accordance with 

paragraph (m) of this section). 

(b) Related persons—(1) In general. 

DPGR does not include any gross 

receipts of the taxpayer derived from 

property leased, licensed, or rented by 

the taxpayer for use by any related 

person. A person is treated as related to 

another person if both persons are 

treated as a single employer under 

either section 52(a) or (b) (without 

regard to section 1563(b)), or section 

414(m) or (o). 

(2) Exceptions. Paragraph (b)(1) of this 

section does not apply to any QPP or 

qualified films leased or rented by the 

taxpayer to a related person if the QPP 

or qualified films are held for sublease 

or rent, or are subleased or rented, by 

the related person to an unrelated 

person for the ultimate use of the 

unrelated person. Similarly, paragraph 

(b)(1) of this section does not apply to 

the license of QPP or qualified films to 

a related person for reproduction and 

sale, exchange, lease, rental or 

sublicense to an unrelated person for 

the ultimate use of the unrelated person. 

(c) Definition of gross receipts. The 

term gross receipts means the taxpayer’s 

receipts for the taxable year that are 

recognized under the taxpayer’s 

methods of accounting used for Federal 

income tax purposes for the taxable 

year. If the gross receipts are recognized 

in an intercompany transaction within 

the meaning of § 1.1502–13, see also 

§ 1.199–7(d). For this purpose, gross 

receipts include total sales (net of 

returns and allowances) and all amounts 

received for services. In addition, gross 

receipts include any income from 

investments and from incidental or 

outside sources. For example, gross 

receipts include interest (including 

original issue discount and tax-exempt 

interest within the meaning of section 

103), dividends, rents, royalties, and 

annuities, regardless of whether the 

amounts are derived in the ordinary 

course of the taxpayer’s trade of 

business. Gross receipts are not reduced 

by cost of goods sold (CGS) or by the 

cost of property sold if such property is 

described in section 1221(a)(1), (2), (3), 

(4), or (5). Gross receipts do not include 

the amounts received in repayment of a 

loan or similar instrument (for example, 

a repayment of the principal amount of 

a loan held by a commercial lender) 

and, except to the extent of gain 

recognized, do not include gross 

receipts derived from a non-recognition 

transaction, such as a section 1031 

exchange. Finally, gross receipts do not 

include amounts received by the 

taxpayer with respect to sales tax or 

other similar state and local taxes if, 

under the applicable state or local law, 

the tax is legally imposed on the 

purchaser of the good or service and the 

taxpayer merely collects and remits the 

tax to the taxing authority. If, in 

contrast, the tax is imposed on the 

taxpayer under the applicable law, then 

gross receipts include the amounts 

received that are allocable to the 

payment of such tax. 

(d) Definition of manufactured, 

produced, grown, or extracted—(1) In 

general. Except as provided in 

paragraphs (d)(2) and (3) of this section, 

the term MPGE includes manufacturing, 

producing, growing, extracting, 

installing, developing, improving, and 

creating QPP; making QPP 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. The term 

MPGE also includes storage, handling, 

or other processing activities (other than 

transportation activities) within the 

United States related to the sale, 

exchange, or other disposition of 

agricultural products, provided the 

products are consumed in connection 

with, or incorporated into, the MPGE of 

QPP whether or not by the taxpayer. 

The taxpayer must have the benefits and 

burdens of ownership of the QPP under 

Federal income tax principles during 

the period the MPGE activity occurs, 

pursuant to paragraph (e)(1) of this 

section, in order for gross receipts 

derived from the MPGE of QPP to 

qualify as DPGR. 

(2) Packaging, repackaging, labeling, 

or minor assembly. If a taxpayer 

packages, repackages, labels, or 

performs minor assembly of QPP and 

the taxpayer engages in no other MPGE 

activity with respect to that QPP, the 

taxpayer’s packaging, repackaging, 

labeling, or minor assembly do not 

qualify as MPGE. 

(3) Installing. If a taxpayer installs an 

item of QPP and engages in no other 

MPGE with respect to the QPP, the 

taxpayer’s installing activity does not 

qualify as MPGE. However, if the 

taxpayer installs an item of QPP MPGE 

by the taxpayer, and the taxpayer has 

the benefits and burdens of ownership 

of the item of QPP under Federal 

income tax principles during the period 

the installing activity occurs, the 

portion of the installing activity that 

relates to the item of QPP is MPGE. 

(4) Consistency with section 263A. A 

taxpayer that has MPGE QPP for the 

taxable year should treat itself as a 

producer under section 263A with 

respect to the QPP for the taxable year 

unless the taxpayer is not subject to 

section 263A. A taxpayer that currently 

is not properly accounting for its 

production activities under section 

263A, and wishes to change its method 

of accounting to comply with the 

producer requirements of section 263A, 

must follow the applicable 

administrative procedures issued under 

§ 1.446–1(e)(3)(ii) for obtaining the 

Commissioner’s consent to a change in 

accounting method (for further 

guidance, for example, see Rev. Proc. 

97–27 (1997–1 C.B. 680), or Rev. Proc. 

67246 Federal Register / Vol. 70, No. 213 / Friday, November 4, 2005 / Proposed Rules 

2002–9 (2002–1 C.B. 327), whichever 

applies (see § 601.601(d)(2) of this 

chapter)). 

(5) Examples. The following examples 

illustrate the application of this 

paragraph (d): 

Example 1. A, B, and C are unrelated 

taxpayers and are not cooperatives to which 

Part I of subchapter T of the Internal Revenue 

Code applies. A owns grain storage bins in 

the United States in which it stores for a fee 

B’s agricultural products that were grown in 

the United States. B sells its agricultural 

products to C. C processes B’s agricultural 

products into refined agricultural products in 

the United States. The gross receipts from 

A’s, B’s, and C’s activities are DPGR from the 

MPGE of QPP. 

Example 2. The facts are the same as in 

Example 1 except that B grows the 

agricultural products outside the United 

States and C processes B’s agricultural 

products into refined agricultural products 

outside the United States. Pursuant to 

paragraph (d)(1) of this section, the gross 

receipts derived by A are DPGR from the 

MPGE of QPP within the United States. B’s 

and C’s respective activities occur outside the 

United States and, therefore, their respective 

gross receipts are non-DPGR. 

Example 3. Y is hired to reconstruct and 

refurbish unrelated customers’ tangible 

personal property. As part of the 

reconstruction and refurbishment, Y installs 

purchased replacement parts in the 

customers’ property. Y’s installation of 

purchased replacement parts does not qualify 

as MPGE pursuant to paragraph (d)(3) of this 

section because Y did not MPGE the 

replacement parts. 

Example 4. The facts are the same as in 

Example 3 except that Y manufactures the 

replacement parts it uses for the 

reconstruction and refurbishment of 

customers’ tangible personal property. Y has 

the benefits and burdens of ownership of the 

replacement parts during the reconstruction 

and refurbishment activity and while 

installing the parts. Y’s gross receipts from 

the MPGE of the replacement parts and Y’s 

gross receipts from the installation of the 

replacement parts, which is an MPGE activity 

pursuant to paragraph (d)(3) of this section, 

are DPGR. 

Example 5. Z MPGE QPP within the 

United States. The following activities are 

performed by Z as part of the MPGE of the 

QPP while Z has the benefits and burdens of 

ownership under Federal income tax 

principles: materials analysis and selection, 

subcontractor inspections and qualifications, 

testing of component parts, assisting 

customers in their review and approval of the 

QPP, routine production inspections, product 

documentation, diagnosis and correction of 

system failure, and packaging for shipment to 

customers. Because Z MPGE the QPP, these 

activities performed by Z are part of the 

MPGE of the QPP. 

Example 6. X purchases automobiles from 

unrelated parties and customizes them by 

adding ground effects, spoilers, custom 

wheels, specialized paint and decals, 

sunroofs, roof racks, and similar accessories. 

X does not manufacture any of the 

accessories. X’s activity is minor assembly 

under paragraph (d)(2) of this section which 

is not an MPGE activity. 

Example 7. The facts are the same as in 

Example 6 except that X manufactures some 

of the accessories it adds to the automobiles. 

Pursuant to § 1.199–1(c)(2), if an automobile 

with accessories does not meet the 

requirements for being an item, X must treat 

each accessory that it manufactures as an 

item for purposes of determining whether X 

MPGE the item in whole or in significant part 

within the United States under paragraph 

(f)(1) of this section and whether the 

installation of the item is MPGE under 

paragraph (d)(3) of this section. 

Example 8. Y manufactures furniture in 

the United States that it sells to unrelated 

persons. Y also engraves customers’ names 

on pens and pencils purchased from 

unrelated persons and sells the pens and 

pencils to such customers. Although Y’s sales 

of furniture qualify as DPGR if all the other 

requirements of this section are met, Y’s sales 

of the engraved pens and pencils do not 

qualify as DPGR because Y does not MPGE 

the pens and pencils. 

(e) Definition of by the taxpayer—(1) 

In general. With the exception of the 

rules applicable to an expanded 

affiliated group (EAG) under § 1.199–7, 

certain oil and gas partnerships under 

paragraph (h)(7) of this section, EAG 

partnerships under paragraph (h)(8) of 

this section, and government contracts 

in paragraph (e)(2) of this section, only 

one taxpayer may claim the deduction 

under § 1.199–1(a) with respect to any 

qualifying activity under paragraph 

(d)(1) of this section performed in 

connection with the same QPP, or the 

production of qualified films or utilities. 

If one taxpayer performs a qualifying 

activity under paragraph (d)(1), (j)(1), or 

(k)(1) of this section pursuant to a 

contract with another party, then only 

the taxpayer that has the benefits and 

burdens of ownership of the property 

under Federal income tax principles 

during the period the qualifying activity 

occurs is treated as engaging in the 

qualifying activity. 

(2) Special rule for certain 

government contracts. QPP, qualified 

films, or utilities will be treated as 

MPGE or otherwise produced by the 

taxpayer notwithstanding the 

requirements of paragraph (e)(1) of this 

section if—

(i) The QPP, qualified films, or 

utilities are MPGE or otherwise 

produced by the taxpayer pursuant to a 

contract with the Federal government; 

and 

(ii) The Federal Acquisition 

Regulation (48 CFR) requires that title or 

risk of loss with respect to the QPP, 

qualified films, or utilities be transferred 

to the Federal government before the 

MPGE of the QPP, or the production of 

the qualified films or utilities, is 

complete. 

(3) Examples. The following examples 

illustrate the application of this 

paragraph (e): 

Example 1. X designs machines that it 

uses in its trade or business. X contracts with 

Y, an unrelated taxpayer, for the manufacture 

of the machines. The contract between X and 

Y is a fixed-price contract. The contract 

specifies that the machines will be 

manufactured in the United States using X’s 

design. X owns the intellectual property 

attributable to the design and provides it to 

Y with a restriction that Y may only use it 

during the manufacturing process and has no 

right to exploit the intellectual property. The 

contract specifies that Y controls the details 

of the manufacturing process while the 

machines are being produced; Y bears the 

risk of loss or damage during manufacturing 

of the machines; and Y has the economic loss 

or gain upon the sale of the machines based 

on the difference between Y’s costs and the 

fixed price. Y has legal title during the 

manufacturing process and legal title to the 

machines is not transferred to X until final 

manufacturing of the machines has been 

completed. Based on all of the facts and 

circumstances, pursuant to paragraph (e)(1) 

of this section Y has the benefits and burdens 

of ownership of the machines under Federal 

income tax principles during the period the 

manufacturing occurs and, as a result, Y is 

treated as the manufacturer of the machines. 

Example 2. X designs and engineers 

machines that it sells to customers. X 

contracts with Y, an unrelated taxpayer, for 

the manufacture of the machines. The 

contract between X and Y is a costreimbursable type contract. X has the benefits 

and burdens of ownership of the machines 

under Federal income tax principles during 

the period the manufacturing occurs except 

that legal title to the machines is not 

transferred to X until final manufacturing of 

the machines is completed. Based on all of 

the facts and circumstances, X is treated as 

the manufacturer of the machines under 

paragraph (e)(1) of this section. 

(f) Definition of in whole or in 

significant part—(1) In general. QPP 

must be MPGE in whole or in significant 

part by the taxpayer and in whole or in 

significant part within the United States 

to qualify under section 

199(c)(4)(A)(i)(I). If a taxpayer enters 

into a contract pursuant to paragraph 

(e)(1) of this section with an unrelated 

party for the unrelated party to MPGE 

QPP for the taxpayer and the taxpayer 

has the benefits and burdens of 

ownership of the QPP under applicable 

Federal income tax principles during 

the period the MPGE activity occurs, 

then the taxpayer is considered to 

MPGE the QPP under this section. The 

unrelated party must perform the MPGE 

activity on behalf of the taxpayer in 

whole or in significant part within the 

United States in order for the taxpayer 

to satisfy the requirements of this 

paragraph (f)(1). 

Federal Register / Vol. 70, No. 213 / Friday, November 4, 2005 / Proposed Rules 67247 

(2) Substantial in nature. QPP will be 

treated as MPGE in significant part by 

the taxpayer within the United States 

for purposes of paragraph (f)(1) of this 

section if the MPGE of the QPP by the 

taxpayer within the United States is 

substantial in nature taking into account 

all of the facts and circumstances, 

including the relative value added by, 

and relative cost of, the taxpayer’s 

MPGE activity within the United States, 

the nature of the property, and the 

nature of the MPGE activity that the 

taxpayer performs within the United 

States. Research and experimental 

activities under section 174 and the 

creation of intangibles do not qualify as 

substantial in nature for any QPP other 

than computer software (as defined in 

paragraph (i)(3) of this section) and 

sound recordings (as defined in 

paragraph (i)(4) of this section). In the 

case of an EAG member, an EAG 

partnership (as defined in paragraph 

(h)(8) of this section), or members of an 

EAG in which the partners of the EAG 

partnership are members, in 

determining whether the substantial in 

nature requirement is met with respect 

to an item of QPP, all of the previous 

activities of the members of the EAG, 

the EAG partnership, and all members 

of the EAG in which the partners of the 

EAG partnership are members, as 

applicable, are taken into account. 

(3) Safe harbor. A taxpayer will be 

treated as having MPGE QPP in whole 

or in significant part within the United 

States for purposes of paragraph (f)(1) of 

this section if, in connection with the 

QPP, conversion costs (direct labor and 

related factory burden) of such taxpayer 

to MPGE the QPP within the United 

States account for 20 percent or more of 

the taxpayer’s CGS of the QPP. For 

purposes of the safe harbor under this 

paragraph (f)(3), research and 

experimental expenditures under 

section 174 and the costs of creating 

intangibles do not qualify as conversion 

costs for any QPP other than computer 

software and sound recordings. In the 

case of tangible personal property (as 

defined in paragraph (i)(2) of this 

section), research and experimental 

expenditures under section 174 and any 

other costs incurred in the creation of 

intangibles may be excluded from CGS 

for purposes of determining whether the 

taxpayer meets the safe harbor under 

this paragraph (f)(3). For purposes of 

this safe harbor, research and 

experimental expenditures under 

section 174 and any other costs of 

creating intangibles for computer 

software and sound recordings must be 

allocated to the computer software and 

sound recordings to which the 

expenditures and costs relate under 

§ 1.199–4(b). In the case of an EAG 

member, an EAG partnership, or 

members of an EAG in which the 

partners of the EAG partnership are 

members, in determining whether the 

requirements of the safe harbor under 

this paragraph (f)(3) are met with 

respect to an item of QPP, all of the 

previous conversion costs of the 

members of the EAG, the EAG 

partnership, and all members of the 

EAG in which the partners of the EAG 

partnership are members, as applicable, 

to MPGE the QPP are taken into 

account. If a taxpayer enters into a 

contract with an unrelated party for the 

unrelated party to MPGE QPP for the 

taxpayer, and the taxpayer is considered 

pursuant to paragraph (e)(1) of this 

section to MPGE the QPP, then for 

purposes of this safe harbor the 

taxpayer’s conversion costs shall 

include both the taxpayer’s conversion 

costs as well as the conversion costs of 

the unrelated party to MPGE the QPP 

under the contract. 

(4) Examples. The following examples 

illustrate the application of this 

paragraph (f): 

Example 1. X purchases from Y unrefined 

oil extracted outside the United States and X 

refines the oil in the United States. The 

refining of the oil by X is an MPGE activity 

that is substantial in nature. 

Example 2. X purchases gemstones and 

precious metal from outside the United 

States and then uses these materials to 

produce jewelry within the United States by 

cutting and polishing the gemstones, melting 

and shaping the metal, and combining the 

finished materials. X’s activity is substantial 

in nature under paragraph (f)(2) of this 

section. Therefore, X has MPGE the jewelry 

in significant part within the United States. 

Example 3. (i) X operates an automobile 

assembly plant in the United States. In 

connection with such activity, X purchases 

assembled engines, transmissions, and 

certain other components from Y, an 

unrelated taxpayer, and X assembles all of 

the component parts into an automobile. X 

also conducts stamping, machining, and 

subassembly operations, and X uses tools, 

jigs, welding equipment, and other 

machinery and equipment in the assembly of 

automobiles. On a per-unit basis, X’s selling 

price and costs of such automobiles are as 

follows: 

Selling price: $2,500 

Cost of goods sold: 

Material—Acquired from Y: $1,475 

Conversion costs (direct labor and 

factory burden): $325 

Total cost of goods sold: $1,800 

Gross profit: $700 

Administrative and selling expenses: 

$300 

Taxable income: $400 

(ii) Although X’s conversion costs are 

less than 20 percent of total CGS ($325/ 

$1,800, or 18 percent), the operations 

conducted by X in connection with the 

property purchased and sold are 

substantial in nature under paragraph 

(f)(2) of this section because of the 

nature of X’s activity and the relative 

value of X’s activity. Therefore, X’s 

automobiles will be treated as MPGE in 

significant part by X within the United 

States for purposes of paragraph (f)(1) of 

this section. 

Example 4. X produces a qualified film (as 

defined in paragraph (j)(1) of this section) 

and licenses the film to Y, an unrelated 

taxpayer, for duplication of the film onto 

DVDs. Y purchases the DVDs from an 

unrelated person. Unless Y satisfies the safe 

harbor under paragraph (f)(3) of this section, 

Y’s income for duplicating X’s qualified film 

onto the DVDs is non-DPGR because the 

duplication is not substantial in nature 

relative to the DVD with the film. 

Example 5. X imports into the United 

States QPP that is partially manufactured. X 

completes the manufacture of the QPP within 

the United States and X’s completion of the 

manufacturing of the QPP within the United 

States satisfies the in whole or in significant 

part requirement under paragraph (f)(1) of 

this section. Therefore, X’s gross receipts 

from the lease, rental, license, sale, exchange, 

or other disposition of the QPP qualify as 

DPGR if all other applicable requirements 

under this section are met. 

Example 6. X manufactures QPP in 

significant part within the United States and 

exports the QPP for further manufacture 

outside the United States. Assuming X meets 

all the requirements under this section for 

the QPP after the further manufacturing, X’s 

gross receipts derived from the lease, rental, 

license, sale, exchange, or other disposition 

of the QPP will be considered DPGR, 

regardless of whether the QPP is imported 

back into the United States prior to the lease, 

rental, license, sale, exchange, or other 

disposition of the QPP. 

Example 7. X is a retailer that sells cigars 

and pipe tobacco that X purchases from an 

unrelated person. While being displayed and 

offered for sale by X, the cigars and pipe 

tobacco age on X’s shelves in a room with 

controlled temperature and humidity. 

Although X’s cigars and pipe tobacco may 

become more valuable as they age, the gross 

receipts derived by X from the sale of the 

cigars and pipe tobacco are non-DPGR 

because the aging of the cigars and pipe 

tobacco while being displayed and offered for 

sale by X does not qualify as an MPGE 

activity that occurs in whole or in significant 

part within the United States. 

(g) Definition of United States. For 

purposes of this section, the term United 

States includes the 50 states, the District 

of Columbia, the territorial waters of the 

United States, and the seabed and 

subsoil of those submarine areas that are 

adjacent to the territorial waters of the 

United States and over which the 

United States has exclusive rights, in 

accordance with international law, with 

respect to the exploration and 

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exploitation of natural resources. The 

term United States does not include 

possessions and territories of the United 

States or the airspace or space over the 

United States and these areas. 

(h) Definition of derived from the 

lease, rental, license, sale, exchange, or 

other disposition—(1) In general. The 

term derived from the lease, rental, 

license, sale, exchange, or other 

disposition is defined as, and limited to, 

the gross receipts directly derived from 

the lease, rental, license, sale, exchange, 

or other disposition, even if the taxpayer 

has already recognized gross receipts 

from a previous lease, rental, license, 

sale, exchange, or other disposition of 

the same property. Applicable Federal 

income tax principles apply to 

determine whether a transaction is, in 

substance, a lease, rental, license, sale, 

exchange or other disposition, or 

whether it is a service (or some 

combination thereof). For example, 

gross receipts derived from the sale of 

QPP includes gross receipts derived 

from the sale of QPP MPGE in whole or 

in significant part within the United 

States by a taxpayer for sale, as well as 

gross receipts derived from the sale of 

QPP MPGE in whole or in significant 

part within the United States by a 

taxpayer and used in the taxpayer’s 

trade or business before being sold. The 

entire amount of lease income including 

any interest that is not separately stated 

is considered derived from the lease of 

QPP or a qualified film. In addition, the 

proceeds from business interruption 

insurance, governmental subsidies, and 

governmental payments not to produce 

are treated as gross receipts derived 

from the lease, rental, license, sale, 

exchange, or other disposition to the 

extent that they are substitutes for gross 

receipts that would qualify as DPGR. 

The value of property received by a 

taxpayer in a taxable exchange of QPP 

MPGE in whole or in significant part 

within the United States, qualified 

films, or utilities for an unrelated 

person’s property is DPGR for the 

taxpayer (assuming all the other 

requirements of this section are met). 

However, unless the taxpayer further 

MPGE the QPP or further produces the 

qualified films or utilities received in 

the exchange, any gross receipts from 

the subsequent sale by the taxpayer of 

the property received in the exchange 

are non-DPGR because the taxpayer did 

not MPGE or otherwise produce such 

property, even if the property was QPP, 

qualified films, or utilities in the hands 

of the other person. 

(2) Examples. The following examples 

illustrate the application of paragraph 

(h)(1) of this section: 

Example 1. X MPGE QPP within the 

United States and sells the QPP to Y, an 

unrelated person. Y leases the QPP for 3 

years to Z, a taxpayer unrelated to both X and 

Y, and shortly thereafter, X repurchases the 

QPP from Y subject to the lease. At the end 

of the lease term, Z purchases the QPP from 

X. X’s proceeds derived from the sale of the 

QPP to Y, from the lease to Z, and from the 

sale of the QPP to Z all qualify as DPGR 

(assuming all the other requirements of this 

section are met). 

Example 2. X MPGE QPP within the 

United States and sells the QPP to Y, an 

unrelated taxpayer, for $25,000. X finances 

Y’s purchase of the QPP and receives total 

payments of $35,000, of which $10,000 

relates to interest and finance charges. The 

$25,000 qualifies as DPGR but the $10,000 in 

interest and finance charges do not qualify as 

DPGR because the $10,000 is not derived 

from the MPGE of QPP within the United 

States but rather from X’s lending activity. 

Example 3. Cable company X charges 

subscribers $15 a month for its basic cable 

television. Y, an unrelated taxpayer, 

produces in the United States all of the 

programs on its cable channel which it 

licenses to X for $.10 per subscriber per 

month. The programs are qualified films 

within the meaning of paragraph (j)(1) of this 

section. The gross receipts derived by Y are 

derived from a license of a qualified film 

produced by Y and are DPGR (assuming all 

the other requirements of this section are 

met). 

(3) Hedging transactions—(i) In 

general. For purposes of this section, 

provided that the risk being hedged 

relates to QPP described in section 

1221(a)(1) or property described in 

section 1221(a)(8) consumed in the 

activity giving rise to DPGR, and 

provided that the transaction is a 

hedging transaction within the meaning 

of section 1221(b)(2) and § 1.1221–2(b), 

then—

(A) In the case of a hedge of purchases 

of property described in section 

1221(a)(1), gain or loss on the hedging 

transaction must be taken into account 

in determining CGS; 

(B) In the case of a hedge of sales of 

property described in section 1221(a)(1), 

gain or loss on the hedging transaction 

must be taken into account in 

determining DPGR; and 

(C) In the case of a hedge of purchases 

of property described in section 

1221(a)(8), gain or loss on the hedging 

transaction must be taken into account 

in determining DPGR. 

(ii) Currency fluctuations. For 

purposes of this section, in the case of 

a transaction that manages the risk of 

currency fluctuations, the determination 

of whether the transaction is a hedging 

transaction within the meaning of 

§ 1.1221–2(b) is made without regard to 

whether the transaction is a section 988 

transaction. See § 1.1221–2(a)(4). The 

preceding sentence applies only to the 

extent that § 1.988–5(b) does not apply. 

(iii) Other rules. See § 1.1221–2(e) for 

rules applicable to hedging by members 

of a consolidated group and § 1.446–4 

for rules regarding the timing of income, 

deductions, gain, or loss with respect to 

hedging transactions. 

(4) Allocation of gross receipts—

embedded services and non-qualified 

property—(i) In general. Except as 

otherwise provided in paragraph 

(h)(4)(ii), paragraph (l) (relating to 

construction), and paragraph (m) 

(relating to architectural and 

engineering services) of this section, 

gross receipts derived from the 

performance of services do not qualify 

as DPGR. In the case of an embedded 

service, that is, a service the price of 

which is not separately stated from the 

amount charged for the lease, rental, 

license, sale, exchange, or other 

disposition of QPP, qualified films, or 

utilities, DPGR includes only the 

receipts from the lease, rental, license, 

sale, exchange, or other disposition of 

the item (if all the other requirements of 

this section are met) and not any 

receipts attributable to the embedded 

service by the taxpayer. In addition, 

DPGR does not include the gross 

receipts derived from the lease, rental, 

license, sale, exchange, or other 

disposition of property that does not 

meet all of the requirements under this 

section (non-qualified property). For 

example, gross receipts derived from the 

lease, rental, license, sale, exchange, or 

other disposition of a replacement part 

that is non-qualified property does not 

qualify as DPGR. 

(ii) Exceptions. There are five 

exceptions to the rules under paragraph 

(h)(4)(i) of this section regarding 

embedded services and non-qualified 

property. A taxpayer may include in 

DPGR, if all the other requirements of 

this section are met with respect to the 

underlying item of property to which 

the embedded services or non-qualified 

property relate, gross receipts derived 

from—

(A) A qualified warranty, that is, a 

warranty that is provided in connection 

with the lease, rental, license, sale, 

exchange, or other disposition of QPP, 

qualified films or utilities if—

(1) In the normal course of the 

taxpayer’s business, the price for the 

warranty is not separately stated from 

the amount charged for the lease, rental, 

license, sale, exchange, or other 

disposition of the property; and 

(2) The warranty is neither separately 

offered by the taxpayer nor separately 

bargained for with the customer (that is, 

a customer cannot purchase the 

property without the warranty); 

Federal Register / Vol. 70, No. 213 / Friday, November 4, 2005 / Proposed Rules 67249 

(B) A qualified delivery, that is, a 

delivery or distribution service that is 

provided in connection with the lease, 

rental, license, sale, exchange, or other 

disposition of QPP if—

(1) In the normal course of the 

taxpayer’s business, the price for the 

delivery or distribution service is not 

separately stated from the amount 

charged for the lease, rental, license, 

sale, exchange, or other disposition of 

the property; and 

(2) The delivery or distribution 

service is neither separately offered by 

the taxpayer nor separately bargained 

for with the customer (that is, a 

customer cannot purchase the property 

without delivery or distribution 

service); 

(C) A qualified operating manual, that 

is, a manual of instructions (including 

electronic instructions) that is provided 

in connection with the lease, rental, 

license, sale, exchange, or other 

disposition of QPP, qualified films or 

utilities if—

(1) In the normal course of the 

taxpayer’s business, the price for the 

manual is not separately stated from the 

amount charged for the lease, rental, 

license, sale, exchange, or other 

disposition of the property; 

(2) The manual is neither separately 

offered by the taxpayer nor separately 

bargained for with the customer (that is, 

a customer cannot purchase the 

property without the manual); and 

(3) The manual is not provided in 

connection with a training course for 

the customer; 

(D) A qualified installation, that is, an 

installation service (including minor 

assembly) for QPP that is provided in 

connection with the lease, rental, 

license, sale, exchange, or other 

disposition of the QPP if—

(1) In the normal course of the 

taxpayer’s business, the price for the 

installation service is not separately 

stated from the amount charged for the 

lease, rental, license, sale, exchange, or 

other disposition of the property; and 

(2) The installation is neither 

separately offered by the taxpayer nor 

separately bargained for with the 

customer (that is, a customer cannot 

purchase the property without the 

installation service); and 

(E) A de minimis amount of gross 

receipts from embedded services and 

non-qualified property for each item of 

QPP, qualified films, or utilities. For 

purposes of the preceding sentence, a de 

minimis amount of gross receipts from 

embedded services and non-qualified 

property is less than 5 percent of the 

total gross receipts derived from the 

lease, rental, license, sale, exchange, or 

other disposition of each item of QPP, 

qualified films, or utilities (including 

the gross receipts for the embedded 

services and property described in 

paragraphs (h)(4)(ii)(A), (B), (C), (D) and 

(k)(4)(iv) of this section). The allocation 

of the gross receipts attributable to the 

embedded services or non-qualified 

property will be deemed to be 

reasonable if the allocation reflects the 

fair market value of the embedded 

services or property. In the case of gross 

receipts derived from the lease, rental, 

license, sale, exchange, or other 

disposition of QPP, qualified films, and 

utilities that are received over a period 

of time (for example, a multi-year lease 

or installment sale), this de minimis 

exception is applied by taking into 

account the total gross receipts derived 

from the lease, rental, license, sale, 

exchange, or other disposition of the 

item of QPP, qualified films, or utilities. 

For purposes of applying this de 

minimis exception, the gross receipts 

described in paragraphs (h)(4)(ii)(A), 

(B), (C), (D) and (k)(4)(iv) of this section 

are treated as DPGR. This de minimis 

exception does not apply if the prices of 

the services or non-qualified property 

are separately stated by the taxpayer, or 

if the services or non-qualified property 

are separately offered or separately 

bargained for with the customer (that is, 

the customer can purchase the property 

without the services or non-qualified 

property). 

(iii) Examples. The following 

examples illustrate the application of 

this paragraph (h)(4): 

Example 1. X MPGE QPP within the 

United States. As part of the sale of the QPP 

to Z, X trains Z’s employees on how to use 

and operate the QPP. No other services or 

property are provided to Z in connection 

with the sale of the QPP to Z. The QPP and 

training services are separately stated in the 

sales contract. Because the training services 

are separately stated, the training services are 

not treated as embedded services under the 

de minimis exception in paragraph 

(h)(4)(ii)(E) of this section. 

Example 2. The facts are the same as in 

Example 1 except that the training services 

are not separately stated in the sales contract 

and the customer cannot purchase the QPP 

without the training services. If the gross 

receipts for the embedded training services 

are less than 5 percent of the gross receipts 

derived from the sale of X’s QPP to Z, 

including the gross receipts for the training 

services, then the gross receipts may be 

included in DPGR under the de minimis 

exception in paragraph (h)(4)(ii)(E) of this 

section. 

Example 3. X MPGE QPP within the 

United States. As part of the sale of the QPP 

to retailers, X charges a fee for delivering the 

QPP. The price of the QPP and the delivery 

fee are separately stated in the sales contract. 

The retailer’s customers cannot purchase the 

QPP without paying for the delivery fee. 

Because the delivery fee is separately stated, 

the delivery fee does not qualify as DPGR 

under the qualified delivery exception in 

paragraph (h)(4)(ii)(B) of this section or the 

de minimis exception under paragraph 

(h)(4)(ii)(E) of this section. 

Example 4. X enters into a single, lumpsum priced contract with Y, an unrelated 

taxpayer, and the contract has the following 

terms: X will produce QPP within the United 

States for Y; X will deliver the QPP to Y; X 

will provide a one-year warranty on the QPP; 

X will provide operating and maintenance 

manuals with the QPP; X will provide 100 

hours of training and training manuals to Y’s 

employees on the use and maintenance of the 

QPP; X will provide purchased spare parts 

for the QPP; and X will provide a 3-year 

service agreement for the QPP. None of the 

services or property was separately offered or 

separately bargained for. The receipts for the 

production of the QPP are DPGR under 

paragraphs (d)(1) and (f) of this section 

(assuming all the other requirements of this 

section are met). X may include in DPGR the 

gross receipts for delivering the QPP, which 

is a qualified delivery under paragraph 

(h)(4)(ii)(B) of this section; the gross receipts 

for the one-year warranty, which is a 

qualified warranty under paragraph 

(h)(4)(ii)(A) of this section; and the gross 

receipts for the operating and maintenance 

manuals, each of which is a qualified 

operating manual under paragraph 

(h)(4)(ii)(C) of this section. If the gross 

receipts for the embedded services consisting 

of the employee training and 3-year service 

agreement, and for the non-qualified property 

consisting of the purchased spare parts and 

the employee training manuals, which are 

not qualified operating manuals, are in total 

less than 5 percent of the gross receipts 

derived from the sale of X’s QPP to Y 

(including the gross receipts for the 

embedded services and non-qualified 

property), those gross receipts may be 

included in DPGR (assuming there are no 

other embedded services or non-qualified 

property under the contract) under the de 

minimis exception in paragraph (h)(4)(ii)(E) 

of this section. If, however, the gross receipts 

for the embedded services and non-qualified 

property consisting of employee training, the 

3-year service agreement, purchased spare 

parts, and employee training manuals equal 

or exceed 5 percent of the gross receipts 

derived from the sale of X’s QPP to Y 

(including the gross receipts for the 

embedded services and non-qualified 

property), those gross receipts do not qualify 

as DPGR under the de minimis exception in 

paragraph (h)(4)(ii)(E) of this section. 

(5) Advertising income—(i) Tangible 

personal property. A taxpayer’s gross 

receipts that are derived from the lease, 

rental, license, sale, exchange, or other 

disposition of newspapers, magazines, 

telephone directories, or periodicals that 

are MPGE in whole or in significant part 

within the United States include 

advertising income from advertisements 

placed in those media, but only to the 

extent the gross receipts, if any, derived 

from the lease, rental, license, sale, 

67250 Federal Register / Vol. 70, No. 213 / Friday, November 4, 2005 / Proposed Rules 

exchange, or other disposition of the 

newspapers, magazines, telephone 

directories, or periodicals are DPGR 

(without regard to this paragraph 

(h)(5)(i)). 

(ii) Qualified films. A taxpayer’s gross 

receipts that are derived from the lease, 

rental, license, sale, exchange, or other 

disposition of a qualified film include 

product-placement income with respect 

to that qualified film, that is, 

compensation for placing or integrating 

a product into the qualified film, but 

only to the extent the gross receipts 

derived from the qualified film (if any) 

are DPGR (without regard to this 

paragraph (h)(5)(ii)). 

(iii) Examples. The following 

examples illustrate the application of 

this paragraph (h)(5): 

Example 1. X MPGE and sells newspapers 

within the United States. X’s gross receipts 

from the newspapers include gross receipts 

derived from the sale of newspapers to 

customers and payments from advertisers to 

publish display advertising or classified 

advertisements in X’s newspapers. X’s gross 

receipts described above are DPGR derived 

from the sale of X’s newspapers. 

Example 2. The facts are the same as in 

Example 1 except that X also distributes with 

its newspapers advertising flyers that are 

MPGE by the advertiser. The fees X receives 

for distributing the advertising flyers are not 

derived from the sale of X’s newspapers 

because X did not MPGE the advertising 

flyers that it distributes. As a result, the 

distribution fee is for the provision of a 

distribution service and is non-DPGR under 

paragraph (h)(5)(i) of this section. 

Example 3. X produces two television 

programs that are qualified films (as defined 

in paragraph (j)(1) of this section). X licenses 

the first television program to Y’s television 

station and X licenses the second television 

program to Z’s television station. Both 

television programs contain product 

placements for which X received 

compensation. Z, but not Y, is a related 

person to X within the meaning of paragraph 

(b)(1) of this section. The gross receipts 

derived by X from licensing the qualified 

film to Y are DPGR. As a result, pursuant to 

paragraph (h)(5)(ii) of this section, all of X’s 

product placement income for the first 

television program is treated as gross receipts 

that are derived from the license of the 

qualified film. The gross receipts derived by 

X from licensing the qualified film to Z are 

non-DPGR under paragraph (b)(1) of this 

section. As a result, pursuant to paragraph 

(h)(5)(ii) of this section, none of X’s product 

placement income for the second television 

program is treated as gross receipts derived 

from the qualified film under paragraph 

(h)(5)(ii) of this section. 

(6) Computer software—(i) In general. 

Gross receipts derived from the lease, 

rental, license, sale, exchange, or other 

disposition of computer software (as 

defined in paragraph (i)(3) of this 

section) do not include gross receipts 

derived from Internet access services, 

online services, customer and technical 

support, telephone services, online 

electronic books and journals, games 

played through a Web site, providercontrolled software online access 

services, and other similar services that 

do not constitute the lease, rental, 

license, sale, exchange, or other 

disposition of computer software that 

was developed by the taxpayer. 

(ii) Examples. The following 

examples illustrate the application of 

this paragraph (h)(6): 

Example 1. X produces and prints a 

newspaper in the United States which it sells 

to customers. X also has an online version of 

the newspaper which is available only to 

subscribers. The gross receipts derived from 

the sale of the newspaper X produces and 

prints qualify as DPGR. However, because X’s 

gross receipts from the online newspaper 

subscription are not derived from the lease, 

rental, license, sale, exchange, or disposition 

of computer software under paragraph 

(h)(6)(i) of this section, the gross receipts 

attributable to the online newspaper 

subscription fees are non-DPGR under 

paragraph (h)(6)(i) of this section. 

Example 2. The facts are the same as in 

Example 1 except that X’s gross receipts 

attributable to the online version of its 

newspaper are derived from fees from 

customers to view the newspaper online and 

payments from advertisers to display 

advertising online. X’s gross receipts derived 

from allowing customers online access to X’s 

newspaper are non-DPGR because, pursuant 

to paragraph (h)(6)(i) of this section, the gross 

receipts relating to online newspapers are not 

derived from the lease, rental, license, sale, 

exchange, or other disposition of QPP, but 

rather is the provision of an online access 

service. As a result, because X’s gross 

receipts from the online access services are 

non-DPGR, the related online advertising 

receipts are similarly non-DPGR under 

paragraph (h)(5)(i) of this section. 

(7) Exception for certain oil and gas 

partnerships—(i) In general. If a 

partnership is engaged solely in the 

extraction, refining, or processing of oil 

or natural gas, and distributes the oil or 

natural gas or products derived from the 

oil or natural gas (products) to one or 

more partners, then each partner is 

treated as extracting, refining, or 

processing any oil or natural gas or 

products extracted, refined, or 

processed by the partnership and 

distributed to that partner. Thus, to the 

extent that the extracting, refining, or 

processing of the distributed oil or 

natural gas or products occurs in whole 

or in significant part within the United 

States, gross receipts derived by each 

partner from the sale, exchange, or other 

disposition of the distributed oil or 

natural gas or products are treated as 

DPGR (provided all requirements of this 

section are met). Solely for purposes of 

section 199(d)(1)(B)(ii), the partnership 

is treated as having gross receipts in the 

taxable year of the distribution equal to 

the fair market value of the distributed 

oil or natural gas or products at the time 

of distribution to the partner and the 

deemed gross receipts are allocated to 

that partner, provided the partner 

derives gross receipts from the 

distributed property during the taxable 

year of the partner with or within which 

the partnership’s taxable year (in which 

the distribution occurs) ends. Costs 

included in the adjusted basis of the 

distributed oil or natural gas or products 

and any other relevant deductions are 

taken into account in computing the 

partner’s QPAI. See § 1.199–5 for the 

application of section 199 to pass-thru 

entities. 

(ii) Example. The following example 

illustrates the application of this 

paragraph (h)(7). Assume that PRS and 

X are calendar year taxpayers. The 

example reads as follows: 

Example. X is a partner in PRS, a 

partnership which engages solely in the 

extraction of oil within the United States. In 

2010, PRS distributes oil to X that PRS 

derived from its oil extraction. PRS incurred 

$600 of CGS, including $500 of W–2 wages 

(as defined in § 1.199–2(f)), extracting the oil 

distributed to X, and X’s adjusted basis in the 

distributed oil is $600. The fair market value 

of the oil at the time of the distribution to X 

is $1,000. X incurs $200 of CGS, including 

$100 of W–2 wages, in refining the oil within 

the United States. In 2010, X sells the oil for 

$1,500 to a customer. Under paragraph 

(h)(7)(i) of this section, X is treated as having 

extracted the oil. The extraction and refining 

of the oil qualify as an MPGE activity under 

paragraph (d)(1) of this section. Therefore, 

X’s $1,500 of gross receipts qualify as DPGR. 

X subtracts from the $1,500 of DPGR the $600 

of CGS incurred by PRS and the $200 of 

refining costs incurred by X. Thus, X’s QPAI 

is $700 for 2010. In addition, PRS is treated 

as having $1,000 of DPGR solely for purposes 

of applying the wage limitation of section 

199(d)(1)(B)(ii). Accordingly, X’s share of 

PRS’s W–2 wages determined under section 

199(d)(1)(B) is $72, the lesser of $500 (X’s 

allocable share of PRS’s W–2 wages included 

in CGS) and $72 (2 × ($400 ($1,000 deemed 

DPGR less $600 of CGS) × .09)). X adds the 

$72 of PRS W–2 wages to its $100 of W–2 

wages incurred in refining the oil for 

purposes of section 199(b). 

(8) Partnerships owned by members of 

a single expanded affiliated group—(i) 

In general. For purposes of this section, 

if all of the interests in the capital and 

profits of a partnership are owned by 

members of a single EAG at all times 

during the taxable year of the 

partnership (EAG partnership), then the 

EAG partnership and all members of 

that EAG are treated as a single taxpayer 

for purposes of section 199(c)(4) during 

that taxable year. Thus, if an EAG 

Federal Register / Vol. 70, No. 213 / Friday, November 4, 2005 / Proposed Rules 67251 

partnership MPGE or produces property 

and distributes, leases, rents, licenses, 

sells, exchanges, or otherwise disposes 

of that property to a member of an EAG 

in which the partners of the EAG 

partnership are members, then the 

MPGE or production activity conducted 

by the EAG partnership will be treated 

as having been conducted by the 

members of the EAG. Similarly, if one 

or more members of an EAG in which 

the partners of an EAG partnership are 

members MPGE or produces property 

and contributes, leases, rents, licenses, 

sells, exchanges, or otherwise disposes 

of that property to the EAG partnership, 

then the MPGE or production activity 

conducted by the EAG member (or 

members) will be treated as having been 

conducted by the EAG partnership. 

Attribution of activities does not apply 

for purposes of the construction of real 

property under § 1.199–3(l)(1) and the 

performance of engineering and 

architectural services under § 1.199–

3(m)(2) and (3), respectively. An EAG 

partnership may not use the small 

business simplified overall method 

described in § 1.199–4(f). Except as 

provided in this paragraph (h)(8), an 

EAG partnership is treated the same as 

other partnerships for purposes of 

section 199. Accordingly, an EAG 

partnership is subject to the rules of 

§ 1.199–5 regarding the application of 

section 199 to pass-thru entities, 

including application of the section 

199(d)(1)(B) wage limitation under 

§ 1.199–5(a)(3). See paragraphs (f)(2) 

and (3) of this section for the 

aggregation of activities and conversion 

costs among EAG partnerships and all 

members of the EAG in which the 

partners of the EAG partnership are 

members. 

(ii) Special rules for distributions from 

EAG partnerships. If an EAG 

partnership distributes property to a 

partner, then, solely for purposes of 

section 199(d)(1)(B)(ii), the EAG 

partnership is treated as having gross 

receipts in the taxable year of the 

distribution equal to the fair market 

value of the property at the time of 

distribution to the partner and the 

deemed gross receipts are allocated to 

that partner, provided the partner 

derives gross receipts from the 

distributed property during the taxable 

year of the partner with or within which 

the partnership’s taxable year (in which 

the distribution occurs) ends. Costs 

included in the adjusted basis of the 

distributed property and any other 

relevant deductions are taken into 

account in computing the partner’s 

QPAI. 

(iii) Examples. The following 

examples illustrate the rules of this 

paragraph (h)(8). Assume that PRS, X, Y, 

and Z all are calendar year taxpayers. 

The examples read as follows: 

Example 1. Contribution. X and Y, both 

members of a single EAG, are the only 

partners in PRS, a partnership, for PRS’s 

entire 2010 taxable year. In 2010, X MPGE 

QPP within the United States and contributes 

the property to PRS. In 2010, PRS sells the 

QPP for $1,000. PRS’s $1,000 gross receipts 

constitute DPGR. PRS, X, and Y must apply 

the rules of § 1.199–5 regarding the 

application of section 199 to pass-thru 

entities with respect to the activity of PRS, 

including application of the section 

199(d)(1)(B) wage limitation under § 1.199–

5(a)(3). 

Example 2. Sale. X, Y, and Z are the only 

members of a single EAG. X and Y each own 

50% of the capital and profits interests in 

PRS, a partnership, for PRS’s entire 2010 

taxable year. In 2010, PRS MPGE QPP within 

the United States and then sells the property 

to X for $6,000, its fair market value at the 

time of the sale. PRS’s gross receipts of 

$6,000 qualify as DPGR. In 2010, X sells the 

QPP to customers for $10,000, incurring 

selling expenses of $2,000. Under this 

paragraph (h)(8), X is treated as having MPGE 

the QPP within the United States, and X’s 

$10,000 of gross receipts qualify as DPGR 

($6,000 of CGS and $2,000 of other selling 

expenses are subtracted from DPGR in 

determining X’s QPAI). The results would be 

the same if PRS sold the property to Z rather 

than to X. 

Example 3. Distribution. X and Y, both 

members of a single EAG, are the only 

partners in PRS, a partnership, for PRS’s 

entire 2010 taxable year. In 2010, PRS MPGE 

QPP within the United States, incurring $600 

of CGS, including $500 of W–2 wages (as 

defined in § 1.199–2(f)), and then distributes 

the QPP to X. X’s adjusted basis in the QPP 

is $600. At the time of the distribution the 

fair market value of the QPP is $1,000. X 

incurs $200 of directly allocable costs, 

including $100 of W–2 wages, to further 

MPGE the QPP within the United States. In 

2010, X sells the QPP for $1,500 to a 

customer. Under paragraph (h)(8)(i) of this 

section, X is treated as having MPGE the QPP 

within the United States, and X’s $1,500 of 

gross receipts qualify as DPGR. X subtracts 

from the $1,500 of DPGR the $600 of CGS 

incurred by PRS and the $200 of direct costs 

incurred by X. Thus, X’s QPAI is $700 for 

2010. In addition, PRS is treated as having 

DPGR of $1,000 solely for purposes of 

applying the wage limitation of section 

199(d)(1)(B)(ii). Accordingly, X’s share of 

PRS’S W–2 wages determined under section 

199(d)(1)(B) is $72, the lesser of $500 (X’s 

allocable share of PRS’S W–2 wages included 

in CGS) and $72 (2 x ($400 ($1,000 deemed 

DPGR less $600 of CGS) x .09)). X adds the 

$72 of PRS W–2 wages to its $100 of W–2 

wages incurred in MPGE the QPP for 

purposes of section 199(b). 

Example 4. Multiple sales. X and Y, both 

non-consolidated members of a single EAG, 

are the only partners in PRS, a partnership, 

for PRS’s entire 2010 taxable year. PRS 

produces in bulk form in the United States 

the active ingredient for a pharmaceutical 

product. Assume that PRS’s own MPGE 

activity with respect to the active ingredient 

is not substantial in nature, taking into 

account all of the facts and circumstances, 

and PRS’s conversion costs to MPGE the 

active ingredient within the United States are 

$15 and account for 15 percent of PRS’s $100 

CGS of the active ingredient. PRS sells the 

active ingredient in bulk form to X. X uses 

the active ingredient to produce the finished 

dosage form drug. Assume that X’s own 

MPGE activity with respect to the drug is not 

substantial in nature, taking into account all 

of the facts and circumstances, and X’s 

conversion costs to MPGE the drug within 

the United States are $12 and account for 10 

percent of X’s $120 CGS of the drug. X sells 

the drug in finished dosage to Y and Y sells 

the drug to customers. Y incurs $2 of 

conversion costs and Y’s CGS in selling the 

drug to customers is $130. PRS’s gross 

receipts from the sale of the active ingredient 

to X are non-DPGR because PRS’s MPGE 

activity is not substantial in nature and PRS 

does not satisfy the safe harbor described in 

paragraph (f)(3) of this section because PRS’s 

conversion costs account for less than 20 

percent of PRS’s CGS of the active ingredient. 

X’s gross receipts from the sale of the drug 

to Y are DPGR because X is considered to 

have MPGE the drug in significant part in the 

United States pursuant to the safe harbor 

described in paragraph (f)(3) of this section 

because the $27 ($15 + $12) of conversion 

costs incurred by PRS and X equals or 

exceeds 20 percent of X’s total CGS ($120) of 

the drug at the time the drug is sold to Y. 

Similarly, Y’s gross receipts from the sale of 

the drug to customers are DPGR because Y 

is considered to have MPGE the drug in 

significant part in the United States pursuant 

to the safe harbor described in paragraph 

(f)(3) of this section because the $29 ($15 + 

$12 + $2) of conversion costs incurred by 

PRS, X, and Y equals or exceeds 20 percent 

of Y’s total CGS ($130) of the drug at the time 

the drug is sold to customers. 

(9) Non-operating mineral interests. 

DPGR does not include gross receipts 

derived from mineral interests other 

than operating mineral interests within 

the meaning of § 1.614–2(b). 

(i) Definition of qualifying production 

property—(1) In general. QPP means—

(i) Tangible personal property (as 

defined in paragraph (i)(2) of this 

section); 

(ii) Computer software (as defined in 

paragraph (i)(3) of this section); and 

(iii) Sound recordings (as defined in 

paragraph (i)(4) of this section). 

(2) Tangible personal property—(i) In 

general. The term tangible personal 

property is any tangible property other 

than land, buildings (including items 

that are structural components of such 

buildings), and any property described 

in paragraph (i)(3), (i)(4), (j)(1), or (k) of 

this section. Property such as 

production machinery, printing presses, 

transportation and office equipment, 

refrigerators, grocery counters, testing 

equipment, display racks and shelves, 

67252 Federal Register / Vol. 70, No. 213 / Friday, November 4, 2005 / Proposed Rules 

and neon and other signs that are 

contained in or attached to a building 

constitutes tangible personal property 

for purposes of this paragraph (i)(2)(i). 

Except as provided in paragraphs 

(i)(5)(ii) and (j)(2)(i) of this section, 

computer software, sound recordings, 

and qualified films are not treated as 

tangible personal property regardless of 

whether they are fixed on a tangible 

medium. However, the tangible medium 

on which such property may be fixed 

(for example, a videocassette, a 

computer diskette, or other similar 

tangible item) is tangible personal 

property. 

(ii) Local law. In determining whether 

property is tangible personal property, 

local law is not controlling. 

(iii) Machinery. Property that is in the 

nature of machinery (other than 

structural components of a building) is 

tangible personal property even if such 

property is located outside a building. 

Thus, for example, a gasoline pump, 

hydraulic car lift, or automatic vending 

machine, although annexed to the 

ground, is considered tangible personal 

property. A structure that is property in 

the nature of machinery or is essentially 

an item of machinery or equipment is 

not an inherently permanent structure 

and is tangible personal property. In the 

case, however, of a building or 

inherently permanent structure that 

includes property in the nature of 

machinery as a structural component, 

the property in the nature of machinery 

is real property. 

(iv) Intangible property. The term 

tangible personal property does not 

include property in a form other than in 

a tangible medium. For example, massproduced books are tangible personal 

property, but neither the rights to the 

underlying manuscript nor an online 

version of the book is tangible personal 

property. 

(3) Computer software—(i) In general. 

The term computer software means any 

program or routine or any sequence of 

machine-readable code that is designed 

to cause a computer to perform a 

desired function or set of functions, and 

the documentation required to describe 

and maintain that program or routine. 

For purposes of this paragraph (i)(3), 

computer software also includes the 

machine-readable code for video games 

and similar programs, for equipment 

that is an integral part of other property, 

and for typewriters, calculators, adding 

and accounting machines, copiers, 

duplicating equipment, and similar 

equipment, regardless of whether the 

code is designed to operate on a 

computer (as defined in section 

168(i)(2)(B)). Computer programs of all 

classes, for example, operating systems, 

executive systems, monitors, compilers 

and translators, assembly routines, and 

utility programs, as well as application 

programs, are included. Except as 

provided in paragraph (i)(5) of this 

section, if the medium in which the 

software is contained, whether written, 

magnetic, or otherwise, is tangible, then 

such medium is considered tangible 

personal property for purposes of this 

section. 

(ii) Incidental and ancillary rights. 

Computer software also includes any 

incidental and ancillary rights that are 

necessary to effect the acquisition of the 

title to, the ownership of, or the right to 

use the computer software, and that are 

used only in connection with that 

specific computer software. Such 

incidental and ancillary rights are not 

included in the definition of trademark 

or trade name under § 1.197–2(b)(10)(i). 

For example, a trademark or trade name 

that is ancillary to the ownership or use 

of a specific computer software program 

in the taxpayer’s trade or business and 

is not acquired for the purpose of 

marketing the computer software is 

included in the definition of computer 

software and is not included in the 

definition of trademark or trade name. 

(iii) Exceptions. Computer software 

does not include any data or 

information base unless the data or 

information base is in the public 

domain and is incidental to a computer 

program. For this purpose, a 

copyrighted or proprietary data or 

information base is treated as in the 

public domain if its availability through 

the computer program does not 

contribute significantly to the cost of the 

program. For example, if a wordprocessing program includes a 

dictionary feature that may be used to 

spell-check a document or any portion 

thereof, the entire program (including 

the dictionary feature) is computer 

software regardless of the form in which 

the dictionary feature is maintained or 

stored. 

(4) Sound recordings—(i) In general. 

The term sound recordings means any 

works that result from the fixation of a 

series of musical, spoken, or other 

sounds under section 168(f)(4). The 

definition of sound recordings is limited 

to the master copy of the recordings (or 

other copy from which the holder is 

licensed to make and produce copies), 

and, except as provided in paragraph 

(i)(5) of this section, if the medium 

(such as compact discs, tapes, or other 

phonorecordings) in which the sounds 

may be embodied is tangible, the 

medium is considered tangible personal 

property for purposes of paragraph (i)(2) 

of this section. 

(ii) Exception. The term sound 

recordings does not include the creation 

of copyrighted material in a form other 

than a sound recording, such as lyrics 

or music composition. 

(5) Tangible personal property with 

computer software or sound 

recordings—(i) Computer software and 

sound recordings. If a taxpayer MPGE 

computer software or sound recordings 

that is fixed on, or added to, tangible 

personal property by the taxpayer (for 

example, a computer diskette, or an 

appliance), then for purposes of this 

section—

(A) The computer software and the 

tangible personal property may be 

treated by the taxpayer as computer 

software. If the taxpayer treats the 

tangible personal property as computer 

software under this paragraph 

(i)(5)(i)(A), any costs under section 174 

attributable to the tangible personal 

property are not considered in 

determining whether the taxpayer’s 

activity is substantial in nature under 

paragraph (f)(2) of this section and are 

not conversion costs under paragraph 

(f)(3) of this section; and 

(B) The sound recordings and the 

tangible personal property with the 

sound recordings may be treated by the 

taxpayer as sound recordings. If the 

taxpayer treats the tangible personal 

property as sound recordings under this 

paragraph (i)(5)(i)(B), any costs under 

section 174 attributable to the tangible 

personal property are not considered in 

determining whether the taxpayer’s 

activity is substantial in nature under 

paragraph (f)(2) of this section and are 

not conversion costs under paragraph 

(f)(3) of this section. 

(ii) Tangible personal property. If a 

taxpayer MPGE tangible personal 

property but not the computer software 

or sound recordings that the taxpayer 

fixes on, or adds to, the tangible 

personal property MPGE by the taxpayer 

(for example, a computer diskette or an 

appliance), then for purposes of this 

section the tangible personal property 

with the computer software or sound 

recordings may be treated by the 

taxpayer as tangible personal property 

under paragraph (i)(2) of this section. 

For purposes of paragraph (f)(3) of this 

section, the taxpayer’s CGS for each 

item includes the taxpayer’s cost of 

licensing the computer software or 

sound recordings. 

(j) Definition of qualified film—(1) In 

general. The term qualified film means 

any motion picture film or video tape 

under section 168(f)(3), or live or 

delayed television programming if not 

less than 50 percent of the total 

compensation paid to all actors, 

production personnel, directors, and 

Federal Register / Vol. 70, No. 213 / Friday, November 4, 2005 / Proposed Rules 67253 

producers relating to the production of 

the motion picture film, video tape, or 

television programming is 

compensation for services performed in 

the United States by those individuals. 

The term production personnel includes 

writers, choreographers and composers 

providing services during the 

production of a film, casting agents, 

camera operators, set designers, lighting 

technicians, make-up artists, and others 

whose activities are directly related to 

the production of the film. The term 

production personnel does not include, 

however, individuals whose activities 

are ancillary to the production, such as 

advertisers and promoters, distributors, 

studio administrators and managers, 

studio security personnel, and personal 

assistants to actors. The term production 

personnel also does not include 

individuals whose activities relate to 

fixing the film on tangible personal 

property. The definition of qualified 

film is limited to the master copy of the 

film (or other copy from which the 

holder is licensed to make and produce 

copies), and, except as provided in 

paragraph (j)(2) of this section, does not 

include tangible personal property 

embodying the qualified film, such as 

DVDs or videocassettes. 

(2) Tangible personal property with a 

film—(i) Film licensed to a taxpayer. If 

a taxpayer MPGE tangible personal 

property (such as a DVD) in whole or in 

significant part in the United States and 

fixes to the tangible personal property a 

film that the taxpayer licenses from the 

producer of the film, then the taxpayer 

may treat the tangible personal property 

with the affixed film as QPP, regardless 

of whether the film is a qualified film. 

The determination of whether gross 

receipts of such a taxpayer from the 

lease, rental, license, sale, exchange, or 

other disposition of the tangible 

personal property with the affixed film 

are DPGR is made under the rules of 

paragraphs (d), (e), and (f) of this 

section. For purposes of paragraph (f)(3) 

of this section, the taxpayer’s CGS for 

each item includes the taxpayer’s cost of 

licensing the film from the producer of 

the film. 

(ii) Film produced by a taxpayer. If a 

taxpayer produces a film and also fixes 

the film on tangible personal property 

(for example, a DVD), then for purposes 

of this section—

(A) Qualified films. If the film is a 

qualified film, the taxpayer may treat 

the tangible personal property on which 

the qualified film is fixed as part of the 

qualified film, in which case the gross 

receipts derived from the lease, rental, 

license, sale, exchange, or other 

disposition of the tangible personal 

property with the affixed qualified film 

will be DPGR (assuming all the other 

requirements of this section are met), 

regardless of whether the taxpayer 

MPGE the tangible personal property in 

whole or in significant part within the 

United States; and 

(B) Nonqualified films. If the film is 

not a qualified film (nonqualified film), 

any gross receipts derived from the 

lease, rental, license, sale, exchange, or 

other disposition of the tangible 

personal property with the nonqualified 

film that are allocable to the 

nonqualified film are non-DPGR. The 

taxpayer, however, may treat the 

tangible personal property (without the 

nonqualified film) as an item of QPP. 

Thus, the determination of whether 

gross receipts of such a taxpayer derived 

from the lease, rental, license, sale, 

exchange, or other disposition of the 

tangible personal property with the 

affixed nonqualified film, that are 

allocable to the tangible personal 

property, are DPGR is made under the 

rules of paragraphs (d), (e), and (f) of 

this section. 

(3) Derived from a qualified film. 

DPGR includes the gross receipts of the 

taxpayer which are derived from any 

lease, rental, license, sale, exchange, or 

other disposition of any qualified film 

produced by the taxpayer. Showing a 

qualified film on a television station is 

not a lease, rental, license, sale, 

exchange, or other disposition of the 

qualified film. Ticket sales for viewing 

qualified films do not constitute DPGR 

because the gross receipts are not 

derived from the lease, rental, license, 

sale, exchange, or other disposition of a 

qualified film. Because a taxpayer that 

merely writes a screenplay or other 

similar material is not considered to 

have produced a qualified film under 

paragraph (j)(1) of this section, the 

amounts that the taxpayer receives from 

the sale of the script or screenplay, even 

if the script is developed into a qualified 

film, are not gross receipts derived from 

a qualified film. In addition, revenue 

from the sale of film-themed 

merchandise is revenue from the sale of 

tangible personal property and not gross 

receipts derived from a qualified film. 

Gross receipts derived from a license of 

the right to use the film characters are 

not gross receipts derived from a 

qualified film. 

(4) Examples. The following examples 

illustrate the application of paragraphs 

(j)(2) and (3) of this section: 

Example 1. X produces a qualified film in 

the United States and duplicates the film 

onto purchased DVDs. X sells the DVDs with 

the qualified film to customers. Under 

paragraph (j)(2)(ii)(A) of this section, X may 

treat the DVD with the qualified film as a 

qualified film. Accordingly, X’s gross receipts 

derived from the sale of the qualified film to 

customers are DPGR (assuming all the other 

requirements of this section are met). 

Example 2. The facts are the same as in 

Example 1 except that the film is a 

nonqualified film because the film does not 

satisfy the 50 percent requirement under 

(j)(1) of this section and X manufactures the 

DVDs in the United States. Under paragraph 

(j)(2)(ii)(B) of this section, X may treat the 

DVD without the nonqualified film as 

tangible personal property. X’s gross receipts 

(not including the gross receipts attributable 

to the nonqualified film) derived from the 

sale of the tangible personal property are 

DPGR (assuming all the other requirements of 

this section are met). 

Example 3. X produces television programs 

that are qualified films. X shows the 

programs on its own television station. X 

sells advertising time slots to advertisers for 

the television programs. Because showing 

qualified films on a television station is not 

a lease, rental, license, sale, exchange, or 

other disposition, pursuant to paragraph (j)(3) 

of this section, the advertising income X 

receives from advertisers is not derived from 

the lease, rental, license, sale, exchange, or 

other disposition of qualified films. 

Example 4. X produces a qualified film and 

contracts with Y, an unrelated taxpayer, to 

duplicate the film onto DVDs. Y 

manufactures blank DVDs within the United 

States, duplicates X’s film onto the DVDs in 

the United States, and sells the DVDs with 

the qualified film to X who then sells them 

to customers. Y has all of the benefits and 

burdens of ownership under Federal income 

tax principles of the DVDs during the MPGE 

and duplication process. Assume Y’s 

activities relating to manufacture of the blank 

DVDs and duplicating the film onto the DVDs 

collectively satisfy the safe harbor under 

paragraph (f)(3) of this section. Y’s gross 

receipts from manufacturing the DVDs and 

duplicating the film onto the DVDs are 

DPGR. X’s gross receipts from the sale of the 

DVDs to customers are DPGR. 

(5) Compensation for services. The 

term compensation for services means 

all payments for services performed by 

actors, production personnel, directors, 

and producers, including participations 

and residuals. In the case of a taxpayer 

that uses the income forecast method of 

section 167(g) and capitalizes 

participations and residuals into the 

adjusted basis of the qualified film, the 

taxpayer must use the same estimate of 

participations and residuals for services 

performed by actors, production 

personnel, directors, and producers for 

purposes of this section. In the case of 

a taxpayer that excludes participations 

and residuals from the adjusted basis of 

the qualified film under section 

167(g)(7)(D)(i), the taxpayer must 

determine the compensation expected to 

be paid for services performed by actors, 

production personnel, directors, and 

producers as participations and 

residuals based on the total forecasted 

income used in determining income 

67254 Federal Register / Vol. 70, No. 213 / Friday, November 4, 2005 / Proposed Rules 

forecast depreciation. Compensation for 

services includes all direct and indirect 

compensation costs required to be 

capitalized under section 263A for film 

producers under § 1.263A–1(e)(2) and 

(3). Compensation for services is not 

limited to W–2 wages and includes 

compensation paid to independent 

contractors. 

(6) Determination of 50 percent. A 

taxpayer may use any reasonable 

method of determining the 

compensation for services performed in 

the United States by actors, production 

personnel, directors, and producers, and 

the total compensation paid to those 

individuals for services relating to the 

production of the property. Among the 

factors to be considered in determining 

whether a taxpayer’s method of 

allocating compensation is reasonable is 

whether the taxpayer uses that method 

consistently. 

(7) Exception. A qualified film does 

not include property with respect to 

which records are required to be 

maintained under 18 U.S.C. 2257. 

Section 2257 of Title 18 requires 

maintenance of certain records with 

respect to any book, magazine, 

periodical, film, videotape, or other 

matter that—

(i) Contains one or more visual 

depictions made after November 1, 

1990, of actual sexually explicit 

conduct; and 

(ii) Is produced in whole or in part 

with materials that have been mailed or 

shipped in interstate or foreign 

commerce, or is shipped or transported 

or is intended for shipment or 

transportation in interstate or foreign 

commerce. 

(k) Electricity, natural gas, or potable 

water—(1) In general. DPGR includes 

gross receipts derived from any lease, 

rental, license, sale, exchange, or other 

disposition of utilities produced by the 

taxpayer in the United States if all other 

requirements of this section are met. In 

the case of an integrated producer that 

both produces and delivers utilities, see 

paragraph (k)(4) of this section that 

describes certain gross receipts that do 

not qualify as DPGR, therefore requiring 

a taxpayer to allocate its gross receipts 

between DPGR and non-DPGR. 

(2) Natural gas. The term natural gas 

includes only natural gas extracted from 

a natural deposit and does not include, 

for example, methane gas extracted from 

a landfill. In the case of natural gas, 

production activities include all 

activities involved in extracting natural 

gas from the ground and processing the 

gas into pipeline quality gas. 

(3) Potable water. The term potable 

water means unbottled drinking water. 

In the case of potable water, production 

activities include the acquisition, 

collection, and storage of raw water 

(untreated water), transportation of raw 

water to a water treatment facility, and 

treatment of raw water at such a facility. 

Gross receipts attributable to any of 

these activities are included in DPGR if 

all other requirements of this section are 

met. 

(4) Exceptions—(i) Electricity. Gross 

receipts attributable to the transmission 

of electricity from the generating facility 

to a point of local distribution and gross 

receipts attributable to the distribution 

of electricity to final customers are nonDPGR. 

(ii) Natural gas. Gross receipts 

attributable to the transmission of 

pipeline quality gas from a natural gas 

field (or, if treatment at a natural gas 

processing plant is necessary to produce 

pipeline quality gas, from a natural gas 

processing plant) to a local distribution 

company’s citygate (or to another 

customer) are non-DPGR. Likewise, 

gross receipts of a local gas distribution 

company attributable to distribution 

from the citygate to the local customers 

are non-DPGR. 

(iii) Potable water. Gross receipts 

attributable to the storage of potable 

water after completion of treatment of 

the potable water, as well as gross 

receipts attributable to the transmission 

and distribution of potable water, are 

non-DPGR. 

(iv) De minimis exception. 

Notwithstanding paragraphs (k)(4)(i), 

(ii), and (iii) of this section, if less than 

5 percent of a taxpayer’s gross receipts 

derived from a sale, exchange, or other 

disposition of utilities are attributable to 

the transmission or distribution of the 

utilities, then the gross receipts derived 

from that lease, rental, license, sale, 

exchange, or other disposition that are 

attributable to the transmission and 

distribution of the utilities must be 

treated for purposes of section 199 as 

being DPGR if all other requirements of 

this section are met. 

(5) Example. The following example 

illustrates the application of this 

paragraph (k): 

Example. X owns a wind turbine in the 

United States that generates electricity and Y 

owns a high voltage transmission line that 

passes near X’s wind turbine and ends near 

the system of local distribution lines of Z. X 

sells the electricity produced at the wind 

turbine to Z and contracts with Y to transmit 

the electricity produced at the wind turbine 

to Z who sells the electricity to customers 

using Z’s distribution network. The gross 

receipts received by X for the sale of 

electricity produced at the wind turbine are 

DPGR. The gross receipts of Y from 

transporting X’s electricity to Z are nonDPGR under paragraph (k)(4)(i) of this 

section. Likewise, the gross receipts of Z from 

distributing the electricity are non-DPGR 

under paragraph (k)(4)(i) of this section. If X 

made direct sales of electricity to customers 

in Z’s service area and Z receives 

remuneration for the distribution of 

electricity, the gross receipts of Z are nonDPGR under paragraph (k)(4)(i) of this 

section. If X, Y, and Z are related persons (as 

defined in paragraph (b) of this section), then 

X, Y, and Z must allocate gross receipts to 

production activities, transmission activities, 

and distribution activities. 

(l) Definition of construction 

performed in the United States—(1) 

Construction of real property—(i) In 

general. The term construction means 

the construction or erection of real 

property (that is, residential and 

commercial buildings (including items 

that are structural components of such 

buildings), inherently permanent 

structures other than tangible personal 

property in the nature of machinery (see 

paragraph (i)(2)(iii) of this section), 

inherently permanent land 

improvements, oil and gas wells, and 

infrastructure) in the United States by a 

taxpayer that, at the time the taxpayer 

constructs the real property, is engaged 

in a trade or business (but not 

necessarily its primary, or only, trade or 

business) that is considered 

construction for purposes of the North 

American Industry Classification 

System (NAICS) on a regular and 

ongoing basis. A trade or business that 

is considered construction under the 

NAICS means a construction activity 

under the two-digit NAICS code of 23 

and any other construction activity in 

any other NAICS code provided the 

construction activity relates to the 

construction of real property such as 

NAICS code 213111 (drilling oil and gas 

wells) and 213112 (support activities for 

oil and gas operations). Tangible 

personal property (for example, 

appliances, furniture, and fixtures) that 

is sold as part of a construction project 

is not considered real property for 

purposes of this paragraph (l)(1)(i). In 

determining whether property is real 

property, the fact that property is real 

property under local law is not 

controlling. Conversely, property may 

be real property for purposes of this 

paragraph (l)(1)(i) even though under 

local law the property is considered 

tangible personal property. 

(ii) De minimis exception. For 

purposes of paragraph (l)(1)(i) of this 

section, if less than 5 percent of the total 

gross receipts derived by a taxpayer 

from a construction project (as 

described in paragraph (l)(1)(i) of this 

section) are derived from activities other 

than the construction of real property in 

the United States (for example, from 

non-construction activities or the sale of 

Federal Register / Vol. 70, No. 213 / Friday, November 4, 2005 / Proposed Rules 67255 

tangible personal property or land) then 

the total gross receipts derived by the 

taxpayer from the project are DPGR from 

construction. 

(2) Activities constituting 

construction. Activities constituting 

construction include activities 

performed in connection with a project 

to erect or substantially renovate real 

property, but do not include tangential 

services such as hauling trash and 

debris, and delivering materials, even if 

the tangential services are essential for 

construction. However, if the taxpayer 

performing construction also, in 

connection with the construction 

project, provides tangential services 

such as delivering materials to the 

construction site and removing its 

construction debris, the gross receipts 

derived from the tangential services are 

DPGR. Improvements to land that are 

not capitalizable to the land (for 

example, landscaping) and painting are 

activities constituting construction only 

if these activities are performed in 

connection with other activities 

(whether or not by the same taxpayer) 

that constitute the erection or 

substantial renovation of real property 

and provided the taxpayer meets the 

requirements under paragraph (l)(1) of 

this section. The taxpayer engaged in 

these activities must make a reasonable 

inquiry to determine whether the 

activity relates to the erection or 

substantial renovation of real property 

in the United States. Construction 

activities also include activities relating 

to drilling an oil well and mining and 

include any activities pursuant to which 

the taxpayer could deduct intangible 

drilling and development costs under 

section 263(c) and § 1.612–4 and 

development expenditures for a mine or 

natural deposit under section 616. The 

lease, license, or rental of equipment, 

for example, bulldozers, generators, or 

computers, to contractors for use by the 

contractors in the construction of real 

property is not a construction activity 

under this paragraph (l)(2). The term 

construction does not include any 

activity that is within the definition of 

engineering and architectural services 

under paragraph (m) of this section. 

(3) Definition of infrastructure. The 

term infrastructure includes roads, 

power lines, water systems, railroad 

spurs, communications facilities, 

sewers, sidewalks, cable, and wiring. 

The term also includes inherently 

permanent oil and gas platforms. 

(4) Definition of substantial 

renovation. The term substantial 

renovation means 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. 

(5) Derived from construction—(i) In 

general. Assuming all the requirements 

of this section are met, DPGR derived 

from the construction of real property 

performed in the United States includes 

the proceeds from the sale, exchange, or 

other disposition of real property 

constructed by the taxpayer in the 

United States (whether or not the 

property is sold immediately after 

construction is completed and whether 

or not the construction project is 

complete). DPGR derived from the 

construction of real property includes 

compensation for the performance of 

construction services by the taxpayer in 

the United States. However, DPGR 

derived from the construction of real 

property does not include gross receipts 

from the lease or rental of real property 

constructed by the taxpayer or, except 

as provided in paragraph (l)(5)(ii) of this 

section, gross receipts attributable to the 

sale or other disposition of land 

(including zoning, planning, entitlement 

costs, and other costs capitalized to the 

land such as the demolition of 

structures under section 280B). In 

addition, DPGR derived from the 

construction of real property includes 

gross receipts from any qualified 

construction warranty, that is, a 

warranty that is provided in connection 

with the constructed real property if—

(A) In the normal course of the 

taxpayer’s business, the price for the 

construction warranty is not separately 

stated from the amount charged for the 

constructed real property; and 

(B) The construction warranty is 

neither separately offered by the 

taxpayer nor separately bargained for 

with the customer (that is, the customer 

cannot purchase the constructed real 

property without the construction 

warranty). 

(ii) Land safe harbor. For purposes of 

paragraph (l)(5)(i) of this section, a 

taxpayer may allocate gross receipts 

between the proceeds from the sale, 

exchange, or other disposition of real 

property constructed by the taxpayer 

and the gross receipts attributable to the 

sale, exchange, or other disposition of 

land by reducing its costs related to 

DPGR under § 1.199–4 by costs of the 

land and any other costs capitalized to 

the land (collectively, land costs) 

(including zoning, planning, entitlement 

costs, and other costs capitalized to the 

land such as the demolition of 

structures under section 280B and land 

costs in any common improvements as 

defined in section 2.01 of Rev. Proc. 92–

29 (1992–1 C.B. 748) (see § 601.601(d)(2) 

of this chapter)) and by reducing its 

DPGR by those land costs plus a 

percentage. The percentage is based on 

the number of years that elapse between 

the date the taxpayer acquires the land, 

including the date the taxpayer enters 

into the first option to acquire all or a 

portion of the land, and ends on the 

date the taxpayer sells each item of real 

property on the land. The percentage is 

5 percent for years zero through 5; 10 

percent for years 6 through 10; and 15 

percent for years 11 through 15. Land 

held by a taxpayer for 16 or more years 

is not eligible for the safe harbor under 

this paragraph (l)(5)(ii) and the taxpayer 

must allocate gross receipts between 

land and qualifying real property. 

(iii) Examples. The following 

examples illustrate the application of 

this paragraph (l)(5): 

Example 1. X, who is in the trade or 

business of construction under NAICS code 

23 on a regular and ongoing basis, purchases 

a building in the United States and retains Y, 

an unrelated taxpayer (a general contractor), 

to oversee a substantial renovation of the 

building (within the meaning of paragraph 

(l)(4) of this section). Y retains Z (a 

subcontractor) to install a new electrical 

system in the building as part of that 

substantial renovation. The amounts that Y 

receives from X for construction services, and 

amounts that Z receives from Y for 

construction services, qualify as DPGR under 

paragraph (l)(5)(i) of this section provided Y 

and Z meet all of the requirements of 

paragraph (l)(1) of this section. The gross 

receipts that X receives from the subsequent 

sale of the building do not qualify as DPGR 

because X did not engage in any activity 

constituting construction under paragraph 

(l)(2) of this section even though X is in the 

trade or business of construction. The results 

would be the same if X and Y were members 

of the same EAG under § 1.199–7(a). 

However, if X and Y were members of the 

same consolidated group, see § 1.199–7(d)(2). 

Example 2. X is engaged as an electrical 

contractor under NAICS code 238210 on a 

regular and ongoing basis. X purchases the 

wires, conduits, and other electrical materials 

that it installs in construction projects in the 

United States. In a particular construction 

project, all of the wires, conduits, and other 

electrical materials installed by X for the 

operation of that building are considered 

structural components of the building. X’s 

gross receipts derived from installing that 

property are derived from the construction of 

real property under paragraph (l)(1) of this 

section. However, X’s gross receipts derived 

from the purchased materials do not qualify 

as DPGR. 

Example 3. X is in a trade or business that 

is considered construction under the twodigit NAICS code of 23. X buys unimproved 

land. X gets the land zoned for residential 

housing through an entitlement process. X 

grades the land and sells the land to home 

builders. The gross receipts that X receives 

from the sale of the land do not qualify as 

DPGR under paragraph (l)(5)(i) of this section 

because the gross receipts are not derived 

from the construction of real property. 

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Example 4. The facts are the same as in 

Example 3 except that X builds roads, 

sewers, sidewalks, and installs power and 

water lines on the land. The gross receipts 

that X receives that are attributable to the sale 

of the roads, sewers, sidewalks, and power 

and water lines, which qualify as 

infrastructure under paragraph (l)(3) of this 

section, are DPGR. X’s gross receipts from the 

land including capitalized costs of 

entitlements do not qualify as DPGR under 

paragraph (l)(5)(i) of this section because the 

gross receipts are not derived from the 

construction of real property. 

Example 5. (i) X is engaged in the business 

activities of constructing housing within the 

meaning of paragraph (l)(1) of this section. 

On June 1, 2005, X pays $50,000,000 for 

1,000 acres of land that X will develop as a 

new housing development. In 2008, after the 

expenditure of $10,000,000 for entitlement 

costs, X receives permits to begin 

construction. After this expenditure, X’s land 

costs total $60,000,000. The development 

consists of 1,000 houses to be built on halfacre lots over 5 years. On January 31, 2010, 

the first house is sold for $300,000. 

Construction costs for each house are 

$170,000. Common improvements consisting 

of streets, sidewalks, sewer lines, 

playgrounds, clubhouses, tennis courts, and 

swimming pools that X is contractually 

obligated or required by law to provide cost 

$55,000 per lot. The common improvements 

include $30,000 in land costs underlying the 

common improvements. 

(ii) Pursuant to the land safe harbor 

under paragraph (l)(5)(ii) of this section, 

X calculates the total costs under 

§ 1.199–4 for each house sold in 2010 as 

$195,000 (total costs of $255,000 

($170,000 in construction costs plus 

$55,000 in common improvements 

(including $30,000 in land costs) plus 

$30,000 in land costs for the lot), which 

are reduced by land costs of $60,000). X 

calculates the DPGR for each house sold 

by May 31, 2010, by taking the gross 

receipts of $300,000 and reducing that 

amount by land costs of $60,000 plus a 

percentage of $60,000. As X acquired 

the land on June 1, 2005, and sold the 

houses on the land between January 31, 

2010, and May 31, 2010, the percentage 

reduction for X is 5 percent because X 

has held the land for not more than 5 

years from the anniversary of the date of 

acquisition. Thus, the DPGR for each 

house is $237,000 

($300,000¥$60,000¥$3,000) with costs 

for each house of $195,000 for a 

calculation of QPAI for each house of 

$42,000. 

Example 6. The facts are the same as in 

Example 5 except some of the houses are 

sold between June 1, 2010, and December 31, 

2010. X calculates the DPGR for each house 

sold between June 1, 2010, and December 31, 

2010, by taking the gross receipts of $300,000 

and reducing that amount by land costs of 

$60,000 plus a percentage of $60,000. As X 

acquired the land on June 1, 2005, and sold 

the houses on the land between June 1, 2010, 

and December 31, 2010, the percentage 

reduction for X is 10 percent because X has 

held the land for more than 5 years but not 

more than 10 years from the anniversary of 

the date of acquisition. Thus, the DPGR for 

each house is $234,000 

($300,000¥$60,000¥$6,000) with costs for 

each house of $195,000 for a calculation of 

QPAI for each house of $39,000. 

(m) Definition of engineering and 

architectural services—(1) In general. 

DPGR includes gross receipts derived 

from engineering or architectural 

services performed in the United States 

for a construction project described in 

paragraph (l) of this section. At the time 

the taxpayer performs the engineering or 

architectural services, the taxpayer must 

be engaged in a trade or business (but 

not necessarily its primary, or only, 

trade or business) that is considered 

engineering or architectural services for 

purposes of the NAICS, for example 

NAICS codes 541330 (engineering 

services) or 541310 (architectural 

services), on a regular and ongoing 

basis. DPGR includes gross receipts 

derived from engineering or 

architectural services, including 

feasibility studies for a construction 

project in the United States, even if the 

planned construction project is not 

undertaken or is not completed. 

(2) Engineering services. Engineering 

services in connection with any 

construction project include any 

professional services requiring 

engineering education, training, and 

experience and the application of 

special knowledge of the mathematical, 

physical, or engineering sciences to 

those professional services such as 

consultation, investigation, evaluation, 

planning, design, or responsible 

supervision of construction for the 

purpose of assuring compliance with 

plans, specifications, and design. 

(3) Architectural services. 

Architectural services in connection 

with any construction project include 

the offering or furnishing of any 

professional services such as 

consultation, planning, aesthetic and 

structural design, drawings and 

specifications, or responsible 

supervision of construction (for the 

purpose of assuring compliance with 

plans, specifications, and design) or 

erection, in connection with any 

construction project. 

(4) De minimis exception for 

performance of services in the United 

States. If less than 5 percent of the total 

gross receipts derived by a taxpayer 

from engineering or architectural 

services performed in the United States 

for a construction project (described in 

paragraph (l) of this section) are derived 

from services not relating to a 

construction project described in 

paragraph (l) of this section (for 

example, the services are performed 

outside the United States or in 

connection with property other than 

real property) then the total gross 

receipts derived by the taxpayer are 

DPGR from engineering or architectural 

services performed in the United States 

for a construction project. 

(n) Exception for sales of certain food 

and beverages—(1) In general. DPGR 

does not include gross receipts of the 

taxpayer that are derived from the sale 

of food or beverages prepared by the 

taxpayer at a retail establishment. A 

retail establishment is defined as 

tangible property (both real and 

personal) leased, occupied, or otherwise 

used by the taxpayer in its trade or 

business of selling food or beverages to 

the public at which retail sales are 

made. In addition, a facility that 

prepares food and beverages solely for 

take out service or delivery is a retail 

establishment (for example, a caterer). A 

facility at which food or beverages are 

prepared will not be treated as a retail 

establishment if less than 5 percent of 

the gross receipts from the sale of food 

or beverages at that facility during the 

taxable year are attributable to retail 

sales. If a taxpayer’s facility is a retail 

establishment in the United States, then, 

for purposes of this section, the taxpayer 

may allocate its gross receipts between 

gross receipts derived from the retail 

sale of the food and beverages prepared 

and sold at the retail establishment 

(which are non-DPGR) and gross 

receipts derived from the wholesale sale 

of the food and beverages prepared at 

the retail establishment (which are 

DPGR). Wholesale sales are sales of food 

and beverages to be resold by the 

purchaser. The exception for sales of 

certain food and beverages also applies 

to food and beverages for non-human 

consumption. A retail establishment 

does not include the bonded premises of 

a distilled spirits plant or wine cellar, or 

the premises of a brewery (other than a 

tavern on the brewery premises). See 

Chapter 51 of Title 26 of the United 

States Code and the implementing 

regulations thereunder. 

(2) Examples. The following examples 

illustrate the application of this 

paragraph (n): 

Example 1. X buys coffee beans and roasts 

those beans at a facility in the United States, 

the only activity of which is the roasting and 

packaging of roasted coffee beans. X sells the 

roasted coffee beans through a variety of 

unrelated third-party vendors and also sells 

roasted coffee beans at X’s retail 

establishments. At X’s retail establishments, 

X prepares brewed coffee and other foods. To 

the extent that the gross receipts of X’s retail 

Federal Register / Vol. 70, No. 213 / Friday, November 4, 2005 / Proposed Rules 67257 

establishments represent receipts from the 

sale of coffee beans roasted at the facility, the 

receipts are DPGR. To the extent the gross 

receipts of X’s retail establishments represent 

receipts from the retail sale of brewed coffee 

or food prepared at the retail establishments, 

the receipts are non-DPGR. However, 

pursuant to § 1.199–1(c)(2), X must allocate 

part of the receipts from the retail sale of the 

brewed coffee as DPGR to the extent of the 

value of the coffee beans that were roasted at 

the facility and that were used to brew coffee. 

Example 2. Y operates a bonded winery 

in California. Bottles of wine produced by Y 

at the bonded winery are sold to consumers 

at the taxpaid premises. Pursuant to 

paragraph (n)(1) of this section, the bonded 

premises is not considered a retail 

establishment and is treated as separate and 

apart from the taxpaid premises, which is 

considered a retail establishment for 

purposes of paragraph (n)(1) of this section. 

Accordingly, the wine produced by Y in the 

bonded premises and sold by Y from the 

taxpaid premises is not considered to have 

been produced at a retail establishment, and 

the sales of the wine are DPGR (assuming all 

the other requirements of this section are 

met). 

§ 1.199–4 Costs allocable to domestic 

production gross receipts. 

(a) In general. To determine its 

qualified production activities income 

(QPAI) (as defined in § 1.199–1(c)) for a 

taxable year, a taxpayer must subtract 

from its domestic production gross 

receipts (DPGR) (as defined in § 1.199–

3(a)) the cost of goods sold (CGS) 

allocable to DPGR, the amount of 

expenses or losses (deductions) directly 

allocable to DPGR, and a ratable portion 

of other deductions not directly 

allocable to DPGR or to another class of 

income. Paragraph (b) of this section 

provides rules for determining CGS 

allocable to DPGR. Paragraph (c) of this 

section provides rules for determining 

the deductions allocated and 

apportioned to DPGR and a ratable 

portion of deductions that are not 

directly allocable to DPGR or to another 

class of income. Paragraph (d) of this 

section provides that a taxpayer 

generally must determine deductions 

allocated and apportioned to DPGR or to 

gross income attributable to DPGR using 

the rules of the regulations at §§ 1.861–

8 through 1.861–17 and §§ 1.861–8T 

through 1.861–14T (the section 861 

regulations), subject to the rules in 

paragraph (d) of this section (the section 

861 method). Paragraph (e) of this 

section provides that certain taxpayers 

may apportion deductions to DPGR 

using the simplified deduction method. 

Paragraph (f) of this section provides a 

small business simplified overall 

method that a qualifying small taxpayer 

may use to apportion CGS and 

deductions to DPGR. 

(b) Cost of goods sold allocable to 

domestic production gross receipts—(1) 

In general. When determining its QPAI, 

a taxpayer must reduce DPGR by the 

CGS allocable to DPGR. A taxpayer 

determines its CGS allocable to DPGR in 

accordance with this paragraph (b) or, if 

applicable, paragraph (f) of this section. 

In the case of a sale, exchange, or other 

disposition of inventory, CGS is equal to 

beginning inventory plus purchases and 

production costs incurred during the 

taxable year and included in inventory 

costs, less ending inventory. CGS is 

determined under the methods of 

accounting that the taxpayer uses to 

compute taxable income. See sections 

263A, 471, and 472. Additional section 

263A costs, as defined in § 1.263A–

1(d)(3), must be included in 

determining CGS. In the case of a sale, 

exchange, or other disposition 

(including, for example, theft, casualty, 

or abandonment) of non-inventory 

property, CGS for purposes of this 

section includes the adjusted basis of 

the property. CGS allocable to DPGR for 

a taxable year may include the 

inventory cost and adjusted basis of 

qualifying production property (QPP) 

(as defined in § 1.199–3(i)(1)), a 

qualified film (as defined in § 1.199–

3(j)(1)), or electricity, natural gas, and 

potable water (as defined in § 1.199–

3(k)) (collectively, utilities) that will, or 

have, generated DPGR notwithstanding 

that the gross receipts attributable to the 

sale of the QPP, qualified films, or 

utilities will, or have been, included in 

the computation of gross income for a 

different taxable year. For example, 

advance payments related to DPGR may 

be included in gross income under 

§ 1.451–5(b)(1)(i) in a different taxable 

year than the related CGS allocable to 

that DPGR. CGS allocable to DPGR 

includes inventory valuation 

adjustments such as writedowns under 

the lower of cost or market method. If 

non-DPGR is treated as DPGR pursuant 

to §§ 1.199–1(d)(2) and 1.199–3(h)(4), 

(k)(4)(iv), (l)(1)(ii), (m)(4), or (n)(1), CGS 

related to such gross receipts that are 

treated as DPGR must be allocated or 

apportioned to DPGR. 

(2) Allocating cost of goods sold. A 

taxpayer must use a reasonable method 

that is satisfactory to the Secretary to 

allocate CGS between DPGR and nonDPGR. Whether an allocation method is 

reasonable is based on all of the facts 

and circumstances including whether 

the taxpayer uses the most accurate 

information available; the relationship 

between CGS and the method used; the 

accuracy of the method chosen as 

compared with other possible methods; 

whether the method is used by the 

taxpayer for internal management and 

other business purposes; whether the 

method is used for other Federal or state 

income tax purposes; the availability of 

costing information; the time, burden, 

and cost of using various methods; and 

whether the taxpayer applies the 

method consistently from year to year. 

If a taxpayer does, or can, without 

undue burden or expense, specifically 

identify from its books and records CGS 

allocable to DPGR, the CGS allocable to 

DPGR is that amount irrespective of 

whether the taxpayer uses another 

allocation method to allocate gross 

receipts between DPGR and non-DPGR. 

A taxpayer that cannot, without undue 

burden or expense, use a specific 

identification method to determine CGS 

allocable to DPGR is not required to use 

a specific identification method to 

determine CGS allocable to DPGR. 

Ordinarily, if a taxpayer uses a method 

to allocate gross receipts between DPGR 

and non-DPGR, the use of a different 

method to allocate CGS that is not 

demonstrably more accurate than the 

method used to allocate gross receipts 

will not be considered reasonable. 

Depending on the facts and 

circumstances, reasonable methods may 

include methods based on gross 

receipts, number of units sold, number 

of units produced, or total production 

costs. 

(3) Special rules for imported items or 

services. The cost of any item or service 

brought into the United States (as 

defined in § 1.199–3(g)) without an 

arm’s length transfer price may not be 

treated as less than its value 

immediately after it entered the United 

States for purposes of determining the 

CGS to be used in the computation of 

QPAI. When an item or service is 

imported into the United States that had 

been exported by the taxpayer for 

further manufacture, the increase in cost 

may not exceed the difference between 

the value of the property when exported 

and the value of the property when 

imported back into the United States 

after further manufacture. For this 

purpose, the value of property is its 

customs value as defined in section 

1059A(b)(1). 

(4) Rules for inventories valued at 

market or bona fide selling prices. If part 

of CGS is attributable to inventory 

valuation adjustments, CGS allocable to 

DPGR includes inventory adjustments to 

QPP that is MPGE in whole or in 

significant part within the United 

States, qualified films produced in the 

United States, or utilities produced in 

the United States. Accordingly, 

taxpayers that value inventory under 

§ 1.471–4 (inventories at cost or market, 

whichever is lower) or § 1.471–2(c) 

67258 Federal Register / Vol. 70, No. 213 / Friday, November 4, 2005 / Proposed Rules 

(subnormal goods at bona fide selling 

prices) must allocate a proper share of 

such adjustments (for example, 

writedowns) to DPGR based on a 

reasonable method that is satisfactory to 

the Secretary based on all of the facts 

and circumstances. Factors taken into 

account in determining whether the 

method is reasonable include whether 

the taxpayer uses the most accurate 

information available; the relationship 

between the adjustment and the 

allocation base chosen; the accuracy of 

the method chosen as compared with 

other possible methods; whether the 

method is used by the taxpayer for 

internal management or other business 

purposes; whether the method is used 

for other Federal or state income tax 

purposes; the time, burden, and cost of 

using various methods; and whether the 

taxpayer applies the method 

consistently from year to year. If a 

taxpayer does, or can, without undue 

burden or expense, specifically identify 

from its books and records the proper 

amount of inventory valuation 

adjustments allocable to DPGR, then the 

taxpayer must allocate that amount to 

DPGR. A taxpayer that cannot, without 

undue burden or expense, use a specific 

identification method to determine the 

proper amount of inventory valuation 

adjustments allocable to DPGR is not 

required to use a specific identification 

method to allocate adjustments to 

DPGR. 

(5) Rules applicable to inventories 

accounted for under the last-in, first-out 

(LIFO) inventory method—(i) In general. 

This paragraph applies to inventories 

accounted for using the specific goods 

last-in, first-out (LIFO) method or the 

dollar-value LIFO method. Whenever a 

specific goods grouping or a dollarvalue pool contains QPP, qualified 

films, or utilities that produces DPGR 

and goods that do not, the taxpayer 

must allocate CGS attributable to that 

grouping or pool between DPGR and 

non-DPGR using a reasonable method. 

Whether a method of allocating CGS 

between DPGR and non-DPGR is 

reasonable must be determined in 

accordance with paragraph (b)(2) of this 

section. In addition, this paragraph 

(b)(5) provides methods that a taxpayer 

may use to allocate CGS for inventories 

accounted for using the LIFO method. If 

a taxpayer uses the LIFO/FIFO ratio 

method provided in paragraph (b)(5)(ii) 

of this section or the change in relative 

base-year cost method provided in 

paragraph (b)(5)(iii) of this section, the 

taxpayer must use that method for all 

inventory accounted for under the LIFO 

method. 

(ii) LIFO/FIFO ratio method. A 

taxpayer using the specific goods LIFO 

method or the dollar-value LIFO method 

may use the LIFO/FIFO ratio method. 

The LIFO/FIFO ratio method is applied 

with respect to all LIFO inventory of a 

taxpayer on a grouping-by-grouping or 

pool-by-pool basis. Under the LIFO/ 

FIFO ratio method, a taxpayer computes 

the CGS of a grouping or pool allocable 

to DPGR by multiplying the CGS of 

QPP, qualified films, or utilities in the 

grouping or pool that produced DPGR 

computed using the first-in, first-out 

(FIFO) method by the LIFO/FIFO ratio 

of the grouping or pool. The LIFO/FIFO 

ratio of a grouping or pool is equal to 

the total CGS of the grouping or pool 

computed using the LIFO method over 

the total CGS of the grouping or pool 

computed using the FIFO method. 

(iii) Change in relative base-year cost 

method. A taxpayer using the dollarvalue LIFO method may use the change 

in relative base-year cost method. The 

change in relative base-year cost method 

is applied with respect to all LIFO 

inventory of a taxpayer on a pool-bypool basis. The change in relative baseyear cost method determines the CGS 

allocable to DPGR by increasing or 

decreasing the total production costs 

(section 471 costs and additional section 

263A costs) of QPP, qualified films, and 

utilities that generate DPGR by a portion 

of any increment or liquidation of the 

dollar-value pool. The portion of an 

increment or liquidation allocable to 

DPGR is determined by multiplying the 

LIFO value of the increment or 

liquidation (expressed as a positive 

number) by the ratio of the change in 

total base-year cost (expressed as a 

positive number) of the QPP, qualifying 

films, and utilities that will generate 

DPGR in ending inventory to the change 

in total base-year cost (expressed as a 

positive number) of all goods in the 

ending inventory. The portion of an 

increment or liquidation allocable to 

DPGR may be zero but cannot exceed 

the amount of the increment or 

liquidation. Thus, a ratio in excess of 

1.0 must be treated as 1.0. 

(6) Taxpayers using the simplified 

production method or simplified resale 

method for additional section 263A 

costs. A taxpayer that uses the 

simplified production method or 

simplified resale method to allocate 

additional section 263A costs, as 

defined in § 1.263A–1(d)(3), to ending 

inventory must follow the rules in 

paragraph (b)(2) of this section to 

determine the amount of additional 

section 263A costs allocable to DPGR. 

Allocable additional section 263A costs 

include additional section 263A costs 

included in beginning inventory as well 

as additional section 263A costs 

incurred during the taxable year. 

Ordinarily, if a taxpayer uses the 

simplified production method or the 

simplified resale method, then 

additional section 263A costs should be 

allocated in the same proportion as 

section 471 costs are allocated. 

(7) Examples. The following examples 

illustrate the application of this 

paragraph (b): 

Example 1. Advance payments.T, a 

calendar year taxpayer, is a manufacturer of 

furniture in the United States. Under its 

method of accounting, T includes advance 

payments in gross income when the 

payments are received. In December 2005, T 

receives an advance payment of $5,000 from 

X with respect to an order of furniture to be 

manufactured for a total price of $20,000. In 

2006, T produces and ships the furniture to 

X. In 2006, T incurs $14,000 of section 471 

and additional section 263A costs to produce 

the furniture ordered by X. T receives the 

remaining $15,000 of the contract price from 

X in 2006. T must include the $5,000 

advance payment in income and DPGR in 

2005. The remaining $15,000 of the contract 

price must be included in income and DPGR 

when received by T in 2006. T must include 

the $14,000 it incurred to produce the 

furniture in CGS and CGS allocable to DPGR 

in 2006. See § 1.199–1(e)(1) for rules 

regarding gross receipts and costs recognized 

in different taxable years. 

Example 2. Use of standard cost method. 

X, a calendar year taxpayer, manufactures 

item A in a factory located in the United 

States and item B in a factory located in 

Country Y. Item A is produced by X in 

significant part within the United States and 

the sale of A generates DPGR. X uses the 

FIFO inventory method to account for its 

inventory and determines the cost of item A 

using a standard cost method. At the 

beginning of its taxable year, X’s inventory 

contains 2,000 units of item A at a standard 

cost of $5 per unit. X did not incur 

significant cost variances in previous taxable 

years. During the 2005 taxable year, X 

produces 8,000 units of item A at a standard 

cost of $6 per unit. X determines that with 

regard to its production of item A it has 

incurred a significant cost variance. When X 

reallocates the cost variance to the units of 

item A that it has produced, the production 

cost of item A is $7 per unit. X sells 7,000 

units of item A during the taxable year. X can 

identify from its books and records that CGS 

related to sale of item A is $45,000 ((2,000 

× $5) + (5,000 × $7)). Accordingly, X has CGS 

allocable to DPGR of $45,000. 

Example 3. Change in relative base-year 

cost method. (i) Y elects, beginning with the 

calendar year 2005, to compute its 

inventories using the dollar-value, LIFO 

method under section 472. Y establishes a 

pool for items A and B. Y produces item A 

in significant part within the United States 

and the sales of item A generate DPGR. Y 

does not produce item B in significant part 

within the United States and the sale of item 

B does not generate DPGR. The composition 

of the inventory for the pool at the base date, 

January 1, 2005, is as follows: 

Federal Register / Vol. 70, No. 213 / Friday, November 4, 2005 / Proposed Rules 67259 

Item Unit Unit cost Total cost 

A ............................................................................................................................................................... 2,000 $5.00 $10,000 

B ............................................................................................................................................................... 1,250 4.00 5,000 

Total .................................................................................................................................................. .................... .................... 15,000 

(ii) Y uses a standard cost method to 

allocate all direct and indirect costs (section 

471 and additional section 263A costs) to the 

units of item A and item B that it produces. 

During 2005, Y incurs $52,500 of section 471 

costs and additional section 263A costs to 

produce 10,000 units of item A and $114,000 

of section 471 costs and additional section 

263A costs to produce 20,000 units of item 

B. 

(iii) The closing inventory of the pools at 

December 31, 2005, contains 3,000 units of 

item A and 2,500 units of item B. The closing 

inventory of the pool at December 31, 2005, 

shown at base-year and current-year cost is 

as follows: 

Item Quantity Base-year 

cost Amount Current-year cost Amount 

A ............................................................................................................... 3,000 $5.00 $15,000 $5.25 $15,750 

B ............................................................................................................... 2,500 4.00 10,000 5.70 14,250 

Totals ................................................................................................ .................... .................... 25,000 .................... 30,000 

(iv) The base-year cost of the closing LIFO 

inventory at December 31, 2005, amounts to 

$25,000, and exceeds the $15,000 base-year 

cost of the opening inventory for the taxable 

year by $10,000 (the increment stated at baseyear cost). The increment valued at currentyear cost is computed by multiplying the 

increment stated at base-year cost by the ratio 

of the current-year cost of the pool to total 

base-year cost of the pool (that is, $30,000/ 

$25,000, or 120 percent). The increment 

stated at current-year cost is $12,000 ($10,000 

× 120%). 

(v) The change in relative base-year cost of 

item A is $5,000 ($15,000¥$10,000). The 

change in relative base-year cost (the 

increment stated at base-year cost) of the total 

inventory is $10,000 ($25,000¥$15,000). The 

ratio of the change in base-year cost of item 

A to the change in base-year cost of the total 

inventory is 50% ($5,000/$10,000). 

(vi) CGS allocable to DPGR is $46,500, 

computed as follows: 

Current-year production costs related to DPGR ........................................................................................................... .................... $52,500 

Less: 

Increment stated at current-year cost .................................................................................................................... $12,000 ......................

Ratio ....................................................................................................................................................................... 50% ......................

Total ........................................................................................................................................................................ .................... (6,000 ) 

Total ................................................................................................................................................................. .................... 46,500 

Example 4. Change in relative base-year 

cost method. (i) The facts are the same as in 

Example 3 except that, during the calendar 

year 2006, Y experiences an inventory 

decrement. During 2006, Y incurs $66,000 of 

section 471 costs and additional section 

263A costs to produce 12,000 units of item 

A and $150,000 of section 471 costs and 

additional section 263A costs to produce 

25,000 units of item B. 

(ii) The closing inventory of the pool at 

December 31, 2006, contains 2,000 units of 

item A and 2,500 units of item B. The closing 

inventory of the pool at December 31, 2006, 

shown at base-year and current-year cost is 

as follows: 

Item Quantity Base-year 

cost Amount Current-year cost Amount 

A ............................................................................................................... 2,000 $5.00 $10,000 $5.50 $11,000 

B ............................................................................................................... 2,500 4.00 10,000 6.00 15,000 

Totals ................................................................................................ .................... .................... 20,000 .................... 26,000 

(iii) The base-year cost of the closing LIFO 

inventory at December 31, 2006, amounts to 

$20,000, and is less than the $25,000 baseyear cost of the opening inventory for that 

year by $5,000 (the decrement stated at baseyear cost). This liquidation is reflected by 

reducing the most recent layer of increment. 

The LIFO value of the inventory at December 

31, 2006 is: 

Base cost Index LIFO value 

January 1, 2005, base cost ..................................................................................................................... $15,000 1.00 $15,000 

December 31, 2005, increment ............................................................................................................... 5,000 1.20 6,000 

Total .................................................................................................................................................. .................... .................... 21,000 

(iv) The change in relative base-year cost 

of item A is $5,000 ($15,000 ¥ $10,000). The 

change in relative base-year cost of the total 

inventory is $5,000 ($25,000 ¥ $20,000). The 

ratio of the change in base-year cost of item 

A to the change in base-year cost of the total 

inventory is 100% ($5,000/$5,000). 

67260 Federal Register / Vol. 70, No. 213 / Friday, November 4, 2005 / Proposed Rules 

(v) CGS allocable to DPGR is $72,000, 

computed as follows: 

Current-year production costs related to DPGR ............................................................................................................. .................... $66,000 

Plus: 

LIFO value of decrement .......................................................................................................................................... $6,000 ...................

Ratio .......................................................................................................................................................................... 100% ...................

Total .......................................................................................................................................................................... .................... 6,000 

Total ................................................................................................................................................................... .................... 72,000 

Example 5. LIFO/FIFO ratio method. (i) 

The facts are the same as in Example 3 

except that Y uses the LIFO/FIFO ratio 

method to determine its CGS allocable to 

DPGR. 

(ii) Y’s CGS related to item A on a FIFO 

basis is $46,750 ((2,000 units at $5) + (7,000 

units at $5.25)). 

(iii) Y’s total CGS computed on a LIFO 

basis is $154,500 (beginning inventory of 

$15,000 plus total production costs of 

$166,500 less ending inventory of $27,000). 

(iv) Y’s total CGS computed on a FIFO 

basis is $151,500 (beginning inventory of 

$15,000 plus total production costs of 

$166,500 less ending inventory of $30,000). 

(v) The ratio of Y’s CGS computed using 

the LIFO method to its CGS computed using 

the FIFO method is 102% ($154,500/ 

$151,500). Y’s CGS related to DPGR 

computed using the LIFO/FIFO ratio method 

is $47,685 ($46,750 × 102%). 

Example 6. LIFO/FIFO ratio method. (i) 

The facts are the same as in Example 4 

except that Y uses the LIFO/FIFO ratio 

method to compute CGS allocable to DPGR. 

(ii) Y’s CGS related to item A on a FIFO 

basis is $70,750 ((3,000 units at $5.25) + 

(10,000 units at $5.50)). 

(iii) Y’s total CGS computed on a LIFO 

basis is $222,000 (beginning inventory of 

$27,000 plus total production costs of 

$216,000 less ending inventory of $21,000). 

(iv) Y’s total CGS computed on a FIFO 

basis is $220,000 (beginning inventory of 

$30,000 plus total production costs of 

$216,000 less ending inventory of $26,000). 

(v) The ratio of Y’s CGS computed using 

the LIFO method to its CGS computed using 

the FIFO method is 101% ($222,000/ 

$220,000). Y’s CGS related to DPGR 

computed using the LIFO/FIFO ratio method 

is $71,457 ($70,750 × 101%). 

(c) Other deductions allocable or 

apportioned to domestic production 

gross receipts or gross income 

attributable to domestic production 

gross receipts—(1) In general. In 

determining its QPAI, a taxpayer must 

subtract from its DPGR, in addition to 

its CGS allocable to DPGR, the 

deductions that are directly allocable to 

DPGR, and a ratable portion of 

deductions that are not directly 

allocable to DPGR or to another class of 

income. A taxpayer generally must 

allocate and apportion these deductions 

using the rules of the section 861 

method. In lieu of the section 861 

method, certain taxpayers may 

apportion these deductions using the 

simplified deduction method provided 

in paragraph (e) of this section. 

Paragraph (f) of this section provides a 

small business simplified overall 

method that may be used by a qualified 

small taxpayer, as defined in that 

paragraph. A taxpayer using the 

simplified deduction method or the 

small business simplified overall 

method must use that method for all 

deductions. A taxpayer eligible to use 

the small business simplified overall 

method may choose at any time to use 

the small business simplified overall 

method, the simplified deduction 

method, or the section 861 method for 

a taxable year. A taxpayer eligible to use 

the simplified deduction method may 

choose at any time to use the simplified 

deduction method or the section 861 

method for a taxable year. 

(2) Treatment of certain deductions—

(i) In general. The rules provided in this 

paragraph (c)(2) apply to net operating 

losses and certain other deductions for 

purposes of allocating and apportioning 

deductions to DPGR or gross income 

attributable to DPGR for all of the 

methods provided by this section. 

(ii) Net operating losses. A deduction 

under section 172 for a net operating 

loss is not allocated or apportioned to 

DPGR or gross income attributable to 

DPGR. 

(iii) Deductions not attributable to the 

conduct of a trade or business. 

Deductions not attributable to the 

conduct of a trade or business are not 

allocated or apportioned to DPGR or 

gross income attributable to DPGR. For 

example, the standard deduction 

provided by section 63(c) and the 

deduction for personal exemptions 

provided by section 151 are not 

allocated or apportioned to DPGR or 

gross income attributable to DPGR. 

(d) Section 861 method—(1) In 

general. A taxpayer must allocate and 

apportion its deductions using the 

allocation and apportionment rules 

provided by the section 861 method 

under which section 199 is treated as an 

operative section described in § 1.861–

8(f). Accordingly, the taxpayer applies 

the rules of the section 861 regulations 

to allocate and apportion deductions 

(including its distributive share of 

deductions from pass-thru entities) to 

gross income attributable to DPGR. If the 

taxpayer applies the allocation and 

apportionment rules of the section 861 

regulations for an operative section 

other than section 199, the taxpayer 

must use the same method of allocation 

and the same principles of 

apportionment for purposes of all 

operative sections (subject to the rules 

provided in paragraphs (c)(2) and (d)(2) 

and (3) of this section). See § 1.861–

8(f)(2)(i). 

(2) Deductions for charitable 

contributions. Deductions for charitable 

contributions (as allowed under sections 

170, 873(b)(2), and 882(c)(1)(B)) must be 

ratably apportioned between gross 

income attributable to DPGR and other 

gross income based on the relative 

amounts of gross income. For 

individuals, this provision applies 

solely to deductions for charitable 

contributions that are attributable to the 

actual conduct of a trade or business. 

(3) Research and experimental 

expenditures. Research and 

experimental expenditures must be 

allocated and apportioned in 

accordance with § 1.861–17 without 

taking into account the exclusive 

apportionment rule of § 1.861–17(b). 

(4) Deductions related to gross 

receipts deemed to be domestic 

production gross receipts. If non-DPGR 

is treated as DPGR pursuant to §§ 1.199–

1(d)(2) and 1.199–3(h)(4), (k)(4)(iv), 

(l)(1)(ii), (m)(4), or (n)(1), deductions 

related to such gross receipts that are 

treated as DPGR must be allocated or 

apportioned to gross income attributable 

to DPGR. 

(5) Examples. The following examples 

illustrate the operation of the section 

861 method. Assume that with respect 

to the allocation and apportionment of 

interest expense, § 1.861–10T does not 

apply in the following examples. The 

examples read as follows: 

Example 1. General section 861 method. (i) 

X, a United States corporation that is not a 

member of an expanded affiliated group 

(EAG) (as defined in § 1.199–7), engages in 

activities that generate both DPGR and nonDPGR. All of X’s production activities that 

generate DPGR are within Standard 

Industrial Classification (SIC) Industry Group 

AAA (SIC AAA)). All of X’s production 

Federal Register / Vol. 70, No. 213 / Friday, November 4, 2005 / Proposed Rules 67261 

activities that generate non-DPGR are within 

SIC Industry Group BBB (SIC BBB). X is able 

to identify from its books and records CGS 

allocable to DPGR and to non-DPGR. X incurs 

$900 of research and experimentation 

expenses (R&E) that are deductible under 

section 174, $300 of which are performed 

with respect to SIC AAA and $600 of which 

are performed with respect to SIC BBB. None 

of the R&E is legally mandated R&E as 

described in § 1.861–17(a)(4) and none of the 

R&E is included in CGS. X incurs section 162 

selling expenses (that include W–2 wages as 

defined in § 1.199–2(f)) that are not 

includible in CGS and not directly allocable 

to any gross income. For 2010, the adjusted 

basis of X’s assets that generate gross income 

attributable to DPGR and to non-DPGR is, 

respectively, $4,000 and $1,000. For 2010, 

X’s taxable income is $1,380 based on the 

following Federal income tax items: 

DPGR (all from sales of products within SIC AAA) .............................................................................................................................. $3,000 

Non-DPGR (all from sales of products within SIC BBB) ...................................................................................................................... 3,000 

CGS allocable to DPGR (includes $100 of W–2 wages) ...................................................................................................................... (600 ) 

CGS allocable to non-DPGR (includes $100 of W–2 wages) .............................................................................................................. (1,800 ) 

Section 162 selling expenses (includes $100 of W–2 wages) ............................................................................................................. (840 ) 

Section 174 R&E–SIC AAA ................................................................................................................................................................... (300 ) 

Section 174 R&E–SIC BBB ................................................................................................................................................................... (600 ) 

Interest expense (not included in CGS) ................................................................................................................................................ (300 ) 

Charitable contributions ......................................................................................................................................................................... (180 ) 

X’s taxable income ................................................................................................................................................................................ 1,380 

(ii) X’s QPAI. X chooses to allocate and 

apportion its deductions to gross income 

attributable to DPGR under the section 861 

method of this paragraph (d). In this case, the 

section 162 selling expenses (including W–2 

wages) are definitely related to all of X’s 

gross income. Based on the facts and 

circumstances of this specific case, 

apportionment of those expenses between 

DPGR and non-DPGR on the basis of X’s 

gross receipts is appropriate. For purposes of 

apportioning R&E, X elects to use the sales 

method as described in § 1.861–17(c). X 

elects to apportion interest expense under the 

tax book value method of § 1.861–9T(g). X 

has $2,400 of gross income attributable to 

DPGR (DPGR of $3,000—CGS of $600 

(includes $100 of W–2 wages) allocated 

based on X’s books and records). X’s QPAI 

for 2010 is $1,320, as shown below: 

DPGR (all from sales of products within SIC AAA) .............................................................................................................................. $3,000 

CGS allocable to DPGR (includes $100 of W–2 wages) ...................................................................................................................... (600 ) 

Section 162 selling expenses (includes $100 of W–2 wages) ($840 × ($3,000 DPGR/$6,000 total gross receipts)) ......................... (420 ) 

Interest expense (not included in CGS) ($300 × ($4,000 (X’s DPGR assets)/$5,000 (X’s total assets))) ........................................... (240 ) 

Charitable contributions (not included in CGS) ($180 × ($2,400 gross income attributable to DPGR/$3,600 total gross income)) ... (120 ) 

Section 174 R&E–SIC AAA ................................................................................................................................................................... (300 ) 

X’s QPAI ................................................................................................................................................................................................ 1,320 

(iii) Section 199 deduction determination. 

X’s tentative deduction under § 1.199–1(a) 

(section 199 deduction) is $119 (.09 × (lesser 

of QPAI of $1,320 and taxable income of 

$1,380)) subject to the wage limitation of 

$150 (50% × $300). Accordingly, X’s section 

199 deduction for 2010 is $119. 

Example 2. Section 861 method and EAG. 

(i) Facts. The facts are the same as in 

Example 1 except that X owns stock in Y, a 

United States corporation, equal to 75 

percent of the total voting power of stock of 

Y and 80 percent of the total value of stock 

of Y. X and Y are not members of an affiliated 

group as defined in section 1504(a). 

Accordingly, the rules of § 1.861–14T do not 

apply to X’s and Y’s selling expenses, R&E, 

and charitable contributions. X and Y are, 

however, members of an affiliated group for 

purposes of allocating and apportioning 

interest expense (see § 1.861–11T(d)(6)) and 

are also members of an EAG. For 2010, the 

adjusted basis of Y’s assets that generate 

gross income attributable to DPGR and to 

non-DPGR is, respectively, $21,000 and 

$24,000. All of Y’s activities that generate 

DPGR are within SIC Industry Group AAA 

(SIC AAA). All of Y’s activities that generate 

non-DPGR are within SIC Industry Group 

BBB (SIC BBB). None of X’s and Y’s sales are 

to each other. Y is not able to identify from 

its books and records CGS allocable to DPGR 

and non-DPGR. In this case, because CGS is 

definitely related under the facts and 

circumstances to all of Y’s gross receipts, 

apportionment of CGS between DPGR and 

non-DPGR based on gross receipts is 

appropriate. For 2010, Y’s taxable income is 

$1,910 based on the following tax items: 

DPGR (all from sales of products within SIC AAA) .............................................................................................................................. $3,000 

Non-DPGR (all from sales of products within SIC BBB) ...................................................................................................................... 3,000 

CGS allocated to DPGR (includes $300 of W–2 wages) ..................................................................................................................... (1,200 ) 

CGS allocated to non-DPGR (includes $300 of W–2 wages) .............................................................................................................. (1,200 ) 

Section 162 selling expenses (includes $300 of W–2 wages) ............................................................................................................. (840 ) 

Section 174 R&E–SIC AAA ................................................................................................................................................................... (100 ) 

Section 174 R&E–SIC BBB ................................................................................................................................................................... (200 ) 

Interest expense (not included in CGS and not subject to § 1.861–10T) ............................................................................................. (500 ) 

Charitable contributions ......................................................................................................................................................................... (50 ) 

Y’s taxable income ................................................................................................................................................................................ 1,910 

(ii) QPAI. (A) X’s QPAI. Determination of 

X’s QPAI is the same as in Example 1 except 

that interest is apportioned to gross income 

attributable to DPGR based on the combined 

adjusted bases of X’s and Y’s assets. See 

§ 1.861–11T(c). Accordingly, X’s QPAI for 

2010 is $1,410, as shown below: 

DPGR (all from sales of products within SIC AAA) .............................................................................................................................. $3,000 

CGS allocated to DPGR (includes $300 of W–2 wages) ..................................................................................................................... (600 ) 

Section 162 selling expenses (includes $100 of W–2 wages) ($840 × ($3,000 DPGR/$6,000 total gross receipts)) ......................... (420 ) 

67262 Federal Register / Vol. 70, No. 213 / Friday, November 4, 2005 / Proposed Rules 

Interest expense (not included in CGS and not subject to § 1.861–10T) ($300 × ($25,000 (tax book value of X’s and Y’s DPGR 

assets)/$50,000 (tax book value of X’s and Y’s total assets))) ......................................................................................................... (150 ) 

Charitable contributions (not included in CGS) ($180 × ($2,400 gross income attributable to DPGR/$3,600 total gross income)) ... (120 ) 

Section 174 R&E–SIC AAA ................................................................................................................................................................... (300 ) 

X’s QPAI ................................................................................................................................................................................................ 1,410 

(B) Y’s QPAI. Y makes the same elections 

under the section 861 method as does X. Y 

has $1,800 of gross income attributable to 

DPGR (DPGR of $3,000—CGS of $1,200 

allocated based on Y’s gross receipts). Y’s 

QPAI for 2010 is $1,005, as shown below: 

DPGR (all from sales of products within SIC AAA) .............................................................................................................................. $3,000 

CGS allocated to DPGR (includes $300 of W–2 wages) ..................................................................................................................... (1,200 ) 

Section 162 selling expenses (includes $300 of W–2 wages) ($840 × ($3,000 DPGR/$6,000 total gross receipts)) ......................... (420 ) 

Interest expense (not included in CGS and not subject to § 1.861–10T) ($500 × ($25,000 (tax book value of X’s and Y’s DPGR 

assets)/$50,000 (tax book value of X’s and Y’s total assets))) ......................................................................................................... (250 ) 

Charitable contributions (not included in CGS) ($50 × ($1,800 gross income attributable to DPGR/$3,600 total gross income)) ..... (25 ) 

Section 174 R&E–SIC AAA ................................................................................................................................................................... (100 ) 

Y’s QPAI ................................................................................................................................................................................................ 1,005 

(iii) Section 199 deduction determination. 

The section 199 deduction of the X and Y 

EAG is determined by aggregating the 

separately determined QPAI, taxable income, 

and W–2 wages of X and Y. See § 1.199–7(b). 

Accordingly, the X and Y EAG’s tentative 

section 199 deduction is $217 (.09 × (lesser 

of combined taxable incomes of X and Y of 

$3,290 (X’s taxable income of $1,380 plus Y’s 

taxable income of $1,910) and combined 

QPAI of $2,415 (X’s QPAI of $1,410 plus Y’s 

QPAI of $1,005)) subject to the wage 

limitation of $600 (50% × ($300 (X’s W–2 

wages) + $900 (Y’s W–2 wages))). 

Accordingly, the X and Y EAG’s section 199 

deduction for 2010 is $217. The $217 is 

allocated to X and Y in proportion to their 

QPAI. See § 1.199–7(c). 

(e) Simplified deduction method—(1) 

In general. A taxpayer with average 

annual gross receipts (as defined in 

paragraph (g) of this section) of 

$25,000,000 or less, or total assets at the 

end of the taxable year (as defined in 

paragraph (h) of this section) of 

$10,000,000 or less, may use the 

simplified deduction method to 

apportion deductions between DPGR 

and non-DPGR. This paragraph does not 

apply to CGS. Under the simplified 

deduction method, a taxpayer’s 

deductions (except the net operating 

loss deduction as provided in paragraph 

(c)(2)(ii) of this section and deductions 

not attributable to the actual conduct of 

a trade or business as provided in 

paragraph (c)(2)(iii) of this section) are 

ratably apportioned between DPGR and 

non-DPGR based on relative gross 

receipts. Accordingly, the amount of 

deductions apportioned to DPGR is 

equal to the same proportion of the total 

deductions that the amount of DPGR 

bears to total gross receipts. Whether an 

owner of a pass-thru entity may use the 

simplified deduction method is 

determined at the level of the owner of 

the pass-thru entity. Whether a trust or 

an estate may use the simplified 

deduction method is determined at the 

trust or estate level. In the case of a trust 

or estate, the simplified deduction 

method is applied at the trust or estate 

level, taking into account the trust’s or 

estate’s DPGR, non-DPGR, and other 

items from all sources, including its 

distributive or allocable share of those 

items of any lower-tier entity, prior to 

any charitable or distribution deduction. 

In the case of an owner of any other 

pass-thru entity, the simplified 

deduction method is applied at the level 

of the owner of the pass-thru entity 

taking into account the owner’s DPGR, 

non-DPGR, and other items from all 

sources including its distributive or 

allocable share of those items of the 

pass-thru entity. 

(2) Members of an expanded affiliated 

group—(i) In general. Whether the 

members of an EAG may use the 

simplified deduction method is 

determined by reference to the average 

annual gross receipts and total assets of 

the EAG. If the average annual gross 

receipts of the EAG are less than or 

equal to $25,000,000 or the total assets 

of the EAG at the end of its taxable year 

are less than or equal to $10,000,000, 

each member of the EAG may 

individually determine whether to use 

the simplified deduction method, 

regardless of the cost allocation method 

used by the other members. 

(ii) Exception. Notwithstanding 

paragraph (e)(2)(i) of this section, all 

members of the same consolidated 

group must use the same cost allocation 

method. 

(iii) Examples. The following 

examples illustrate the application of 

paragraph (e)(2) of this section: 

Example 1. Corporations X, Y, and Z are 

the only three members of an EAG. Neither 

X, Y, nor Z is a member of a consolidated 

group. X, Y, and Z have average annual gross 

receipts of $2,000,000, $7,000,000, and 

$13,000,000, respectively. X, Y, and Z each 

have total assets at the end of the taxable year 

of $5,000,000. Because the average annual 

gross receipts of the EAG are less than or 

equal to $25,000,000, each of X, Y, and Z 

may use either the simplified deduction 

method or the section 861 method. 

Example 2. The facts are the same as in 

Example 1 except that X and Y are members 

of the same consolidated group. X, Y, and Z 

may use either the simplified deduction 

method or the section 861 method. However, 

X and Y must use the same cost allocation 

method. 

Example 3. The facts are the same as in 

Example 1 except that Z’s average annual 

gross receipts are $17,000,000. Because the 

average annual gross receipts of the EAG are 

greater than $25,000,000 and the total assets 

of the EAG at the end of the taxable year are 

greater than $10,000,000, X, Y, and Z must 

each use the section 861 method. 

(f) Small business simplified overall 

method—(1) In general. A qualifying 

small taxpayer may use the small 

business simplified overall method to 

apportion CGS and deductions between 

DPGR and non-DPGR. Under the small 

business simplified overall method, a 

taxpayer’s total costs for the current 

taxable year (as defined in paragraph (i) 

of this section) are apportioned between 

DPGR and other receipts based on 

relative gross receipts. Accordingly, the 

amount of total costs for the current 

taxable year apportioned to DPGR is 

equal to the same proportion of total 

costs for the current taxable year that 

the amount of DPGR bears to total gross 

receipts. In the case of a pass-thru 

entity, whether the small business 

simplified overall method may be used 

by such entity is determined at the passthru entity level and, if such entity is 

eligible, the small business simplified 

overall method is applied at the passthru entity level. 

Federal Register / Vol. 70, No. 213 / Friday, November 4, 2005 / Proposed Rules 67263 

(2) Qualifying small taxpayer. For 

purposes of this paragraph (f), a 

qualifying small taxpayer is—

(i) A taxpayer that has both average 

annual gross receipts (as defined in 

paragraph (g) of this section) of 

$5,000,000 or less and total costs for the 

current taxable year of $5,000,000 or 

less; 

(ii) A taxpayer that is engaged in the 

trade or business of farming that is not 

required to use the accrual method of 

accounting under section 447; or 

(iii) A taxpayer that is eligible to use 

the cash method as provided in Rev. 

Proc. 2002–28 (2002–1 C.B. 815) (that is, 

certain taxpayers with average annual 

gross receipts of $10,000,000 or less that 

are not prohibited from using the cash 

method under section 448, including 

partnerships, S corporations, C 

corporations, or individuals). See 

§ 601.601(d)(2) of this chapter. 

(3) Members of an expanded affiliated 

group—(i) In general. Whether the 

members of an EAG may use the small 

business simplified overall method is 

determined by reference to all the 

members of the EAG. If both the average 

annual gross receipts and the total costs 

for the current taxable year of the EAG 

are less than or equal to $5,000,000; the 

EAG, viewed as a single corporation, is 

engaged in the trade or business of 

farming that is not required to use the 

accrual method of accounting under 

section 447; or the EAG, viewed as a 

single corporation, is eligible to use the 

cash method as provided in Rev. Proc. 

2002–28, then each member of the EAG 

may individually determine whether to 

use the small business simplified 

overall method, regardless of the cost 

allocation method used by the other 

members. 

(ii) Exception. Notwithstanding 

paragraph (f)(3)(i) of this section, all 

members of the same consolidated 

group must use the same cost allocation 

method. 

(iii) Examples. The following 

examples illustrate the application of 

paragraph (f)(3) of this section: 

Example 1. Corporations L, M, and N are 

the only three members of an EAG. Neither 

L, M, nor N is a member of a consolidated 

group. L, M, and N have average annual gross 

receipts and total costs for the current taxable 

year of $1,000,000, $1,500,000, and 

$2,000,000, respectively. Because both the 

average annual gross receipts and total costs 

for the current taxable year of the EAG are 

less than or equal to $5,000,000, each of L, 

M, and N may use the small business 

simplified overall method, the simplified 

deduction method, or the section 861 

method. 

Example 2. The facts are the same as in 

Example 1 except that M and N are members 

of the same consolidated group. L, M, and N 

may use the small business simplified overall 

method, the simplified deduction method, or 

the section 861 method. However, M and N 

must use the same cost allocation method. 

Example 3. The facts are the same as in 

Example 1 except that N has average annual 

gross receipts of $4,000,000. Unless the EAG, 

viewed as a single corporation, is engaged in 

the trade or business of farming that is not 

required to use the accrual method of 

accounting under section 447, or the EAG, 

viewed as a single corporation, is eligible to 

use the cash method as provided in Rev. 

Proc. 2002–28, because the average annual 

gross receipts of the EAG are greater than 

$5,000,000, L, M, and N are all ineligible to 

use the small business simplified overall 

method. 

(4) Ineligible pass-thru entities. 

Qualifying oil and gas partnerships 

under § 1.199–3(h)(7), EAG partnerships 

under § 1.199–3(h)(8), and trusts and 

estates under § 1.199–5(d) may not use 

the small business simplified overall 

method. 

(g) Average annual gross receipts—(1) 

In general. For purposes of the 

simplified deduction method and the 

small business simplified overall 

method, average annual gross receipts 

means the average annual gross receipts 

of the taxpayer for the 3 taxable years 

(or, if fewer, the taxable years during 

which the taxpayer was in existence) 

preceding the current taxable year, even 

if one or more of such taxable years 

began before the effective date of section 

199. In the case of any taxable year of 

less than 12 months (a short taxable 

year), the gross receipts shall be 

annualized by multiplying the gross 

receipts for the short period by 12 and 

dividing the result by the number of 

months in the short period. 

(2) Members of an EAG. To compute 

the average annual gross receipts of an 

EAG, the gross receipts, for the entire 

taxable year, of each corporation that is 

a member of the EAG at the end of its 

taxable year that ends with or within the 

taxable year of the computing member 

(as described in § 1.199–7(h)) are 

aggregated. 

(h) Total assets—(1) In general. For 

purposes of the simplified deduction 

method provided by paragraph (e) of 

this section, total assets means the total 

assets the taxpayer has at the end of the 

taxable year that are attributable to the 

taxpayer’s trade or business. In the case 

of a C corporation, the corporation’s 

total assets at the end of the taxable year 

is the amount required to be reported on 

Schedule L of the Form 1120, ‘‘United 

States Corporation Income Tax Return,’’

in accordance with the Form 1120 

instructions. 

(2) Members of an EAG. To compute 

the total assets at the end of the taxable 

year of an EAG, the total assets, at the 

end of its taxable year, of each 

corporation that is a member of the EAG 

at the end of its taxable year that ends 

with or within the taxable year of the 

computing member are aggregated. 

(i) Total costs for the current taxable 

year—(1) In general. For purposes of the 

small business simplified overall 

method, total costs for the current 

taxable year means the total CGS and 

deductions (excluding the net operating 

loss deduction as provided in paragraph 

(c)(2)(ii) of this section and deductions 

not attributable to the conduct of a trade 

or business as provided in paragraph 

(c)(2)(iii) of this section) for the current 

taxable year. 

(2) Members of an EAG. To compute 

the total costs for the current taxable 

year of an EAG, the total costs for the 

entire taxable year of each corporation 

that is a member of the EAG at the end 

of the taxable year that ends with or 

within the taxable year of the computing 

member are aggregated. 

§ 1.199–5 Application of section 199 to 

pass-thru entities. 

(a) Partnerships—(1) Determination at 

partner level. The deduction allowable 

under § 1.199–1(a) (section 199 

deduction) is determined at the partner 

level. As a result, each partner must 

compute its deduction separately. For 

purposes of this section, each partner is 

allocated, in accordance with sections 

702 and 704, its share of partnership 

items (including items of income, gain, 

loss, and deduction), cost of goods sold 

(CGS) allocated to such items of income, 

and gross receipts that are included in 

such items of income, even if the 

partner’s share of CGS and other 

deductions and losses exceeds domestic 

production gross receipts (DPGR) (as 

defined in § 1.199–3(a)). A partnership 

may specially allocate items of income, 

gain, loss, or deduction to its partners, 

subject to the rules of section 704(b) and 

the supporting regulations. To 

determine its section 199 deduction for 

the taxable year, a partner generally 

aggregates its distributive share of such 

items, to the extent they are not 

otherwise disallowed by the Internal 

Revenue Code, with those items it 

incurs outside the partnership (whether 

directly or indirectly) for purposes of 

allocating and apportioning deductions 

to DPGR and computing its qualified 

production activities income (QPAI) (as 

defined in § 1.199–1(c)). However, if a 

partnership uses the small business 

simplified overall method described in 

§ 1.199–4(f), then each partner is 

allocated its share of QPAI and W–2 

wages (as defined in § 1.199–2(f)), 

which (subject to the limitation under 

section 199(d)(1)(B)) are combined with 

67264 Federal Register / Vol. 70, No. 213 / Friday, November 4, 2005 / Proposed Rules 

the partner’s QPAI and W–2 wages from 

other sources. Under this method, a 

partner’s distributive share of QPAI 

from a partnership may be less than 

zero. 

(2) Disallowed deductions. 

Deductions of a partnership that 

otherwise would be taken into account 

in computing the partner’s section 199 

deduction are taken into account only if 

and to the extent the partner’s 

distributive share of those deductions 

from all of the partnership’s activities is 

not disallowed by section 465, 469, 

704(d), or any other provision of the 

Internal Revenue Code. If only a portion 

of the partner’s distributive share of the 

losses or deductions is allowed for a 

taxable year, a proportionate share of 

those allowable losses or deductions 

that are allocated to the partnership’s 

qualified production activities, 

determined in a manner consistent with 

sections 465, 469, 704(d), and any other 

applicable provision of the Internal 

Revenue Code, is taken into account in 

computing the section 199 deduction for 

that taxable year. To the extent that any 

of the disallowed losses or deductions 

are allowed in a later taxable year, the 

partner takes into account a 

proportionate share of those losses or 

deductions in computing its QPAI for 

that later taxable year. 

(3) Partner’s share of W–2 wages. 

Under section 199(d)(1)(B), a partner’s 

share of W–2 wages of a partnership for 

purposes of determining the partner’s 

section 199(b) limitation is the lesser of 

the partner’s allocable share of those 

wages (without regard to section 

199(d)(1)(B)), or 2 times 9 percent (3 

percent for taxable years beginning in 

2005 or 2006, and 6 percent for taxable 

years beginning in 2007, 2008, or 2009) 

of the QPAI computed by taking into 

account only the items of the 

partnership allocated to the partner for 

the taxable year of the partnership. In 

general, this QPAI calculation is 

performed by the partner using the same 

cost allocation method that the partner 

uses in calculating the partner’s section 

199 deduction. However, if a 

partnership uses the small business 

simplified overall method described in 

§ 1.199–4(f), the QPAI used by each 

partner to determine the wage limitation 

under section 199(d)(1)(B) is the same as 

the share of QPAI allocated to the 

partner. Each partner must compute its 

share of W–2 wages from the 

partnership in accordance with section 

199(d)(1)(B) (with W–2 wages being 

allocated to the partner in the same 

manner as is wage expense), and then 

add that share to its W–2 wages from 

other sources, if any. The application of 

section 199(d)(1)(B) therefore means 

that if QPAI, computed by taking into 

account only the items of the 

partnership allocated to the partner for 

the taxable year, is not greater than zero, 

the partner may not take into account 

any W–2 wages of the partnership in 

computing the partner’s section 199 

deduction. See § 1.199–2 for the 

computation of W–2 wages, and 

paragraph (f) of this section for rules 

regarding pass-thru entities in a tiered 

structure. 

(4) Examples. The following examples 

illustrate the application of this 

paragraph (a). Assume that each partner 

has sufficient adjusted gross income or 

taxable income so that the section 199 

deduction is not limited under section 

199(a)(1)(B); that the partnership and 

each of its partners (whether individual 

or corporate) are calendar year 

taxpayers; and that the amount of the 

partnership’s W–2 wages equals wage 

expense for each taxable year. The 

examples read as follows: 

Example 1. Section 861 method with 

interest expense. (i) Partnership Federal 

income tax items. X and Y, unrelated United 

States corporations, are each 50% partners in 

PRS, a partnership that engages in 

production activities that generate both 

DPGR and non-DPGR. X and Y share all 

items of income, gain, loss, deduction, and 

credit 50% each. PRS is not able to identify 

from its books and records CGS allocable to 

DPGR and non-DPGR. In this case, because 

CGS is definitely related under the facts and 

circumstances to all of PRS’s gross income, 

apportionment of CGS between DPGR and 

non-DPGR based on gross receipts is 

appropriate. For 2010, the adjusted basis of 

PRS business assets is $5,000, $4,000 of 

which generate gross income attributable to 

DPGR and $1,000 of which generate gross 

income attributable to non-DPGR. For 2010, 

PRS has the following Federal income tax 

items: 

DPGR ....................................................................................................................................................................................................... $3,000 

Non-DPGR ............................................................................................................................................................................................... 3,000 

CGS (includes $200 of W–2 wages) ....................................................................................................................................................... 3,240 

Section 162 selling expenses (includes $300 of W–2 wages) ............................................................................................................... 1,200 

Interest expense (not included in CGS) .................................................................................................................................................. 300 

(ii) Allocation of PRS’s items of income, 

gain, loss, deduction, or credit. X and Y each 

receive the following distributive share of 

PRS’s items of income, gain, loss, deduction 

or credit, as determined under the principles 

of § 1.704–1(b)(1)(vii): 

Gross income attributable to 

DPGR ($1,500 (DPGR) ¥ 

$810 (allocable CGS, includes $50 of W–2 wages)) .. $690 

Gross income attributable to 

non-DPGR ($1,500 (nonDPGR) – $810 (allocable 

CGS, includes $50 of W–2 

wages)) ................................. 690 

Section 162 selling expenses 

(includes $150 of W–2 

wages) ................................... 600 

Interest expense (not included 

in CGS) ................................. 150 

(iii) Determination of QPAI. (A) X’s QPAI. 

Because the section 199 deduction is 

determined at the partner level, X determines 

its QPAI by aggregating, to the extent 

necessary, its distributive share of PRS’s 

Federal income tax items with all other such 

items from all other, non-PRS-related 

activities. For 2010, X does not have any 

other such items. For 2010, the adjusted basis 

of X’s non-PRS assets, all of which are 

investment assets, is $10,000. X’s only gross 

receipts for 2010 are those attributable to the 

allocation of gross income from PRS. X 

allocates and apportions its deductible items 

to gross income attributable to DPGR under 

the section 861 method of § 1.199–4(d). In 

this case, the section 162 selling expenses 

(including W–2 wages) are definitely related 

to all of PRS’s gross receipts. Based on the 

facts and circumstances of this specific case, 

apportionment of those expenses between 

DPGR and non-DPGR on the basis of PRS’s 

gross receipts is appropriate. X elects to 

apportion its distributive share of interest 

expense under the tax book value method of 

§ 1.861–9T(g). X’s QPAI for 2010 is $366, as 

shown below: 

DPGR ....................................... $1,500 

CGS allocable to DPGR (includes $50 of W–2 wages) ... (810) 

Section 162 selling expenses 

(includes $75 of W–2 wages) 

($600 × $1,500/$3,000) ........ (300) 

Interest expense (not included 

in CGS) ($150 × $2,000 (X’s 

share of PRS’s DPGR assets)/ $12,500 (X’s non-PRS 

assets and X’s share of PRS 

assets)) ................................. (24) 

X’s QPAI ................................... 366 

(B) Y’s QPAI. (1) For 2010, in addition to 

the activities of PRS, Y engages in production 

activities that generate both DPGR and nonDPGR. Y is able to identify from its books 

and records CGS allocable to DPGR and to 

non-DPGR. For 2010, the adjusted basis of 

Y’s non-PRS assets attributable to its 

production activities that generate DPGR is 

$8,000 and to other production activities that 

Federal Register / Vol. 70, No. 213 / Friday, November 4, 2005 / Proposed Rules 67265 

generate non-DPGR is $2,000. Y has no other 

assets. Y has the following Federal income 

tax items relating to its non-PRS activities: 

Gross income attributable to 

DPGR ($1,500 

(DPGR)¥$900 (allocable 

CGS, includes $70 of W–2 

wages)) ................................. $600 

Gross income attributable to 

non-DPGR ($3,000 (other 

gross receipts) – $1,620 (allocable CGS, includes $150 

of W–2 wages)) ..................... 1,380 

Section 162 selling expenses 

(includes $30 of W–2 wages) 540 

Interest expense (not included 

in CGS) ................................. 90 

(2) Y determines its QPAI in the same 

general manner as X. However, because Y has 

activities outside of PRS, Y must aggregate its 

distributive share of PRS’s Federal income 

tax items with its own such items. Y allocates 

and apportions its deductible items to gross 

income attributable to DPGR under the 

section 861 method of § 1.199–4(d). In this 

case, Y’s distributive share of PRS’s section 

162 selling expenses (including W–2 wages), 

as well as those selling expenses from Y’s 

non-PRS activities, are definitely related to 

all of its gross income. Based on the facts and 

circumstances of this specific case, 

apportionment of those expenses between 

DPGR and non-DPGR on the basis of Y’s 

gross receipts is appropriate. Y elects to 

apportion its distributive share of interest 

expense under the tax book value method of 

§ 1.861–9T(g). Y has $1,290 of gross income 

attributable to DPGR ($3,000 DPGR ($1,500 

from PRS and $1,500 from non-PRS 

activities) ¥$1,710 CGS ($810 from PRS and 

$900 from non-PRS activities). Y’s QPAI for 

2010 is $642, as shown below: 

DPGR ($1,500 from PRS and 

$1,500 from non-PRS activities) ....................................... $3,000 

CGS allocable to DPGR ($810 

from PRS and $900 from 

non-PRS activities) (includes 

$120 of W–2 wages) ............. (1,710) 

Section 162 selling expenses 

(includes $180 of W–2 

wages) ($1,140 ($600 from 

PRS and $540 from nonPRS activities) × ($1,500 

PRS DPGR + $1,500 nonPRS DPGR)/($3,000 PRS 

total gross receipts + $4,500 

non-PRS total gross receipts)) .................................. (456) 

Interest expense (not included 

in CGS) ($240 ($150 from 

PRS and $90 from non-PRS 

activities) × $10,000 (Y’s 

non-PRS DPGR assets and 

Y’s share of PRS DPGR assets)/$12,500 (Y’s non-PRS 

assets and Y’s share of PRS 

assets)) ................................. (192) 

Y’s QPAI ................................... 642 

(iv) PRS W–2 wages allocated to X and Y 

under section 199(d)(1)(B). Solely for 

purposes of calculating the PRS W–2 wages 

that are allocated to them under section 

199(d)(1)(B) for purposes of the wage 

limitation of section 199(b), X and Y must 

separately determine QPAI taking into 

account only the items of PRS allocated to 

them. X and Y must use the same methods 

of allocation and apportionment that they use 

to determine their QPAI in paragraphs (iii)(A) 

and (B) of this Example 1, respectively. 

Accordingly, X and Y must apportion 

deductible section 162 selling expenses 

which includes W–2 wage expense on the 

basis of gross receipts, and apportion interest 

expense according to the tax book value 

method of § 1.861–9T(g). 

(A) QPAI of X and Y, solely for this 

purpose, is determined by allocating and 

apportioning each partner’s share of PRS 

expenses to each partner’s share of PRS gross 

income of $690 attributable to DPGR ($1,500 

DPGR¥$810 CGS, apportioned based on 

gross receipts). Thus, QPAI of X and Y solely 

for this purpose is $270, as shown below: 

DPGR ....................................... $1,500 

CGS allocable to DPGR ........... (810) 

Section 162 selling expenses 

(including W–2 wages) ($600 

× ($1,500/$3,000)) ................ (300) 

Interest expense (not included 

in CGS) ($150 × $2,000 

(partner’s share of adjusted 

basis of PRS’s DPGR assets)/$2,500 (partner’s share 

of adjusted basis of total 

PRS assets)) ......................... (120) 

QPAI ......................................... 270 

(B) X’s and Y’s shares of PRS’s W–2 wages 

determined under section 199(d)(1)(B) for 

purposes of the wage limitation of section 

199(b) are $49, the lesser of $250 (partner’s 

allocable share of PRS’s W–2 wages ($100 

included in CGS, and $150 included in 

selling expenses) and $49 (2 × ($270 × .09)). 

(v) Section 199 deduction determination. 

(A) X’s tentative section 199 deduction is $33 

(.09 × $366 (that is, QPAI determined at 

partner level)) subject to the wage limitation 

of $25 (50% × $49). Accordingly, X’s section 

199 deduction for 2010 is $25. 

(B) Y’s tentative section 199 deduction is 

$58 (.09 × $642 (that is, QPAI determined at 

the partner level) subject to the wage 

limitation of $150 (50% × ($49 (from PRS)) 

and $250 (from non-PRS activities)). 

Accordingly, Y’s section 199 deduction for 

2010 is $58. 

Example 2. Section 861 method with R&E 

expense. (i) Partnership items of income, 

gain, loss, deduction or credit. X and Y, 

unrelated United States corporations, are 

partners in PRS, a partnership that engages 

in production activities that generate both 

DPGR and non-DPGR. Neither X nor Y is a 

member of an affiliated group. X and Y share 

all items of income, gain, loss, deduction, 

and credit 50% each. All of PRS’s domestic 

production activities that generate DPGR are 

within Standard Industrial Classification 

(SIC) Industry Group AAA (SIC AAA). All of 

PRS’s production activities that generate nonDPGR are within SIC Industry Group BBB 

(SIC BBB). PRS is not able to identify from 

its books and records CGS allocable to DPGR 

and to non-DPGR and, therefore, apportions 

CGS to DPGR and non-DPGR based on its 

gross receipts. PRS incurs $900 of research 

and experimentation expenses (R&E) that are 

deductible under section 174, $300 of which 

are performed with respect to SIC AAA and 

$600 of which are performed with respect to 

SIC BBB. None of the R&E is legally 

mandated R&E as described in § 1.861–

17(a)(4) and none is included in CGS. PRS 

incurs section 162 selling expenses (that 

include W–2 wage expense) that are not 

includible in CGS and not directly allocable 

to any gross income. For 2010, PRS has the 

following Federal income tax items: 

DPGR (all from sales of products within SIC AAA) ............ $3,000 

Non-DPGR (all from sales of 

products within SIC BBB) ..... 3,000 

CGS (includes $200 of W–2 

wages) ................................... 2,400 

Section 162 selling expenses 

(includes $100 of W–2 

wages) ................................... 840 

Section 174 R&E–SIC AAA ...... 300 

Section 174 R&E–SIC BBB ...... 600 

(ii) Allocation of PRS’s items of income, 

gain, loss, deduction, or credit. X and Y each 

receive the following distributive share of 

PRS’s items of income, gain, loss, deduction, 

or credit, as determined under the principles 

of § 1.704–1(b)(1)(vii): 

Gross income attributable to 

DPGR ($1,500 (DPGR) 

¥$600 (CGS, includes $50 

of W–2 wages)) ..................... $900 

Gross income attributable to 

non-DPGR ($1,500 (other 

gross receipts) – $600 (CGS, 

includes $50 of W–2 wages)) 900 

Section 162 selling expenses 

(includes $50 of W–2 wages) 420 

Section 174 R&E–SIC AAA ...... 150 

Section 174 R&E–SIC BBB ...... 300 

(iii) Determination of QPAI. (A) X’s QPAI. 

Because the section 199 deduction is 

determined at the partner level, X determines 

its QPAI by aggregating, to the extent 

necessary, its distributive shares of PRS’s 

Federal income tax items with all other such 

items from all other, non-PRS-related 

activities. For 2010, X does not have any 

other such tax items. X’s only gross receipts 

for 2010 are those attributable to the 

allocation of gross income from PRS. As 

stated, all of PRS’s domestic production 

activities that generate DPGR are within SIC 

AAA. X allocates and apportions its 

deductible items to gross income attributable 

to DPGR under the section 861 method of 

§ 1.199–4(d). In this case, the section 162 

selling expenses (including W–2 wages) are 

definitely related to all of PRS’s gross 

income. Based on the facts and 

circumstances of this specific case, 

apportionment of those expenses between 

DPGR and non-DPGR on the basis of PRS’s 

gross receipts is appropriate. For purposes of 

apportioning R&E, X elects to use the sales 

method as described in § 1.861–17(c). 

Because X has no direct sales of products, 

67266 Federal Register / Vol. 70, No. 213 / Friday, November 4, 2005 / Proposed Rules 

and because all of PRS’s SIC AAA sales 

attributable to X’s share of PRS’s gross 

income generate DPGR, all of X’s share of 

PRS’s section 174 R&E attributable to SIC 

AAA is taken into account for purposes of 

determining X’s QPAI. Thus, X’s total QPAI 

for 2010 is $540, as shown below: 

DPGR (all from sales of products within SIC AAA) ............ $1,500 

CGS (includes $50 of W–2 

wages) ................................... (600) 

Section 162 selling expenses 

(including W–2 wages) ($420 

× ($1,500 DPGR/$3,000 total 

gross receipts)) ..................... (210) 

Section 174 R&E–SIC AAA ...... (150) 

X’s QPAI ................................... 540 

(B) Y’s QPAI. (1) For 2010, in addition to 

the activities of PRS, Y engages in domestic 

production activities that generate both 

DPGR and non-DPGR. With respect to those 

non-PRS activities, Y is not able to identify 

from its books and records CGS allocable to 

DPGR and to non-DPGR. In this case, because 

CGS is definitely related under the facts and 

circumstances to all of Y’s non-PRS gross 

receipts, apportionment of CGS between 

DPGR and non-DPGR based on Y’s non-PRS 

gross receipts is appropriate. For 2010, Y has 

the following non-PRS Federal income tax 

items: 

DPGR (from sales of products 

within SIC AAA) .................... $1,500 

DPGR (from sales of products 

within SIC BBB) .................... 1,500 

Non-DPGR (from sales of products within SIC BBB) ............ 3,000 

CGS (allocated to DPGR within 

SIC AAA) (includes $56 of 

W–2 wages) .......................... 750 

CGS (allocated to DPGR within 

SIC BBB) (includes $56 of 

W–2 wages) .......................... 750 

CGS (allocated to non-DPGR 

within SIC BBB) (includes 

$113 of W–2 wages) ............. 1,500 

Section 162 selling expenses 

(includes $30 of W–2 wages) 540 

Section 174 R&E–SIC AAA ...... 300 

Section 174 R&E–SIC BBB ...... 450 

(2) Because Y has DPGR as a result of 

activities outside PRS, Y must aggregate its 

distributive share of PRS’s Federal income 

tax items with such items from all its other, 

non-PRS-related activities. Y allocates and 

apportions its deductible items to gross 

income attributable to DPGR under the 

section 861 method of § 1.199–4(d). In this 

case, the section 162 selling expenses 

(including W–2 wages) are definitely related 

to all of Y’s gross income. Based on the facts 

and circumstances of the specific case, 

apportionment of such expenses between 

DPGR and non-DPGR on the basis of Y’s 

gross receipts is appropriate. For purposes of 

apportioning R&E, Y elects to use the sales 

method as described in § 1.861–17(c). 

(3) With respect to sales that generate 

DPGR, Y has gross income of $2,400 ($4,500 

DPGR ($1,500 from PRS and $3,000 from 

non-PRS activities)¥$2,100 CGS ($600 from 

sales of products by PRS and $1,500 from 

non-PRS activities)). Because all of the sales 

in SIC AAA generate DPGR, all of Y’s share 

of PRS’s section 174 R&E attributable to SIC 

AAA and the section 174 R&E attributable to 

SIC AAA that Y incurs in its non-PRS 

activities are taken into account for purposes 

of determining Y’s QPAI. Because only a 

portion of the sales within SIC BBB generate 

DPGR, only a portion of the section 174 R&E 

attributable to SIC BBB is taken into account 

in determining Y’s QPAI. Thus, Y’s QPAI for 

2010 is $1,282, as shown below: 

DPGR ($4,500 DPGR ($1,500 

from PRS and $3,000 from 

non-PRS activities ................. $4,500 

CGS ($600 from sales of products by PRS and $1,500 

from non-PRS activities ........ (2,100) 

Section 162 selling expenses 

(including W–2 wages) ($420 

from PRS + $540 from nonPRS activities) × ($4,500 

DPGR/$9,000 total gross receipts)) .................................. (480) 

Section 174 R&E–SIC AAA 

($150 from PRS and $300 

from non-PRS activities) ....... (450) 

Section 174 R&E–SIC BBB 

($300 from PRS + $450 from 

non-PRS activities) × ($1,500 

DPGR/$6,000 total gross receipts allocated to SIC BBB) (188) 

Y’s QPAI ................................... 1,282 

(iv) PRS W–2 wages allocated to X and Y 

under section 199(d)(1)(B). Solely for 

purposes of calculating the PRS W–2 wages 

that are allocated to X and Y under section 

199(d)(1)(B) for purposes of the wage 

limitation of section 199(b), X and Y must 

separately determine QPAI taking into 

account only the items of PRS allocated to 

them. X and Y must use the same methods 

of allocation and apportionment that they use 

to determine their QPAI in paragraphs (iii)(A) 

and (B) of this Example 2, respectively. 

Accordingly, X and Y must apportion section 

162 selling expense which includes W–2 

wage expense on the basis of gross receipts, 

and apportion section 174 R&E expense 

under the sales method as described in 

§ 1.861–17(c). 

(A) QPAI of X and Y, solely for this 

purpose, is determined by allocating and 

apportioning each partner’s share of PRS 

expenses to each partner’s share of PRS gross 

income of $900 attributable to DPGR ($1,500 

DPGR¥$600 CGS, allocated based on PRS’s 

gross receipts). Because all of PRS’s SIC AAA 

sales generate DPGR, all of X’s and Y’s shares 

of PRS’s section 174 R&E attributable to SIC 

AAA is taken into account for purposes of 

determining X’s and Y’s QPAI. None of PRS’s 

section 174 R&E attributable to SIC BBB is 

taken into account because PRS has no DPGR 

within SIC BBB. Thus, X and Y each has 

QPAI, solely for this purpose, of $540, as 

shown below: 

DPGR (all from sales of products within SIC AAA) ............ $1,500 

CGS (includes $50 of W–2 

wages .................................... (600) 

Section 162 selling expenses 

(including W–2 wages) ($420 

× $1,500/$3,000) ................... (210) 

Section 174 R&E–SIC AAA ...... (150) 

QPAI ......................................... 540 

(B) X’s and Y’s shares of PRS’s W–2 wages 

determined under section 199(d)(1)(B) for 

purposes of the wage limitation of section 

199(b) are $97, the lesser of $150 (partner’s 

allocable share of PRS’s W–2 wages ($100 

included in CGS, and $50 included in selling 

expenses)) and $97 (2 × ($540 × .09)). 

(v) Section 199 deduction determination. 

(A) X’s tentative section 199 deduction is $49 

(.09 × $540 (QPAI determined at partner 

level)) subject to the wage limitation of $49 

(50% × $97). Accordingly, X’s section 199 

deduction for 2010 is $49. 

(B) Y’s tentative section 199 deduction is 

$115 (.09 × $1,282 (QPAI determined at 

partner level) subject to the wage limitation 

of $176 (50% × $352 ($97 from PRS + $255 

from non-PRS activities)). Accordingly, Y’s 

section 199 deduction for 2010 is $115. 

Example 3. Simplified deduction method 

with special allocations. (i) In general. X and 

Y are unrelated corporate partners in PRS. 

PRS engages in a domestic production 

activity and other activities. In general, X and 

Y share all partnership items of income, gain, 

loss, deduction, and credit equally, except 

that 80% of the wage expense of PRS and 

20% of PRS’s other expenses are specially 

allocated to X (substantial economic effect 

under section 704(b) is presumed). In the 

2010 taxable year, PRS’s only wage expense 

is $2,000 for marketing, which is not 

included in CGS. PRS has $8,000 of gross 

receipts ($6,000 of which is DPGR), $4,000 of 

CGS ($3,500 of which is allocable to DPGR), 

and $3,000 of deductions (comprised of 

$2,000 of wages for marketing and $1,000 of 

other expenses). X qualifies for and uses the 

simplified deduction method under § 1.199–

4(e). Y does not qualify to use that method 

and therefore, must use the section 861 

method under § 1.199–4(d). In the 2010 

taxable year, X has gross receipts attributable 

to non-partnership activities of $1,000 and 

wages of $200. None of X’s non-PRS gross 

receipts is DPGR. 

(ii) Allocation and apportionment of costs. 

Under the partnership agreement, X’s 

distributive share of the items of the 

partnership is $1,250 of gross income 

attributable to DPGR ($3,000 DPGR¥$1,750 

allocable CGS), $750 of gross income 

attributable to non-DPGR ($1,000 nonDPGR¥$250 allocable CGS), and $1,800 of 

deductions (comprised of X’s special 

allocations of $1,600 of wage expense for 

marketing and $200 of other expenses). 

Under the simplified deduction method, X 

apportions $1,200 of other deductions to 

DPGR ($2,000 ($1,800 from the partnership 

and $200 from non-partnership activities) × 

($3,000 DPGR/$5,000 total gross receipts)). 

Accordingly, X’s QPAI is $50 ($3,000 

DPGR¥$1,750 CGS ¥$1,200 of deductions). 

However, in determining the section 

199(d)(1)(B) wage limitation, QPAI is 

computed taking into account only the items 

of the partnership allocated to the partner for 

the taxable year of the partnership. Thus, X 

Federal Register / Vol. 70, No. 213 / Friday, November 4, 2005 / Proposed Rules 67267 

apportions $1,350 of deductions to DPGR 

($1,800 × ($3,000 DPGR/$4,000 total gross 

receipts from PRS)). Accordingly, X’s QPAI 

for purposes of the section 199(d)(1)(B) wage 

limitation is $0 ($3,000 DPGR¥$1,750 CGS 

¥$1,350 of deductions). X’s share of PRS’s 

W–2 wages is $0, the lesser of $1,600 (X’s 

80% allocable share of $2,000 of wage 

expense for marketing) or $0 (2 × ($0 QPAI 

x .09)). X’s tentative deduction is $5 ($50 

QPAI × .09), subject to the section 199(b)(1) 

wage limitation of $100 (50% × $200 ($0 of 

PRS-related W–2 wages + $200 of non-PRS 

W–2 wages)). Accordingly, X’s total section 

199 deduction for the 2010 taxable year is $5. 

Example 4. Small business simplified 

overall method. A, an individual, and X, a 

corporation, are partners in PRS. PRS engages 

in manufacturing activities that generate both 

DPGR and non-DPGR. A and X share all 

items of income, gain, loss, deduction, and 

credit equally. In the 2010 taxable year, PRS 

has total gross receipts of $2,000 ($1,000 of 

which is DPGR), CGS of $800 (including 

$400 of W–2 wages), and deductions of $800. 

A and PRS use the small business simplified 

overall method under § 1.199–4(f). X uses the 

section 861 method. Under the small 

business simplified overall method, PRS’s 

CGS and deductions apportioned to DPGR 

equal $800 (($800 CGS plus $800 of other 

deductions) × ($1,000 DPGR/$2,000 total 

gross receipts)). Accordingly, PRS’s QPAI is 

$200 ($1,000 DPGR¥$800 CGS and other 

deductions). Under the partnership 

agreement, PRS’s QPAI is allocated $100 to 

A and $100 to X. A’s share of partnership W–

2 wages for purposes of the section 

199(d)(1)(B) limitation is $18, the lesser of 

$200 (A’s 50% allocable share of PRS’s $400 

of W–2 wages) or $18 (2 × ($100 QPAI × .09)). 

A’s tentative deduction is $9 ($100 QPAI × 

.09), subject to the section 199(b)(1) wage 

limitation of $9 (50% × $18). Assuming that 

A engages in no other activities generating 

DPGR, A’s total section 199 deduction for the 

2010 taxable year is $9. X must use $100 of 

QPAI and $18 of W–2 wages to determine its 

section 199 deduction using the section 861 

method. 

(b) S corporations—(1) Determination 

at shareholder level. The section 199 

deduction is determined at the 

shareholder level. As a result, each 

shareholder must compute its deduction 

separately. For purposes of this section, 

each shareholder is allocated, in 

accordance with section 1366, its pro 

rata share of S corporation items 

(including items of income, gain, loss, 

and deduction), CGS allocated to such 

items of income, and gross receipts 

included in such items of income, even 

if the shareholder’s share of CGS and 

other deductions and losses exceeds 

DPGR. To determine its section 199 

deduction for the taxable year, the 

shareholder generally aggregates its pro 

rata share of such items, to the extent 

they are not otherwise disallowed by the 

Internal Revenue Code, with those items 

it incurs outside the S corporation 

(whether directly or indirectly) for 

purposes of allocating and apportioning 

deductions to DPGR and computing its 

QPAI. However, if an S corporation uses 

the small business simplified overall 

method described in § 1.199–4(f), then 

each shareholder is allocated its share of 

QPAI and W–2 wages, which (subject to 

the limitation under section 

199(d)(1)(B)) are combined with the 

shareholder’s QPAI and W–2 wages 

from other sources. Under this method, 

a shareholder’s share of QPAI from an 

S corporation may be less than zero. 

(2) Disallowed deductions. 

Deductions of the S corporation that 

otherwise would be taken into account 

in computing the shareholder’s section 

199 deduction are taken into account 

only if and to the extent the 

shareholder’s pro rata share of the losses 

or deductions from all of the S 

corporation’s activities are not 

disallowed by section 465, 469, 1366(d), 

or any other provision of the Internal 

Revenue Code. If only a portion of the 

shareholder’s pro rata share of the losses 

or deductions is allowed for a taxable 

year, a proportionate share of the losses 

or deductions allocated to the S 

corporation’s qualified production 

activities, determined in a manner 

consistent with sections 465, 469, 

1366(d), and any other applicable 

provision of the Internal Revenue Code, 

is taken into account in computing the 

section 199 deduction for that taxable 

year. To the extent that any of the 

disallowed losses or deductions is 

allowed in a later taxable year, the 

shareholder takes into account a 

proportionate share of those losses or 

deductions in computing its QPAI for 

that later taxable year. 

(3) Shareholder’s share of W–2 wages. 

Under section 199(d)(1)(B), an S 

corporation shareholder’s share of the 

W–2 wages of the S corporation for 

purposes of determining the 

shareholder’s section 199(b) limitation 

is the lesser of the shareholder’s 

allocable share of those wages (without 

regard to section 199(d)(1)(B)), or 2 

times 9 percent (3 percent for taxable 

years beginning in 2005 or 2006, and 6 

percent for taxable years beginning in 

2007, 2008, or 2009) of the QPAI 

computed by taking into account only 

the items of the S corporation allocated 

to the shareholder for the taxable year. 

In general, this QPAI calculation is 

performed by the shareholder using the 

same cost allocation method that the 

shareholder uses in calculating the 

shareholder’s section 199 deduction. 

However, if an S corporation uses the 

small business simplified overall 

method described in § 1.199–4(f), the 

QPAI used by each shareholder to 

determine the wage limitation under 

section 199(d)(1)(B) is the same as the 

share of QPAI allocated to the 

shareholder. Each shareholder must 

compute its share of W–2 wages from an 

S corporation in accordance with 

section 199(d)(1)(B) (with W–2 wages 

being allocated to the shareholder in the 

same manner as is wage expense), and 

then add that share to the shareholder’s 

W–2 wages from other sources, if any. 

The application of section 199(d)(1)(B) 

therefore means that if QPAI, computed 

by taking into account only the items of 

the S corporation allocated to the 

shareholder for the taxable year, is not 

greater than zero, the shareholder may 

not take into account any W–2 wages of 

the S corporation in computing the 

shareholder’s section 199 deduction. 

See § 1.199–2 for the computation of W–

2 wages, and paragraph (f) of this 

section for rules regarding pass-thru 

entities in a tiered structure. 

(c) Grantor trusts. To the extent that 

the grantor or another person is treated 

as owning all or part (the owned 

portion) of a trust under sections 671 

through 679, the owner computes its 

QPAI with respect to the owned portion 

of the trust as if that QPAI had been 

generated by activities performed 

directly by the owner. Similarly, for 

purposes of the section 199(b) wage 

limitation, the owner of the trust takes 

into account the owner’s share of the 

W–2 wages of the trust that are 

attributable to the owned portion of the 

trust. The section 199(d)(1)(B) wage 

limitation is not applicable to the 

owned portion of the trust. 

(d) Non-grantor trusts and estates—(1) 

Computation of section 199 deduction. 

Except as provided in paragraph (c) of 

this section, solely for purposes of 

determining the section 199 deduction 

for the taxable year, the QPAI of a trust 

or estate must be computed by 

allocating expenses described in section 

199(d)(5) under § 1.652(b)–3 with 

respect to directly attributable expenses, 

and under the simplified deduction 

method of § 1.199–4(e) with respect to 

other expenses described in section 

199(d)(5) (unless the trust or estate does 

not qualify to use the simplified 

deduction method, in which case it 

must use the section 861 method of 

§ 1.199–4(d) with respect to such other 

expenses). For this purpose, the trust’s 

or estate’s share of other expenses from 

a lower-tier pass-thru entity is not 

directly attributable to any class of 

income (whether or not those other 

expenses are directly attributable to the 

aggregate pass-thru gross income as a 

class for purposes other than section 

199). A trust or estate may not use the 

small business simplified overall 

method for computing its QPAI. See 

67268 Federal Register / Vol. 70, No. 213 / Friday, November 4, 2005 / Proposed Rules 

§ 1.199–4(f)(4). The QPAI (which will be 

less than zero if the CGS and deductions 

allocated and apportioned to DPGR 

exceed the trust’s or estate’s DPGR) and 

W–2 wages of the trust or estate are 

allocated to each beneficiary and to the 

trust or estate based on the relative 

proportion of the trust’s or estate’s 

distributable net income (DNI), as 

defined by section 643(a), for the taxable 

year that is distributed or required to be 

distributed to the beneficiary or is 

retained by the trust or estate. To the 

extent that the trust or estate has no DNI 

for the taxable year, any QPAI and W–

2 wages are allocated entirely to the 

trust or estate. A trust or estate may 

claim the section 199 deduction in 

computing its taxable income to the 

extent that QPAI and W–2 wages are 

allocated to the trust or estate. A 

beneficiary of a trust or estate is allowed 

the section 199 deduction in computing 

its taxable income based on its share of 

QPAI and W–2 wages from the trust or 

estate, which (subject to the wage 

limitation of section 199(d)(1)(B)) are 

aggregated with the beneficiary’s QPAI 

and W–2 wages from other sources. 

Each beneficiary must compute its share 

of W–2 wages from a trust or estate in 

accordance with section 199(d)(1)(B). 

The application of section 199(d)(1)(B) 

therefore means that if QPAI, computed 

by taking into account only the items of 

the trust or estate allocated to the 

beneficiary for the taxable year, is not 

greater than zero, the beneficiary may 

not take into account any W–2 wages of 

the trust or estate in computing the 

beneficiary’s section 199 deduction. See 

paragraph (f) of this section for rules 

applicable to pass-thru entities in a 

tiered structure. 

(2) Example. The following example 

illustrates the application of this 

paragraph (d). Assume that the 

partnership, trust, and trust beneficiary 

all are calendar year taxpayers. The 

example is as follows: 

Example. (i) Computation of DNI and 

inclusion and deduction amounts. (A) Trust’s 

distributive share of partnership items. Trust, 

a complex trust, is a partner in PRS, a 

partnership that engages in activities that 

generate DPGR and non-DPGR. In 2010, PRS 

distributes $10,000 to Trust. Trust’s 

distributive share of PRS items, which are 

properly included in Trust’s DNI, is as 

follows: 

Gross income attributable to DPGR ($15,000 DPGR¥$5,000 CGS (including W–2 wages of 1,000)) ................................................ $10,000 

Gross income attributable to other gross receipts ($5,000 other gross receipts¥$0 CGS) .................................................................. 5,000 

Selling expenses (includes W–2 wages of $2,000). ............................................................................................................................... 3,000 

Other expenses (includes W–2 wages of $1,000) .................................................................................................................................. 2,000 

(B) Trust’s direct activities. In addition to 

receiving in 2010 the distribution from PRS, 

Trust also directly has the following items 

which are properly included in Trust’s DNI: 

Dividends ................................................................................................................................................................................................. $10,000 

Tax-exempt interest ................................................................................................................................................................................. 10,000 

Rents from commercial real property that is subject to a section 6166 election .................................................................................... 10,000 

Real estate taxes ..................................................................................................................................................................................... 1,000 

Trustee commissions ............................................................................................................................................................................... 3,000 

State income and personal property taxes ............................................................................................................................................. 5,000 

W–2 wages .............................................................................................................................................................................................. 2,000 

Other business expenses ........................................................................................................................................................................ 1,000 

(C) Allocation of deductions under 

§ 1.652(b)–3. (1) Directly attributable 

expenses. In computing Trust’s DNI for the 

taxable year, the distributive share of 

expenses of PRS are directly attributable 

under § 1.652(b)–3(a) to the distributive share 

of income of PRS. Accordingly, the $20,000 

of gross receipts from PRS is reduced by 

$5,000 of CGS, $3,000 of selling expenses, 

and $2,000 of other expenses, resulting in net 

income from PRS of $10,000. With respect to 

the Trust’s direct expenses, $1,000 of the 

trustee commissions, the $1,000 of real estate 

taxes, and the $2,000 of W–2 wages are 

directly attributable under § 1.652(b)–3(a) to 

the rental income. 

(2) Non-directly attributable expenses. 

Under § 1.652(b)–3(b), the trustee must 

allocate a portion of the sum of the balance 

of the trustee commissions ($2,000), state 

income and personal property taxes ($5,000), 

and the other business expenses ($1,000) to 

the $10,000 of tax-exempt interest. The 

portion to be attributed to tax-exempt interest 

is $2,222 ($8,000 × ($10,000 tax exempt 

interest/$36,000 gross receipts net of direct 

expenses)), resulting in $7,778 

($10,000¥$2,222) of net tax-exempt interest. 

Pursuant to its authority recognized under 

§ 1.652(b)–3(b), the trustee allocates the 

entire amount of the remaining $5,778 of 

trustee commissions, state income and 

personal property taxes, and other business 

expenses to the $6,000 of net rental income, 

resulting in $222 ($6,000¥$5,778) of net 

rental income. 

(D) Amounts included in taxable income. 

For 2010, Trust has DNI of $28,000 (net 

dividend income of $10,000 + net PRS 

income of $10,000 + net rental income of 

$222 + net tax-exempt income of $7,778). 

Pursuant to Trust’s governing instrument, 

Trustee distributes 50%, or $14,000, of that 

DNI to B, an individual who is a 

discretionary beneficiary of Trust. Assume 

that there are no separate shares under Trust, 

and no distributions are made to any other 

beneficiary that year. Consequently, with 

respect to the $14,000 distribution, B 

properly includes in B’s gross income $5,000 

of income from PRS, $111 of rents, and 

$5,000 of dividends, and properly excludes 

from B’s gross income $3,889 of tax-exempt 

interest. Trust includes $20,222 in its 

adjusted total income and deducts $10,111 

under section 661(a) in computing its taxable 

income. 

(ii) Section 199 deduction. (A) Simplified 

deduction method. For purposes of 

computing the section 199 deduction for the 

taxable year, assume Trust qualifies for the 

simplified deduction method under § 1.199–

4(e). Determining Trust’s QPAI under the 

simplified deduction method requires a 

multi-step approach to allocating costs. In 

step 1, the Trust’s DPGR is first reduced by 

the Trust’s expenses directly attributable to 

DPGR under § 1.652(b)–3(a). In this step, the 

$15,000 of DPGR from PRS is reduced by the 

directly attributable $5,000 of CGS and 

selling expenses of $3,000. In step 2, Trust 

allocates its other business expenses on the 

basis of its total gross receipts. In this 

example, the portion of the trustee 

commissions not directly attributable to the 

rental operation, as well as the portion of the 

state income and personal property taxes not 

directly attributable to either the PRS 

interests or the rental operation, are not trade 

or business expenses and, thus, are ignored 

in computing QPAI. The portion of the state 

income and personal property taxes that is 

treated as other trade or business expenses is 

$3,000 ($5,000 × $30,000 total trade or 

business gross receipts/$50,000 total gross 

receipts). Trust then combines its nondirectly attributable (other) expenses ($2,000 

from PRS + $4,000 ($1,000 + $3,000) from its 

own activities) and then apportions this total 

between DPGR and other receipts on the 

basis of Trust’s total gross receipts ($6,000 × 

$15,000 DPGR/$50,000 total gross receipts = 

$1,800). Thus, for purposes of computing 

Trust’s and B’s section 199 deduction, Trust’s 

QPAI is $5,200 ($7,000 ¥$1,800). Because 

the distribution of Trust’s DNI to B equals 

Federal Register / Vol. 70, No. 213 / Friday, November 4, 2005 / Proposed Rules 67269 

one-half of Trust’s DNI, Trust and B each has 

QPAI from PRS for purposes of the section 

199 deduction of $2,600. 

(B) Section 199(d)(1)(B) wage limitation. 

The wage limitation under section 

199(d)(1)(B) must be applied both at the 

Trust level and at B’s level. After applying 

this limitation to the Trust’s share of PRS’s 

W–2 wages, Trust is allocated $990 of W–2 

wages from PRS (the lesser of Trust’s 

allocable share of PRS’s W–2 wages ($4,000) 

or 2 × 9% of PRS’s QPAI ($5,500)). PRS’s 

QPAI for purposes of the section 199(d)(1)(B) 

limitation is determined by taking into 

account only the items of PRS allocated to 

Trust ($15,000 DPGR—($5,000 of CGS + 

$3,000 selling expenses + $1,500 of other 

expenses). For this purpose, the $1,500 of 

other expenses is determined by multiplying 

$2,000 of other expenses from PRS by 

$15,000 of DPGR from PRS, divided by 

$20,000 of total gross receipts from PRS. 

Trust adds this $990 of W–2 wages to Trust’s 

own $2,000 of W–2 wages (thus, $2,990). 

Because the $14,000 distribution to B equals 

one-half of Trust’s DNI, Trust and B each has 

W–2 wages of $1,495. After applying the 

section 199(d)(1)(B) wage limitation to B’s 

share of the W–2 wages allocated from Trust, 

B has W–2 wages of $468 from Trust (lesser 

of $1,495 (allocable share of W–2 wages) or 

2 × .09 × $2,600 (Trust’s QPAI)). B has W–

2 wages of $100 from non-Trust activities for 

a total of $568 of W–2 wages. 

(C) Section 199 deduction computation. (1) 

B’s computation. B is eligible to use the small 

business simplified overall method. Assume 

that B has sufficient adjusted gross income so 

that the section 199 deduction is not limited 

under section 199(a)(1)(B). B has $1,000 of 

QPAI from non-Trust activities which is 

added to the $2,600 QPAI from Trust for a 

total of $3,600 of QPAI. B’s tentative 

deduction is $324 (.09 × $3,600) which is 

limited under section 199(b) to $284 (50% × 

$568 W–2 wages). Accordingly, B’s section 

199 deduction for 2010 is $284. 

(2) Trust’s computation. Trust has 

sufficient taxable income so that the section 

199 deduction is not limited under section 

199(a)(1)(B). Trust’s tentative deduction is 

$234 (.09 × $2,600 QPAI) which is limited 

under section 199(b) to $748 (50% × $1,495 

W–2 wages). Accordingly, Trust’s section 199 

deduction for 2010 is $234. 

(e) Gain or loss from the disposition 

of an interest in a pass-thru entity. 

DPGR generally does not include gain or 

loss recognized on the sale, exchange, or 

other disposition of an interest in a 

pass-thru entity. However, with respect 

to partnerships, if section 751(a) or (b) 

applies, gain or loss attributable to 

assets of the partnership giving rise to 

ordinary income under section 751(a) or 

(b), the sale, exchange, or other 

disposition of which would give rise to 

DPGR, is taken into account in 

computing the partner’s section 199 

deduction. Accordingly, to the extent 

that money or property received by a 

partner in a sale or exchange for all or 

part of its partnership interest is 

attributable to unrealized receivables or 

inventory items within the meaning of 

section 751(c) or (d), respectively, and 

the sale or exchange of the unrealized 

receivable or inventory items would 

give rise to DPGR if sold or exchanged 

or otherwise disposed of by the 

partnership, the money or property 

received is taken into account by the 

partner in determining its DPGR for the 

taxable year. Likewise, to the extent that 

a distribution of property to a partner is 

treated under section 751(b) as a sale or 

exchange of property between the 

partnership and the distributee partner, 

and any property deemed sold or 

exchanged would give rise to DPGR if 

sold or exchanged by the partnership, 

the deemed sale or exchange of the 

property must be taken into account in 

determining the partnership’s and 

distributee partner’s DPGR. See § 1.751–

1(b). 

(f) Section 199(d)(1)(B) wage 

limitation and tiered structures—(1) In 

general. If a pass-thru entity owns an 

interest, directly or indirectly, in one or 

more pass-thru entities, the wage 

limitation of section 199(d)(1)(B) must 

be applied at each tier (that is, 

separately for each entity). Thus, at each 

tier, the owner of a pass-thru entity 

calculates the amounts described in 

sections 199(d)(1)(B)(i) (allocable share) 

and 199(d)(1)(B)(ii) (twice the 

applicable percentage of QPAI from that 

entity) separately with regard to its 

interest in that pass-thru entity. 

(2) Share of W–2 wages. For purposes 

of section 199(d)(1)(B)(i) and section 

199(b), the W–2 wages of the owner of 

an interest in a pass-thru entity (uppertier entity) that owns an interest in one 

or more pass-thru entities (lower-tier 

entities) are equal to the sum of the 

owner’s allocable share of W–2 wages of 

the upper-tier entity, as limited in 

accordance with section 199(d)(1)(B), 

and the owner’s own W–2 wages. The 

upper-tier entity’s W–2 wages are equal 

to the sum of the upper-tier entity’s 

allocable share of W–2 wages of the next 

lower-tier entity, as limited in 

accordance with section 199(d)(1)(B), 

and the upper-tier entity’s own W–2 

wages. The W–2 wages of each lowertier entity in a tiered structure, in turn, 

is computed as described in the 

preceding sentence. Although all wages 

paid during that taxable year are taken 

into account in computing QPAI, only 

the W–2 wages as described in § 1.199–

2 are taken into account in computing 

the W–2 wage limitation. 

(3) Example. The following example 

illustrates the application of this 

paragraph (f). Assume that each 

partnership and each partner (whether 

or not an individual) is a calendar year 

taxpayer. The example is as follows: 

Example. (i) In 2010, A, an individual, 

owns a 50% interest in a partnership, UTP, 

which in turn owns a 50% interest in another 

partnership, LTP. All partnership items are 

allocated in proportion to these ownership 

percentages. Both partnerships are eligible 

for and use the small business simplified 

overall method under § 1.199–4(f). LTP has 

QPAI of $400 ($900 DPGR—$450 CGS (which 

includes W–2 wages of $100)—$50 other 

deductions). Before taking into account its 

distributive share from LTP, UTP has QPAI 

of ($500) ($500 DPGR—$500 CGS (which 

includes W–2 wages of $200)—$500 other 

deductions). UTP’s distributive share of 

LTP’s QPAI is $200. 

(ii) UTP’s share of LTP’s W–2 wages for 

purposes of the section 199(d)(1)(B) 

limitation is $36, the lesser of $50 (UTP’s 

allocable share of LTP’s W–2 wages paid) or 

$36 (2 × ($200 QPAI × .09)). After taking into 

account its distributive share from LTP, UTP 

has QPAI of ($300) and W–2 wages of $236. 

A’s distributive share of UTP’s QPAI is 

($150). A’s limitation under section 

199(d)(1)(B) with respect to A’s interest in 

UTP is $0, the lesser of $118 (A’s allocable 

share of UTP’s W–2 wages paid) or $0 

(because A’s share of QPAI, ($150), is less 

than zero). 

(g) No attribution of qualified 

activities. Except as provided in 

§ 1.199–3(h)(7) regarding certain 

qualifying oil and gas partnerships and 

§ 1.199–3(h)(8) regarding EAG 

partnerships, for purposes of section 

199, an owner of a pass-thru entity is 

not treated as conducting the qualified 

production activities of the pass-thru 

entity, and vice versa. This rule applies 

to all partnerships, including 

partnerships that have elected out of 

subchapter K under section 761(a). 

Accordingly, if a partnership MPGE 

QPP within the United States, or 

otherwise produces a qualified film or 

utilities in the United States, and 

distributes or leases, rents, licenses, 

sells, exchanges, or otherwise disposes 

of the property to a partner who then 

leases, rents, licenses, sells, exchanges, 

or otherwise disposes of the property, 

the partner’s gross receipts from this 

latter lease, rental, license, sale, 

exchange, or other disposition are not 

treated as DPGR under § 1.199–3. In 

addition, if a partner MPGE QPP within 

the United States, or otherwise produces 

a qualified film or utilities in the United 

States, and contributes or leases, rents, 

licenses, sells, exchanges, or otherwise 

disposes of the property to a partnership 

which then leases, rents, licenses, sells, 

exchanges, or otherwise disposes of the 

property, the partnership’s gross 

receipts from this latter disposition are 

not treated as DPGR under § 1.199–3. 

§ 1.199–6 Agricultural and horticultural 

cooperatives. 

(a) In general. This section applies to 

a cooperative to which Part I of 

67270 Federal Register / Vol. 70, No. 213 / Friday, November 4, 2005 / Proposed Rules 

subchapter T of the Internal Revenue 

Code applies and its patrons if the 

cooperative has manufactured, 

produced, grown, or extracted (MPGE) 

(as defined in § 1.199–3(d)) in whole or 

significant part (as defined in § 1.199–

3(f)) within the United States (as 

defined in § 1.199–3(g)) any agricultural 

or horticultural product, or has 

marketed agricultural or horticultural 

products. For this purpose, agricultural 

or horticultural products also include 

fertilizer, diesel fuel, and other supplies 

used in agricultural or horticultural 

production. If any amount of a 

patronage dividend or per-unit retain 

allocation received by a patron is 

allocable to the qualified production 

activities income (QPAI) (as defined in 

§ 1.199–1(c)) of the cooperative, would 

be allowable as a deduction under 

§ 1.199–1(a) (section 199 deduction) by 

the cooperative, and is designated as 

such in a written notice to the patron 

during the payment period defined 

under section 1382(d), then such 

amount is deductible by the patron as a 

section 199 deduction. For this purpose, 

patronage dividends and per-unit retain 

allocations include any advances on 

patronage or per-unit retains paid in 

money during the taxable year. 

(b) Written notice to patrons. In order 

for a patron to qualify for the section 

199 deduction, paragraph (a) of this 

section requires that the cooperative 

designate in a written notice the amount 

of the patron’s patronage dividend or 

per-unit retain allocation that is 

allocable to QPAI and deductible by the 

cooperative. This written notice 

designating the patron’s portion of the 

section 199 deduction must be mailed 

by the cooperative to its patrons no later 

than the 15th day of the ninth month 

following the close of the taxable year. 

The cooperative may use the same 

written notice, if any, that it uses to 

notify patrons of their respective 

allocations of patronage dividends, or 

may use a separate timely written 

notice(s) to comply with this section. 

The cooperative must report the amount 

of the patron’s section 199 deduction on 

Form 1099–PATR, ‘‘Taxable 

Distributions Received from 

Cooperative,’’ issued to the patron. 

(c) Determining cooperative’s 

qualified production activities income. 

In determining the portion of the 

cooperative’s QPAI that would be 

allowable as a section 199 deduction by 

the cooperative, the cooperative’s 

taxable income is computed without 

taking into account any deduction 

allowable under section 1382(b) or (c) 

(relating to patronage dividends, perunit retain allocations, and 

nonpatronage distributions) and, in the 

case of a cooperative engaged in the 

marketing of agricultural and/or 

horticultural products, the cooperative 

is treated as having MPGE in whole or 

in significant part within the United 

States any agricultural or horticultural 

products marketed by the cooperative 

that its patrons have MPGE. 

(d) Additional rules relating to passthrough of section 199 deduction. The 

cooperative may, at its discretion, pass 

through all, some, or none of the section 

199 deduction to its patrons. A 

cooperative member of a federated 

cooperative may pass through the 

section 199 deduction it receives from 

the federated cooperative to its member 

patrons. Patrons may claim the section 

199 deduction for the taxable year in 

which they receive the written notice 

from the cooperative informing them of 

the section 199 amount without regard 

to the taxable income limitation under 

§ 1.199–1(a) and (b). 

(e) W–2 wages. The W–2 wage 

limitation described in § 1.199–2 shall 

be applied at the cooperative level 

whether or not the cooperative chooses 

to pass through some or all of the 

section 199 deduction. Any section 199 

deduction that has been passed through 

by a cooperative to its patrons is not 

subject to the W–2 wage limitation a 

second time at the patron level. 

(f) Recapture of section 199 

deduction. If the amount of the section 

199 deduction that was passed through 

to patrons exceeds the amount 

allowable as a section 199 deduction as 

determined on audit or reported on the 

amended return, recapture of the excess 

will occur at the cooperative level. 

(g) Section is exclusive. This section 

is the exclusive method for cooperatives 

and their patrons to compute the 

amount of the section 199 deduction. 

Thus, a patron may not deduct any 

amount with respect to a patronage 

dividend or a per-unit retain allocation 

unless the requirements of this section 

are satisfied. 

(h) No double counting. A patronage 

dividend or per-unit retain allocation 

received by a patron of a cooperative is 

not QPAI in the hands of the patron. 

(i) Examples. The following examples 

illustrate the application of this section: 

Example 1. (i) Cooperative X markets corn 

grown by its members within the United 

States for sale to retail grocers. For its 

calendar year ended December 31, 2005, 

Cooperative X has gross receipts of 

$1,500,000, all derived from the sale of corn 

grown by its members. Cooperative X’s W–

2 wages for 2005 total $500,000. Cooperative 

X has no other costs. Patron A is a member 

of Cooperative X. Patron A is a cash basis 

taxpayer and files Federal income tax returns 

on a calendar year basis. All corn grown by 

Patron A in 2005 is sold through Cooperative 

X and Patron A is eligible to share in 

patronage dividends paid by Cooperative X 

for that year. 

(ii) Cooperative X is an agricultural 

cooperative described in paragraph (a) of this 

section. Accordingly, this section applies to 

Cooperative X and its patrons and all of 

Cooperative X’s gross receipts from the sale 

of its patrons’ corn qualify as domestic 

production gross receipts (as defined § 1.199–

3(a)). Cooperative X’s QPAI under paragraph 

(c) of this section is $1,000,000. Cooperative 

X’s section 199 deduction for its taxable year 

2005 is $30,000 (.03 × $1,000,000). Since this 

amount is less than 50% of Cooperative X’s 

W–2 wages, the entire amount is deductible. 

Example 2. (i) The facts are the same as in 

Example 1 except that Cooperative X decides 

to pass its entire section 199 deduction 

through to its members. Cooperative X 

declares a patronage dividend for its 2005 

taxable year of $1,000,000, which it pays on 

March 15, 2006. Pursuant to paragraph (b) of 

this section, Cooperative X notifies members 

in written notices which accompany the 

patronage dividend notification that it is 

allocating to them the section 199 deduction 

it is entitled to claim in the taxable year 

2005. On March 15, 2006, Patron A receives 

a $10,000 patronage dividend from 

Cooperative X. In the notice that 

accompanies the patronage dividend, Patron 

A is designated a $300 section 199 

deduction. Under paragraph (d) of this 

section, Patron A may claim a $300 section 

199 deduction for the taxable year ending 

December 31, 2006, without regard to the 

taxable income limitation under § 1.199–1(a) 

and (b). Cooperative X must report the 

amount of Patron A’s section 199 deduction 

on Form 1099–PATR, ‘‘Taxable Distributions 

Received from Cooperative,’’ issued to the 

Patron A for the calendar year 2006. 

(ii) Under section 199(d)(3)(A), Cooperative 

X is required to reduce its patronage 

dividend deduction of $1,000,000 by the 

$30,000 section 199 deduction passed 

through to members (whether or not 

Cooperative X pays patronage on book or tax 

net earnings). As a consequence, Cooperative 

X is entitled to a patronage dividend 

deduction for the taxable year ending 

December 31, 2005, in the amount of 

$970,000 ($1,000,000¥$30,000) and to a 

section 199 deduction in the amount of 

$30,000 ($1,000,000 × .03). Its taxable income 

for 2005 is $0. 

Example 3. (i) The facts are the same as in 

Example 1 except that Cooperative X paid 

out $500,000 to its patrons as advances on 

expected patronage net earnings. In 2005, 

Cooperative X pays its patrons a $500,000 

($1,000,000¥$500,000 already paid) 

patronage dividend in cash or a combination 

of cash and qualified written notices of 

allocation. Under sections 199(d)(3)(A) and 

1382, Cooperative X is allowed a patronage 

dividend deduction of $470,000 

($500,000¥$30,000 section 199 deduction), 

whether patronage net earnings are 

distributed on book or tax net earnings. 

(ii) The patrons will have received a gross 

amount of $1,000,000 from Cooperative X 

($500,000 paid during the taxable year as 

advances and the additional $500,000 paid as 

Federal Register / Vol. 70, No. 213 / Friday, November 4, 2005 / Proposed Rules 67271 

qualified patronage dividends). If 

Cooperative X passes through its entire 

section 199 deduction to its members by 

providing the notice required by paragraph 

(b) of this section, the patrons will be 

allowed a $30,000 section 199 deduction, 

resulting in a net $970,000 taxable 

distribution from Cooperative X. Pursuant to 

paragraph (h) of this section, the $1,000,000 

received by the patrons from Cooperative X 

is not QPAI in the hands of the patrons. 

§ 1.199–7 Expanded affiliated groups. 

(a) In general. All members of an 

expanded affiliated group (EAG) are 

treated as a single corporation for 

purposes of section 199. 

Notwithstanding the preceding 

sentence, except as otherwise provided 

in the Internal Revenue Code and 

regulations (see, for example, sections 

199(c)(7) and 267, § 1.199–3(b), 

paragraph (a)(3) of this section, and the 

consolidated return regulations), each 

member of an EAG is a separate 

taxpayer that computes its own taxable 

income or loss, qualified production 

activites income (QPAI) (as defined in 

§ 1.199–1(c)), and W–2 wages (as 

defined in § 1.199–2(f)). If members of 

an EAG are also members of a 

consolidated group, see paragraph (d) of 

this section. 

(1) Definition of expanded affiliated 

group. An EAG is an affiliated group as 

defined in section 1504(a), determined 

by substituting ‘‘more than 50 percent’’

for ‘‘at least 80 percent’’ each place it 

appears and without regard to section 

1504(b)(2) and (4). 

(2) Identification of members of an 

expanded affiliated group—(i) In 

general. A corporation must determine 

if it is a member of an EAG on a daily 

basis. 

(ii) Becoming or ceasing to be a 

member of an expanded affiliated 

group. If a corporation becomes or 

ceases to be a member of an EAG, the 

corporation is treated as becoming or 

ceasing to be a member of the EAG at 

the end of the day on which its status 

as a member changes. 

(3) Attribution of activities. In general, 

if a member of an EAG (the disposing 

member) derives gross receipts (as 

defined in § 1.199–3(c)) from the lease, 

rental, license, sale, exchange, or other 

disposition (as defined in § 1.199–3(h)) 

of qualifying production property (QPP) 

(as defined in § 1.199–3(i)) that was 

manufactured, produced, grown or 

extracted (MPGE) (as defined in § 1.199–

3(d)), in whole or in significant part (as 

defined in § 1.199–3(f)), in the United 

States (as defined in § 1.199–3(g)), a 

qualifed film (as defined in § 1.199–3(j)) 

that was produced in the United States, 

or electricity, natural gas, or potable 

water (as defined in § 1.199–3(k)) 

(collectively, utilities) that was 

produced in the United States by 

another member or members of the same 

EAG, the disposing member is treated as 

conducting the activities conducted by 

each other member of the EAG with 

respect to the QPP, qualified film, or 

utilities in determining whether its 

gross receipts are domestic production 

gross receipts (DPGR) (as defined in 

§ 1.199–3(a)). However, attribution of 

activities does not apply for purposes of 

the construction of real property under 

§ 1.199–3(l) or the performance of 

engineering and architectural services 

under § 1.199–3(m). A member of an 

EAG must engage in a construction 

activity under § 1.199–3(l)(2), provide 

engineering services under § 1.199–

3(m)(2), or provide architectural 

services under § 1.199–3(m)(3) in order 

for the member’s gross receipts to be 

derived from construction, engineering, 

or architectural services. 

(4) Examples. The following examples 

illustrate the application of paragraph 

(a)(3) of this section: 

Example 1. Corporations M and N are 

members of the same EAG. M is engaged 

solely in the trade or business of 

manufacturing furniture in the United States 

that it sells to unrelated persons. N is 

engaged solely in the trade or business of 

engraving companies’ names on pens and 

pencils purchased from unrelated persons 

and then selling the pens and pencils to such 

companies. If N was not a member of an 

EAG, its activities would not qualify as 

MPGE. Accordingly, although M’s sales of 

the furniture qualify as DPGR (assuming all 

the other requirements of § 1.199–3 are met), 

N’s sales of the engraved pens and pencils do 

not qualify as DPGR because neither N nor 

another member of the EAG MPGE the pens 

and pencils. 

Example 2. For the entire 2006 taxable 

year, Corporations A and B are members of 

the same EAG. A is engaged solely in the 

trade or business of manufacturing QPP in 

the United States. A and B each own 45 

percent of partnership C and unrelated 

persons own the remaining 10 percent. C is 

engaged solely in the trade or business of 

manufacturing the same type of QPP in the 

United States as A. In 2006, B purchases and 

then resells the QPP manufactured in 2006 

by A and C. B also resells QPP it purchases 

from unrelated persons. If only B’s activities 

were considered, B would not qualify for the 

deduction under § 1.199–1(a) (section 199 

deduction). However, because B is a member 

of the EAG that includes A, B is treated as 

conducting A’s manufacturing activities in 

determining whether B’s gross receipts are 

DPGR. C is not a member of the EAG and 

thus C’s MPGE activities are not attributed to 

B in determining whether B’s gross receipts 

are DPGR. Accordingly, B’s gross receipts 

attributable to its sale of the QPP it purchases 

from A are DPGR (assuming all the other 

requirements of § 1.199–3 are met). B’s gross 

receipts attributable to its sale of the QPP it 

purchases from C and from the unrelated 

persons are non-DPGR because no member of 

the EAG MPGE the QPP. If rather than 

reselling the QPP, B rented the QPP it 

acquired from A to unrelated persons, B’s 

gross receipts attributable to the rental of the 

QPP would also be DPGR (assuming all the 

other requirements of § 1.199–3 are met). 

(5) Anti-avoidance rule. If a 

transaction between members of an EAG 

is engaged in or structured with a 

principal purpose of qualifying for, or 

increasing the amount of, the section 

199 deduction of the EAG or the portion 

of the section 199 deduction allocated to 

one or more members of the EAG, 

adjustments must be made to eliminate 

the effect of the transaction on the 

computation of the section 199 

deduction. 

(b) Computation of expanded 

affiliated group’s section 199 

deduction—(1) In general. The section 

199 deduction for an EAG is determined 

by aggregating each member’s taxable 

income or loss, QPAI, and W–2 wages. 

For this purpose, a member’s QPAI is 

determined under § 1.199–1. For 

purposes of this determination, a 

member’s QPAI may be positive or 

negative. A member’s taxable income or 

loss and QPAI shall be determined by 

reference to the member’s methods of 

accounting. 

(2) Net operating loss carryovers. In 

determing the taxable income of an 

EAG, if a member of an EAG has a net 

operating loss (NOL) carryback or 

carryover to the taxable year, then the 

amount of the NOL used to offset 

taxable income cannot exceed the 

taxable income of that member. 

(c) Allocation of an expanded 

affiliated group’s section 199 deduction 

among members of the expanded 

affiliated group—(1) In general. An 

EAG’s section 199 deduction is 

allocated among the members of the 

EAG in proportion to each member’s 

QPAI regardless of whether the EAG 

member has taxable income or loss or 

W–2 wages for the taxable year. For this 

purpose, if a member has negative 

QPAI, the QPAI of the member shall be 

treated as zero. 

(2) Use of section 199 deduction to 

create or increase a net operating loss. 

Notwithstanding § 1.199–1(b), which 

generally prevents the section 199 

deduction from creating or increasing an 

NOL, if a member of an EAG has some 

or all of the EAG’s section 199 

deduction allocated to it under 

paragraph (c)(1) of this section and the 

amount allocated exceeds the member’s 

taxable income (determined prior to 

allocation of the section 199 deduction), 

the section 199 deduction will create an 

NOL for the member. Similarly, if a 

member of an EAG, prior to the 

67272 Federal Register / Vol. 70, No. 213 / Friday, November 4, 2005 / Proposed Rules 

allocation of some or all of the EAG’s 

section 199 deduction to the member, 

has an NOL for the taxable year, the 

portion of the EAG’s section 199 

deduction allocated to the member will 

increase the member’s NOL. 

(d) Special rules for members of the 

same consolidated group—(1) 

Intercompany transactions. In the case 

of an intercompany transaction between 

consolidated group members S and B 

(intercompany transaction, S, and B as 

defined in § 1.1502–13(b)(1)), S takes an 

intercompany transaction into account 

in computing the section 199 deduction 

at the same time and in the same 

proportion as S takes into account the 

income, gain, deduction, or loss from 

the intercompany transaction under 

§ 1.1502–13. 

(2) Attribution of activities in the 

construction of real property and the 

performance of engineering and 

architectural services. Notwithstanding 

paragraph (a)(3) of this section, a 

disposing member (as described in such 

paragraph) is treated as conducting the 

activities conducted by each other 

member of the consolidated group with 

respect to the construction of real 

property under § 1.199–3(l) and the 

performance of engineering and 

architectural services under § 1.199–

3(m). 

(3) Application of the simplified 

deduction method and the small 

business simplified overall method. For 

purposes of applying the simplified 

deduction method under § 1.199–4(e) 

and the small business simplified 

overall method under § 1.199–4(f), a 

consolidated group determines its QPAI 

by reference to its members’ DPGR, nonDPGR, cost of goods sold (CGS), and all 

other deductions, expenses, or losses 

(deductions), determined on a 

consolidated basis. 

(4) Determining the section 199 

deduction—(i) Expanded affiliated 

group consists of consolidated group 

and non-consolidated group members. If 

an EAG includes corporations that are 

members of the same consolidated 

group and corporations that are not 

members of the same consolidated 

group, in computing the taxable income 

of the EAG, the consolidated taxable 

income or loss, QPAI, and W–2 wages 

of the consolidated group, not the 

separate taxable income or loss, QPAI, 

and W–2 wages of the members of the 

consolidated group, are aggregated with 

the taxable income or loss, QPAI, and 

W–2 wages of the non-consolidated 

group members. For example, if A, B, C, 

S1, and S2 are members of the same 

EAG, and A, S1, and S2 are members of 

the same consolidated group (the A 

consolidated group), the A consolidated 

group is treated as one member of the 

EAG. Accordingly, the EAG is 

considered to have three members, the 

A consolidated group, B, and C. The 

consolidated taxable income or loss, 

QPAI, and W–2 wages of the A 

consolidated group are aggregated with 

the taxable income or loss, QPAI, and 

W–2 wages of B and C in determining 

the EAG’s section 199 deduction. 

(ii) Expanded affiliated group consists 

only of members of a single 

consolidated group. If all the members 

of an EAG are members of the same 

consolidated group, the consolidated 

group’s section 199 deduction is 

determined by reference to the 

consolidated group’s consolidated 

taxable income or loss, QPAI, and W–

2 wages, not the separate taxable income 

or loss, QPAI, and W–2 wages of its 

members. 

(5) Allocation of the section 199 

deduction of a consolidated group 

among its members. The section 199 

deduction of a consolidated group (or 

the section 199 deduction allocated to a 

consolidated group that is a member of 

an EAG) must be allocated to the 

members of the consolidated group in 

proportion to each consolidated group 

member’s QPAI, regardless of whether 

the consolidated group member has 

separate taxable income or loss or W–2 

wages for the taxable year. For purposes 

of allocating the section 199 deduction 

of a consolidated group among its 

members, any redetermination of a 

corporation’s receipts from an 

intercompany transaction as DPGR or 

non-DPGR or as non-receipts, and any 

redetermination of a corporation’s CGS 

or other deductions from an 

intercompany transaction as either 

allocable to or not allocable to DPGR 

under § 1.1502–13(c)(1)(i) or (c)(4) is not 

taken into account. Also, for purposes of 

this allocation, if a consolidated group 

member has negative QPAI, the QPAI of 

the member shall be treated as zero. 

(e) Examples. The following examples 

illustrate the application of paragraphs 

(b), (c), and (d) of this section: 

Example 1. Corporations X and Y are 

members of the same EAG but are not 

members of a consolidated group. X and Y 

each use the section 861 method described in 

§ 1.199–4(d) for allocating and apportioning 

their deductions. X incurs $5,000 in costs in 

manufacturing a machine, all of which are 

capitalized. X is entitled to a $1,000 

depreciation deduction for the machine in 

the current taxable year. X rents the machine 

to Y for $1,500. Y uses the machine in 

manufacturing QPP within the United States. 

Y incurs $1,400 of CGS in manufacturing the 

QPP. Y sells the QPP to unrelated persons for 

$7,500. Pursuant to section 199(c)(7) and 

§ 1.199–3(b), X’s rental income is non-DPGR 

(and its related costs are not attributable to 

DPGR). Accordingly, Y has $4,600 of QPAI 

(Y’s $7,500 DPGR received from unrelated 

persons ¥ Y’s $1,400 CGS allocable to such 

receipts ¥ Y’s $1,500 of rental expense), X 

has $0 of QPAI, and the EAG has $4,600 of 

QPAI. 

Example 2. The facts are the same as in 

Example 1 except that X and Y are members 

of the same consolidated group. Pursuant to 

section 199(c)(7) and § 1.199–3(b), X’s rental 

income ordinarily would not be DPGR (and 

its related costs would not be allocable to 

DPGR). However, because X and Y are 

members of the same consolidated group, 

§ 1.1502–13(c)(1)(i) provides that the separate 

entity attributes of X’s income or Y’s 

expenses, or both X’s income and Y’s 

expenses, may be redetermined in order to 

produce the same effect as if X and Y were 

divisions of a single corporation. If X and Y 

were divisions of a single corporation, X and 

Y would have QPAI of $5,100 ($7,500 DPGR 

received from unrelated persons ¥ $1,400 

CGS allocable to such receipts ¥ $1,000 

depreciation deduction). To obtain this same 

result for the consolidated group, X’s rental 

income is recharacterized as DPGR, which 

results in the consolidated group having 

$9,000 of DPGR (the sum of Y’s DPGR of 

$7,500 + X’s DPGR of $1,500) and $3,900 of 

costs allocable to DPGR (the sum of Y’s 

$1,400 CGS + Y’s $1,500 rental expense + X’s 

$1,000 depreciation expense). For purposes 

of determining how much of the consolidated 

group’s section 199 deduction is allocated to 

X and Y, pursuant to paragraph (d)(5) of this 

section, the redetermination of X’s rental 

income as DPGR under § 1.1502–13(c)(1)(i) is 

not taken into account (X’s costs are 

considered to be allocable to DPGR because 

they are allocable to the consolidated group 

deriving DPGR). Accordingly, for this 

purpose, X is deemed to have ($1,000) of 

QPAI (X’s $0 DPGR ¥ X’s $1,000 

depreciation deduction). Because X is 

deemed to have negative QPAI, also pursuant 

to paragraph (d)(5) of this section, X’s QPAI 

is treated as zero. Y has $4,600 of QPAI (Y’s 

$7,500 DPGR ¥ Y’s $1,400 CGS allocable to 

such receipts ¥ Y’s $1,500 of rental 

expense). Accordingly, X is allocated $0/($0 

+ $4,600) of the consolidated group’s section 

199 deduction and Y is allocated $4,600/($0 

+ $4,600) of the consolidated group’s section 

199 deduction. 

Example 3. (i) Facts. Corporations A and B 

are the only two members of an EAG but are 

not members of a consolidated group. A and 

B each file Federal income tax returns on a 

calendar year basis. The average annual gross 

receipts of the EAG are less than or equal to 

$25,000,000 and A and B each use the 

simplified deduction method under § 1.199–

4(e). In 2006, A MPGE televisions within the 

United States. A has $10,000,000 of DPGR 

from sales of televisions to unrelated persons 

and $2,000,000 of DPGR from sales of 

televisions to B. In addition, A has gross 

receipts from computer consulting services 

with unrelated persons of $3,000,000. A has 

CGS of $6,000,000. A is able to determine 

from its books and records that $4,500,000 of 

its CGS are attributable to televisions sold to 

unrelated persons and $1,500,000 are 

attributable to televisions sold to B (see 

§ 1.199–4(b)(2)). A has other deductions of 

Federal Register / Vol. 70, No. 213 / Friday, November 4, 2005 / Proposed Rules 67273 

$4,000,000. A has no other items of income, 

gain, or deductions. In 2006, B sells the 

televisions it purchased from A to unrelated 

persons for $4,100,000 and pays $100,000 for 

administrative services performed in 2006. B 

has no other items of income, gain, or 

deductions. 

(ii) QPAI. (A) A’s QPAI. In order to 

determine A’s QPAI, A subtracts its 

$6,000,000 CGS from its $12,000,000 DPGR. 

Under the simplified deduction method, A 

then apportions its remaining $4,000,000 of 

deductions to DPGR in proportion to the ratio 

of its DPGR to total gross receipts. Thus, of 

A’s $4,000,000 of deductions, $3,200,000 is 

apportioned to DPGR ($4,000,000 × 

$12,000,000/$15,000,000). Accordingly, A’s 

QPAI is $2,800,000 ($12,000,000 DPGR ¥ 

$6,000,000 CGS ¥ $3,200,000 deductions 

apportioned to its DPGR). 

(B) B’s QPAI. Although B did not MPGE 

the televisions it sold, pursuant to paragraph 

(a)(3) of this section, B is treated as 

conducting A’s MPGE of the televisions in 

determining whether B’s gross receipts are 

DPGR. Thus, B has $4,100,000 of DPGR. In 

order to determine B’s QPAI, B subtracts its 

$2,000,000 CGS from its $4,100,000 DPGR. 

Under the simplified deduction method, B 

then apportions its remaining $100,000 of 

deductions to DPGR in proportion to the ratio 

of its DPGR to total gross receipts. Thus, 

because B has no other gross receipts, all of 

B’s $100,000 of deductions is apportioned to 

DPGR ($100,000 × $4,100,000/$4,100,000). 

Accordingly, B’s QPAI is $2,000,000 

($4,100,000 DPGR ¥ $2,000,000 CGS ¥ 

$100,000 deductions apportioned to its 

DPGR). 

Example 4. (i) Facts. The facts are the same 

as in Example 3 except that A and B are 

members of the same consolidated group, B 

does not sell the televisions purchased from 

A until 2007, and B’s $100,000 paid for 

administrative services are paid in 2007 for 

services performed in 2007. In addition, in 

2007, A has $3,000,000 in gross receipts from 

computer consulting services with unrelated 

persons and $1,000,000 in related 

deductions. 

(ii) Consolidated group’s 2006 QPAI. The 

consolidated group’s DPGR and total gross 

receipts in 2006 are $10,000,000 and 

$13,000,000, respectively, because, pursuant 

to paragraph (d)(1) of this section and 

§ 1.1502–13, the sale of the televisions from 

A to B is not taken into account in 2006. In 

order to determine the consolidated group’s 

QPAI, the consolidated group subtracts its 

$4,500,000 CGS from the televisions sold to 

unrelated persons from its $10,000,000 

DPGR. Under the simplified deduction 

method, the consolidated group apportions 

its remaining $4,000,000 of deductions to 

DPGR in proportion to the ratio of its DPGR 

to total gross receipts. Thus, $3,076,923 

($4,000,000 × $10,000,000/$13,000,000) is 

allocated to DPGR. Accordingly, the 

consolidated group’s QPAI for 2006 is 

$2,423,077 ($10,000,000 DPGR ¥ $4,500,000 

CGS ¥ $3,076,923 deductions apportioned to 

its DPGR). 

(iii) Allocation of consolidated group’s 

2006 section 199 deduction to its members. 

Because B’s only activity during 2006 is the 

purchase of televisions from A, B has no 

DPGR or deductions and thus, no QPAI, in 

2006. Accordingly, the entire section 199 

deduction in 2006 for the consolidated group 

will be allocated to A. 

(iv) Consolidated group’s 2007 QPAI. 

Pursuant to paragraph (d)(1) of this section 

and § 1.1502–13(c), A’s sale of televisions to 

B in 2006 is taken into account in 2007 when 

B sells the televisions to unrelated persons. 

However, because A and B are members of 

a consolidated group, § 1.1502–13(c)(1)(i) 

provides that the separate entity attributes of 

A’s income or B’s expenses, or both A’s 

income and B’s expenses, may be 

redetermined in order to produce the same 

effect as if A and B were divisions of a single 

corporation. Accordingly, A’s $2,000,000 of 

gross receipts are redetermined to be nonDPGR and non-receipts and B’s $2,000,000 

CGS are redetermined to be not allocable to 

DPGR. Notwithstanding that A’s receipts are 

redetermined to be non-DPGR and nonreceipts, A’s CGS are still considered to be 

allocable to DPGR because they are allocable 

to the consolidated group deriving DPGR. 

Accordingly, the consolidated group’s DPGR 

in 2007 is $4,100,000 from B’s sales of 

televisions, and its total receipts are 

$7,100,000 ($4,100,000 DPGR plus 

$3,000,000 non-DPGR from A’s computer 

consulting services). To determine the 

consolidated group’s QPAI, the consolidated 

group subtracts A’s $1,500,000 CGS from the 

televisions sold to B from its $4,100,000 

DPGR. Under the simplified deduction 

method, the consolidated group apportions 

its remaining $1,100,000 of deductions 

($1,000,000 from A and $100,000 from B) to 

DPGR in proportion to the consolidated 

group’s ratio of its DPGR to total gross 

receipts. Thus, $635,211 ($1,100,000 × 

$4,100,000/$7,100,000) is allocated to DPGR. 

Accordingly, the consolidated group’s QPAI 

for 2007 is $1,964,789 ($4,100,000 DPGR ¥ 

$1,500,000 CGS ¥ $635,211 deductions 

apportioned to its DPGR), the same QPAI that 

would result if A and B were divisions of a 

single corporation. 

(v) Allocation of consolidated group’s 2007 

section 199 deduction to its members. (A) A’s 

QPAI. For purposes of allocating the 

consolidated group’s section 199 deduction 

to its members, pursuant to paragraph (d)(5) 

of this section, the redetermination of A’s 

$2,000,000 in receipts as non-DPGR and nonreceipts is disregarded. Accordingly, for this 

purpose, A’s DPGR is $2,000,000 (receipts 

from the sale of televisions to B taken into 

account in 2007) and its total receipts are 

$5,000,000 ($2,000,000 DPGR + $3,000,000 

non-DPGR from its computer consulting 

services). In determining A’s QPAI, A 

subtracts its $1,500,000 CGS from the 

televisions sold to B from its $2,000,000 

DPGR. Under the simplified deduction 

method, A apportions its remaining 

$1,000,000 of deductions in proportion to the 

ratio of its DPGR to total receipts. Thus, 

$400,000 ($1,000,000 × $2,000,000/ 

$5,000,000) is allocated to DPGR. Thus, A’s 

QPAI is $100,000 ($2,000,000 DPGR ¥ 

$1,500,000 CGS ¥ $400,000 deductions 

allocated to its DPGR). 

(B) B’s QPAI. B’s DPGR and its total gross 

receipts are each $4,100,000. For purposes of 

allocating the consolidated group’s section 

199 deduction to its members, pursuant to 

paragraph (d)(5) of this section, the 

redetermination of B’s $2,000,000 CGS as not 

allocable to DPGR is disregarded. In 

determining B’s QPAI, B subtracts its 

$2,000,000 CGS from the televisions 

purchased from A from its $4,100,000 DPGR. 

Under the simplified deduction method, B 

apportions its remaining $100,000 

deductions in proportion to the ratio of its 

DPGR to total receipts. Thus, all $100,000 

($100,000 × $4,100,000/$4,100,000) is 

allocated to DPGR. Thus, B’s QPAI is 

$2,000,000 ($4,100,000 DPGR ¥ $2,000,000 

CGS ¥ $100,000 deductions allocated to its 

DPGR). 

(C) Allocation to A and B. Pursuant to 

paragraph (d)(5) of this section, the 

consolidated group’s section 199 deduction 

for 2007 is allocated $100,000/($100,000 + 

$2,000,000) to A and $2,000,000/($100,000 + 

$2,000,000) to B. 

Example 5. Corporations S and B are 

members of the same consolidated group. In 

2006, S manufactures office furniture for B to 

use in B’s corporate headquarters and S sells 

the office furniture to B. S and B have no 

other activities in the taxable year. If S and 

B were not members of a consolidated group, 

S’s gross receipts from the sale of the office 

furniture to B would be DPGR (assuming all 

the other requirements of § 1.199–3 are met) 

and S’s CGS or other deductions, expenses, 

or losses from the sale to B would be 

allocable to S’s DPGR. However, because S 

and B are members of a consolidated group, 

the separate entity attributes of S’s income or 

B’s expenses, or both S’s income and B’s 

expenses, may be redetermined under 

§ 1.1502–13(c)(1)(i) or (c)(4) in order to 

produce the same effect as if S and B were 

divisions of a single corporation. If S and B 

were divisions of a single corporation, there 

would be no DPGR with respect to the office 

furniture because there would be no lease, 

rental, license, sale, exchange, or other 

disposition of the furniture by the single 

corporation (and no CGS or other deductions 

allocable to DPGR). Thus, in order to produce 

the same effect as if S and B were divisions 

of a single corporation, S’s gross receipts are 

redetermined as non-DPGR. Accordingly, the 

consolidated group has no DPGR (and no 

CGS or other deductions allocated or 

apportioned to DPGR) and receives no 

section 199 deduction in 2006. 

Example 6. Corporations X, Y, and Z are 

members of the same EAG but are not 

members of a consolidated group. X, Y, and 

Z each files Federal income tax returns on a 

calendar year basis. Assume that the EAG has 

W–2 wages in excess of the section 199(b) 

wage limitation. Prior to 2006, X had no 

taxable income or loss. In 2006, X has $0 of 

taxable income and $2,000 of QPAI, Y has 

$4,000 of taxable income and $3,000 of QPAI, 

and Z has $4,000 of taxable income and 

$5,000 of QPAI. Accordingly, the EAG has 

taxable income of $8,000, the sum of X’s 

taxable income of $0, Y’s taxable income of 

$4,000, and Z’s taxable income of $4,000. 

The EAG has QPAI of $10,000, the sum of X’s 

QPAI of $2,000, Y’s QPAI of $3,000, and Z’s 

QPAI of $5,000. Because X’s, Y’s, and Z’s 

taxable years all began in 2006, the transition 

percentage under section 199(a)(2) is 3 

67274 Federal Register / Vol. 70, No. 213 / Friday, November 4, 2005 / Proposed Rules 

percent. Thus, the EAG’s section 199 

deduction for 2006 is $240 (3% of the lesser 

of the EAG’s taxable income of $8,000 or the 

EAG’s QPAI of $10,000). Pursuant to 

paragraph (c)(1) of this section, the $240 

section 199 deduction is allocated to X, Y, 

and Z in proportion to their respective 

amounts of QPAI, that is $48 to X ($240 × 

$2,000/$10,000), $72 to Y ($240 × $3,000/ 

$10,000), and $120 to Z ($240 × $5,000/ 

$10,000). Although X’s taxable income for 

2006 determined prior to allocation of a 

portion of the EAG’s section 199 deduction 

to it was $0, pursuant to paragraph (c)(2) of 

this section X will have an NOL for 2006 

equal to $48. Because X’s NOL for 2006 

cannot be carried back to a previous taxable 

year, X’s NOL carryover to 2007 will be $48. 

(f) Allocation of income and loss by a 

corporation that is a member of the 

expanded affiliated group for only a 

portion of the year—(1) In general. A 

corporation that becomes or ceases to be 

a member of an EAG during its taxable 

year must allocate its taxable income or 

loss, QPAI, and W–2 wages between the 

portion of the taxable year that it is a 

member of the EAG and the portion of 

the taxable year that it is not a member 

of the EAG. In general, this allocation of 

items must be made by using the pro 

rata allocation method described in 

paragraph (f)(1)(i) of this section. 

However, a corporation may elect to use 

the section 199 closing of the books 

method described in paragraph (f)(1)(ii) 

of this section. Neither the pro rata 

allocation method nor the section 199 

closing of the books method is a method 

of accounting. 

(i) Pro rata allocation method. Under 

the pro rata allocation method, an equal 

portion of a corporation’s taxable 

income or loss, QPAI, and W–2 wages 

for the taxable year is assigned to each 

day of the corporation’s taxable year. 

Those items assigned to those days that 

the corporation was a member of the 

EAG are then aggregated. 

(ii) Section 199 closing of the books 

method. Under the section 199 closing 

of the books method, a corporation’s 

taxable income or loss, QPAI, and W–

2 wages for the period during which the 

corporation was a member of an EAG 

are computed by treating the 

corporation’s taxable year as two 

separate taxable years, the first of which 

ends at the close of the day on which 

the corporation’s status as a member of 

the EAG changes and the second of 

which begins at the beginning of the day 

after the corporation’s status as a 

member of the EAG changes. 

(iii) Making the section 199 closing of 

the books election. A corporation makes 

the section 199 closing of the books 

election by making the following 

statement: ‘‘The section 199 closing of 

the books election is hereby made with 

respect to [insert name of corporation 

and its employer identification number] 

with respect to the following periods 

[insert dates of the two periods between 

which items are allocated pursuant to 

the closing of the books method].’’ The 

statement must be filed with the 

corporation’s timely filed (including 

extensions) Federal income tax return 

for the taxable year that includes the 

periods that are subject to the election. 

Once made, a section 199 closing of the 

books election is irrevocable. 

(2) Coordination with rules relating to 

the allocation of income under 

§ 1.1502–76(b). If § 1.1502–76(b) 

(relating to items included in a 

consolidated return) applies to a 

corporation that is a member of an EAG, 

any allocation of items required under 

this paragraph (f) is made only after the 

allocation of the corporation’s items 

pursuant to § 1.1502–76(b). 

(g) Total section 199 deduction for a 

corporation that is a member of an 

expanded affiliated group for some or 

all of its taxable year—(1) Member of 

the same expanded affiliated group for 

the entire taxable year. If a corporation 

is a member of the same EAG for its 

entire taxable year, the corporation’s 

section 199 deduction for the taxable 

year is the amount of the section 199 

deduction allocated to the corporation 

by the EAG under paragraph (c)(1) of 

this section. 

(2) Member of the expanded affiliated 

group for a portion of the taxable year. 

If a corporation is a member of an EAG 

only for a portion of its taxable year and 

is either not a member of any EAG or 

is a member of another EAG, or both, for 

another portion of the taxable year, the 

corporation’s section 199 deduction for 

the taxable year is the sum of its section 

199 deductions for each portion of the 

taxable year. 

(3) Example. The following example 

illustrates the application of paragraphs 

(f) and (g) of this section: 

Example. Corporations X and Y, calendar 

year corporations, are members of the same 

EAG for the entire 2005 taxable year. 

Corporation Z, also a calendar year 

corporation, is a member of the EAG of 

which X and Y are members for the first half 

of 2005 and not a member of any EAG for the 

second half of 2005. During the 2005 taxable 

year, Z does not join in the filing of a 

consolidated return. Z makes a section 199 

closing of the books election. As a result, Z 

has $80 of taxable income and $100 of QPAI 

that is allocated to the first half of the taxable 

year and a $150 taxable loss and ($200) of 

QPAI that is allocated to the second half of 

the taxable year. Taking into account Z’s 

taxable income, QPAI, and W–2 wages 

allocated to the first half of the taxable year 

pursuant to the section 199 closing of the 

books election, the EAG has positive taxable 

income and QPAI for the taxable year and 

W–2 wages in excess of the section 199(b) 

wage limitation. Because the EAG has both 

positive taxable income and QPAI and 

sufficient W–2 wages, and because Z has 

positive QPAI for the first half of the year, 

a portion of the EAG’s section 199 deduction 

is allocated to Z. Because Z has negative 

QPAI for the second half of the year, Z is 

allowed no section 199 deduction for the 

second half of the taxable year. Thus, despite 

the fact that Z has a $70 taxable loss and 

($100) of QPAI for the entire 2005 taxable 

year, Z is entitled to a section 199 deduction 

for the taxable year equal to the section 199 

deduction allocated to Z as a member of the 

EAG. 

(h) Computation of section 199 

deduction for members of an expanded 

affiliated group with different taxable 

years—(1) In general. If members of an 

EAG have different taxable years, in 

determining the section 199 deduction 

of a member (the computing member), 

the computing member is required to 

take into account the taxable income or 

loss, QPAI, and W–2 wages of each 

group member that are both—

(i) Attributable to the period that the 

member of the EAG and the computing 

member are both members of the EAG; 

and 

(ii) Taken into account in a taxable 

year that begins after the effective date 

of section 199 and ends with or within 

the taxable year of the computing 

member with respect to which the 

section 199 deduction is computed. 

(2) Example. The following example 

illustrates the application of this 

paragraph (h): 

Example. (i) Corporations X, Y, and Z are 

members of the same EAG. Neither X, Y, nor 

Z is a member of a consolidated group. X and 

Y are calendar year taxpayers and Z is a June 

30 fiscal year taxpayer. Each corporation has 

taxable income that exceeds its QPAI and has 

sufficient W–2 wages to avoid the limitation 

under section 199(b). For its taxable year 

ending June 30, 2005, Z’s QPAI is $4,000. For 

the taxable year ending December 31, 2005, 

X’s QPAI is $8,000 and Y’s QPAI is ($6,000). 

For its taxable year ending June 30, 2006, Z’s 

QPAI is $2,000. 

(ii) Because Z’s taxable year ending June 

30, 2005, began on July 1, 2004, prior to the 

effective date of section 199, Z is not allowed 

a section 199 deduction for its taxable year 

ending June 30, 2005. 

(iii) In computing X’s and Y’s respective 

section 199 deductions for their taxable years 

ending December 31, 2005, Z’s items from its 

taxable year ending June 30, 2005, are not 

taken into account because Z’s taxable year 

began before the effective date of section 199. 

Instead, only X’s and Y’s taxable income, 

QPAI, and W–2 wages from their respective 

taxable years ending December 31, 2005, are 

aggregated. The EAG’s QPAI for this purpose 

is $2,000 (X’s QPAI of $8,000 + Y’s QPAI of 

($6,000)). Because the taxable years of the 

computing members, X and Y, began in 2005, 

the transition percentage under section 

Federal Register / Vol. 70, No. 213 / Friday, November 4, 2005 / Proposed Rules 67275 

199(a)(2) is 3 percent. Accordingly, the EAG’s 

section 199 deduction is $60 ($2,000 × .03). 

The $60 deduction is allocated to each of X 

and Y in proportion to their respective QPAI 

as a percentage of the QPAI of each member 

of the EAG that was taken into account in 

computing the EAG’s section 199 deduction. 

Pursuant to paragraph (c)(1) of this section, 

in allocating the section 199 deduction 

between X and Y, because Y’s QPAI is 

negative, Y’s QPAI is treated as being $0. 

Accordingly, X’s section 199 deduction for 

its taxable year ending December 31, 2005, is 

$60 ($60 × $8,000/($8,000 + $0)). Y’s section 

199 deduction for its taxable year ending 

December 31, 2005, is $0 ($60 × $0/($8,000 

+ $0)). 

(iv) In computing Z’s section 199 

deduction for its taxable year ending June 30, 

2006, X’s and Y’s items from their respective 

taxable years ending December 31, 2005, are 

taken into account. Therefore, X’s and Y’s 

taxable income or loss, QPAI, and W–2 wages 

from their taxable years ending December 31, 

2005, are aggregated with Z’s taxable income 

or loss, QPAI, and W–2 wages from its 

taxable year ending June 30, 2006. The EAG’s 

QPAI is $4,000 (X’s QPAI of $8,000 + Y’s 

QPAI of ($6,000) + Z’s QPAI of $2,000). 

Because the taxable year of the computing 

member, Z, began in 2005, the transition 

percentage under section 199(a)(2) is 3 

percent. Accordingly, the EAG’s section 199 

deduction is $120 ($4,000 × .03). A portion 

of the $120 deduction is allocated to Z in 

proportion to its QPAI as a percentage of the 

QPAI of each member of the EAG that was 

taken into account in computing the EAG’s 

section 199 deduction. Pursuant to paragraph 

(c)(1) of this section, in allocating a portion 

of the $120 deduction to Z, because Y’s QPAI 

is negative, Y’s QPAI is treated as being $0. 

Z’s section 199 deduction for its taxable year 

ending June 30, 2006, is $24 ($120 × $2,000/ 

($8,000 + $0 + $2,000)). 

§ 1.199–8 Other rules. 

(a) Individuals. In the case of an 

individual, the deduction under 

§ 1.199–1(a) (section 199 deduction) is 

equal to the applicable percentage of the 

lesser of the taxpayer’s qualified 

production activities income (QPAI) (as 

defined in § 1.199–1(c)) for the taxable 

year, or adjusted gross income (AGI) for 

the taxable year determined after 

applying sections 86, 135, 137, 219, 221, 

222, and 469, and without regard to 

section 199. 

(b) Trade or business requirement. 

Section 1.199–3 is applied by taking 

into account only items that are 

attributable to the actual conduct of a 

trade or business. 

(c) Coordination with alternative 

minimum tax. For purposes of 

determining alternative minimum 

taxable income (AMTI) under section 

55, a taxpayer that is not a corporation 

may deduct an amount equal to 9 

percent (3 percent in the case of taxable 

years beginning in 2005 or 2006, and 6 

percent in the case of taxable years 

beginning in 2007, 2008, or 2009) of the 

lesser of the taxpayer’s QPAI for the 

taxable year, or the taxpayer’s taxable 

income for the taxable year, determined 

without regard to the section 199 

deduction (or in the case of an 

individual, AGI). For purposes of 

determining AMTI in the case of a 

corporation (including a corporation 

subject to tax under section 511(a)), a 

taxpayer may deduct an amount equal 

to 9 percent (3 percent in the case of 

taxable years beginning in 2005 or 2006, 

and 6 percent in the case of taxable 

years beginning in 2007, 2008, or 2009) 

of the lesser of the taxpayer’s QPAI for 

the taxable year, or the taxpayer’s AMTI 

for the taxable year, determined without 

regard to the section 199 deduction. For 

purposes of computing AMTI, QPAI is 

determined without regard to any 

adjustments under sections 56 through 

59. In the case of an individual or a 

trust, AGI and taxable income are also 

determined without regard to any 

adjustments under sections 56 through 

59. The amount of the deduction 

allowable under this paragraph (c) for 

any taxable year cannot exceed 50 

percent of the W–2 wages of the 

employer for the taxable year (as 

determined under § 1.199–2). 

(d) Nonrecognition transactions—(1) 

In general. Except as provided for an 

expanded affiliated group (EAG) (as 

defined in § 1.199–7) and EAG 

partnerships (as defined in § 1.199–

3(h)(8)), if property is transferred by the 

taxpayer to an entity in a transaction to 

which section 351 or 721 applies, then 

whether the gross receipts derived by 

the entity are domestic production gross 

receipts (DPGR) (as defined in § 1.199–

3) shall be determined based on the 

activities performed by the entity 

without regard to the activities 

performed by the taxpayer prior to the 

contribution of the property to the 

entity. Except as provided in § 1.199–

3(h)(7) and (8) (exceptions for certain oil 

and gas partnerships and EAG 

partnerships), if property is transferred 

by a partnership to a partner in a 

transaction to which section 731 

applies, then whether gross receipts 

derived by the partner are DPGR shall 

be determined based on the activities 

performed by the partner without regard 

to the activities performed by the 

partnership before the distribution of 

the property to the partner. 

(2) Section 1031 exchanges. If a 

taxpayer exchanges property for 

replacement property in a transaction to 

which section 1031 applies, then 

whether the gross receipts derived from 

the lease, rental, license, sale, exchange, 

or other disposition of the replacement 

property are DPGR shall be determined 

based solely on the activities performed 

by the taxpayer with respect to the 

replacement property. 

(3) Section 381 transactions. If a 

corporation (the acquiring corporation) 

acquires the assets of another 

corporation (the target corporation) in a 

transaction to which section 381(a) 

applies, the acquiring corporation shall 

be treated as performing those activities 

of the target corporation with respect to 

the acquired assets of the target 

corporation. Therefore, to the extent that 

the acquired assets of the target 

corporation would have given rise to 

DPGR if leased, rented, licensed, sold, 

exchanged, or otherwise disposed of by 

the target corporation, then the assets 

will give rise to DPGR if leased, rented, 

licensed, sold, exchanged, or otherwise 

disposed of by the acquiring 

corporation. 

(e) Taxpayers with a 52–53 week 

taxable year. For purposes of applying 

§ 1.441–2(c)(1) in the case of a taxpayer 

using a 52–53 week taxable year, any 

reference in section 199(a)(2) (the phasein rule), §§ 1.199–1 through 1.199–7, 

and this section to a taxable year 

beginning after a particular calendar 

year means a taxable year beginning 

after December 31st of that year. 

Similarly, any reference to a taxable 

year beginning in a particular calendar 

year means a taxable year beginning 

after December 31st of the preceding 

calendar year. For example, a 52–53 

week taxable year that begins on 

December 26, 2004, is deemed to begin 

on January 1, 2005, and the transition 

percentage for that taxable year is 3 

percent. 

(f) Section 481(a) adjustments. For 

purposes of determining QPAI, a section 

481(a) adjustment, whether positive or 

negative, taken into account during the 

taxable year that is solely attributable to 

either gross receipts, cost of goods sold 

(CGS), or deductions, expenses, or 

losses (deductions) must be allocated or 

apportioned in the same manner as the 

gross receipts, CGS, or deductions to 

which it is attributable. See §§ 1.199–

1(d), 1.199–4(b), and 1.199–4(c) for rules 

related to the allocation and 

apportionment of gross receipts, CGS, 

and deductions. For example, if a 

taxpayer changes its method of 

accounting for inventories from the lastin, first-out (LIFO) method to the firstin, first-out (FIFO) method, the taxpayer 

is required to allocate the resulting 

section 481(a) adjustment, whether 

positive or negative, in the same manner 

as the CGS computed for the taxable 

year with respect to those inventories. If 

a section 481(a) adjustment is not solely 

attributable to either gross receipts, 

CGS, or deductions (for example, the 

67276 Federal Register / Vol. 70, No. 213 / Friday, November 4, 2005 / Proposed Rules 

taxpayer changes its overall method of 

accounting from an accrual method to 

the cash method and the section 481(a) 

adjustment cannot be specifically 

identified with either gross receipts, 

CGS, or deductions), the section 481(a) 

adjustment, whether positive or 

negative, must be attributed to, or 

among, gross receipts, CGS, or 

deductions using any reasonable 

method that is satisfactory to the 

Secretary and allocated or apportioned 

in the same manner as the gross 

receipts, CGS, or deductions to which it 

is attributable. Factors taken into 

consideration in determining whether 

the method is reasonable include 

whether the taxpayer uses the most 

accurate information available; the 

relationship between the section 481(a) 

adjustment and the apportionment base 

chosen; the accuracy of the method 

chosen as compared with other possible 

methods; and the time, burden, and cost 

of using various methods. If a section 

481(a) adjustment is spread over more 

than one taxable year, a taxpayer must 

attribute the section 481(a) adjustment 

among gross receipts, CGS, or 

deductions, as applicable, in the same 

manner for each taxable year within the 

spread period. For example, if a 

taxpayer, using a reasonable method, 

determines that a section 481(a) 

adjustment that is required to be spread 

over four taxable years should be 

attributed entirely to gross receipts, then 

the taxpayer must attribute the section 

481(a) adjustment entirely to gross 

receipts in each of the four taxable years 

of the spread period. 

(g) Effective date. The final 

regulations will be applicable to taxable 

years beginning after December 31, 

2004. In the case of pass-thru entities 

described in § 1.199–5, the final 

regulations will be applicable to taxable 

years of pass-thru entities beginning 

after December 31, 2004. Until the date 

final regulations are published in the 

Federal Register, taxpayers may rely on 

the interim guidance on section 199 as 

set forth in Notice 2005–14 (2005–7 

I.R.B. 498) (see § 601.601(d)(2) of this 

chapter), as well as the proposed 

regulations under §§ 1.199–1 through 

1.199–7, and this section. For this 

purpose, if the proposed regulations and 

Notice 2005–14 include different rules 

for the same particular issue, then the 

taxpayer may rely on either the rule set 

forth in the proposed regulations or the 

rule set forth in Notice 2005–14. 

However, if the proposed regulations 

include a rule that was not included in 

Notice 2005–14, taxpayers are not 

permitted to rely on the absence of a 

rule to apply a rule contrary to the 

proposed regulations. 

Kevin M. Brown, 

Acting Deputy Commissioner for Services and 

Enforcement. 

[FR Doc. 05–21484 Filed 11–3–05; 8:45 am] 

BILLING CODE 4830–01–P