[Federal Register Volume 70, Number 213 (Friday, November 4, 2005)]
[Proposed Rules]
[Pages 67220-67276]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 05-21484]



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Part II





Department of the Treasury





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Internal Revenue Service



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26 CFR Part 1



Income Attributable to Domestic Production Activities; Proposed Rule

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

[[Page 67220]]


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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.

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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 Sec. Sec.  1.199-1, 1.199-
3, 1.199-6, and 1.199-8, Paul Handleman or Lauren Ross Taylor, (202) 
622-3040; concerning Sec.  1.199-2, Alfred Kelley, (202) 622-6040; 
concerning Sec.  1.199-4(c) and (d), Richard Chewning, (202) 622-3850; 
concerning all other provisions of Sec.  1.199-4, Scott Rabinowitz, 
(202) 622-4970; concerning Sec.  1.199-5, Martin Schaffer, (202) 622-
3080; concerning Sec.  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 
Sec.  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 for-profit 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

[[Page 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

[[Page 67222]]

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 Sec.  
1.1502-13, see also Sec.  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-by-item basis. Some commentators stated that applying section 
199 on an item-by-item 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-by-item 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

[[Page 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 
Sec.  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 Sec.  
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 Sec.  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

[[Page 67224]]

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 Sec.  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 Sec.  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, ``Self-Employment 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 self-employment 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 Sec.  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 
self-employment 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 Sec.  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 Sec.  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 Sec.  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

[[Page 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 Sec.  1.199-3(h)(3) concerning hedges 
(within the meaning of section 1221(b)(2) and Sec.  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 Sec.  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 Sec.  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 Sec.  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 Sec.  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

[[Page 67226]]

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 non-DPGR, 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 (non-
DPGR). 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

[[Page 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 non-
DPGR, 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 Sec.  
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

[[Page 67228]]

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 long-term 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 Sec.  
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 Sec.  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, Sec.  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 Sec.  1.199-
3(d)(4) of the proposed regulations does not affect the rules provided 
in Sec.  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 Sec.  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 Sec.  1.199-3(h)(7), EAG partnerships 
described in Sec.  1.199-3(h)(8), and certain government contracts 
described in Sec.  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, Sec.  
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 Sec.  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 Sec.  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 Sec.  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 Sec.  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 Sec.  
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

[[Page 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 
Sec.  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 Sec.  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 Sec.  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 Sec.  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 Sec.  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 Sec.  1.199-3(f)(2) or conversion costs 
under Sec.  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 Sec.  
1.199-3(i)(3)(i) that these exceptions do not apply for purposes of 
section 199 and 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.
    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

[[Page 67230]]

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 Sec.  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 Sec.  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 Sec.  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 
Sec.  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 Sec.  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 Sec.  
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 Sec.  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

[[Page 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 Sec.  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, Sec.  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 Sec.  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 Sec.  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 Sec.  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

[[Page 67232]]

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 on-site (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 non-DPGR. 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

[[Page 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 non-DPGR 
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 non-DPGR 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 Sec.  1.861-8(f). Accordingly, a 
taxpayer determines the deductions allocated and apportioned to DPGR by 
applying the allocation and apportionment rules provided by Sec. Sec.  
1.861-8 through 1.861-17 and Sec. Sec.  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

[[Page 67234]]

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 pass-thru 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 Sec.  1.199-5 regarding the application of 
section 199 to pass-thru entities, and the application of the section 
199(d)(1)(B)

[[Page 67235]]

wage limitation under Sec.  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 
upper-tier 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 pass-thru 
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 pass-thru 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 Sec.  
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 Sec.  
1.199-4(e) must use that method, and any other trust or estate must use 
the section 861 method described in Sec.  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

[[Page 67236]]

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 Sec.  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 Sec.  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 Sec.  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 Sec.  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 Sec.  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 Sec.  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 Sec.  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 Sec.  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, Sec. Sec.  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

[[Page 67237]]

activities does not apply for purposes of the construction of real 
property under Sec.  1.199-3(l)(1) or the performance of engineering 
and architectural services under Sec.  1.199-3(m)(1). A member of an 
EAG must engage in a construction activity under Sec.  1.199-3(l)(2), 
provide engineering services under Sec.  1.199-3(m)(2), or provide 
architectural services under Sec.  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 anti-
avoidance 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 Sec.  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 Sec.  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 Sec.  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 Sec.  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 Sec.  1.1502-13(c) or the acceleration rule of 
Sec.  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

[[Page 67238]]

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 Sec.  1.1502-13. 
The consolidated return regulations already prevent this result. Under 
Sec.  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 non-receipts) 
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 Sec.  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 Sec.  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 Sec.  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 Sec.  
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 Sec.  1.1502-
32(b)(3)(i) (resulting in $91 of the increase) and $9 of the income 
also is taken into account under Sec.  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 Sec.  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

[[Page 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 pass-thru 
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 Sec.  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 
Sec. Sec.  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, Sec.  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 Sec. Sec.  
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 
Sec. Sec.  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 Sec. Sec.  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

[[Page 67240]]

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:


Sec.  1.199-0  Table of contents.

    This section lists the headings that appear in Sec. Sec.  1.199-1 
through 1.199-8.


Sec.  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.


Sec.  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.


Sec.  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.

[[Page 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.


Sec.  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.


Sec.  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.


Sec.  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 pass-through of section 199 
deduction.
    (e) W-2 wages.
    (f) Recapture of section 199 deduction.
    (g) Section is exclusive.
    (h) No double counting.
    (i) Examples.


Sec.  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 Sec.  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.


Sec.  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.


Sec.  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

[[Page 67242]]

percent of the W-2 wages of the employer for the taxable year (as 
determined under Sec.  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 Sec.  
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, x incurs W-2 wages of $300. x 
has an NOL carryover to 2010 of $500. X's deduction under this 
section for 2010 is $9 (.09 x (lesser of QPAI of $600 and taxable 
income of $100) subject to the wage limitation of $150 (50% x 
$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 x (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 Sec. Sec.  1.199-3 and 1.199-4. For purposes of this paragraph (c), 
QPAI is determined on an item-by-item basis (and not, for example, on a 
division-by-division, product line-by-product line, or transaction-by-
transaction 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 
Sec. Sec.  1.199-1 through 1.199-8, the property offered for sale to 
customers that meets all of the requirements under this section and 
Sec.  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 Sec.  1.199-3(l)(1)) 
or engineering and architectural services (as defined in Sec.  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 Sec.  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 Sec.  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 Sec.  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 Sec.  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 Sec.  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 Sec.  1.199-3, Z must treat the 
active ingredient portion as the item if the ingredient meets the 
requirements under this section and Sec.  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 Sec.  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

[[Page 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 non-DPGR (after application of exceptions provided in 
Sec.  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 Sec.  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 non-DPGR. The determination of whether gross receipts 
qualify as DPGR or non-DPGR, and whether CGS or deductions relate to 
DPGR or non-DPGR, must be made in accordance with the rules provided in 
Sec. Sec.  1.199-1 through 1.199-8, as applicable. If the gross 
receipts are recognized in an intercompany transaction within the 
meaning of Sec.  1.1502-13, see also Sec.  1.199-7(d). See Sec.  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 Sec.  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 Sec.  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.

Sec.  1.199-2  Wage limitation.

    (a) Rules of application--(1) In general. The amount of the 
deduction allowable under Sec.  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

[[Page 67244]]

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 non-duplication 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

[[Page 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.


Sec.  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 Sec.  1.1502-13, see 
also Sec.  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 Sec.  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.

[[Page 67246]]

2002-9 (2002-1 C.B. 327), whichever applies (see Sec.  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 Sec.  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 Sec.  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 Sec.  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 cost-
reimbursable 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).

[[Page 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 Sec.  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

[[Page 67248]]

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 Sec.  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 Sec.  1.1221-2(b) is made without regard to 
whether the transaction is a section 988 transaction. See Sec.  1.1221-
2(a)(4). The preceding sentence applies only to the extent that Sec.  
1.988-5(b) does not apply.
    (iii) Other rules. See Sec.  1.1221-2(e) for rules applicable to 
hedging by members of a consolidated group and Sec.  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);

[[Page 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, lump-sum 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,

[[Page 67250]]

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, 
provider-controlled 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 Sec.  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 
Sec.  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 
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 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

[[Page 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 Sec.  1.199-3(l)(1) and the 
performance of engineering and architectural services under Sec.  
1.199-3(m)(2) and (3), respectively. An EAG partnership may not use the 
small business simplified overall method described in Sec.  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 Sec.  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 
Sec.  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 Sec.  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 Sec.  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 
Sec.  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 Sec.  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,

[[Page 67252]]

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, mass-produced 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 
Sec.  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 word-processing 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

[[Page 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

[[Page 67254]]

forecast depreciation. Compensation for services includes all direct 
and indirect compensation costs required to be capitalized under 
section 263A for film producers under Sec.  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 non-DPGR.
    (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 non-DPGR 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 non-DPGR 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

[[Page 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 Sec.  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 Sec.  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 Sec.  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 Sec.  1.199-7(a). However, if X and Y were members of the same 
consolidated group, see Sec.  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 two-digit 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.

[[Page 67256]]

    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 
half-acre 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 Sec.  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

[[Page 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 
Sec.  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).


Sec.  1.199-4  Costs allocable to domestic production gross receipts.

    (a) In general. To determine its qualified production activities 
income (QPAI) (as defined in Sec.  1.199-1(c)) for a taxable year, a 
taxpayer must subtract from its domestic production gross receipts 
(DPGR) (as defined in Sec.  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 Sec. Sec.  1.861-8 through 1.861-17 and Sec. Sec.  
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 Sec.  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 Sec.  
1.199-3(i)(1)), a qualified film (as defined in Sec.  1.199-3(j)(1)), 
or electricity, natural gas, and potable water (as defined in Sec.  
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 Sec.  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 
Sec. Sec.  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 non-DPGR. 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 Sec.  
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 Sec.  1.471-4 (inventories at cost or market, whichever 
is lower) or Sec.  1.471-2(c)

[[Page 67258]]

(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 dollar-value 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 dollar-value 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-by-pool 
basis. The change in relative base-year 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 Sec.  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 Sec.  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 x $5) + (5,000 x $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:

[[Page 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:

----------------------------------------------------------------------------------------------------------------
                                                               Base-year                  Current-
                      Item                         Quantity       cost        Amount     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 base-year cost). The increment valued at 
current-year 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 x 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:

----------------------------------------------------------------------------------------------------------------
                                                               Base-year                  Current-
                      Item                         Quantity       cost        Amount     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 
base-year cost of the opening inventory for that year by $5,000 (the 
decrement stated at base-year 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).

[[Page 67260]]

    (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 x 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 x 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 Sec.  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 Sec.  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 Sec.  1.861-17 without taking into account the 
exclusive apportionment rule of Sec.  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 
Sec. Sec.  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, Sec.  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 Sec.  1.199-7), engages in activities that 
generate both DPGR and non-DPGR. 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

[[Page 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 Sec.  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 Sec.  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 Sec.  1.861-17(c). X elects to apportion interest expense under 
the tax book value method of Sec.  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)          (420)
 ($840 x ($3,000 DPGR/$6,000 total gross receipts)).......
Interest expense (not included in CGS) ($300 x ($4,000             (240)
 (X's DPGR assets)/$5,000 (X's total assets)))............
Charitable contributions (not included in CGS) ($180 x             (120)
 ($2,400 gross income attributable to DPGR/$3,600 total
 gross income))...........................................
Section 174 R&E-SIC AAA...................................         (300)
                                                           -------------
X's QPAI..................................................        1,320
------------------------------------------------------------------------

    (iii) Section 199 deduction determination. X's tentative 
deduction under Sec.  1.199-1(a) (section 199 deduction) is $119 
(.09 x (lesser of QPAI of $1,320 and taxable income of $1,380)) 
subject to the wage limitation of $150 (50% x $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 Sec.  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 Sec.  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           (500)
 Sec.   1.861-10T)........................................
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 Sec.  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)          (420)
 ($840 x ($3,000 DPGR/$6,000 total gross receipts)).......

[[Page 67262]]

 
Interest expense (not included in CGS and not subject to           (150)
 Sec.   1.861-10T) ($300 x ($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)))......................................
Charitable contributions (not included in CGS) ($180 x             (120)
 ($2,400 gross income attributable to DPGR/$3,600 total
 gross income))...........................................
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)          (420)
 ($840 x ($3,000 DPGR/$6,000 total gross receipts)).......
Interest expense (not included in CGS and not subject to           (250)
 Sec.   1.861-10T) ($500 x ($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)))......................................
Charitable contributions (not included in CGS) ($50 x               (25)
 ($1,800 gross income attributable to DPGR/$3,600 total
 gross income))...........................................
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 Sec.  1.199-7(b). Accordingly, the X and Y EAG's tentative 
section 199 deduction is $217 (.09 x (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% x ($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 Sec.  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 pass-thru entity level and, if 
such entity is eligible, the small business simplified overall method 
is applied at the pass-thru entity level.

[[Page 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 Sec.  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 Sec.  1.199-3(h)(7), EAG partnerships under Sec.  
1.199-3(h)(8), and trusts and estates under Sec.  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 Sec.  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.


Sec.  1.199-5  Application of section 199 to pass-thru entities.

    (a) Partnerships--(1) Determination at partner level. The deduction 
allowable under Sec.  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 Sec.  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 Sec.  
1.199-1(c)). However, if a partnership uses the small business 
simplified overall method described in Sec.  1.199-4(f), then each 
partner is allocated its share of QPAI and W-2 wages (as defined in 
Sec.  1.199-2(f)), which (subject to the limitation under section 
199(d)(1)(B)) are combined with

[[Page 67264]]

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 Sec.  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 Sec.  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 Sec.  1.704-1(b)(1)(vii):

------------------------------------------------------------------------
 
------------------------------------------------------------------------
Gross income attributable to DPGR ($1,500 (DPGR) - $810             $690
 (allocable CGS, includes $50 of W-2 wages))...............
Gross income attributable to non-DPGR ($1,500 (non-DPGR) -           690
 $810 (allocable CGS, includes $50 of W-2 wages))..........
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 Sec.  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 Sec.  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)           (300)
 ($600 x $1,500/$3,000)....................................
Interest expense (not included in CGS) ($150 x $2,000 (X's          (24)
 share of PRS's DPGR assets)/ $12,500 (X's non-PRS assets
 and X's share of PRS assets)).............................
                                                            ------------
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 
non-DPGR. 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

[[Page 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               $600
 (allocable CGS, includes $70 of W-2 wages))...............
Gross income attributable to non-DPGR ($3,000 (other gross         1,380
 receipts) - $1,620 (allocable CGS, includes $150 of W-2
 wages))...................................................
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 
Sec.  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 Sec.  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       (1,710)
 activities) (includes $120 of W-2 wages)..................
Section 162 selling expenses (includes $180 of W-2 wages)          (456)
 ($1,140 ($600 from PRS and $540 from non-PRS activities) x
 ($1,500 PRS DPGR + $1,500 non-PRS DPGR)/($3,000 PRS total
 gross receipts + $4,500 non-PRS total gross receipts))....
Interest expense (not included in CGS) ($240 ($150 from PRS        (192)
 and $90 from non-PRS activities) x $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))..............
                                                            ------------
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 
Sec.  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 x         (300)
 ($1,500/$3,000))..........................................
Interest expense (not included in CGS) ($150 x $2,000              (120)
 (partner's share of adjusted basis of PRS's DPGR assets)/
 $2,500 (partner's share of adjusted basis of total PRS
 assets))..................................................
                                                            ------------
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 x ($270 x .09)).
    (v) Section 199 deduction determination. (A) X's tentative 
section 199 deduction is $33 (.09 x $366 (that is, QPAI determined 
at partner level)) subject to the wage limitation of $25 (50% x 
$49). Accordingly, X's section 199 deduction for 2010 is $25.
    (B) Y's tentative section 199 deduction is $58 (.09 x $642 (that 
is, QPAI determined at the partner level) subject to the wage 
limitation of $150 (50% x ($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 non-
DPGR 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 Sec.  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 Sec.  1.704-1(b)(1)(vii):

------------------------------------------------------------------------
 
------------------------------------------------------------------------
Gross income attributable to DPGR ($1,500 (DPGR) -$600              $900
 (CGS, includes $50 of W-2 wages)).........................
Gross income attributable to non-DPGR ($1,500 (other gross           900
 receipts) - $600 (CGS, includes $50 of W-2 wages))........
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 Sec.  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 Sec.  1.861-17(c). Because X has no direct sales of 
products,

[[Page 67266]]

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 x         (210)
 ($1,500 DPGR/$3,000 total gross receipts))................
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          750
 wages)....................................................
CGS (allocated to DPGR within SIC BBB) (includes $56 of W-2          750
 wages)....................................................
CGS (allocated to non-DPGR within SIC BBB) (includes $113          1,500
 of W-2 wages).............................................
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 Sec.  
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 
Sec.  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        $4,500
 activities................................................
CGS ($600 from sales of products by PRS and $1,500 from non-     (2,100)
 PRS activities............................................
Section 162 selling expenses (including W-2 wages) ($420           (480)
 from PRS + $540 from non-PRS activities) x ($4,500 DPGR/
 $9,000 total gross receipts)).............................
Section 174 R&E-SIC AAA ($150 from PRS and $300 from non-          (450)
 PRS activities)...........................................
Section 174 R&E-SIC BBB ($300 from PRS + $450 from non-PRS         (188)
 activities) x ($1,500 DPGR/$6,000 total gross receipts
 allocated to SIC BBB).....................................
                                                            ------------
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 Sec.  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 x         (210)
 $1,500/$3,000)............................................
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 x ($540 x .09)).
    (v) Section 199 deduction determination. (A) X's tentative 
section 199 deduction is $49 (.09 x $540 (QPAI determined at partner 
level)) subject to the wage limitation of $49 (50% x $97). 
Accordingly, X's section 199 deduction for 2010 is $49.
    (B) Y's tentative section 199 deduction is $115 (.09 x $1,282 
(QPAI determined at partner level) subject to the wage limitation of 
$176 (50% x $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 Sec.  1.199-4(e). 
Y does not qualify to use that method and therefore, must use the 
section 861 method under Sec.  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 non-DPGR-$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) x ($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

[[Page 67267]]

apportions $1,350 of deductions to DPGR ($1,800 x ($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 x ($0 QPAI x .09)). X's 
tentative deduction is $5 ($50 QPAI x .09), subject to the section 
199(b)(1) wage limitation of $100 (50% x $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 Sec.  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) x ($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 x ($100 QPAI x .09)). A's tentative deduction is $9 
($100 QPAI x .09), subject to the section 199(b)(1) wage limitation 
of $9 (50% x $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 Sec.  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 Sec.  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 
Sec.  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 Sec.  1.652(b)-3 with 
respect to directly attributable expenses, and under the simplified 
deduction method of Sec.  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 Sec.  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

[[Page 67268]]

Sec.  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       $10,000
 (including W-2 wages of 1,000))...........................
Gross income attributable to other gross receipts ($5,000          5,000
 other gross receipts-$0 CGS)..............................
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          10,000
 section 6166 election.....................................
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 Sec.  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 Sec.  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 Sec.  1.652(b)-3(a) to the 
rental income.
    (2) Non-directly attributable expenses. Under Sec.  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 x ($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 Sec.  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 Sec.  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 Sec.  
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 x $30,000 total trade or 
business gross receipts/$50,000 total gross receipts). Trust then 
combines its non-directly 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 x $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

[[Page 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 x 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 x .09 x $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 x $3,600) which is limited under section 199(b) to $284 
(50% x $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 x $2,600 
QPAI) which is limited under section 199(b) to $748 (50% x $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 Sec.  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 (upper-tier 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 lower-tier 
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 Sec.  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 Sec.  
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 x ($200 QPAI x .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 
Sec.  1.199-3(h)(7) regarding certain qualifying oil and gas 
partnerships and Sec.  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 Sec.  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 Sec.  1.199-3.


Sec.  1.199-6  Agricultural and horticultural cooperatives.

    (a) In general. This section applies to a cooperative to which Part 
I of

[[Page 67270]]

subchapter T of the Internal Revenue Code applies and its patrons if 
the cooperative has manufactured, produced, grown, or extracted (MPGE) 
(as defined in Sec.  1.199-3(d)) in whole or significant part (as 
defined in Sec.  1.199-3(f)) within the United States (as defined in 
Sec.  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 Sec.  1.199-1(c)) of 
the cooperative, would be allowable as a deduction under Sec.  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, per-unit 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 pass-through 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 Sec.  1.199-1(a) and (b).
    (e) W-2 wages. The W-2 wage limitation described in Sec.  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 Sec.  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 x $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 Sec.  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 x .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

[[Page 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.

Sec.  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, Sec.  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 Sec.  
1.199-1(c)), and W-2 wages (as defined in Sec.  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 Sec.  
1.199-3(c)) from the lease, rental, license, sale, exchange, or other 
disposition (as defined in Sec.  1.199-3(h)) of qualifying production 
property (QPP) (as defined in Sec.  1.199-3(i)) that was manufactured, 
produced, grown or extracted (MPGE) (as defined in Sec.  1.199-3(d)), 
in whole or in significant part (as defined in Sec.  1.199-3(f)), in 
the United States (as defined in Sec.  1.199-3(g)), a qualifed film (as 
defined in Sec.  1.199-3(j)) that was produced in the United States, or 
electricity, natural gas, or potable water (as defined in Sec.  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 Sec.  1.199-3(a)). However, attribution 
of activities does not apply for purposes of the construction of real 
property under Sec.  1.199-3(l) or the performance of engineering and 
architectural services under Sec.  1.199-3(m). A member of an EAG must 
engage in a construction activity under Sec.  1.199-3(l)(2), provide 
engineering services under Sec.  1.199-3(m)(2), or provide 
architectural services under Sec.  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 Sec.  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 Sec.  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 Sec.  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 Sec.  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 
Sec.  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 Sec.  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

[[Page 67272]]

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 Sec.  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 Sec.  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 Sec.  1.199-
3(l) and the performance of engineering and architectural services 
under Sec.  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 Sec.  1.199-4(e) and the small 
business simplified overall method under Sec.  1.199-4(f), a 
consolidated group determines its QPAI by reference to its members' 
DPGR, non-DPGR, 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 Sec.  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 Sec.  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 Sec.  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 Sec.  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, Sec.  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 Sec.  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 Sec.  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 Sec.  1.199-4(b)(2)). A has other deductions of

[[Page 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 x $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 x $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 Sec.  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 x $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 Sec.  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, Sec.  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 non-DPGR 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 non-receipts, 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 x $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 non-receipts 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 x $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 x 
$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 Sec.  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 Sec.  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

[[Page 67274]]

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 x 
$2,000/$10,000), $72 to Y ($240 x $3,000/$10,000), and $120 to Z 
($240 x $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 Sec.  1.1502-76(b). If Sec.  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 Sec.  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

[[Page 67275]]

199(a)(2) is 3 percent. Accordingly, the EAG's section 199 deduction 
is $60 ($2,000 x .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 x $8,000/($8,000 + $0)). 
Y's section 199 deduction for its taxable year ending December 31, 
2005, is $0 ($60 x $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 x .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 x $2,000/($8,000 + 
$0 + $2,000)).


Sec.  1.199-8  Other rules.

    (a) Individuals. In the case of an individual, the deduction under 
Sec.  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 Sec.  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 Sec.  1.199-2).
    (d) Nonrecognition transactions--(1) In general. Except as provided 
for an expanded affiliated group (EAG) (as defined in Sec.  1.199-7) 
and EAG partnerships (as defined in Sec.  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 
Sec.  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 Sec.  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 Sec.  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 phase-in 
rule), Sec. Sec.  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 Sec. Sec.  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 last-in, first-out (LIFO) method to the first-
in, 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

[[Page 67276]]

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 Sec.  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 
Sec.  601.601(d)(2) of this chapter), as well as the proposed 
regulations under Sec. Sec.  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