Unresolved Issues Remain After Final Domestic Production Regs.
Robert Feinschreiber, ProductionIncentive.com
Margaret Kent, ProductionIncentive.com

The IRS and Treasury Department issued a plethora of section 199 domestic production deduction materials on May 23, 2006. In response to this issuance, the authors examine general and procedural modifications reflected in the final production incentive regulations, and the impact of these changes to the then-proposed regulations. The authors leave for a subsequent issue of the journal substantive product-specific production incentive issues, including computer software, film, real property, construction, and other production activities. The reader should be cautioned that the final production incentive regulations, similar to the proposed regulations, spent little time and effort on manufacturing issues themselves.

As background, the May 23 issuance contains the following the following material:

• Final regulation T.D. 9263, pertaining to income attributable to domestic production activities under section 199.
• Temporary regulation T.D. 9262, pertaining to transactions involving computer software.
• Notice of hearing pertaining to computer software transactions under section 199(c)(5)(B).
• Review Procedure 2006-22, pertaining to methods of calculating W-2 wages for purposes of the section 199(b)(1) limitation.

Defining Taxable Income
The IRS and Treasury Department, in the waning days of the extraterritorial income provisions, provided taxpayers with a potential partial doubling up of benefits through the definition of taxable income. A taxpayer claiming an extraterritorial income exclusion does not thereby reduce the taxpayer’s taxable income for section 199(a)(1)(B) purposes. Thus, the taxpayer receives a full deduction based on 199 taxable income, notwithstanding the fact that the taxpayer also might receive an extraterritorial income exclusion. The final regulations fail to address the treatment of export DISC income, the United States’ only remaining tax incentive, in computing the section 199 production incentive, or vice versa.

The final regulations clarify the treatment of 199 deductions in computing net operating losses (NOL) or the amount of any carryback or carryover. As a general matter, the 199 deduction cannot create or increase the amount of an NOL deduction. Section 1.199-7(c)(2) concerns the portion of a section 199 deduction allocated to a member of an expanded affiliated group (EAG). That section 1.199-7(c)(2) provides an exception to this general NOL rule.

Wage Limitations
TIPRA section 514(a) amended 199(b)(2) as to the definition of W-2 wages. Section 514(a) provides that W-2 wages excludes any wage amount that is not properly allocable to domestic production gross receipts (DPGR). For example, a business is engaged in both production activities and services activities. In this example, Section 514(a) would presumably preclude the taxpayer from claiming W-2 wages for services for purposes of the computing the production incentive. The IRS and Treasury Department plan on issuing regulations pertaining to TIPRA section 514(a).