Congress intended section 199 to facilitate job growth in the US by
providing a tax subsidy for domestic production and to replace a series
of export subsidies that violated the Raymond J. Ahearn, Cong. Research
Serv., RL 32698, Trade Legislation in 108th Congress, 1 (2004).
But section 199 contains a built-in tension: Although seeking to
incentivise US production, section 199 also strives to limit its
benefits to such activities. This has resulted in the Treasury and
Internal Revenue Service (IRS) promulgating a complex set of rules to
restrict benefits to activities that promote US job growth, which has
led to substantial compliance burdens for both the IRS and taxpayers.
When Congress enacted section 199 in 2004, the IRS "anticipate[d] a
significant increase in controversies between taxpayers and the IRS"
because it is a very complex provision that is difficult to administer.
Letter from Mark Everson to George Lin, IRS Commissioner, Joint
Committee On Taxation, (October 7 2004). Concerns about the complexity
of compliance led some legislators to predict that, similar to a
Canadian tax provision, section 199 would eventually be repealed as
unworkable (H.R. Rep. No 108-755, at 803-04 (2004) (Conf. Rep.)).
Although section 199 has not been repealed, the degree of difficulty in
applying the provision has lived-up to predictions.
Section 199 overview
Section 199 generally allows a taxpayer to deduct a specified
percentage of the lesser of its qualified production activities income
(QPAI) or taxable income for a given tax year. The specified percentage
was phased-in over several years before reaching its maximum rate of 9%
in 2010. There are several limitations to this general rule. The "W-2
wage" limitation limits the deduction to 50% of employee wages for the
tax year, which since May 2006 was further limited to include only
amounts allocable to the taxpayer's domestic production gross receipts
(DPGR). And, for tax years after 2009, a section 199 deduction from oil
related QPAI is subject to an additional limitation (I.R.C. §
Calculating QPAI can present challenges. QPAI equals the amount by
which DPGR exceeds the sum of the cost of goods sold and other expenses,
losses or deductions (not including any section 199 deduction) that are
allocable to gross receipts. DPGR generally includes certain qualifying
activities such as the sale of qualifying production property (tangible
personal property, computer software and sound recordings) that the
taxpayer manufactured, produced, grew, or extracted in whole or in
significant part within the US, any qualified film it produced, or
electricity, natural gas, or potable water it produced in the US. In
general, services do not qualify but an exception exists for certain
DPGR is determined on an item-by-item basis. If the entire item sold
does not satisfy section 199 requirements (as in, the taxpayer sells
shoes where the soles were made in the US but the upper part was made
abroad), the taxpayer must treat each component offered for sale as a
separate item and allocate costs and revenue accordingly. Treas. Reg. §
The complexity that section 199 presents has resulted in a
significant volume of guidance, including extensive Treasury
regulations, that taxpayers and IRS examiners must try to implement to
determine the deduction. Two recent IRS announcements focusing on
contract manufacturing and software illustrate the types of difficulties
taxpayers face when applying section 199.
Because only one taxpayer can take a section 199 deduction for an
item of property in a contract manufacturing arrangement, a
determination must be made as to which party is entitled to claim a
deduction under section 199. Treasury Regulation section 1.199-3(f)(1)
provides that only the party with the benefits and burdens of ownership
for the property during the tax year in which the qualifying activity
occurred may claim the deduction.
In February 2012, the IRS issued a directive to its examiners
(LB&I-4-0112-001), which contains a three-part test for determining
which party may take the deduction. Each part has its own focus:
contract terms, production activities, and economic risks. And, within
each part there are three questions. If the examiner determines that a
taxpayer satisfies two of the three questions in two of the three parts,
the taxpayer has the benefits and burdens of ownership. If the examiner
determines that a taxpayer doesn't satisfy two of the three parts, the
directive instructs the examiner to consider all relevant facts and
circumstances, not just those used in the directive's questions.
The directive gives taxpayers some guidance on which factors an
examiner will focus on. But the directive has several limitations
taxpayers should be aware of:
- It is not an "official pronouncement of law, and cannot be used,
cited or relied upon as such". This significantly limits the value of
the directive because it doesn't provide taxpayers with a "safe
harbour". Nor is it clear that this will necessarily provide taxpayers
with protection from the imposition of penalties.
- It doesn't apply to related persons, thus excluding a common contract manufacturing relationship.
- It doesn't contain sufficient guidance to examiners, making the
answers to the questions difficult to resolve. For example, in step
three, which focuses on economic risks such as product quality and
production efficiency, there may not be a definitive answer to any of
the three questions since both parties in a contract manufacturing
agreement can have risks. It is not uncommon for the principal to
provide training and servicing for consumers and for the contract
manufacturer to have financial liability for products that cannot be
- It fails to define certain key terms. Although one question in the
second step focuses on whether the taxpayer "develop[ed] the qualifying
activity process", the directive doesn't define the terms "develop" or
"qualifying activity process".
Section 199 can treat economically similar situations differently.
For example, software sold on CDs or via downloads may qualify for the
deduction. However, software only offered to customers on-line is not
DPGR because Treasury regulations limit the definition to software
affixed to a tangible medium.
Two exceptions to the general rule exist. The first exception allows a
taxpayer's computer software to qualify if the taxpayer's business, on a
regular and continued basis, derives gross receipts from the sale of
nearly identical software that was part of a tangible medium or
downloadable and developed by the taxpayer in the US. Second, a
taxpayer's software will qualify if another person in its business
generates gross receipts on a regular and continued basis from
substantially identical software, which is affixed to a tangible medium
or available via download. Treas. Reg. § 1.199-3(i)(6)(iii).
Over the next decade, it is reasonable to expect online computing to
capture a more significant portion of the software market. Cloud
computing and software companies' need to protect their intellectual
property are among the factors compelling this result. As such, the
exceptions described above are becoming increasingly important to
The IRS recently issued a legal memorandum (CCA 201226025) for the
second exception described above. The memorandum provides that in
determining whether a software program available offline is
substantially identical to a taxpayer's online software, the taxpayer
cannot aggregate the features from multiple programs. Following the
reasoning in the memorandum, if the taxpayer is unable to find a single
offline program with all of the same features as its online program, the
taxpayer will not be able to aggregate multiple offline programs to
satisfy the third-party comparable exception.
The recent guidance did note, however, that the taxpayer can break
its online software program into its individual components. This would
allow the taxpayer to favourably use the "shrink back rule" to qualify
the gross receipts from features of its online software program for
which it could identify substantially identical offline programs. Each
feature would of course need to satisfy the general section 199
requirements. Although the IRS favourably concluded that the taxpayer
may break its online software program into its various components, it
provided no guidance on how the taxpayer should allocate gross receipts
to qualifying and non-qualifying features.
Complex and difficult
Given that section 199 is a complicated provision that is difficult
to administer, it is not surprising that the IRS and taxpayers have been
forced to dedicate significant resources to this issue during
examinations. Although the Treasury and the IRS have provided guidance,
the guidance, as well as the statute, is complex and applying it to
specific facts is difficult. Section 199 provides a valuable benefit but
that comes with a high compliance cost, which may include the
imposition of financial reserves under FIN 48. Taxpayers desiring a
greater level of certainty should consider steps they can take to
protect their section 199 deductions. Taxpayers may consider seeking a
pre-filing agreement with the IRS that can result in a statutory closing
agreement, which would resolve the issue for a taxpayer's current tax
year and up to four years into the future.