Domestic Production Activities Deduction – Section 199 March 26, 2007 Pamela C. Beckey

Copyright © 2006 Deloitte Development LLP. All rights reserved.2 Agenda Introduction -General Application Key Impact of TIPRA Changes Changing certain Section 861 elections Rev Proc Exam Experience –LMSB Examination Guidelines – Minimum Checks –IDR / Exam Experience

Copyright © 2006 Deloitte Development LLP. All rights reserved.3 Introduction – General Application Deduction equal to a fixed percentage times the lesser of: –Qualified Production Activities Income (“QPAI”) or Taxable Income QPAI is Domestic Production Gross Receipts (“DPGR”) less COGS and directly and indirectly allocable expenses Fixed percentage increases from 3% to 6% for FY beginning after 12/31/2006, then 9% after 12/31/2009 Taxable income & wage limitations Broad application to US activities manufacturing, film, software, sound recording, construction, engineering & architectural, power generation, mining, agricultural

Copyright © 2006 Deloitte Development LLP. All rights reserved.4 Introduction – General Application Requirements to identify DPGR and COGS at Item Level Definition of an “item” is critical –Shrink-back QPAI can be positive or negative –Loss transactions may not be excluded Safe Harbor vs. Substantial in Nature Documentation

Copyright © 2006 Deloitte Development LLP. All rights reserved.5 TIPRA – Key § 199 changes TIPRA effective for taxable years beginning after May 17, 2006 W-2 wages include only amounts described in (e)(1) that are properly allocable to DPGR Pass-thru entities report each owner’s share of wages instead of 2 x 3% x QPAI

Copyright © 2006 Deloitte Development LLP. All rights reserved.6 Limitation on W-2 wages May use any reasonable method to determine amount of W-2 wages properly allocable to DPGR –Method must be satisfactory to the Secretary based on all of the facts and circumstances Temporary regulations provide two safe harbors –Wage expense safe harbor for taxpayers using the § 861 method or simplified deduction method –Small business simplified overall method safe harbor for taxpayers using the small business simplified overall method

Copyright © 2006 Deloitte Development LLP. All rights reserved.7 Limitation on W-2 wages (cont.) Wage expense safe harbor –W-2 wages properly allocable to DPGR are equal to W-2 wages multiplied by ratio of wage expense included in computing QPAI to total wage expense used in computing taxable income W-2 wages X QPAI wages Total wages –Must use the same allocation and apportionment methods used to determine QPAI to allocate and apportion wage expense for safe harbor

Copyright © 2006 Deloitte Development LLP. All rights reserved.8 Limitation on W-2 wages (cont.) Wage expense included in cost of goods sold (“COGS”) determined using any reasonable method, including –Direct labor in COGS or § 263A labor costs in simplified service cost method included in COGS COGS often includes goods manufactured in prior years –COGS would therefore include W-2 wages from prior years attributable to DPGR –Creates difficulty in determining amount of W-2 wages in COGS

Copyright © 2006 Deloitte Development LLP. All rights reserved.9 EAG caution TIPRA amendments may impact EAG members –EAG member uses employees of another EAG member to perform activities attributable to DPGR and does not have W-2 wages Each EAG member computes its taxable income or loss, QPAI, and W-2 wages, which are aggregated to determine the EAG’s § 199 deduction –With the TIPRA changes, an EAG member with W- 2 wages must also have DPGR to which the wages are properly allocable to qualify those wages as W-2 wages –What if EAG members file a consolidated return?

Copyright © 2006 Deloitte Development LLP. All rights reserved.10 Pass-thru entities The Secretary is authorized to permit a pass- thru entity to calculate an owner’s share of QPAI at the entity level –By publication in the Internal Revenue Bulletin –Determination currently made at owner level Under TIPRA, a pass-thru entity must allocate its W-2 wages among its owners in the same way wage expense is allocated –Includes W-2 wages from a lower-tier partnership of which the pass-thru entity is a partner

Copyright © 2006 Deloitte Development LLP. All rights reserved.11 Changing certain Section 861 Elections Rev Proc provides guidance for securing automatic approval to change certain pre- existing expense allocation elections under Section 861 –Interest Expense –Research and Development Expenditures Must file appropriate statement on Form 1118 with either the 2005 or 2006 tax return filing

Copyright © 2006 Deloitte Development LLP. All rights reserved.12 Exam Issues LMSB-Directive re: § 199 exam procedures -December 6, 2006 Minimum audit checks to examine 199 and incorporated in a team's risk analysis Domestic Production Deduction (DPD) technical advisor, significant support identified from the Computer Audit Specialist (CAS), engineering, and international programs Each programs has designated personnel to assist in key aspects of § 199 relevant to their programs Designated 14 industry technical advisors The DPD is not an accounting method that would permit teams to challenge the computation at any time Directive to challenge in early years even when # is not material, significant issue seen with attempts to challenge later Identification of 199 as a Tier 1 coordinated issue

Copyright © 2006 Deloitte Development LLP. All rights reserved.13 LMSB Examination Guidelines Minimum Audit Checks to be performed by examining agents: –Does the taxpayer's business make sense with the activity requirements of the domestic production deduction? –Comparison of the domestic production gross receipts (DPGR) reported on Form 8903 to the gross receipts or sales less returns and allowances on the taxpayer's tax return, line 1c of the Form –Is the taxpayer required to allocate gross receipts to remove nonqualified embedded service income, or determine the qualified income portion of a component of an item? If so, how did the taxpayer determine an allocation method? –If the taxpayer is required to use the Section 861 method to allocate and apportion deductions has the taxpayer used it and is it consistent with the application of Section 861 for purposes of the foreign tax credit, if applicable? –Has the taxpayer applied the wage and taxable income limitations?

Copyright © 2006 Deloitte Development LLP. All rights reserved.14 IDR / Exam experience Standard § 199 IDR Describe qualified activities and income Is DPGR => Line 1c? –Did the taxpayer use the 95% rule? –If yes, show support Provide item-level detail files showing 20% safe harbor testing –Distinct preference for safe harbor approach

Copyright © 2006 Deloitte Development LLP. All rights reserved.15 IDR / Exam experience (cont.) Standard § 199 IDR (cont.) Benefits and Burdens Describe use of “Shrink Back” to remove embedded services Confirm consistency with § 861 method for FTC and ETI purposes Confirm application of taxable income and wage limitations and show supporting schedules

Copyright © 2006 Deloitte Development LLP. All rights reserved.16 The information contained in this publication is for general purposes only and is not intended, and should not be construed, as legal, accounting, or tax advice or opinion provided by Deloitte & Touche to the reader. This material may not be applicable or suitable for, the reader’s specific circumstances of needs. Therefore, the information should not be used as a substitute for consultation with professional accounting, tax, or other competent advisors. Please contact a local Deloitte & Touche professional before taking any action based upon this information.

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