Section 199: Planning and Compliance Considerations for High Technology 22 nd Annual SJSU—TEI High Technology Tax Institute Section 199: Planning and Compliance Considerations for High Technology 22 nd Annual SJSU—TEI High Technology Tax Institute Carol Conjura, Partner Washington National Tax Palo Alto, California November 5, 2006 Carol Conjura, Partner Washington National Tax Palo Alto, California November 5, 2006 TAX //

© 2006 KPMG LLP, the U.S. member firm of KPMG International, a Swiss cooperative. All rights reserved. KPMG and the KPMG logo are registered trademarks of KPMG International. Printed in the U.S.A. 2 NOTICE ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY KPMG TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY OTHER PERSON OR ENTITY FOR THE PURPOSE OF: (I) AVOIDING PENALTIES THAT MAY BE IMPOSED ON ANY TAXPAYER OR (II) PROMOTING, MARKETING OR RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN. The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavor to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act on such information without appropriate professional advice after a thorough examination of the particular situation.

© 2006 KPMG LLP, the U.S. member firm of KPMG International, a Swiss cooperative. All rights reserved. KPMG and the KPMG logo are registered trademarks of KPMG International. Printed in the U.S.A. 3 Overview of Section 199 Deduction 3% of the lesser of: Qualified production activities income (QPAI); or Taxable income (or AMTI) Deduction may not exceed 50% of W-2 wages Effective for tax years beginning after Dec. 31, 2004 Phase-in of 9% benefits: 2005—2006: 3% 2007—2009: 6% 2010— : 9% Expanded Affiliated Group (EAG) = Single Taxpayer

© 2006 KPMG LLP, the U.S. member firm of KPMG International, a Swiss cooperative. All rights reserved. KPMG and the KPMG logo are registered trademarks of KPMG International. Printed in the U.S.A. 4 Qualified Production Activities Income (QPAI) QPAI = Domestic Production Gross Receipts (DPGR), minus: (i) Allocable COGS; and (i) Allocable COGS; and (ii) Other expenses, losses, and deductions properly allocable to DPGR* (ii) Other expenses, losses, and deductions properly allocable to DPGR* * Generally includes: – Directly allocable expenses – Ratable portion of other expenses that are not directly allocable to non-DPGR

© 2006 KPMG LLP, the U.S. member firm of KPMG International, a Swiss cooperative. All rights reserved. KPMG and the KPMG logo are registered trademarks of KPMG International. Printed in the U.S.A. 5 Step-by-Step Implementation Process 1.Identify EAG members and related flow-through entities that affect deduction 2.For each entity, allocate revenue between DPGR and non-DPGR 3.For each entity, allocate CGS, directly allocable deductions, and other non-directly allocable deductions to DPGR and non-DPGR 4.Allocate EAG level expenses across the EAG and partnerships 5.Calculate QPAI for each entity (Step 2 – [Steps 3 + 4] = QPAI) 6.Determine deduction as lesser of X% of aggregate QPAI, taxable income or AMTI, and 50% of W-2 wages 7.Apply for state tax purposes

© 2006 KPMG LLP, the U.S. member firm of KPMG International, a Swiss cooperative. All rights reserved. KPMG and the KPMG logo are registered trademarks of KPMG International. Printed in the U.S.A. 6 DPGR Derived from lease, rental, license, sale exchange or other disposition of QPP (tangible personal property, computer software, records) MPGE by taxpayer in whole or significant part in the US Qualified film produced by taxpayer Electricity, natural gas, potable water produced by taxpayer in US Derived from Construction of real property performed by taxpayer in active conduct of construction trade or business in US Engineering or architectural services performed by taxpayer in active conduct of such business in US

© 2006 KPMG LLP, the U.S. member firm of KPMG International, a Swiss cooperative. All rights reserved. KPMG and the KPMG logo are registered trademarks of KPMG International. Printed in the U.S.A. 7 Estimated Tax Relief by Industry Utilities $7.9 Petroleum and coal products manufacturing $5.1 Beverage and tobacco products $4.4 Construction $3.9 Transportation equipment manufacturing $3.4 Food manufacturing $2.9 Chemical Manufacturing $11.2 Publishing, motion picture, and sound recording $8.8 Computer and electronic product manufacturing $7.9 Wholesale and retail trade $2.7 All other $18.5 (Estimated Tax Benefit in $ Billion over FY 2005 – 2014 Period)

© 2006 KPMG LLP, the U.S. member firm of KPMG International, a Swiss cooperative. All rights reserved. KPMG and the KPMG logo are registered trademarks of KPMG International. Printed in the U.S.A. 8 Section 199 Milestones October 22, 2004Enacted by AJCA January 19, 2005Notice – Interim Guidance October 20, 2005Proposed regulations issued December 21, 2005Technical corrections enacted January 11, 2006 Public hearing May 17, 2006 Wage limitation modified by TIPRA May 24, 2006Final regulations issued

© 2006 KPMG LLP, the U.S. member firm of KPMG International, a Swiss cooperative. All rights reserved. KPMG and the KPMG logo are registered trademarks of KPMG International. Printed in the U.S.A. 9 Content of Final Regulations Sec : General calculation rules Sec : Wage limitation Sec : Domestic production gross receipts Sec : Cost allocation rules Sec : Pass-through entities post-TIPRA Sec : Agricultural and horticultural co-ops Sec : Expanded affiliated groups Sec : Other rules and effective dates Sec : Pass-through entities pre-TIPRA

© 2006 KPMG LLP, the U.S. member firm of KPMG International, a Swiss cooperative. All rights reserved. KPMG and the KPMG logo are registered trademarks of KPMG International. Printed in the U.S.A. 10 Other Guidance Issued (or to be Issued) On-line computer software Temporary Reg T Methods for calculating W-2 wage limitation Rev. Proc —Pre-TIPRA Rev. Proc —Post-TIPRA Determination of W-2 wage limitation Temporary Reg T Automatic change procedure for section 861 expense allocation methods Rev. Proc To be issued Statistical sampling guidance Other Pass-through entity issues Entity calculations may be permitted Treatment of disallowed losses under passive loss and other rules

© 2006 KPMG LLP, the U.S. member firm of KPMG International, a Swiss cooperative. All rights reserved. KPMG and the KPMG logo are registered trademarks of KPMG International. Printed in the U.S.A. 11 Computer Software General definition: Any program or routine or any sequence of machine-readable code (includes coding for video games and similar programs, regardless of whether the program is designed to operate on a “computer”) Gross receipts derived from computer software exclude receipts from: Customer and technical support Telephone and other telecommunications services Online services, including Internet access services, online banking services, and access to online publications Other similar services

© 2006 KPMG LLP, the U.S. member firm of KPMG International, a Swiss cooperative. All rights reserved. KPMG and the KPMG logo are registered trademarks of KPMG International. Printed in the U.S.A. 12 On-line Computer Software On-line access of computer software is generally an ineligible service Two exceptions: Taxpayer sells or licenses qualifying software that Has only minor or immaterial differences from online version, and Is provided to customers by disk or download Unrelated person sells or licenses software that is substantially identical to taxpayer’s online version Substantially identical software has same functional result and significant overlap in features Computer games are deemed substantially identical Expanded eligibility applies retroactively Not applicable to on-line “publications”

© 2006 KPMG LLP, the U.S. member firm of KPMG International, a Swiss cooperative. All rights reserved. KPMG and the KPMG logo are registered trademarks of KPMG International. Printed in the U.S.A. 13 Item-by-Item Qualification Item-by-item determination only required for assessing eligibility QPAI does not have to be calculated on an item-by-item basis For example, division by division, product line by product line, transaction by transaction Definition of “item” Property offered by taxpayer in normal course of business to customers if all gross receipts qualify as DPGR, or If all gross receipts do not qualify, any component of such property for which the gross receipts qualify (the “shrinkback rule”) Components may not be combined “Item” may include packages of 2 or more items if customarily sold in that manner

© 2006 KPMG LLP, the U.S. member firm of KPMG International, a Swiss cooperative. All rights reserved. KPMG and the KPMG logo are registered trademarks of KPMG International. Printed in the U.S.A. 14 Shrinkback Example: Software Developer The taxpayer in engaged in the development and sale of prepackaged business accounting software A full package includes five modules that serve discrete business functions The taxpayer develops 2 of the 5 modules exclusively outside the US and the remaining 3 exclusively in the US Each module involves a similar amount of development effort Material costs are insignificant If the customer may purchase each module separately, then the taxpayer must treat each module as a separate item and test each separately If the customer must purchase all five modules as a package, then it is likely that the taxpayer may treat the package as the item, and therefore all the revenue from the software as DPGR

© 2006 KPMG LLP, the U.S. member firm of KPMG International, a Swiss cooperative. All rights reserved. KPMG and the KPMG logo are registered trademarks of KPMG International. Printed in the U.S.A. 15 Embedded Services and Non-Qualifying Property Generally required to be allocated and excluded Item-by-item exceptions for QPP: Qualified warranty Qualified installation Qualified delivery Qualified manuals Qualified software maintenance Less than 5% of total price is nonqualifying service or property Applicable only if neither separately priced nor separately offered for sale nor bargained for In normal course of business

© 2006 KPMG LLP, the U.S. member firm of KPMG International, a Swiss cooperative. All rights reserved. KPMG and the KPMG logo are registered trademarks of KPMG International. Printed in the U.S.A. 16 Qualified Computer Software Maintenance Agreement An agreement that entitles the customer to receive future updates, cyclical releases, releases, rewrites of the underlying software, or customer support services for the computer software Agreement may have qualifying and nonqualifying services Software Coalition: Eligibility of 1 st year embedded warranty uncertain

© 2006 KPMG LLP, the U.S. member firm of KPMG International, a Swiss cooperative. All rights reserved. KPMG and the KPMG logo are registered trademarks of KPMG International. Printed in the U.S.A. 17 Overall Gross Receipts De Minimis Rule Applies to any non-qualifying receipts after item-by- item exception: Less than 5% of total gross receipts is non-DPGR Pass-through apply separately at owner and entity level Consolidated groups (but not EAGs) apply at group level Otherwise applied at entity level Reverse de minimis rule added

© 2006 KPMG LLP, the U.S. member firm of KPMG International, a Swiss cooperative. All rights reserved. KPMG and the KPMG logo are registered trademarks of KPMG International. Printed in the U.S.A. 18 Allocation of DPGR/Non-DPGR Issue for non-US production, non-production activities, embedded services Specific identification required if Information readily available, and Taxpayer can specifically identify without undue burden or expense Other reasonable methods Most accurate information available Factual relationship of factors used to allocate Use of method for management, business purposes, other federal and state income tax purposes Consistency from year to year

© 2006 KPMG LLP, the U.S. member firm of KPMG International, a Swiss cooperative. All rights reserved. KPMG and the KPMG logo are registered trademarks of KPMG International. Printed in the U.S.A. 19 Multi-year Transactions Advance payments for maintenance and related expenses Agreements that span effective date of section 199 Costs not allocated if revenue preceded effective date Use of historical data to allocate between DPGR and non-DPGR is acceptable Must use most recent data

© 2006 KPMG LLP, the U.S. member firm of KPMG International, a Swiss cooperative. All rights reserved. KPMG and the KPMG logo are registered trademarks of KPMG International. Printed in the U.S.A. 20 Production “By the Taxpayer” The final regulations retain the basic requirements for eligibility of QPP Property must be manufactured, produced, grown, or extracted (MPGE) In whole or significant part by the taxpayer and in the US Taxpayer must have tax ownership (i.e., benefits and burdens of ownership) during the production activity

© 2006 KPMG LLP, the U.S. member firm of KPMG International, a Swiss cooperative. All rights reserved. KPMG and the KPMG logo are registered trademarks of KPMG International. Printed in the U.S.A. 21 Contract Manufacturing Factors to consider in “benefits and burdens” analysis Title (alone not determinative) Economic risk of loss Control over manufacturing process Right to accept or reject goods Right to market or sell the property Right to alter the property Right to intellectual property associated with the property Property tax burden and others: See Grodt & McKay No one factor is determinative

© 2006 KPMG LLP, the U.S. member firm of KPMG International, a Swiss cooperative. All rights reserved. KPMG and the KPMG logo are registered trademarks of KPMG International. Printed in the U.S.A. 22 In Whole or Significant Part MPGE by taxpayer in US must be “substantial in nature” Facts and circumstances test Relative value added, relative cost incurred Packing, repackaging, labeling, and minor assembly operations are disregarded activities MPGE of key component not sufficient (e.g., circuit board) 20% safe harbor Taxpayer’s direct labor and overhead are 20% or more of COGS (or adjusted basis if property not inventory) R&E costs and intangible creation costs are excluded Software: R&E costs and intangible creation costs are included for both tests

© 2006 KPMG LLP, the U.S. member firm of KPMG International, a Swiss cooperative. All rights reserved. KPMG and the KPMG logo are registered trademarks of KPMG International. Printed in the U.S.A. 23 Mixed Products Taxpayer may sell products that consist of mixture of: Software Hardware and circuitry Other tangible personal property (e.g., disks) For testing eligibility, taxpayer may treat the product as either: Two separate products (software and tangible personal property) Software Tangible personal property

© 2006 KPMG LLP, the U.S. member firm of KPMG International, a Swiss cooperative. All rights reserved. KPMG and the KPMG logo are registered trademarks of KPMG International. Printed in the U.S.A. 24 Advertising Revenue Proposed regulations treat advertising revenue in print media as DPGR If revenue is received in a “disposition” (or would be) Examples: Newspapers, magazines, phone directories, periodicals Final regulations expand eligibility to advertising associated with certain films and TV programs If revenue is received in a “disposition” (or would be) Qualifying disposition: Taxpayer licenses TV program Nonqualifying disposition: Taxpayer broadcasts TV program Online advertising revenue is non-DPGR No qualifying disposition

© 2006 KPMG LLP, the U.S. member firm of KPMG International, a Swiss cooperative. All rights reserved. KPMG and the KPMG logo are registered trademarks of KPMG International. Printed in the U.S.A. 25 Attribution of Related Party Activities Certain related parties take into account all previous MPGE activities prior to their own EAG members EAG partnership, its partners, and other EAG members of partners Consolidated group rules will result in attribution of subsequent activities for consolidated groups Sale of partnership interest to extent of section 751 assets that would be DPGR at partnership level

© 2006 KPMG LLP, the U.S. member firm of KPMG International, a Swiss cooperative. All rights reserved. KPMG and the KPMG logo are registered trademarks of KPMG International. Printed in the U.S.A. 26 Allocation of COGS Allocable COGS is specifically identified amount if Information is readily available and Taxpayer can, without undue burden or expense, specifically identify COGS allocable to DPGR Reasonable method If not identifiable from books and records, use reasonable method Presumption that reasonable method, if used, should be consistent for COGS and gross receipts Similar factors Taxpayer’s methods of accounting used Special rules for LIFO, simplified section 263A methods

© 2006 KPMG LLP, the U.S. member firm of KPMG International, a Swiss cooperative. All rights reserved. KPMG and the KPMG logo are registered trademarks of KPMG International. Printed in the U.S.A. 27 Section 861 Method Default for allocation of other deductions Section 199 is operative section (consistency required between operative sections) Step 1: Allocate to class of gross income Step 2: Apportion between statutory grouping (DPGR) and residual grouping Specific rules for interest, research and experimental expenditures Factors for allocation and apportionment General presumption of consistency between years Mechanism for changing allocation/apportionment methodology Preamble to final regulations anticipates revenue procedure

© 2006 KPMG LLP, the U.S. member firm of KPMG International, a Swiss cooperative. All rights reserved. KPMG and the KPMG logo are registered trademarks of KPMG International. Printed in the U.S.A. 28 Rev. Proc Permits automatic changes in allocation method for: Interest expense Change from FMV or Alternative Tax Book Value to Tax Book Value R&E expense Change to or from sales or gross income methods Procedure 1 st or 2 nd section 199 year Statement by later of tax return or 1 year after Oct. 30, 2006 Is Rev Proc computer software treated as R&E for this purpose?

© 2006 KPMG LLP, the U.S. member firm of KPMG International, a Swiss cooperative. All rights reserved. KPMG and the KPMG logo are registered trademarks of KPMG International. Printed in the U.S.A. 29 Simplified Methods Simplified deduction method Eligible taxpayers: Average annual gross receipts $100 million or less (was $25 million or less under proposed regulations) or Total assets at the end of the taxable year of $10 million or less, Apportion deductions based on relative gross receipts Small business simplified overall method Eligibility taxpayers: Average annual gross receipts of $5 million or less and (under proposed regulations only) COGS and deductions for the current year of $5 million or less, Engaged in farming business under section 447, or Eligible to use cash method under Rev. Proc Apportion COGS and all deductions based on relative gross receipts

© 2006 KPMG LLP, the U.S. member firm of KPMG International, a Swiss cooperative. All rights reserved. KPMG and the KPMG logo are registered trademarks of KPMG International. Printed in the U.S.A. 30 Other Significant Changes Interaction with Extraterritorial Income Exclusion Qualified production activities income Excludes any amount of income excluded under section 114 Taxable income limit Includes amounts excluded as income under section 114 Hedging gains and losses are allocated irrespective of identification

© 2006 KPMG LLP, the U.S. member firm of KPMG International, a Swiss cooperative. All rights reserved. KPMG and the KPMG logo are registered trademarks of KPMG International. Printed in the U.S.A. 31 Interaction with NOLs Taxable income limit determined after taking into account NOL c/o or c/b NOL c/o or c/b does not reduce TI of non- consolidated group EAG members Non-duplication rule added by temporary regulation Consol. group Other EAG Total EAG QPAI$2000$200 Taxable income $200$300$500 NOL c/o $(600)0$(600) 199 Deduction $6$6

© 2006 KPMG LLP, the U.S. member firm of KPMG International, a Swiss cooperative. All rights reserved. KPMG and the KPMG logo are registered trademarks of KPMG International. Printed in the U.S.A. 32 TIPRA Modifications to Wage Limit Tax years beginning before May 18, 2006 Wages of EAG from all sources (DPGR and non-DPGR related) are taken into account in 50% limit Wages from a pass-through entity limited to lesser of: Distributive share of W-2 wages, or 2 x applicable percentage of owner’s distributive share of QPAI Tax years beginning after May 17, 2006 Only wages that are taken into account in computing QPAI may be included (i.e., wages that are properly allocable to DPGR as COGS or other deductions) Wages from pass-through entity no longer limited to 2 x applicable percentage of owner’s QPAI share

© 2006 KPMG LLP, the U.S. member firm of KPMG International, a Swiss cooperative. All rights reserved. KPMG and the KPMG logo are registered trademarks of KPMG International. Printed in the U.S.A. 33 Temp. Reg T (Wage Safe Harbors) Problem (e)(1) W-2 wages differs from deductible “wage expense” Safe harbor Multiply (e)(1) wages by ratio of wage expense included in QPAI to total wage expense For COGS, taxpayer may use direct labor or section 263A labor included in QPAI

© 2006 KPMG LLP, the U.S. member firm of KPMG International, a Swiss cooperative. All rights reserved. KPMG and the KPMG logo are registered trademarks of KPMG International. Printed in the U.S.A. 34 Effective Date Options For tax years beginning before June 1, 2006 Option 1 (Cherry picking) Any one or more provisions in Notice Unless notice silent on rule in proposed regulations Any one or more provisions in proposed regulations Option 2 Final regulations For tax years beginning on or after June 1, 2006 Final regulations only Temporary regulations for software May be applied separately for 2005 and 2006 irrespective of option selected above

© 2006 KPMG LLP, the U.S. member firm of KPMG International, a Swiss cooperative. All rights reserved. KPMG and the KPMG logo are registered trademarks of KPMG International. Printed in the U.S.A. 35 Implementation Considerations Mapping of business processes Mapping of accounting processes Identify relevant data sources Develop optimal calculation methodology Quarterly estimated tax, year-end extension payments State income tax calculations Adequate documentation for IRS, SOX 404, FIN 48, states IRS dedicated team and training CAP program Proactive planning

© 2006 KPMG LLP, the U.S. member firm of KPMG International, a Swiss cooperative. All rights reserved. KPMG and the KPMG logo are registered trademarks of KPMG International. Printed in the U.S.A. 36 Implementation Challenges Contract manufacturing – who has benefits and burdens of ownership Revenue allocation matrix US vs. non-U.S Produced by taxpayer vs. purchased Qualifying software vs. tangible personal property Embedded non-qualifying items Transfer pricing model for bundled revenue Intercompany product flow – how to capture all revenue streams Does qualified activity exist – grey areas, items that don’t meet the safe harbor When to apply statistical sampling and how to determine sample attributes Selection of most appropriate cost allocation methods Impact of the structure on calculation

© 2006 KPMG LLP, the U.S. member firm of KPMG International, a Swiss cooperative. All rights reserved. KPMG and the KPMG logo are registered trademarks of KPMG International. Printed in the U.S.A. 37 Section 199 Software Functionality Calculates section 199 deduction Regular taxable income AMTI 5 statutory groups Member-by-member allocations EAG level allocations Partnership allocations Permits user selected apportionment bases Addresses phase-in Supports 10-year projections Produces detailed report

38 ©2006 KPMG LLP, the U.S. member firm of KPMG International, a Swiss cooperative. All rights reserved. Questions?

39 ©2006 KPMG LLP, the U.S. member firm of KPMG International, a Swiss cooperative. All rights reserved. Contact Information: Carol Conjura (202)