Federal Tax Alert - September 2015

September 2015

Section 199 Temporary and Proposed Regulations Issued

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On August 27, 2015, the Federal Register published IRS temporary regulations (T.D. 9731) related to how to calculate Section 199’s W-2 wage limitation for short taxable years, and proposed regulations (REG-136459-09) related to qualified oil related activities, qualified film rules, Puerto Rico gross receipts, the term “manufactured, produced, grown, or extracted,” contract manufacturing arrangements, construction activities, cost of goods sold allocations, and agricultural and horticultural cooperatives.

The most significant sections of the proposed regulations eliminate the benefits-and-burdens test for activities performed under contract manufacturing arrangements and provide further guidance on what activities the IRS deems non-qualifying by clarifying the definition of “minor assembly.”


The Section 199 domestic production activities deduction was enacted in 2004 to incentivize a broad range of domestic production activities and to maintain and enhance job opportunities in the United States.

Under Section 199, an eligible taxpayer can compute a deduction for taxable years equal to the lesser of:
  • 9% of the taxpayer’s qualified production activities income (“QPAI”);
  • 9% of the taxpayer’s taxable income for the tax year; and
  • 50% of the taxpayer’s W-2 wages for such year that are properly allocable to domestic production gross receipts (“DPGR”).

Temporary Regulations: Allocation of W-2 Wages in Short Taxable Years and for Acquisitions and Dispositions

Historically, determining W-2 wages for taxpayers with either a short taxable year or an acquisition or disposition has been challenging.

Prior to the temporary regulations, W-2 wages were deemed to be the amount paid by the taxpayer for employment of employees by that taxpayer during the calendar year ending within that taxable year.

In the case of a taxpayer’s short taxable year that does not include a calendar year that ends within that short taxable year—e.g., a taxable year starting June 1 and ending September 30—it was unclear before the new regulations what wages were to be allocated to that taxpayer. Moreover, if the answer were none, then that taxpayer’s deduction would be zero, because its W-2 wage limitation would have been zero.

The newly issued temporary regulations clarify that wages paid by a taxpayer during such a short taxable year to employees for employment by such taxpayer are treated as W-2 wages for that short taxable year.

In addition, and following the same logic, the regulations provide that W-2 wages paid during the calendar year to employees of an acquired or disposed-of trade or business are to be allocated between each taxpayer based on the period during which the employees of the acquired or disposed of trade or business were employed by the respective taxpayers.

The temporary regulations are effective for tax years beginning on or after August 27, 2015, expire on August 24, 2018, and may be relied on for earlier tax years still open under the statute of limitations.

BDO Observation: Fiscal year taxpayers who did not take a Section 199 deduction for a short taxable year which did not include a calendar year end may now consider amending prior year tax returns for any open years to claim the Section 199 deduction.

Proposed Regulations - Highlights

The proposed regulations have potential implications specifically for the oil-and-gas, film, and construction industries. Two of the more general provisions, however—regarding the benefits-and-burdens test under contract manufacturing arrangements and the definition of “minor assembly”—are likely to have a broader impact.

Elimination of Benefits-and-Burdens Test
The proposed regulations would replace the benefits-and-burdens-of-ownership test under Treas. Reg. Sec. 1.199-3(f)(1). This test allows only one taxpayer that is a party to a contract manufacturing arrangement to claim the deduction, namely, the taxpayer that has the benefits and burdens of ownership of the qualified production property during the production period.

The IRS Large Business and International Division (“LB&I”) has attempted several times to provide guidance on the treatment of contract manufacturing arrangements. For example, LB&I’s most recent directive on this matter (LB&I-04-1013-008) allows parties to a contract manufacturing arrangement to designate, by signing a certification statement, which party may claim the deduction.

This guidance, however, has not eliminated the uncertainty as to which party has the benefits and burdens under a contract manufacturing arrangement. Taxpayers, therefore, have resorted to finding a reliable basis for their position based on recent court cases addressing issues such as whether legal title passes, which party bears the risk of loss during production, how the parties treat the transaction, and whether an equity interest was acquired.

In part to reduce the administrative burden involved in analyzing these and other factors, the proposed regulations provide that, if a qualified activity is performed under a contract, then the party that performs the activity is the taxpayer eligible to claim the deduction for that activity. By drastically simplifying the benefits-and-burdens test, reducing it to simply the “benefit” or “burden” of performing the activity involved, this provision essentially eliminates the benefits-and-burdens test altogether.

BDO Observation: The proposed regulations may impact some taxpayers’ decisions about where and how to do their manufacturing. Currently, companies that do not have internal manufacturing capabilities, but are still in the business of manufacturing or selling products have been able to outsource production domestically and still claim the deduction using contracts drafted in a manner so as to meet the benefits-and-burdens test. This not only provided a benefit to the taxpayer; it also fostered the spirit of the original intent of Section 199 by keeping manufacturing jobs in the United States.

Under the proposed regulations, taxpayers would not be able to do this. Some taxpayers, therefore, may be inclined to contract less with more expensive domestic manufacturers and more with less expensive non-U.S. manufacturers. On the positive side, the proposed regulations increase the opportunity many U.S. contract manufacturers have to claim the deduction.

“Minor Assembly”
The proposed regulations supplement the IRS position on what activities constitute “minor assembly.” Treas. Reg. Sec. 1.199-3(e)(1) provides that the term “MPGE” includes manufacturing, producing, growing, extracting, installing, developing, improving and creating qualified production property; making qualified production property 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. MPGE does not include packaging, repackaging, labeling, or minor assembly alone, without engaging in other MPGE activities. The LB&I issued a directive in March 2015 delineating six activities that fall outside the definition of “MPGE” in Treas. Reg. Sec. 1.199-3(e), and the proposed regulations add an example that provides some clarity on the definition of “minor assembly.”
In United States v. Dean, 945 F. Supp. 2d 1110 (C.D. Cal 2013), the U.S. Tax Court decided in favor of the taxpayer, concluding that the taxpayer’s activity of preparing gift baskets by assembling third party-produced products was substantial assembly, akin to a manufacturing activity, and not solely packaging or repackaging. The proposed regulations would reverse this, providing an example of a taxpayer specifically engaged in assembling third party products into gift baskets and concluding that such activities do not amount to MPGE.
BDO Observation: The definition of “minor assembly” has historically been a topic of much debate and disagreement between taxpayers, the IRS, and the courts. The Treasury Department and the IRS candidly admit that they have found it difficult to identify an objective test that would be widely acceptable. Therefore, the government has requested comments on, among other things, how the term “minor assembly” should be defined.

The proposed regulations would be effective for tax years beginning on or after the date that they are published as final regulations in the Federal Register.

Questions and Contact:
BDO is here to help our clients and prospects navigate through the complexities of the newly issued temporary and proposed regulations. Please contact a member of our Section 199 national team with any questions or to discuss whether and how the new regulations may affect your business.
Yuan Chou
Tax Senior Director
  David Wong
R&D Principal

Chris Bard
R&D Practice Leader
  David Kalman
R&D Manager

Travis Butler
Tax Senior Director
  Jonathan Forman
R&D Principal

Sara Chun
R&D Manager