Income Attributable to Domestic Production Activities, 31268-31333 [06-4829]

Agencies

• Internal Revenue Service
• DEPARTMENT OF THE TREASURY

[Federal Register Volume 71, Number 105 (Thursday, June 1, 2006)]
[Rules and Regulations]
[Pages 31268-31333]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 06-4829]



[[Page 31267]]

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Part II





Department of the Treasury





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Internal Revenue Service



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26 CFR Parts 1 and 602



Income Attributable to Domestic Production Activities; Final Rule

Federal Register / Vol. 71, No. 105 / Thursday, June 1, 2006 / Rules 
and Regulations

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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1 and 602

[TD 9263]
RIN 1545-BE33


Income Attributable to Domestic Production Activities

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations concerning the 
deduction for income attributable to domestic production activities 
under section 199 of the Internal Revenue Code. Section 199 was enacted 
as part of the American Jobs Creation Act of 2004 (Act). The 
regulations will affect taxpayers engaged in certain domestic 
production activities.

DATES: Effective Date: These regulations are effective June 1, 2006.
    Date of Applicability: For date of applicability see Sec. Sec.  
1.199-8(i) and 1.199-9(k).

FOR FURTHER INFORMATION CONTACT: Concerning Sec. Sec.  1.199-1, 1.199-
3, 1.199-6, and 1.199-8, Paul Handleman or Lauren Ross Taylor, (202) 
622-3040; concerning Sec.  1.199-2, Alfred Kelley, (202) 622-6040; 
concerning Sec.  1.199-4(c) and (d), Richard Chewning, (202) 622-3850; 
concerning all other provisions of Sec.  1.199-4, Jeffery Mitchell, 
(202) 622-4970; concerning Sec.  1.199-7, Ken Cohen, (202) 622-7790; 
concerning Sec.  1.199-9, Martin Schaffer, (202) 622-3080 (not toll-
free numbers).

SUPPLEMENTARY INFORMATION: 

Paperwork Reduction Act

    The collection of information contained in these final regulations 
has been reviewed and approved by the Office of Management and Budget 
in accordance with the Paperwork Reduction Act (44 U.S.C. 3507) under 
control number 1545-1966. Responses to this collection of information 
are mandatory so that patrons of agricultural and horticultural 
cooperatives may claim the section 199 deduction.
    An agency may not conduct or sponsor, and a person is not required 
to respond to, a collection of information unless the collection of 
information displays a valid control number assigned by the Office of 
Management and Budget.
    The estimated annual burden per respondent varies from 15 minutes 
to 10 hours, depending on individual circumstances, with an estimated 
average of 3 hours.
    Comments concerning the accuracy of this burden estimate and 
suggestions for reducing this burden should be sent to the Internal 
Revenue Service, Attn: IRS Reports Clearance Officer, 
SE:W:CAR:MP:T:T:SP Washington, DC 20224, and to the Office of 
Management and Budget, Attn: Desk Officer for the Department of the 
Treasury, Office of Information and Regulatory Affairs, Washington, DC 
20503.
    Books or records relating to this collection of information must be 
retained as long as their contents may become material in the 
administration of any internal revenue law. Generally, tax returns and 
tax return information are confidential, as required by 26 U.S.C. 6103.

Background

    This document amends 26 CFR part 1 to provide rules relating to the 
deduction for income attributable to domestic production activities 
under section 199 of the Internal Revenue Code (Code). Section 199 was 
added to the Code by section 102 of the American Jobs Creation Act of 
2004 (Pub. L. 108-357, 118 Stat. 1418) (Act), and amended by section 
403(a) of the Gulf Opportunity Zone Act of 2005 (Pub. L. 109-135, 119 
Stat. 25) (GOZA) and section 514 of the Tax Increase Prevention and 
Reconciliation Act of 2005 (Public Law 109-222, 120 Stat. 345) (TIPRA). 
On January 19, 2005, the IRS and Treasury Department issued Notice 
2005-14 (2005-1 C.B. 498) providing interim guidance on section 199. On 
November 4, 2005, the IRS and Treasury Department published in the 
Federal Register proposed regulations under section 199 (70 FR 67220) 
(proposed regulations). On January 11, 2006, the IRS and Treasury 
Department held a public hearing on the proposed regulations. Written 
and electronic comments responding to the proposed regulations were 
received. This preamble describes the most significant comments 
received by the IRS and Treasury Department. Because of the large 
volume of comments received, however, the IRS and Treasury Department 
are not able to address all of the comments in this preamble. After 
consideration of all of the comments, the proposed regulations are 
adopted as amended by this Treasury decision. Contemporaneous with the 
publication of these final regulations, temporary and proposed 
regulations have been published involving the treatment under section 
199 of computer software provided to customers over the Internet.

General Overview

    Section 199(a)(1) allows a deduction equal to 9 percent (3 percent 
in the case of taxable years beginning in 2005 or 2006, and 6 percent 
in the case of taxable years beginning in 2007, 2008, or 2009) of the 
lesser of (A) the qualified production activities income (QPAI) of the 
taxpayer for the taxable year, or (B) taxable income (determined 
without regard to section 199) for the taxable year (or, in the case of 
an individual, adjusted gross income (AGI)).
    Section 199(b)(1) limits the deduction for a taxable year to 50 
percent of the W-2 wages paid by the taxpayer during the calendar year 
that ends in such taxable year. For this purpose, section 199(b)(2) 
defines the term W-2 wages to mean, with respect to any person for any 
taxable year of such person, the sum of the amounts described in 
section 6051(a)(3) and (8) paid by such person with respect to 
employment of employees by such person during the calendar year ending 
during such taxable year. The term W-2 wages does not include any 
amount that is not properly included in a return filed with the Social 
Security Administration on or before the 60th day after the due date 
(including extensions) for the return. Section 199(b)(3) provides that 
the Secretary shall prescribe rules for the application of section 
199(b) in the case of an acquisition or disposition of a major portion 
of either a trade or business or a separate unit of a trade or business 
during the taxable year.
    Section 514(a) of TIPRA amended section 199(b)(2) by excluding from 
the term W-2 wages any amount that is not properly allocable to 
domestic production gross receipts (DPGR) for purposes of section 
199(c)(1). The IRS and Treasury Department plan on issuing regulations 
on the amendments made to section 199(b)(2) by section 514 of TIPRA.

Qualified Production Activities Income

    Section 199(c)(1) defines QPAI for any taxable year as an amount 
equal to the excess (if any) of (A) the taxpayer's DPGR for such 
taxable year, over (B) the sum of (i) the cost of goods sold (CGS) that 
are allocable to such receipts; and (ii) other expenses, losses, or 
deductions (other than the deduction under section 199) that are 
properly allocable to such receipts.
    Section 199(c)(2) provides that the Secretary shall prescribe rules 
for the proper allocation of items described in section 199(c)(1) for 
purposes of determining QPAI. Such rules shall provide for the proper 
allocation of

[[Page 31269]]

items whether or not such items are directly allocable to DPGR.
    Section 199(c)(3) provides special rules for determining costs in 
computing QPAI. Under these special rules, any item or service brought 
into the United States is treated as acquired by purchase, and its cost 
is treated as not less than its value immediately after it enters the 
United States. A similar rule applies in determining the adjusted basis 
of leased or rented property when the lease or rental gives rise to 
DPGR. If the property has been exported by the taxpayer for further 
manufacture, the increase in cost or adjusted basis must not exceed the 
difference between the value of the property when exported and its 
value when brought back into the United States after further 
manufacture.
    Section 199(c)(4)(A) defines DPGR to mean the taxpayer's gross 
receipts that are derived from: (i) Any lease, rental, license, sale, 
exchange, or other disposition of (I) qualifying production property 
(QPP) that was manufactured, produced, grown, or extracted (MPGE) by 
the taxpayer in whole or in significant part within the United States; 
(II) any qualified film produced by the taxpayer; or (III) electricity, 
natural gas, or potable water (collectively, utilities) produced by the 
taxpayer in the United States; (ii) in the case of a taxpayer engaged 
in the active conduct of a construction trade or business, construction 
of real property performed in the United States by the taxpayer in the 
ordinary course of such trade or business; or (iii) in the case of a 
taxpayer engaged in the active conduct of an engineering or 
architectural services trade or business, engineering or architectural 
services performed in the United States by the taxpayer in the ordinary 
course of such trade or business with respect to the construction of 
real property in the United States.
    Section 199(c)(4)(B) excepts from DPGR gross receipts of the 
taxpayer that are derived from: (i) The sale of food and beverages 
prepared by the taxpayer at a retail establishment; (ii) the 
transmission or distribution of utilities; or (iii) the lease, rental, 
license, sale, exchange, or other disposition of land.
    Section 199(c)(4)(C) provides that gross receipts derived from the 
manufacture or production of any property described in section 
199(c)(4)(A)(i)(I) shall be treated as meeting the requirements of 
section 199(c)(4)(A)(i) if (i) such property is manufactured or 
produced by the taxpayer pursuant to a contract with the Federal 
Government, and (ii) the Federal Acquisition Regulation requires that 
title or risk of loss with respect to such property be transferred to 
the Federal Government before the manufacture or production of such 
property is complete.
    Section 199(c)(4)(D) provides that for purposes of section 
199(c)(4), if all of the interests in the capital and profits of a 
partnership are owned by members of a single expanded affiliated group 
(EAG) at all times during the taxable year of such partnership, the 
partnership and all members of such group shall be treated as a single 
taxpayer during such period.
    Section 199(c)(5) defines QPP to mean: (A) Tangible personal 
property; (B) any computer software; and (C) any property described in 
section 168(f)(4) (certain sound recordings).
    Section 199(c)(6) defines a qualified film to mean any property 
described in section 168(f)(3) if not less than 50 percent of the total 
compensation relating to production of the property is compensation for 
services performed in the United States by actors, production 
personnel, directors, and producers. The term does not include property 
with respect to which records are required to be maintained under 18 
U.S.C. 2257 (generally, films, videotapes, or other matter that depict 
actual sexually explicit conduct and are produced in whole or in part 
with materials that have been mailed or shipped in interstate or 
foreign commerce, or are shipped or transported or are intended for 
shipment or transportation in interstate or foreign commerce).
    Section 199(c)(7) provides that DPGR does not include any gross 
receipts of the taxpayer derived from property leased, licensed, or 
rented by the taxpayer for use by any related person. However, DPGR may 
include such property if the property is held for sublease, sublicense, 
or rent, or is subleased, sublicensed, or rented, by the related person 
to an unrelated person for the ultimate use of the unrelated person. 
See footnote 29 of H.R. Conf. Rep. No. 755, 108th Cong. 2d Sess. 260 
(2004) (Conference Report). A person is treated as related to another 
person if both persons are treated as a single employer under either 
section 52(a) or (b) (without regard to section 1563(b)), or section 
414(m) or (o).

Pass-Thru Entities

    Section 199(d)(1)(A) provides that, in the case of a partnership or 
S corporation, (i) section 199 shall be applied at the partner or 
shareholder level, (ii) each partner or shareholder shall take into 
account such person's allocable share of each item described in section 
199(c)(1)(A) or (B) (determined without regard to whether the items 
described in section 199(c)(1)(A) exceed the items described in section 
199(c)(1)(B)), and (iii) each partner or shareholder shall be treated 
for purposes of section 199(b) as having W-2 wages for the taxable year 
in an amount equal to the lesser of (I) such person's allocable share 
of the W-2 wages of the partnership or S corporation for the taxable 
year (as determined under regulations prescribed by the Secretary), or 
(II) 2 times 9 percent (3 percent in the case of taxable years 
beginning in 2005 or 2006, and 6 percent in the case of taxable years 
beginning in 2007, 2008, or 2009) of so much of such person's QPAI as 
is attributable to items allocated under section 199(d)(1)(A)(ii) for 
the taxable year.
    Section 514(b) of TIPRA amended section 199(d)(1)(A)(iii) to 
provide instead that each partner or shareholder shall be treated for 
purposes of section 199(b) as having W-2 wages for the taxable year 
equal to such person's allocable share of the W-2 wages of the 
partnership or S corporation for the taxable year (as determined under 
regulations prescribed by the Secretary). The IRS and Treasury 
Department plan on issuing regulations on the amendments made to 
section 199(d)(1)(A)(iii) by section 514 of TIPRA.
    Section 199(d)(1)(B) provides that, in the case of a trust or 
estate, (i) the items referred to in section 199(d)(1)(A)(ii) (as 
determined therein) and the W-2 wages of the trust or estate for the 
taxable year, shall be apportioned between the beneficiaries and the 
fiduciary (and among the beneficiaries) under regulations prescribed by 
the Secretary, and (ii) for purposes of section 199(d)(2), AGI of the 
trust or estate shall be determined as provided in section 67(e) with 
the adjustments described in such paragraph.
    Section 199(d)(1)(C) provides that the Secretary may prescribe 
rules requiring or restricting the allocation of items and wages under 
section 199(d)(1) and may prescribe such reporting requirements as the 
Secretary determines appropriate.

Individuals

    In the case of an individual, section 199(d)(2) provides that the 
deduction is equal to the applicable percent of the lesser of the 
taxpayer's (A) QPAI for the taxable year, or (B) AGI for the taxable 
year determined after applying sections 86, 135, 137, 219, 221, 222, 
and 469, and without regard to section 199.

[[Page 31270]]

Patrons of Certain Cooperatives

    Section 199(d)(3)(A) provides that any person who receives a 
qualified payment from a specified agricultural or horticultural 
cooperative shall be allowed for the taxable year in which such payment 
is received a deduction under section 199(a) equal to the portion of 
the deduction allowed under section 199(a) to such cooperative which is 
(i) allowed with respect to the portion of the QPAI to which such 
payment is attributable, and (ii) identified by such cooperative in a 
written notice mailed to such person during the payment period 
described in section 1382(d).
    Section 199(d)(3)(B) provides that the taxable income of a 
specified agricultural or horticultural cooperative shall not be 
reduced under section 1382 by reason of that portion of any qualified 
payment as does not exceed the deduction allowable under section 
199(d)(3)(A) with respect to such payment.
    Section 199(d)(3)(C) provides that, for purposes of section 199, 
the taxable income of a specified agricultural or horticultural 
cooperative shall be computed without regard to any deduction allowable 
under section 1382(b) or (c) (relating to patronage dividends, per-unit 
retain allocations, and nonpatronage distributions).
    Section 199(d)(3)(D) provides that, for purposes of section 199, a 
specified agricultural or horticultural cooperative described in 
section 199(d)(3)(F)(ii) shall be treated as having MPGE in whole or in 
significant part any QPP marketed by the organization that its patrons 
have so MPGE.
    Section 199(d)(3)(E) provides that, for purposes of section 
199(d)(3), the term qualified payment means, with respect to any 
person, any amount that (i) is described in section 1385(a)(1) or (3), 
(ii) is received by such person from a specified agricultural or 
horticultural cooperative, and (iii) is attributable to QPAI with 
respect to which a deduction is allowed to such cooperative under 
section 199(a).
    Section 199(d)(3)(F) provides that, for purposes of section 
199(d)(3), the term specified agricultural or horticultural cooperative 
means an organization to which part I of subchapter T applies that is 
engaged (i) in the MPGE in whole or in significant part of any 
agricultural or horticultural product, or (ii) in the marketing of 
agricultural or horticultural products.

Expanded Affiliated Group

    Section 199(d)(4)(A) provides that all members of an EAG are 
treated as a single corporation for purposes of section 199. Section 
199(d)(4)(B) provides that an EAG is an affiliated group as defined in 
section 1504(a), determined by substituting ``more than 50 percent'' 
for ``at least 80 percent'' each place it appears and without regard to 
section 1504(b)(2) and (4).
    Section 199(d)(4)(C) provides that, except as provided in 
regulations, the section 199 deduction is allocated among the members 
of the EAG in proportion to each member's respective amount (if any) of 
QPAI.

Trade or Business Requirement

    Section 199(d)(5) provides that section 199 is applied by taking 
into account only items that are attributable to the actual conduct of 
a trade or business.

Alternative Minimum Tax

    Section 199(d)(6) provides that, for purposes of determining the 
alternative minimum taxable income under section 55, (A) QPAI shall be 
determined without regard to any adjustments under sections 56 through 
59, and (B) in the case of a corporation, section 199(a)(1)(B) shall be 
applied by substituting ``alternative minimum taxable income'' for 
``taxable income.''

Unrelated Business Taxable Income

    Section 199(d)(7) provides that, for purposes of determining the 
tax imposed by section 511, section 199(a)(1)(B) shall be applied by 
substituting ``unrelated business taxable income'' for ``taxable 
income.''

Authority To Prescribe Regulations

    Section 199(d)(8) authorizes the Secretary to prescribe such 
regulations as are necessary to carry out the purposes of section 199, 
including regulations that prevent more than one taxpayer from being 
allowed a deduction under section 199 with respect to any activity 
described in section 199(c)(4)(A)(i).

Effective Date

    The effective date of section 199 in section 102(e) of the Act was 
amended by section 403(a)(19) of the GOZA. Section 102(e)(1) of the Act 
provides that the amendments made by section 102 of the Act shall apply 
to taxable years beginning after December 31, 2004. Section 102(e)(2) 
of the Act provides that, in determining the deduction under section 
199, items arising from a taxable year of a partnership, S corporation, 
estate, or trust beginning before January 1, 2005, shall not be taken 
into account for purposes of section 199(d)(1). Section 514(c) of TIPRA 
provides that the amendments made by section 514 apply to taxable years 
beginning after May 17, 2006, the enactment date of TIPRA.

Summary of Comments and Explanation of Provisions

Taxable Income

    The section 199 deduction is not taken into account in computing 
any net operating loss (NOL) or the amount of any NOL carryback or 
carryover. Thus, except as otherwise provided in Sec.  1.199-7(c)(2) of 
the final regulations (concerning the portion of a section 199 
deduction allocated to a member of an EAG), the section 199 deduction 
cannot create, or increase, the amount of an NOL deduction.
    For purposes of section 199(a)(1)(B), taxable income is determined 
without regard to section 199 and without regard to any amount excluded 
from gross income pursuant to section 114 of the Code or pursuant to 
section 101(d) of the Act. Thus, any extraterritorial income exclusion 
or amount excluded from gross income pursuant to section 101(d) of the 
Act does not reduce taxable income for purposes of section 
199(a)(1)(B), even though such excluded amounts are taken into account 
in determining QPAI.

Wage Limitation

    The final regulations give the Secretary authority to provide for 
methods of calculating W-2 wages. Contemporaneous with the publication 
of these final regulations, Rev. Proc. 2006-22 (2006-22 I.R.B.) has 
been published and provides for taxable years beginning on or before 
May 17, 2006, the enactment date of TIPRA, the same three methods of 
calculating W-2 wages as were contained in Notice 2005-14 and the 
proposed regulations. It is expected that any new revenue procedure 
applicable for taxable years beginning after May 17, 2006, will contain 
methods for calculating W-2 wages similar to the three methods in Rev. 
Proc. 2006-22. The methods are included in a revenue procedure rather 
than the final regulations so that if changes are made to Form W-2, 
``Wage and Tax Statement,'' a new revenue procedure can be issued 
reflecting those changes more promptly than an amendment to the final 
regulations.
    Taxpayers have inquired whether remuneration paid to employees for 
domestic services in a private home of the employer, which remuneration 
may be reported on Schedule H (Form 1040), ``Household Employment 
Taxes,'' or, under certain conditions, on Form 941, ``Employer's 
Quarterly Federal Tax

[[Page 31271]]

Return,'' are included in W-2 wages. Such remuneration is generally 
excepted from wages for income tax withholding purposes by section 
3401(a)(3) of the Code. Section 199(b)(5) provides that section 199 
shall be applied by only taking into account items that are 
attributable to the actual conduct of a trade or business. Payments to 
employees of a taxpayer for domestic services in a private home of the 
taxpayer are not attributable to the actual conduct of a trade or 
business of the taxpayer. Accordingly, such payments are not included 
in W-2 wages for purposes of section 199(b)(2).
    The IRS and Treasury Department have also received numerous 
inquiries concerning whether amounts paid to workers who receive Forms 
W-2 from professional employer organizations (PEOs), or employee 
leasing firms, may be included in the W-2 wages of the clients of the 
PEOs or employee leasing firms. In order for wages reported on a Form 
W-2 to be included in the determination of W-2 wages of a taxpayer, the 
Form W-2 must be for employment by the taxpayer. Employees of the 
taxpayer are defined in Sec.  1.199-2(a)(1) of the final regulations as 
including only common law employees of the taxpayer and officers of a 
corporate taxpayer. Thus, the issue of whether the payments to the 
employees are included in W-2 wages depends on an application of the 
common law rules in determining whether the PEO, the employee leasing 
firm, or the client is the employer of the worker. As noted in Sec.  
1.199-2(a)(2) of the final regulations, taxpayers may take into account 
wages reported on Forms W-2 issued by other parties provided that the 
wages reported on the Forms W-2 were paid to employees of the taxpayer 
for employment by the taxpayer. However, with respect to individuals 
who taxpayers assert are their common law employees for purposes of 
section 199, taxpayers are reminded of their duty to file returns and 
apply the tax law on a consistent basis.
    Commentators also raised the issue of whether an individual filing 
as part of a joint return may include wages paid by his or her spouse 
to employees of his or her spouse in determining the amount of the 
individual's W-2 wages for purposes of the section 199 deduction. The 
example given was an individual who had a trade or business reported on 
Schedule C (Form 1040) with QPAI but no W-2 wages, and the individual's 
spouse had W-2 wages in a second trade or business reported on Schedule 
C (Form 1040) but no QPAI. Section 1.199-2(a)(4) of the final 
regulations provides that married individuals who file a joint return 
are treated as one taxpayer for purposes of determining W-2 wages. 
Therefore, an individual filing as part of a joint return may take into 
account wages paid to employees of his or her spouse in determining the 
amount of W-2 wages provided the wages are paid in a trade or business 
of the spouse and the other requirements of the final regulations are 
met. In contrast, if the taxpayer and the taxpayer's spouse file 
separate returns, the taxpayer may not use the spouse's wages in 
determining the taxpayer's W-2 wages for purposes of the taxpayer's 
section 199 deduction because they are not considered one taxpayer.

Domestic Production Gross Receipts

    Commentators suggested that rules similar to the de minimis rules 
provided in Sec. Sec.  1.199-1(d)(2) (gross receipts allocation), 
1.199-3(h)(4) (embedded services), 1.199-3(l)(1)(ii) (construction 
services), and 1.199-3(m)(4) (engineering or architectural services) of 
the proposed regulations, under which taxpayers may treat de minimis 
amounts of non-DPGR as DPGR, should be available in the opposite 
situation. Thus, for example, if a taxpayer's gross receipts that are 
allocable to DPGR are less than 5 percent of its overall gross receipts 
for the taxable year, the commentators suggested that the final 
regulations allow the taxpayer to treat those gross receipts as non-
DPGR. The IRS and Treasury Department agree with this suggestion, and 
the final regulations provide such rules for the provisions discussed 
above as well as under Sec.  1.199-3(l)(4)(iv)(B) for utilities.
    Several comments were received regarding the burden imposed by the 
requirement in the proposed regulations that QPAI be computed on an 
item-by-item basis (rather than on a division-by-division, or product 
line-by-product line basis). Several commentators urged the IRS and 
Treasury Department to limit the item-by-item standard to the 
requirements of Sec.  1.199-3 in determining DPGR (that is, the lease, 
rental, license, sale, exchange, or other disposition requirement, the 
in-whole-or-in-significant-part requirement, etc.). Specifically, the 
commentators argued that the item-by-item standard is inconsistent with 
the cost allocation methods provided in Sec.  1.199-4. The IRS and 
Treasury Department agree with this comment. Therefore, the final 
regulations clarify that the item-by-item standard applies solely for 
purposes of the requirements of Sec.  1.199-3 noted above in 
determining whether the gross receipts derived from an item are DPGR. 
The final regulations also provide that a taxpayer must determine, 
using any reasonable method that is satisfactory to the Secretary based 
on all of the facts and circumstances, whether gross receipts qualify 
as DPGR on an item-by-item basis.
    The proposed regulations provide that an item is defined as the 
property offered for lease, rental, license, sale, exchange or other 
disposition to customers that meets the requirements of section 199. 
The proposed regulations also provide several examples to illustrate 
this rule. Some commentators observed that the examples involving a 
manufacturer of toy cars that sold the cars to toy stores appear to 
imply that, in the case of property offered for lease, rental, license, 
sale, exchange or other disposition by a wholesaler, the item is 
defined with reference to the property offered for sale to retail 
consumers by the wholesaler's customer. The rules for defining an item, 
and the related examples, have been clarified in the final regulations 
to provide that an item is defined with reference to the property 
offered by the taxpayer for lease, rental, license, sale, exchange or 
other disposition to the taxpayer's customers in the normal course of 
the taxpayer's business, whether the taxpayer is a wholesaler or a 
retailer.
    The proposed regulations provide that, if the property offered for 
lease, rental, license, sale, exchange or other disposition by the 
taxpayer does not meet the requirements of section 199, then the 
taxpayer must treat as the item any portion of that property that does 
meet those requirements. In a case where two or more portions of the 
property meet the requirements of section 199, commentators inquired 
whether the two or more portions are properly treated as a single item 
or as two or more items. The final regulations generally are consistent 
with the rules of the proposed regulations, and provide that if the 
gross receipts derived from the lease, rental, license, sale, exchange 
or other disposition of the property offered in the normal course of a 
taxpayer's business do not qualify as DPGR, then any component of such 
property is treated as the item, provided the gross receipts 
attributable to the component qualify as DPGR. Allowing more than one 
component to be treated as a single item would effectively permit 
taxpayers to define an item as any combination of components that, in 
the aggregate, meets the requirements of section 199, a result that the 
IRS and Treasury Department believe could lead to significant 
distortions. Thus, the IRS and Treasury Department believe that 
treating two or more components of the property offered for lease, 
rental, license, sale, exchange or other

[[Page 31272]]

disposition by the taxpayer as separate items is the appropriate 
result. The final regulations clarify that, if the property offered for 
lease, rental, license, sale, exchange or other disposition by the 
taxpayer does not meet the requirements of section 199, then each 
component that meets the requirements of Sec.  1.199-3 must be treated 
as a separate item and such component may not be combined with a 
component that does not meet the requirements to be treated as an item. 
The final regulations provide examples illustrating this rule. It 
follows that the de minimis rule for embedded services and 
nonqualifying property, as well as any other de minimis exception that 
is applied at the item level, must be applied separately to each 
component of the property that is treated as a separate item.
    The proposed regulations provide that gross receipts derived from a 
lease, rental, license, sale, exchange or other disposition of 
qualifying property constitute DPGR even if the taxpayer has already 
recognized gross receipts from a previous lease, rental, license, sale, 
exchange or other disposition of the property. The IRS and Treasury 
Department recognize that in some cases, such as where the original 
item (for example, steel) that was MPGE or produced by the taxpayer 
within the United States is disposed of by the taxpayer, and 
incorporated by another person into other property (for example, an 
automobile) that is subsequently acquired by the taxpayer, it would be 
extremely difficult for the taxpayer to identify the item the gross 
receipts of which constitute DPGR upon lease, rental, license, sale, 
exchange or other disposition of the acquired property. Therefore, the 
final regulations provide that if a taxpayer cannot reasonably 
determine without undue burden and expense whether the acquired 
property contains any of the original qualifying property, or the 
amount, grade, or kind of the original qualifying property, that the 
taxpayer MPGE or produced within the United States, then the taxpayer 
is not required to determine whether any portion of the acquired 
property qualifies as an item. In such cases, the taxpayer may treat 
any gross receipts derived from the disposition of the acquired 
property that are attributable to the original qualifying property as 
non-DPGR.
    The proposed regulations provide that, for purposes of the 
requirement to allocate gross receipts between DPGR and non-DPGR, if a 
taxpayer can, without undue burden or expense, specifically identify 
where an item was manufactured, or if the taxpayer uses a specific 
identification method for other purposes, then the taxpayer must use 
that specific identification method to determine DPGR. One commentator 
observed that Notice 2005-14 applies a readily available rather than an 
undue burden or expense standard for this purpose, and questioned 
whether the proposed regulations were intended to impose a 
substantively different standard. The standard was changed in the 
proposed regulations in response to comments received on Notice 2005-
14. The commentators were concerned that taxpayers would be required 
under Notice 2005-14 to use specific identification to allocate gross 
receipts under section 199 if their information systems contained the 
information necessary to use specific identification, even if capturing 
such information would require costly system reconfigurations. The 
undue burden and expense standard, however, was not intended to expand 
the scope of the requirement to use specific identification to include 
taxpayers for whom the information necessary to use that method is not 
readily available in their existing systems. Accordingly, the final 
regulations utilize both terms.
    Commentators were concerned that the disposition of qualifying 
property would not give rise to DPGR if provided as part of a service 
related contract. However, the proposed regulations in Example 4 in 
Sec.  1.199-3(d)(5) already address this issue by illustrating a 
qualifying disposition resulting in DPGR as part of a service related 
contract. In that example, Y is hired to reconstruct and refurbish 
unrelated customers' tangible personal property. Y installs the 
replacement parts (QPP) that Y MPGE within the United States. The 
example concludes that Y's gross receipts from the MPGE of the 
replacement parts are DPGR. The final regulations retain this example 
and include other examples of service related contracts that also 
involve the disposition of qualifying property giving rise to DPGR if 
all of the other section 199 requirements are met.
    The proposed regulations provide that, if a taxpayer recognizes and 
reports on a Federal income tax return for a taxable year gross 
receipts that the taxpayer identifies as DPGR, then the taxpayer must 
treat the CGS related to such receipts as relating to DPGR, even if 
they are incurred in a subsequent taxable year. The final regulations 
retain this rule in Sec.  1.199-4(b)(2). One commentator questioned 
whether this rule applies to CGS incurred in a taxable year to which 
section 199 applies, if the gross receipts were recognized in a taxable 
year prior to the effective date of section 199 but would have 
qualified as DPGR in that taxable year if section 199 had been in 
effect. The IRS and Treasury Department believe that all gross receipts 
and costs must be allocated between DPGR and non-DPGR on a year-by-year 
basis, and the final regulations provide that for taxpayers using the 
section 861 method or the simplified deduction method, CGS that relates 
to gross receipts recognized in a taxable year prior to the effective 
date of section 199 must be allocated to non-DPGR.
    For items that are disposed of under contracts that span two or 
more taxable years, the final regulations permit the use of historical 
data to allocate gross receipts between DPGR and non-DPGR. If a 
taxpayer makes allocations using historical data, and subsequently 
updates the data, then the taxpayer must use the more recent or updated 
data, starting in the taxable year in which the update is made.
    Two commentators suggested that the final regulations permit 
taxpayers to classify multi-year contracts for purposes of section 199 
with reference to their classification under section 460. For example, 
if a contract is classified as a construction contract under section 
460, the commentators suggested that the contract also be classified as 
a construction contract under section 199. The IRS and Treasury 
Department have determined, however, that the statutory requirements 
under sections 199 and 460, and the regulations thereunder, are 
sufficiently different that it would not be appropriate for the final 
regulations to permit the classification of multi-year contracts under 
section 460 to determine whether the requirements of section 199 are 
met with respect to that contract. Accordingly, the final regulations 
do not adopt this suggestion.

By the Taxpayer

    One commentator suggested a simplifying convention to determine 
which party to a contract manufacturing arrangement has the benefits 
and burdens of ownership under Federal income tax principles. The 
commentator requested that the final regulations permit unrelated 
parties to a contract manufacturing arrangement to designate, through a 
written and signed agreement between the parties, which of them shall 
be treated for purposes of section 199 as engaging in MPGE activities 
conducted pursuant to the arrangement. The final regulations do not 
adopt the commentator's suggestion. The IRS and Treasury Department 
continue to believe that the benefits and burdens of ownership must be 
determined based on all of the facts and circumstances and a 
designation of

[[Page 31273]]

benefits and burdens would not be appropriate.

Government Contracts

    Section 403(a)(7) of the GOZA added new section 199(c)(4)(C), which 
contains a special rule for certain government contracts. The final 
regulations clarify that the special rule for government contracts also 
applies to gross receipts derived from certain subcontracts to 
manufacture or produce property for the Federal government. See The 
Joint Committee on Taxation Staff, Technical Explanation of the Revenue 
Provisions of H.R. 4440, The Gulf Opportunity Zone Act of 2005, 109th 
Cong., 1st Sess. 77 (2005).

In Whole or in Significant Part

    The proposed regulations, like Notice 2005-14, provide generally 
that QPP is MPGE in whole or in significant part by the taxpayer within 
the United States only if the taxpayer's MPGE activity in the United 
States is substantial in nature. Although some language in the section 
199 substantial-in-nature requirement bears similarities to language in 
the definition of manufacture in Sec.  1.954-3(a)(4), the two standards 
are different both in purpose and in substance. Whether operations are 
substantial in nature is relevant under section 954 in determining 
whether manufacturing has occurred. By contrast, the substantial-in-
nature requirement under section 199 is relevant in determining whether 
the MPGE activity, already determined to have occurred under the 
requirement provided in Sec.  1.199-3(d) of the proposed regulations 
(Sec.  1.199-3(e) of the final regulations), was performed in whole or 
in significant part by the taxpayer within the United States. 
Accordingly, as stated in the preamble to Notice 2005-14, case law and 
other precedent under section 954 are not relevant for purposes of the 
substantial-in-nature requirement under section 199. Nor are they 
relevant for purposes of determining whether an activity is an MPGE 
activity under section 199. Similarly, the regulations under section 
199 are not relevant for purposes of section 954.
    Because the substantial-in-nature requirement is generally applied 
by taking into account all of the facts and circumstances, both the 
proposed regulations and Notice 2005-14 provide a safe harbor under 
which the in-whole-or-in-significant-part requirement is satisfied if 
the taxpayer's conversion costs (that is, direct labor and related 
factory burden) are 20 percent or more of the taxpayer's CGS with 
respect to the property. Commentators expressed confusion concerning 
the related factory burden component of this safe harbor, and suggested 
that overhead be substituted for related factory burden in the final 
regulations. Commentators further noted that not all transactions 
yielding DPGR under section 199 involve CGS (for example, a lease, 
rental, or license of QPP). In response to these comments, the IRS and 
Treasury Department have changed the safe harbor in the final 
regulations. The final regulations provide that the in-whole-or-in-
significant-part requirement is satisfied if the taxpayer's direct 
labor and overhead to MPGE the QPP within the United States account for 
20 percent or more of the taxpayer's CGS, or in a transaction without 
CGS (for example, a lease, rental, or license) account for 20 percent 
or more of the taxpayer's unadjusted depreciable basis of the QPP. No 
inference is intended regarding any similar safe harbor under the Code, 
including the safe harbor in Sec.  1.954-3(a)(4)(iii). For taxpayers 
subject to section 263A, overhead is all costs required to be 
capitalized under section 263A except direct materials and direct 
labor. For taxpayers not subject to section 263A, overhead may be 
computed using any reasonable method that is satisfactory to the 
Secretary based on all of the facts and circumstances, but may not 
include any cost, or amount of any cost, that would not be required to 
be capitalized under section 263A if the taxpayer were subject to 
section 263A. In no event are section 174 costs, and the cost of 
creating intangible assets, attributable to tangible personal property 
ever treated as direct labor and overhead, and taxpayers should exclude 
such costs from their CGS or unadjusted depreciable basis, as 
applicable.
    However, the final regulations also clarify that, in the case of 
computer software and sound recordings, research and experimental 
expenditures under section 174 relating to the computer software or 
sound recordings, the cost of creating intangible assets for computer 
software or sound recordings, and (in the case of computer software) 
costs of developing the computer software that are described in Rev. 
Proc. 2000-50 (2000-1 C.B. 601) (software development costs), are 
included in both direct labor and overhead and CGS or unadjusted 
depreciable basis for purposes of the safe harbor, even if the costs 
are incurred in a prior taxable year. In addition, the final 
regulations also clarify that this is the case whether the computer 
software or sound recording is itself the item for purposes of section 
199, or is affixed or added to tangible personal property and the 
taxpayer treats the combined property as computer software or a sound 
recording under the rules of Sec.  1.199-3(i)(5)). In the case where 
the taxpayer produces computer software and manufactures part of the 
tangible personal property to which the computer software is affixed, 
the taxpayer may combine the direct labor and overhead for the computer 
software and tangible personal property produced or manufactured by the 
taxpayer in determining whether it meets the safe harbor.
    The final regulations provide that, in applying the safe harbor to 
an item for the taxable year, all computer software development costs, 
any cost of creating intangible assets for computer software or sound 
recordings, and section 174 costs (for computer software or sound 
recordings), including those paid or incurred in a prior taxable year, 
must be allocated over the estimated number of units of the item of 
which the taxpayer expects to dispose. An example of this rule is 
provided in the final regulations.
    The proposed regulations provide that an EAG member must take into 
account all of the previous MPGE or production activities of the other 
members of the EAG in determining whether its MPGE or production 
activities are substantial in nature. It has been suggested that this 
rule be modified to allow the EAG member to take into account all MPGE 
or production activities of the other EAG members rather than just the 
previous MPGE or production activities of the members. The final 
regulations do not adopt this suggestion because the IRS and Treasury 
Department believe that the EAG member must determine whether its MPGE 
or production activities meet the substantial-in-nature requirement at 
or before the time EAG member disposes of the property. Similar rules 
apply for purposes of the safe harbor under Sec.  1.199-3(g)(3)(i).
    Section 3.04(5)(d) of Notice 2005-14 generally provides that design 
and development activities must be disregarded in applying the general 
substantial-in-nature requirement and the safe harbor for tangible 
personal property. The proposed regulations clarify that research and 
experimental activities under section 174 and the creation of 
intangibles do not qualify as substantial in nature. A commentator 
questioned whether, with respect to tangible personal property, 
activities that constitute both an MPGE activity as well as a section 
174 activity must nonetheless be excluded from the determination of 
whether the taxpayer's MPGE of the QPP is substantial in nature because 
all section 174 activities are disregarded in making such a

[[Page 31274]]

determination. The IRS and Treasury Department continue to believe 
that, with the exception of computer software and sound recordings, it 
is not appropriate to include any section 174 activities in the 
determination of whether the MPGE of QPP is substantial in nature. 
However, the IRS and Treasury Department recognize that, although 
section 174 costs are not required to be capitalized under section 263A 
to the produced property, a taxpayer may capitalize such costs to the 
QPP under section 263A. Accordingly, the final regulations permit, as a 
matter of administrative convenience, a taxpayer to include such costs 
as CGS or unadjusted depreciable basis for purposes of the 20 percent 
safe harbor.
    A commentator asked that the final regulations clarify that gross 
receipts relating to computer software updates that are provided as 
part of a computer software maintenance contract qualify as DPGR if all 
of the requirements of section 199(c)(4) are met. The final regulations 
include an example demonstrating that gross receipts relating to 
computer software updates may qualify as DPGR even if the computer 
software updates are provided pursuant to a computer software 
maintenance agreement.
    The preamble to the proposed regulations states that the creation 
and licensing of copyrighted business information reports do not 
constitute the MPGE of QPP because the database is not QPP. However, it 
has come to the attention of the IRS and Treasury Department that some 
business information reports published by the taxpayer may qualify as 
QPP, for example, business information reports published by the 
taxpayer in books that qualify as QPP. Therefore, no inference should 
be drawn from the preamble to the proposed regulations as to whether 
business information reports qualify for the section 199 deduction.
    The proposed regulations provide in Sec.  1.199-3(f)(2) that QPP 
will be treated as MPGE in significant part by the taxpayer within the 
United States if the MPGE of the QPP by the taxpayer within the United 
States is substantial in nature taking into account all of the facts 
and circumstances, including the relative value added by, and relative 
cost of, the taxpayer's MPGE activity within the United States, the 
nature of the property, and the nature of the MPGE activity that the 
taxpayer performs within the United States.
    One commentator suggested that, if a taxpayer manufactures a key 
component of QPP and purchases the rest of the components, the fact 
that the taxpayer manufactured the key component should satisfy the 
substantial-in-nature requirement with respect to the QPP that 
incorporates the key component. For example, X manufactures computer 
chips within the United States. X installs the computer chips that it 
manufactures in computers that X purchases from unrelated persons and 
sells the finished computers individually to customers. Although the 
computer chips are key components of the computers and the computers 
will not operate without them, the manufacture of the key components 
does not, by itself, satisfy the substantial-in-nature requirement with 
respect to the finished computers and the taxpayer's activities with 
respect to the finished computers must meet either the substantial-in-
nature requirement under Sec.  1.199-3(g)(2) or the safe harbor under 
Sec.  1.199-3(g)(3) of the final regulations. The final regulations 
contain an example to illustrate this rule.
    In Example 4 in Sec.  1.199-3(f)(4) of the proposed regulations, X 
licenses a qualified film to Y for duplication of the film onto DVDs. Y 
purchases the DVDs from an unrelated person. The example concludes that 
unless Y satisfies the safe harbor under Sec.  1.199-3(f)(3) of the 
proposed regulations, Y's income for duplicating X's qualified film 
onto DVDs is non-DPGR because the duplication is not substantial in 
nature relative to the DVD with the film. One commentator disagreed 
with the conclusion in this example because duplicating a DVD may 
involve considerable activities. This example and other examples 
illustrating the substantial-in-nature requirement have been removed 
from the final regulations because the determination of what is 
substantial in nature is determined based on all the facts and 
circumstances. No inference should be drawn as to whether an activity 
is, or is not, substantial in nature by the removal of any example.

Derived From a Lease, Rental, License, Sale, Exchange, or Other 
Disposition

    Section 1.199-3(h)(1) of the proposed regulations provides that 
applicable Federal income tax principles apply to determine whether a 
transaction is, in substance, a lease, rental, license, sale, exchange, 
or other disposition of QPP, whether it is a service, or whether it is 
some combination thereof. In the preamble to the proposed regulations, 
the IRS and Treasury Department acknowledge that the short-term nature 
of a transaction does not, by itself, render the transaction a service 
for purposes of section 199 and that many transactions include both 
service and property rental elements. The preamble further states that 
not every transaction in which property is used in connection with 
providing a service to customers, however, constitutes a mixture of 
services and rental for which allocation of gross receipts is 
appropriate and provides an example of a video arcade that features 
video game machines that the taxpayer MPGE. The machines remain in the 
taxpayer's possession during the customers' use. The example concludes 
that gross receipts derived from customers' use of the machines at the 
taxpayer's arcade are not derived from the lease, rental, license, 
sale, exchange, or other disposition of the machines. Rather, the 
machines are used to provide a service and, thus, the gross receipts 
are non-DPGR. While the general rule stated in Sec.  1.199-3(h)(1) of 
the proposed regulations is retained in the final regulations under 
Sec.  1.199-(3)(I)(1), the preamble example is not included in the 
final regulations because the determination of whether a transaction is 
a service or a rental is based upon all the facts and circumstances. No 
inference should be drawn as to whether the transaction constitutes a 
service or rental (or some combination thereof) by the removal of the 
example.
    Section 1.199-3(h)(1) of the proposed regulations provides that the 
value of property received by a taxpayer in a taxable exchange of QPP 
MPGE in whole or in significant part within the United States, a 
qualified film produced by the taxpayer, or utilities produced by the 
taxpayer in the United States, for an unrelated person's property is 
DPGR for the taxpayer. However, unless the taxpayer meets all of the 
requirements under section 199 with respect to any further MPGE by the 
taxpayer of the QPP or any further production by the taxpayer of the 
film or utilities received in the taxable exchange, any gross receipts 
derived from the sale by the taxpayer of the property received in the 
taxable exchange are non-DPGR, because the taxpayer did not MPGE or 
produce such property, even if the property was QPP, a qualified film, 
or utilities in the hands of the other party to the transaction.
    A commentator requested that, with regard to certain taxable 
exchanges, the final regulations provide a safe harbor that would 
accommodate long-standing industry accounting practices for these 
exchanges. The final regulations provide a safe harbor whereby the 
gross receipts derived by the taxpayer from the sale of eligible 
property (as defined later) received in a taxable exchange, net of any 
adjustments between the parties

[[Page 31275]]

involved in the taxable exchange to account for differences in the 
eligible property exchanged (for example, location differentials and 
product differentials), may be treated as the value of the eligible 
property received by the taxpayer in the taxable exchange. In addition, 
if the taxpayer engages in any further MPGE or production activity with 
respect to the eligible property received in the taxable exchange, 
then, unless the taxpayer meets the in-whole-or-in significant-part 
requirement under Sec.  1.199-3(g)(1) with respect to the property 
sold, the taxpayer must also value the property sold without taking 
into account the gross receipts attributable to the further MPGE or 
production activity. The final regulations define eligible property as 
oil, natural gas, and petrochemicals, or products derived from oil, 
natural gas, petrochemicals, or any other property or product 
designated by publication in the Internal Revenue Bulletin. Under the 
safe harbor, the taxable exchange is deemed to occur on the date of the 
sale of the eligible property received in the exchange to the extent 
that the sale occurs no later than the last day of the month following 
the month in which the exchanged eligible property is received by the 
taxpayer.
    The proposed regulations provide that, in the case of gross 
receipts derived from a lease of QPP or a qualified film, the entire 
amount of the lease income, including any interest that is not 
separately stated, is considered derived from the lease of the QPP or 
qualified film. Commentators noted that many leases of personal 
property separately state a finance or interest component. The IRS and 
Treasury Department believe that Congress intended for all financing or 
interest components of a lease of qualifying property to be considered 
DPGR (assuming all the other requirements of section 199 are met). 
Accordingly, the final regulations provide that all financing and 
interest components of a lease of qualifying property are considered to 
be derived from the lease of such qualifying property.
    Section 1.199-3(h)(4) of the proposed regulations provides 
exceptions to the general rule that DPGR does not include gross 
receipts derived from services or nonqualifying property. The 
exceptions are for embedded qualified warranties, delivery, operating 
manuals, and installation. The final regulations retain these 
exceptions and provide a new exception for embedded computer software 
maintenance contracts. None of these exceptions, which allow gross 
receipts attributable to such embedded services and nonqualifying 
property to be treated as DPGR, is available if, in the normal course 
of the taxpayer's trade or business, the price for the service or 
nonqualifying property is separately stated or is separately offered to 
the customer.
    One commentator asked for clarification concerning the meaning of 
the term normal course of a taxpayer's trade or business and when 
something would be considered to be separately stated or separately 
offered to a customer. The purpose of the exceptions is to reduce the 
burden on a taxpayer of having to allocate a portion of its gross 
receipts to these commonly occurring types of services and property if 
the taxpayer does not normally price or offer such items separately. 
Whether a taxpayer separately offers or states the price for such an 
item in the normal course of its trade or business depends on the facts 
and circumstances. If, for example, a taxpayer separately states the 
price for installation for a few of its customers on a case by case 
basis, then the taxpayer may be considered to have not separately 
stated the price of installation in the normal course of its trade or 
business. The requirements have been changed in the final regulations 
to clarify that the normal-course-of-trade-or-business requirement 
applies to both the separately stated price prong and the separately 
offered prong of the embedded services and nonqualifying property 
rules.
    Several comments were received concerning the rule in the proposed 
regulations under which gross receipts attributable to advertising in 
newspapers, magazines, telephone directories, or periodicals may 
qualify as DPGR to the extent that the gross receipts, if any, derived 
from the disposition of those printed materials qualifies as DPGR. The 
final regulations clarify that this list is not limited to these four 
types of printed materials, and that the rule applies to other similar 
printed materials.
    Section 3 of Notice 2005-14 explains that the basis for the rule 
relating to advertising income is that such income is inextricably 
linked to the gross receipts (if any) derived from the disposition of 
the printed materials listed in the proposed regulations. After 
considering the comments received, the IRS and Treasury Department 
believe that the same reasoning applies in the case of a qualified film 
(for example, a television program). Accordingly, the rule for 
advertising has been extended in the final regulations to apply to 
qualified films. The wording of the advertising rule has been changed 
to clarify that the amount of gross receipts attributable to the 
disposition of the printed materials or qualified film does not limit 
the amount of gross receipts attributable to the advertising that may 
be treated as DPGR under the rule. In addition, the final regulations 
clarify that there need be no gross receipts attributable to the 
disposition of the printed materials or qualified film for the gross 
receipts from the advertising to qualify as DPGR.
    One commentator requested that the final regulations recognize that 
gross receipts derived from the sale of advertising slots in live or 
delayed television broadcasts (that are produced by the taxpayer and 
that otherwise meet the requirements for a qualified film) are DPGR. 
While live and delayed television programming may otherwise meet the 
requirements to be treated as a qualified film, in order for the gross 
receipts derived from advertising slots to be DPGR, there must also be 
a qualifying disposition of the qualified film. The IRS and Treasury 
Department continue to believe that a live or delayed television 
broadcast of a qualified film is not a lease, rental, license, sale, 
exchange or other disposition of the qualified film. Commentators 
noted, however, that if the live or delayed television programming is 
licensed to an unrelated cable company, then the license of the 
programming is a qualifying disposition that gives rise to DPGR and if 
the rule for advertising were extended to qualified films, then the 
portion of the advertising receipts relating to the license of the 
qualified film would also be DPGR. The IRS and Treasury Department 
agree with these comments, and the final regulations provide examples 
to clarify these points.

Qualifying Production Property

    Under Sec.  1.199-3(i)(5)(i) of the proposed regulations, if a 
taxpayer MPGE computer software or sound recordings that is affixed or 
added to tangible personal property by the taxpayer (for example, a 
computer diskette or an appliance), then the taxpayer may treat the 
tangible personal property as computer software or sound recordings, as 
applicable. A commentator questioned whether this rule should apply if, 
for example, a taxpayer hires an unrelated person to affix computer 
software or sound recordings produced by the taxpayer to a compact 
disc. In response to this comment, the final regulations have dropped 
the by-the-taxpayer requirement in this context. A similar rule has 
been provided for qualified films.

[[Page 31276]]

Qualified Films

    Section Sec.  1.199-3(j)(1) of the proposed regulations provides 
that, a qualified film means any motion picture film or video tape 
under section 168(f)(3), or live or delayed television programming, if 
not less than 50 percent of the total compensation paid to all actors, 
production personnel, directors, and producers relating to the 
production of the motion picture film, video tape, or television 
programming is compensation for services performed in the United States 
by those individuals. One commentator was concerned that the list of 
production personnel described under Sec.  1.199-3(j)(1) of the 
proposed regulations diminishes the general rule under Sec.  1.199-
3(j)(5) that compensation for services includes all direct and indirect 
compensation costs required to be capitalized under section 263A for 
film producers under Sec.  1.263A-1(e)(2) and (3). The commentator also 
stated that it may be difficult to determine which persons are 
production personnel. The final regulations under Sec.  1.199-3(k)(1) 
clarify that the list of production personnel is not exclusive, and 
that compensation for services includes all direct and indirect 
compensation costs required to be capitalized under Sec.  1.263A-
1(e)(2) and (3).
    In response to questions received by the IRS and Treasury 
Department, the final regulations clarify that actors may include 
players, newscasters, or any other persons performing in a qualified 
film. The final regulations also clarify that the not-less-than-50-
percent-of-the-total-compensation requirement is determined by 
reference to all compensation paid in the production of the film and is 
calculated using a fraction. The numerator of the fraction is the 
compensation paid by the taxpayer to actors, production personnel, 
directors, and producers for services relating to the production of the 
film (production services) performed in the United States, and the 
denominator is the sum of the total compensation paid by the taxpayer 
to all such individuals regardless of where the production services are 
performed and the total compensation paid by others to all such 
individuals regardless of where the production services are performed. 
The final regulations provide an example of this calculation.

Tangible Personal Property and Real Property

    Commentators requested that the final regulations define tangible 
personal property and real property for purposes of section 199. The 
final regulations define tangible personal property as any tangible 
property other than land, real property described in the construction 
rules in Sec.  1.199-3(m)(1), computer software described in Sec.  
1.199-3(j)(3), sound recordings described in Sec.  1.199-3(j)(4), a 
qualified film described in Sec.  1.199-3(k)(1), and utilities 
described in Sec.  1.199-3(l). In response to commentators' 
suggestions, the final regulations further define tangible personal 
property as also including any gas (other than natural gas described in 
Sec.  1.199-3(l)(2)), chemicals, and similar property, for example, 
steam, oxygen, hydrogen, and nitrogen.
    The final regulations define the term real property to mean 
buildings (including items that are structural components of such 
buildings), inherently permanent structures (as defined in Sec.  
1.263A-8(c)(3)) other than machinery (as defined in Sec.  1.263A-
8(c)(4)) (including items that are structural components of such 
inherently permanent structures), inherently permanent land 
improvements, oil and gas wells, and infrastructure (as defined in 
Sec.  1.199-3(m)(4)). Property MPGE by a taxpayer that is not real 
property in the hands of such taxpayer, but that may be incorporated 
into real property by another taxpayer, is not treated as real property 
by the producing taxpayer (for example, bricks, nails, paint, and 
windowpanes). Structural components of buildings and inherently 
permanent structures in