Qualified Films Under Section 199, 31478-31483 [E7-10821]

Agencies

• Internal Revenue Service
• DEPARTMENT OF THE TREASURY

[Federal Register Volume 72, Number 109 (Thursday, June 7, 2007)]
[Proposed Rules]
[Pages 31478-31483]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: E7-10821]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-103842-07]
RIN 1545-BG33


Qualified Films Under Section 199

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

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SUMMARY: This document contains proposed amendments to the regulations 
involving the deduction for income attributable to domestic production 
activities under section 199. The proposed amendments affect taxpayers 
who produce qualified films under section 199(c)(4)(A)(i)(II) and 
(c)(6) and taxpayers who are members of an expanded affiliated group 
under section 199(d)(4). This document also contains a notice of a 
public hearing on these proposed regulations.

DATES: Written or electronic comments must be received by September 5, 
2007. Outlines of topics to be discussed at the public hearing 
scheduled for October 2, 2007, must be received by September 11, 2007.

ADDRESSES: Send submissions to: CC:PA:LPD:PR (REG-103842-07), room 
5203, Internal Revenue Service, PO Box 7604, Ben Franklin Station, 
Washington, DC 20044. Submissions may be hand-delivered Monday through 
Friday between the hours of 8 a.m. and 4 p.m. to CC:PA:LPD:PR (REG-
103842-07), Courier's Desk, Internal Revenue Service, 1111 Constitution 
Avenue, NW., Washington, DC, or sent electronically, via the Federal 
eRulemaking Portal at www.regulations.gov (IRS-REG-103842-07). The 
public hearing will be held in the auditorium, Internal Revenue 
Building, 1111 Constitution Avenue, NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning Sec.  1.199-3(k) of the 
proposed regulations, David McDonnell, at (202) 622-3040; concerning 
Sec.  1.199-7 of the proposed regulations, Ken Cohen (202) 622-7790; 
concerning submissions of comments, the hearing, or to be placed on the 
building access list to attend the hearing, Richard Hurst at 
Richard.A.Hurst@irscounsel.treas.gov or (202) 622-7180 (not toll-free 
numbers).

SUPPLEMENTARY INFORMATION: 

Background

    This document contains proposed amendments to Sec. Sec.  1.199-3(k) 
and 1.199-7 of the Income Tax Regulations (26 CFR Part 1). Section 
1.199-3(k) relates to the definition of qualified film produced by the 
taxpayer under section 199(c)(4)(A)(i)(II) and (c)(6) of the Internal 
Revenue Code (Code) and Sec.  1.199-7 involves expanded affiliated 
groups under section 199(d)(4). 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), and amended by section 403(a) of the Gulf Opportunity 
Zone Act of 2005 (Pub. L. 109-135, 119 Stat. 25), section 514 of the 
Tax Increase Prevention and

[[Page 31479]]

Reconciliation Act of 2005 (Public Law 109-222, 120 Stat. 345), and 
section 401 of the Tax Relief and Health Care Act of 2006 (Pub. L. 109-
432, 120 Stat. 2922).

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).
    Section 199(c)(1) defines QPAI for any taxable year as an amount 
equal to the excess (if any) of (A) The taxpayer's domestic production 
gross receipts (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)(4)(A)(i) provides that the term DPGR means the 
taxpayer's gross receipts that are derived from any lease, rental, 
license, sale, exchange, or other disposition of (I) Qualifying 
production property (QPP) that was manufactured, produced, grown, or 
extracted 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 produced by the 
taxpayer in the United States.
    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(d)(4)(A) provides that all members of an expanded 
affiliated group (EAG) are treated as a single corporation for purposes 
of section 199. Under section 199(d)(4)(B), 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)(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).

Explanation of Provisions

Qualified Film Produced by the Taxpayer

    On June 1, 2006, final regulations (TD 9263) under section 199 were 
published in the Federal Register (71 FR 31268). Subsequent to the 
publication of the final regulations, the IRS and Treasury Department 
became aware that the definition of a qualified film produced by a 
taxpayer as outlined in the final regulations may not be consistent 
with the statute. Under section 199(c)(4)(A)(i)(II), a taxpayer's gross 
receipts qualify as DPGR if the receipts are derived from any lease, 
rental, license, sale, exchange, or other disposition of any qualified 
film (as defined in section 199(c)(6)) produced by the taxpayer. A film 
must be both a ``qualified film'' under section 199(c)(6) and 
``produced by the taxpayer'' under section 199(c)(4)(A)(i)(II) in order 
for the gross receipts to qualify as DPGR. Section 1.199-3(k)(5) of the 
final regulations addresses these two requirements by adding ``by the 
taxpayer'' to the not-less-than-50-percent-of-the-total-compensation 
requirement under Sec.  1.199-3(k)(1). However, under the test provided 
in Sec.  1.199-3(k)(5) of the final regulations, a film that was 
produced entirely within the United States could fail to qualify for 
the section 199 deduction if less than 50 percent of the total 
compensation relating to production was paid ``by the taxpayer.''
    The proposed regulations more closely follow the statutory language 
in section 199(c)(6) by revising the fraction in Sec.  1.199-3(k)(5) 
for determining the not-less-than-50-percent-of-the-total-compensation 
requirement under Sec.  1.199-3(k)(1). Under the fraction set forth in 
the proposed regulations, the numerator of the revised fraction is the 
compensation for services performed in the United States and the 
denominator is the total compensation for services regardless of where 
the production activities are performed. The revised fraction 
essentially compares (in the numerator) the sum of the compensation for 
services paid by the taxpayer for services performed in the United 
States and the compensation for services paid by others for services 
performed in the United States to (in the denominator) the sum of the 
total compensation for services paid by the taxpayer for services and 
the total compensation for services paid by others for services 
regardless of location. The proposed regulations also clarify in Sec.  
1.199-8(a) that, for purposes of Sec. Sec.  1.199-1 through 1.199-9, 
use of terms such as ``payment,'' ``paid,'' ``incurred,'' or ``paid or 
incurred'' is not intended to provide any specific rule based upon the 
use of one term versus another. In general, the use of the term 
``payment,'' ``paid,'' ``incurred,'' or ``paid or incurred'' is 
intended to convey the appropriate standard under the taxpayer's method 
of accounting.
    Under Sec.  1.199-3(k)(6) of the proposed regulations, a film that 
is a qualified film under Sec.  1.199-3(k)(1) will be treated as 
``produced by the taxpayer'' for purposes of section 
199(c)(4)(A)(i)(II) if the production activity performed by the 
taxpayer is substantial in nature within the meaning of Sec.  1.199-
3(g)(2). The special rules of Sec.  1.199-3(g)(4) regarding a contract 
with an unrelated person and aggregation apply in determining whether 
the taxpayer's production activity is substantial in nature. Section 
1.199-3(g)(2) and (4) are applied by substituting the term ``qualified 
film'' for QPP and disregarding the requirement that the production 
activity must be within the United States. Thus, a qualified film will 
be treated as produced by the taxpayer if the production of the 
qualified film by the taxpayer 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 production 
activity, the nature of the qualified film, and the nature of the 
production activity that the taxpayer performs.
    The rules provided in Sec.  1.199-3(k)(5) of the proposed 
regulations closely follow the statutory language in section 199(c)(6) 
by referencing all compensation for services related to the production 
as opposed to a more limited ``by the taxpayer'' compensation test. 
Commentators have expressed concern over the difficulty of obtaining 
information related to the compensation paid by others. In response to 
this concern, the IRS and Treasury Department have provided a safe 
harbor in Sec.  1.199-3(k)(7) of the proposed regulations provides a 
safe harbor that will treat a film as a qualified film if not less than 
50 percent of the total

[[Page 31480]]

compensation for services paid by the taxpayer is compensation for 
services performed in the United States. The safe harbor further 
provides that a qualified film will be treated as produced by the 
taxpayer if the taxpayer satisfies the safe harbor in Sec.  1.199-
3(g)(3) with respect to the qualified film, which requires that the 
direct labor and overhead costs incurred by the taxpayer to produce the 
qualified film within the United States account for 20 percent or more 
of the total costs of the film.
    Similar to Sec.  1.199-3(k)(6) of the proposed regulations, the 
special rules of Sec.  1.199-3(g)(4) regarding a contract with an 
unrelated person and aggregation apply in determining whether the 
taxpayer satisfies Sec.  1.199-3(g)(3). Section 1.199-3(g)(3) and (4) 
are applied by substituting the term ``qualified film'' for QPP but not 
disregarding the requirement that the direct labor and overhead of the 
taxpayer to produce the qualified film must be within the United 
States. Thus, a taxpayer will be treated as having produced a qualified 
film if, in connection with the qualified film, the direct labor and 
overhead of the taxpayer to produce the qualified film within the 
United States account for 20 percent or more of the taxpayer's CGS of 
the qualified film, 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'' (as defined in Sec.  1.199-
3(g)(3)(ii)) in the qualified film.

Expanded Affiliated Groups

    After issuance of the final regulations, several commentators noted 
that Sec.  1.199-7(e), Example 10, of the final regulations misapplies 
Sec.  1.1502-13 of the consolidated return regulations. In Example 10, 
a member of a consolidated group sells QPP to another member of the 
consolidated group. Before the QPP is sold to an unrelated party, the 
purchasing corporation is disaffiliated from the consolidated group. 
Example 10 provides that neither the selling corporation nor the 
purchasing corporation has DPGR. After further consideration, the IRS 
and Treasury Department have determined that Example 10 does not 
properly apply Sec.  1.1502-13 of the consolidated return regulations 
and that both the selling corporation and the purchasing corporation 
have DPGR in the facts described. Accordingly, the proposed regulations 
remove Example 10 of the final regulations and replace it with a new 
Example 10, properly applying Sec.  1.1502-13 of the consolidated 
return regulations.
    In addition, the IRS and Treasury Department discovered a problem 
concerning the section 199 closing of the books method under Sec.  
1.199-7(f)(1)(ii) of the final regulations. A corporation that becomes 
or ceases to be a member of an EAG during its taxable year must 
allocate its taxable income or loss, QPAI, and W-2 wages between the 
portion of the taxable year that it is a member of the EAG and the 
portion of the taxable year that it is not a member of the EAG. In 
general, this allocation is made by using the pro rata allocation 
method described in Sec.  1.199-7(f)(1)(i) of the final regulations. 
Section 1.199-7(f)(1)(ii) provides that in lieu of the pro rata 
allocation method, a corporation may elect to apply the section 199 
closing of the books method under which a corporation treats its 
taxable year as two separate taxable years, the first of which ends at 
the close of the day on which the corporation's status as a member of 
the EAG changes and the second of which begins at the beginning of the 
day after the corporation's status as a member of the EAG changes.
    In certain situations, the section 199 closing of the books method 
can create a larger section 199 deduction than is warranted. The facts 
of the Example in Sec.  1.199-7(g)(3) of the final regulations 
demonstrate such a situation. In the Example, Corporations X and Y, 
calendar year corporations, are members of the same EAG for the entire 
2007 taxable year. Corporation Z, also a calendar year corporation, is 
a member of the EAG of which X and Y are members for the first half of 
2007 and not a member of any EAG for the second half of 2007. During 
the 2007 taxable year, Z does not join in the filing of a consolidated 
return. Z makes a section 199 closing of the books election. As a 
result, Z has $80 of taxable income and $100 of QPAI that is allocated 
to the first half of 2007 and a $150 taxable loss and ($200) of QPAI 
that is allocated to the second half of 2007. In addition to the facts 
presented in the Example, assume that X and Y each have $60 of taxable 
income and QPAI in 2007, Z has $170 of taxable income and QPAI in 2008, 
and that X, Y, and Z each have W-2 wages in excess of the section 
199(b) wage limitation for all relevant periods. After applying the 
section 199 closing of the books method, the EAG has $200 of taxable 
income and $220 of QPAI in 2007. Accordingly, the EAG will have a 
section 199 deduction of $12 (6 percent of the lesser of the EAG's $200 
of taxable income and $220 of QPAI). Z, as a stand-alone corporation 
for the second half of 2007, will have both negative taxable income and 
negative QPAI and therefore will have no section 199 deduction. In 
2008, notwithstanding that Z made a section 199 closing of the books 
election pursuant to which Z is deemed to have a $150 taxable loss for 
the second half of 2007, for purposes of computing its taxable income 
in 2008, Z only has a $70 NOL carryover from 2007. Accordingly, Z will 
have taxable income of $100 in 2008 and will have a section 199 
deduction of $6 (6 percent of the lesser of its $100 of taxable income 
and $170 of QPAI). Because X and Y had a total of $120 of taxable 
income and Z had total taxable income in 2007 and 2008 of $100, the 
maximum aggregate section 199 deduction should have been $13.20 (6 
percent of the aggregate taxable income of X, Y, and Z of $220), 
instead of the aggregate $18 deduction derived in the above example 
because of the use of the section 199 closing of the books method. The 
section 199 closing of the books method effectively eliminated $80 of 
Z's losses from being used to offset taxable income for purposes of the 
section 199 deduction in either 2007 or 2008.
    The proposed regulations remove the section 199 closing of the 
books method and revise the Example in Sec.  1.199-7(g)(3) to apply the 
pro rata allocation method. However, the IRS and Treasury Department 
invite comments concerning the necessity for a section 199 closing of 
the books method and suggestions under which a section 199 closing of 
the books election would be allowable, provided that the election does 
not create an unwarranted section 199 deduction nor does it impose an 
undue burden on either taxpayers or the government.

Proposed Effective Date

    Sections 1.199-3(k), 1.199-7(e), Example 10, and 1.199-7(f)(1) are 
proposed to be applicable to taxable years beginning on or after the 
date the final regulations are published in the Federal Register. Until 
the date the final regulations are published in the Federal Register, 
taxpayers may rely on Sec.  1.199-3(k) and Sec.  1.199-7(e), Example 
10, of the proposed regulations for taxable years beginning after 
December 31, 2004. However, for taxable years beginning before June 1, 
2006, a taxpayer may rely on Sec.  1.199-3(k) of the proposed 
regulations only if the taxpayer does not apply Notice 2005-14 (2005-1 
C.B. 498) (see Sec.  601.601(d)(2)) or REG-105847-05 (2005-2 CB 987) 
(see Sec.  601.601(d)(2)(ii)(b)) to the taxable year.

Special Analyses

    It has been determined that this notice of proposed rulemaking is 
not a

[[Page 31481]]

significant regulatory action as defined in Executive Order 12866. 
Therefore, a regulatory assessment is not required. It also has been 
determined that section 553(b) of the Administrative Procedure Act (5 
U.S.C. chapter 5) does not apply to these regulations, and because the 
regulations do not impose a collection of information on small 
entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not 
apply. Pursuant to section 7805(f) of the Code, this notice of proposed 
rulemaking has been submitted to the Chief Counsel for Advocacy of the 
Small Business Administration for comment on their impact on small 
business.

Comments and Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any written comments (a signed original 
and eight (8) copies) or electronic comments that are submitted timely 
to the IRS. Comments are requested on all aspects of the proposed 
regulations. In addition, the IRS and Treasury Department specifically 
request comments on the clarity of the proposed rules and how they can 
be made easier to understand. All comments will be available for public 
inspection and copying.
    A public hearing has been scheduled for October 2, 2007, at 10 a.m. 
in the auditorium of the Internal Revenue Building, 1111 Constitution 
Avenue, NW., Washington, DC. Because of access restrictions, visitors 
will not be admitted beyond the Internal Revenue Building lobby more 
than 30 minutes before the hearing starts. Due to building security 
procedures, visitors must enter at the Constitution Avenue entrance. In 
addition, all visitors must present photo identification to enter the 
building. For information about having your name placed on the building 
access list to attend the hearing, see the FOR FURTHER INFORMATION 
CONTACT section of this preamble.
    The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons who 
wish to present oral comments at the hearing must submit electronic or 
written comments by September 5, 2007 and submit an outline of the 
topics to be discussed and the time to be devoted to each topic (signed 
original and eight (8) copies) by September 11, 2007. A period of 10 
minutes will be allotted to each person for making comments. An agenda 
showing the scheduling of the speakers will be prepared after the 
deadline for receiving outlines has passed. Copies of the agenda will 
be available free of charge at the hearing.

Drafting Information

    The principal authors of these regulations are Lauren Ross Taylor 
and David M. McDonnell, Office of the Associate Chief Counsel 
(Passthroughs and Special Industries), IRS. However, other personnel 
from the IRS and Treasury Department participated in their development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

    Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1--INCOME TAXES

    Paragraph 1. The authority citation for part 1 continues to read, 
in part, as follows:

    Authority: 26 U.S.C. 7805 * * *

    Section 1.199-3 also issued under 26 U.S.C. 199(d). * * *
    Section 1.199-7 also issued under 26 U.S.C. 199(d). * * *
    Section 1.199-8 also issued under 26 U.S.C. 199(d). * * *
    Par. 2. Section 1.199-3 is amended by:
    1. Revising paragraphs (k)(1), (k)(4), and (k)(5).
    2. Redesignating paragraph (k)(6) as (k)(9).
    3. Redesignating paragraph (k)(7) as (k)(10).
    4. Adding new paragraphs (k)(6), (k)(7), and (k)(8).
    5. Revising Example 6 of newly designated paragraph (k)(10).
    The revisions and additions read as follows:


Sec.  1.199-3  Domestic production gross receipts.

* * * * *
    (k) * * *
    (1) In general. The term qualified film means any motion picture 
film or video tape under section 168(f)(3), or live or delayed 
television programming (film), if not less than 50 percent of the total 
compensation relating to the production of such film is compensation 
for services performed in the United States by actors, production 
personnel, directors, and producers. For purposes of this paragraph 
(k), the term actors includes players, newscasters, or any other 
persons who are compensated for their performance or appearance in a 
film. For purposes of this paragraph (k), the term production personnel 
includes writers, choreographers and composers who are compensated for 
providing services during the production of a film, as well as casting 
agents, camera operators, set designers, lighting technicians, make-up 
artists, and other persons who are compensated for providing services 
that are directly related to the production of the film. Except as 
provided in paragraph (k)(2) of this section, the definition of a 
qualified film does not include tangible personal property embodying 
the qualified film, such as DVDs or videocassettes.
* * * * *
    (4) Compensation for services. For purposes of this paragraph (k), 
the term compensation for services means all payments for services 
performed by actors, production personnel, directors, and producers 
relating to the production of the film, including participations and 
residuals. Payments for services include all elements of compensation 
as provided for in Sec.  1.263A-1(e)(2)(i)(B) and (3)(ii)(D). 
Compensation for services is not limited to W-2 wages and includes 
compensation paid to independent contractors. In the case of a taxpayer 
that uses the income forecast method of section 167(g) and capitalizes 
participations and residuals into the adjusted basis of the qualified 
film, the taxpayer must use the same estimate of participations and 
residuals in determining compensation for services. In the case of a 
taxpayer that excludes participations and residuals from the adjusted 
basis of the qualified film under section 167(g)(7)(D)(i), the taxpayer 
must use the amount expected to be paid as participations and residuals 
based on the total forecasted income used in determining income 
forecast depreciation in determining compensation for services.
    (5) Determination of 50 percent. The not-less-than-50-percent-of-
the-total-compensation requirement under paragraph (k)(1) of this 
section is calculated using a fraction. The numerator of the fraction 
is the compensation for services performed in the United States and the 
denominator is the total compensation for services regardless of where 
the production activities are performed. A taxpayer may use any 
reasonable method that is satisfactory to the Secretary based on all of 
the facts and circumstances, including all historic information 
available, to determine the compensation for services performed in the 
United States and the total compensation for services regardless of 
where the production activities are performed. Among the factors to be 
considered in determining whether a taxpayer's method of allocating 
compensation is reasonable is whether

[[Page 31482]]

the taxpayer uses that method consistently from one taxable year to 
another.
    (6) Produced by the taxpayer. A qualified film will be treated as 
produced by the taxpayer for purposes of section 199(c)(4)(A)(i)(II) if 
the production activity performed by the taxpayer is substantial in 
nature within the meaning of paragraph (g)(2) of this section. The 
special rules of paragraph (g)(4) of this section regarding a contract 
with an unrelated person and aggregation apply in determining whether 
the taxpayer's production activity is substantial in nature. Paragraphs 
(g)(2) and (4) of this section are applied by substituting the term 
qualified film for QPP and disregarding the requirement that the 
production activity must be within the United States. The production 
activity of the taxpayer must consist of more than the minor or 
immaterial combination or assembly of two or more components of a film. 
For purposes of paragraph (g)(2) of this section, the relative value 
added by affixing trademarks or trade names as defined in Sec.  1.197-
2(b)(10)(i) will be treated as zero.
    (7) Qualified film produced by the taxpayer--safe harbor. A film 
will be treated as a qualified film under paragraph (k)(1) of this 
section and produced by the taxpayer under paragraph (k)(6) of this 
section (qualified film produced by the taxpayer) if the taxpayer meets 
the requirements of paragraphs (k)(7)(i) and (ii) of this section. A 
taxpayer that chooses to use this safe harbor must apply all the 
provisions of this paragraph (k)(7).
    (i) Safe harbor. A film will be treated as a qualified film 
produced by the taxpayer if not less than 50 percent of the total 
compensation for services paid by the taxpayer is compensation for 
services performed in the United States and the taxpayer satisfies the 
safe harbor in paragraph (g)(3) of this section. The special rules of 
paragraph (g)(4) of this section regarding a contract with an unrelated 
person and aggregation apply in determining whether the taxpayer 
satisfies paragraph (g)(3) of this section. Paragraphs (g)(3) and (4) 
of this section are applied by substituting the term qualified film for 
QPP but not disregarding the requirement that the direct labor and 
overhead of the taxpayer to produce the qualified film must be within 
the United States. Paragraph (g)(4)(ii)(A) of this section includes any 
election under section 181.
    (ii) Determination of 50 percent. The not-less-than-50-percent-of-
the-total-compensation requirement under paragraph (k)(7)(i) of this 
section is calculated using a fraction. The numerator of the fraction 
is the compensation for services paid by the taxpayer for services 
performed in the United States and the denominator is the total 
compensation for services paid by the taxpayer regardless of where the 
production activities are performed. For purposes of this paragraph 
(k)(7)(ii), the term paid by the taxpayer includes amounts that are 
treated as paid by the taxpayer under paragraph (g)(4) of this section. 
A taxpayer may use any reasonable method that is satisfactory to the 
Secretary based on all of the facts and circumstances, including all 
historic information available, to determine the compensation for 
services paid by the taxpayer for services performed in the United 
States and the total compensation for services paid by the taxpayer 
regardless of where the production activities are performed. Among the 
factors to be considered in determining whether a taxpayer's method of 
allocating compensation is reasonable is whether the taxpayer uses that 
method consistently from one taxable year to another.
    (8) Production pursuant to a contract. With the exception of the 
rules applicable to an expanded affiliated group (EAG) under Sec.  
1.199-7 and EAG partnerships under Sec.  1.199-3T(i)(8), only one 
taxpayer may claim the deduction under Sec.  1.199-1(a) with respect to 
any activity related to the production of a qualified film performed in 
connection with the same qualified film. If one taxpayer performs a 
production activity pursuant to a contract with another party, then 
only the taxpayer that has the benefits and burdens of ownership of the 
qualified film under Federal income tax principles during the period in 
which the production activity occurs is treated as engaging in the 
production activity.
* * * * *
    (10) * * *

    Example 6. X creates a television program in the United States 
that includes scenes from films licensed by X from unrelated persons 
Y and Z. Assume that Y and Z produced the films licensed by X. The 
not-less-than-50-percent-of-the-total-compensation requirement under 
paragraph (k)(1) of this section is determined by reference to all 
compensation for services paid in the production of the television 
program, including the films licensed by X from Y and Z, and is 
calculated using a fraction as described in paragraph (k)(5) of this 
section. The numerator of the fraction is the compensation for 
services performed in the United States and the denominator is the 
total compensation for services regardless of where the production 
activities are performed. However, for purposes of calculating the 
denominator, in determining the total compensation paid by Y and Z, 
X need only include the total compensation paid by Y and Z to 
actors, production personnel, directors, and producers for the 
production of the scenes used by X in creating its television 
program.

    Par. 3. Section 1.199-7 is amended by:
    1. Revising Example 10 of paragraph (e).
    2. Revising paragraphs (f)(1) and (g)(3).
    The revisions read as follows:


Sec.  1.199-7  Expanded affiliated groups.

* * * * *
    (e) * * *

    Example 10. (i) Facts. Corporation P owns all of the stock of 
Corporations S and B. P, S, and B file a consolidated Federal income 
tax return on a calendar year basis. P, S, and B each use the 
section 861 method for allocating and apportioning their deductions. 
In 2010, S MPGE QPP in the United States at a cost of $1,000. On 
November 30, 2010, S sells the QPP to B for $2,500. On February 28, 
2011, P sells 60% of the stock of B to X, an unrelated person. On 
June 30, 2011, B sells the QPP to U, another unrelated person, for 
$3,000.
    (ii) Consolidated group's 2010 QPAI. Because S and B are members 
of a consolidated group in 2010, pursuant to Sec.  1.199-7(d)(1) and 
Sec.  1.1502-13, neither S's $1,500 of gain on the sale of QPP to B 
nor S's $2,500 gross receipts from the sale are taken into account 
in 2010. Accordingly, neither S nor B has QPAI in 2010.
    (iii) Consolidated group's 2011 QPAI. B becomes a nonmember of 
the consolidated group at the end of the day on February 28, 2011, 
the date on which P sells 60% of the B stock to X. Under Sec.  
1.199-7(d)(1) and Sec.  1.1502-13(d), S takes the intercompany 
transaction into account immediately before B becomes a non-member 
of the consolidated group. Pursuant to Sec.  1.1502-
13(d)(1)(ii)(A)(1), because the QPP is owned by B, a nonmember of 
the consolidated group immediately after S's gain is taken into 
account, B is treated as selling the QPP to a nonmember for $2,500, 
B's adjusted basis in the property, immediately before B becomes a 
nonmember of the consolidated group. Accordingly, immediately before 
B becomes a nonmember of the consolidated group, S takes into 
account $1,500 of QPAI (S's $2,500 DPGR received from B-S's $1,000 
cost of MPGE the QPP).
    (iv) B's 2011 QPAI. Pursuant to Sec.  1.1502-13(d)(2)(i)(B), the 
attributes of B's corresponding item, that is, its sale of the QPP 
to U, are determined as if the S division (but not the B division) 
were transferred by the P, S, and B consolidated group (treated as a 
single corporation) to an unrelated person. Thus, S's activities in 
MPGE the QPP before the intercompany sale of the QPP to B continue 
to affect the attributes of B's sale of the QPP. As such, B is 
treated as having MPGE the QPP. Accordingly, upon its sale of the 
QPP, B has $500 of QPAI (B's $3,000 DPGR received from U-B's $2,500 
cost of MPGE the QPP).
* * * * *


[[Page 31483]]


    (f) Allocation of income and loss by a corporation that is a member 
of the expanded affiliated group for only a portion of the year--(1) In 
general. A corporation that becomes or ceases to be a member of an EAG 
during its taxable year must allocate its taxable income or loss, QPAI, 
and W-2 wages between the portion of the taxable year that it is a 
member of the EAG and the portion of the taxable year that it is not a 
member of the EAG. This allocation of items is made by using the pro 
rata allocation method described in this paragraph (f)(1). Under the 
pro rata allocation method, an equal portion of a corporation's taxable 
income or loss, QPAI, and W-2 wages for the taxable year is assigned to 
each day of the corporation's taxable year. Those items assigned to 
those days that the corporation was a member of the EAG are then 
aggregated.
* * * * *
    (g) * * *
    (3) Example. The following example illustrates the application of 
paragraphs (f) and (g) of this section:

    Example. (i) Facts. Corporations X and Y, calendar year 
corporations, are members of the same EAG for the entire 2010 
taxable year. Corporation Z, also a calendar year corporation, is a 
member of the EAG of which X and Y are members for the first half of 
2010 and not a member of any EAG for the second half of 2010. During 
the 2010 taxable year, neither X, Y, nor Z join in the filing of a 
consolidated Federal income tax return. Assume that X, Y, and Z each 
have W-2 wages in excess of the section 199(b) wage limitation for 
all relevant periods. In 2010, X has taxable income of $2,000 and 
QPAI of $600, Y has a taxable loss of $400 and QPAI of ($200), and Z 
has taxable income of $1,400 and QPAI of $2,400.
    (ii) Analysis. Pursuant to the pro rata allocation method, $700 
of Z's 2010 taxable income and $1,200 of Z's 2010 QPAI are allocated 
to the first half of the 2010 taxable year (the period in which Z is 
a member of the EAG) and $700 of Z's 2010 taxable income and $1,200 
of Z's 2010 QPAI are allocated to the second half of the 2010 
taxable year (the period in which Z is not a member of any EAG). 
Accordingly, in 2010, the EAG has taxable income of $2,300 (X's 
$2,000 + Y's ($400) + Z's $700) and QPAI of $1,600 (X's $600 + Y's 
($200) + Z's $1,200). The EAG's section 199 deduction for 2010 is 
therefore $144 (9% of the lesser of the EAG's $2,300 of taxable 
income or $1,600 of QPAI). Pursuant to Sec.  1.199-7(c)(1), this 
$144 deduction is allocated to X, Y, and Z in proportion to their 
respective QPAI. Accordingly, X is allocated $48 of the EAG's 
section 199 deduction, Y is allocated $0 of the EAG's section 199 
deduction, and Z is allocated $96 of the deduction. For the second 
half of 2010, Z has taxable income of $700 and QPAI of $1,200. 
Therefore, for the second half of 2010, Z has a section 199 
deduction of $63 (9% of the lesser of its $700 taxable income or 
$1,200 QPAI for the second half of 2010). Accordingly, X's 2010 
section 199 deduction is $48, Y's 2010 section 199 deduction is $0, 
and Z's 2010 section 199 deduction is $159, the sum of the $96 
section 199 deduction of the EAG allocated to Z for the first half 
of 2010 and Z's $63 section 199 deduction for the second half of 
2010.

    Par. 4. Section 1.199-8 is amended by:
    1. Adding two sentences at the end of paragraph (a).
    2. Adding new paragraphs (i)(8) and (i)(9).
    The revisions and additions read as follows:


Sec.  1.199-8  Other rules.

    (a) * * * For purposes of Sec. Sec.  1.199-1 through 1.199-9, use 
of terms such as payment, paid, incurred, or paid or incurred is not 
intended to provide any specific rule based upon the use of one term 
versus another. In general, the use of the term payment, paid, 
incurred, or paid or incurred is intended to convey the appropriate 
standard under the taxpayer's method of accounting.
* * * * *
    (i) * * *
    (8) Qualified film produced by the taxpayer. Section 1.199-3(k) is 
proposed to be applicable to taxable years beginning on or after the 
date the final regulations are published in the Federal Register. Until 
the date the final regulations are published in the Federal Register, 
taxpayers may rely on Sec.  1.199-3(k) of these proposed regulations 
for taxable years beginning after December 31, 2004. However, for 
taxable years beginning before June 1, 2006, a taxpayer may rely on 
Sec.  1.199-3(k) of the proposed regulations only if the taxpayer does 
not apply Notice 2005-14 (2005-1 CB 498) (see Sec.  
601.601(d)(2)(ii)(b) of this chapter) or REG-105847-05 (2005-2 CB 987) 
(see Sec.  601.601(d)(2)(ii)(b) of this chapter) to the taxable year.
    (9) Expanded affiliated groups. Section 1.199-7(e), Example 10, and 
Sec.  1.199-7(f)(1) are proposed to be applicable to taxable years 
beginning on or after the date the final regulations are published in 
the Federal Register. Until the date the final regulations are 
published in the Federal Register, taxpayers may rely on Sec.  1.199-
7(e), Example 10, of these proposed regulations for taxable years 
beginning after December 31, 2004.

Kevin M. Brown,
Deputy Commissioner for Services and Enforcement.
 [FR Doc. E7-10821 Filed 6-6-07; 8:45 am]
BILLING CODE 4830-01-P