[Federal Register Volume 71, Number 105 (Thursday, June 1, 2006)]
[Rules and Regulations]
[Pages 31268-31333]
From the Federal Register Online via the Government Publishing 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  

[[Page 31268]]


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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 include property such as walls, partitions, doors, 
wiring, plumbing, central air conditioning and heating systems, pipes 
and ducts, elevators and escalators, and other similar property. In 
addition, an entire utility plant including both the shell and the 
interior will be treated as an inherently permanent structure.

Construction of Real Property

    One commentator recommended that DPGR derived from the construction 
of real property as well as DPGR from engineering and architectural 
services for a construction project include W-2 wages earned as an 
employee. At the time the taxpayer performs construction activities, or 
engineering or architectural services, the taxpayer must be engaged in 
a trade or business that is considered construction, engineering or 
architectural services for purposes of the North American Industry 
Classification System (NAICS). W-2 wages earned by an employee are not 
earned in connection with a trade or business that is considered 
construction, or engineering or architectural services, for purposes of 
the NAICS. Consequently, this recommendation has not been adopted in 
the final regulations.
    The proposed regulations include within the definition of 
construction services activities relating to drilling an oil well and 
mining pursuant to which the taxpayer could deduct intangible drilling 
and development costs under section 263(c) and Sec.  1.612-4, and 
development expenditures for a mine or natural deposit under section 
616. The IRS and Treasury Department are aware that in many situations 
taxpayers provide these services with respect to property owned by 
another party, and therefore such taxpayers are ineligible to claim the 
deductions for such costs under the provisions described above. The 
language of the final regulations has been changed to clarify that 
taxpayers providing such services are engaging in construction services 
that may qualify under section 199.
    The preamble to the proposed regulations states that commentators 
requested that qualifying construction activities include construction 
activities related to oil and gas wells. The preamble further states 
that the proposed regulations provide as a matter of administrative 
grace that qualifying construction activities include activities 
relating to drilling an oil well. Similarly, under Sec.  1.199-3(l)(2) 
of the proposed regulations, construction activities include activities 
relating to drilling an oil well. A commentator noted the inadvertent 
omission of gas wells and the final regulations correct the omission.
    The proposed regulations provide that DPGR does not include gross 
receipts attributable to the sale or other disposition of land 
(including zoning, planning, entitlement costs, and other costs 
capitalized into the land such as grading and demolition of structures 
under section 280B). Commentators contended that grading and demolition 
are construction-related activities, and that gross receipts 
attributable to these activities should qualify as DPGR. After 
considering the comments, the IRS and Treasury Department believe it is 
appropriate to apply to grading and demolition activities the same rule 
that the proposed regulations apply to other construction activities, 
such as landscaping and painting. Accordingly, services such as 
grading, demolition, clearing, excavating, and any other activities 
that physically transform the land are activities constituting 
construction only if these services are performed in connection with 
other activities (whether or not by the same taxpayer) that constitute 
the erection or substantial renovation of real property. The IRS and 
Treasury Department

[[Page 31277]]

continue to believe that gross receipts attributable to the sale or 
other disposition of land (including zoning, planning, and entitlement 
costs) are properly considered gross receipts attributable to the land, 
not to a qualifying construction activity, and, therefore, are non-
DPGR.
    In response to a suggestion by a commentator, the final regulations 
provide that a taxpayer engaged in a construction activity must make a 
reasonable inquiry or a reasonable determination whether the activity 
relates to the erection or substantial renovation of real property in 
the United States.
    The proposed regulations contain an example of an electrical 
contractor who purchases wires, conduits, and other electrical 
materials that the contractor installs in construction projects in the 
United States and that are considered structural components. The 
example concludes that the gross receipts that the contractor derives 
from installing these materials are derived from construction, but that 
the gross receipts attributable to the purchased materials are not. 
Commentators objected to this result, contending that it places an 
unreasonable administrative burden on taxpayers performing construction 
activities. The final regulations, including the example, provide that, 
in such circumstances, the taxpayer performing the construction 
services is not required to allocate gross receipts to the purchased 
materials and treat such gross receipts as non-DPGR, provided the 
materials and supplies are consumed in the construction project or 
become part of the constructed real property.
    Section 199(c)(4)(A), as amended by the GOZA, requires that a 
taxpayer be engaged in the active conduct of a construction trade or 
business for the taxpayer's construction activity to qualify under 
section 199. The proposed regulations provide that a taxpayer may not 
treat as DPGR gross receipts derived from construction unless the 
taxpayer is engaged in a construction trade or business on a regular 
and ongoing basis. Commentators expressed concern that this requirement 
would preclude construction project-specific joint ventures or 
partnerships, a common business structure in the construction industry, 
from qualifying under section 199. Typically, such entities are formed 
for the purpose of a specific construction project, and are terminated 
or dissolved when the project is completed. The final regulations 
continue to require that a taxpayer be engaged in a regular and ongoing 
construction trade or business, but provide a safe harbor rule under 
which entities formed specifically for purposes of a particular 
construction project may qualify. Under the safe harbor rule, if a 
taxpayer is engaged in a construction trade or business, then the 
taxpayer will be considered to be engaged in such trade or business on 
a regular and ongoing basis if the taxpayer derives gross receipts from 
an unrelated person by selling or exchanging the constructed real 
property within 60 months of the date on which construction is 
complete.
    Commentators also expressed concern that taxpayers would not meet 
the requirement of being engaged in a construction business on a 
regular and ongoing basis if the taxpayer is newly-formed or otherwise 
is in the first taxable year of a new construction trade or business. 
Although some taxpayers may meet the regular-and-ongoing-business 
requirement under the safe harbor rule discussed previously, the final 
regulations provide that, in the case of a newly-formed trade or 
business or a taxpayer in its first taxable year, the taxpayer will 
satisfy the regular-and-ongoing-basis requirement if it reasonably 
expects to be engaged in a construction trade or business on a regular 
and ongoing basis.
    The IRS and Treasury Department received a comment requesting 
clarification of the land safe harbor of Sec.  1.199-3(l)(5)(ii) of the 
proposed regulations. Under the land safe harbor, the taxpayer is 
permitted to allocate gross receipts between real property other than 
land, and land, according to a formula. The taxpayer must reduce gross 
receipts by the costs of the land and any other costs capitalized to 
the land, plus a percentage of those costs, and costs related to DPGR 
must be reduced by the costs of the land and any other costs 
capitalized to the land. The percentage ranges from 5 to 15 percent, 
depending upon the length of time the taxpayer held the land. The 
commentator asked whether the holding period of a previous owner of the 
land would be attributed to the new owner, and what rules apply for 
purposes of computing the new owner's cost basis. Generally, if an 
existing provision of the Code or regulations would apply to require 
attribution of the holding period of a previous owner of property to a 
new owner, the same rules will apply in the case of a previous owner's 
holding period in land for purposes of the land safe harbor rule of 
section 199. For example, the holding period of the previous owner (P) 
would carry over to the new owner (N) under existing Federal income tax 
principles if P were a partner in partnership N, and P contributed the 
land to N. The same result would apply if, instead, the land was 
distributed by partnership P to N, its partner. In the case of 
partnership or other pass-thru entity, the land safe harbor is applied 
at the partnership or other pass-thru entity level and is not applied 
at the partner or owner level.
    With regard to the land safe harbor discussed in the preceding 
paragraph, the proposed regulations state that the length of time a 
taxpayer is deemed to hold the land begins on the date the taxpayer 
acquires the land, including the date the taxpayer enters into the 
first option to acquire all or a portion of the land, and ends on the 
date the taxpayer sells each item of real property on the land. 
Commentators stated that development of the land generally does not 
begin until the land is acquired and any option to acquire land is 
based on the land's fair market value. Because developers are paying 
fair market value, the commentators suggested that the period for 
determining the percentage should not include any option period. The 
IRS and Treasury Department generally agree with the commentator's 
suggestion, and the final regulations do not include the option period 
except where the option does not include provisions to adjust the 
purchase price to approximate fair market value.
    Example 1 in Sec.  1.199-3(m)(5)(iii) of the proposed regulations 
provides that X, who is in a construction trade or business under NAICS 
Code 23 on a regular and ongoing basis, purchases a building and 
retains Y, a general contractor, to perform construction services in 
connection with a substantial renovation of the building. The example 
concludes that X's gross receipts derived from the disposition of the 
building are non-DPGR, and that Y's gross receipts from amounts paid to 
it by X are DPGR. In addition, the example illustrates that gross 
receipts of subcontractors hired by Y qualify as DPGR. Some 
commentators inferred from this example that the taxpayer must, at a 
minimum, be a legally designated general contractor before its gross 
receipts may qualify as DPGR. The example was not intended to imply 
that a taxpayer must be a licensed general contractor. The final 
regulations clarify that activities constituting construction include 
activities typically performed by a general contractor, or that 
constitute general contractor-level work, such as activities relating 
to management and oversight of the construction process (for example, 
approvals, periodic inspection of the progress of the construction 
project, and required job modifications). The example has been modified 
in the final regulations to illustrate that the person

[[Page 31278]]

hired by the building owner, although not a licensed general 
contractor, qualifies as engaging in construction activities by virtue 
of providing management and oversight of the construction process.
    Several commentators recommended that the final regulations provide 
that, for purposes of the de minimis exception of Sec.  1.199-
3(l)(5)(ii) (regarding construction services), gross receipts 
attributable to land be disregarded for purposes of calculating the de 
minimis exception. In response to the comments, the final regulations 
clarify that, if a taxpayer applies the land safe harbor, then the 
gross receipts excluded under the land safe harbor are excluded in 
determining total gross receipts under the de minimis exception. The 
final regulations also provide that, if a taxpayer does not apply the 
land safe harbor and uses any reasonable method (for example, an 
appraisal of the land) to allocate gross receipts attributable to the 
land to non-DPGR, then a taxpayer applies the de minimis exception by 
excluding such gross receipts derived from the sale, exchange, or other 
disposition of the land from total gross receipts.
    A commentator requested that the definition of construction 
activities not be limited to direct activities and should include 
services incidental to the performance of such activities. As an 
administrative convenience, the final regulations provide that 
construction activities include certain administrative support services 
such as billing and secretarial services performed by the taxpayer. The 
final regulations provide a similar rule for engineering and 
architectural services.

Engineering and Architectural Services

    A commentator suggested that the definition of engineering and 
architectural services include services related to the inspection or 
evaluation of real property after construction has been completed. The 
final regulations do not adopt this suggestion because engineering and 
architectural services relating to post-construction activities are not 
activities constituting construction.

Allocation of Cost of Goods Sold and Deductions

    A commentator requested clarification as to whether a taxpayer's 
CGS allocable to DPGR is determined using the methods of accounting 
used to compute CGS for the taxpayer's books or financial statements or 
the methods of accounting used to compute CGS in determining Federal 
taxable income. Section 1.199-4(b) of the proposed regulations provides 
that CGS is determined under the methods of accounting that the 
taxpayer uses to compute Federal taxable income. Accordingly, this 
section has not been modified and the final regulations continue to 
provide that, in determining CGS allocable to DPGR, CGS is determined 
using the methods of accounting that the taxpayer uses to compute its 
Federal taxable income.
    Consistent with both the proposed regulations and Notice 2005-14, 
the final regulations continue to provide three methods for allocating 
and apportioning deductions (that is, the section 861 method, the 
simplified deduction method, and the small business simplified overall 
method). However, modifications have been made in the final regulations 
to the qualification requirements of the simplified deduction method.
    Under the simplified deduction method, a taxpayer's expenses, 
losses, or deductions (deductions) (other than a net operating loss 
deduction) are apportioned between DPGR and non-DPGR based on relative 
gross receipts. The proposed regulations permit a taxpayer to use the 
simplified deduction method if it has average annual gross receipts of 
$25,000,000 or less, or total assets at the end of the taxable year of 
$10,000,000 or less. Several commentators requested that the average 
annual gross receipts threshold for the simplified deduction method be 
either increased or removed. In response to these comments, the IRS and 
Treasury Department have modified the eligibility requirements for the 
simplified deduction method. Under the final regulations, a taxpayer 
may use the simplified deduction method if it has average annual gross 
receipts of $100,000,000 or less, or total assets at the end of the 
taxable year of $10,000,000 or less. The IRS and Treasury Department 
continue to believe that for taxpayers above these thresholds the 
section 861 method is the appropriate method for allocating and 
apportioning deductions for purposes of determining QPAI.
    Under the land safe harbor provided in Sec.  1.199-3(l)(5)(ii) of 
the proposed regulations, a taxpayer may allocate gross receipts 
between the proceeds from the sale, exchange, or other disposition of 
real property constructed by the taxpayer and land by reducing its 
costs related to DPGR under Sec.  1.199-4 by the cost of land and other 
costs capitalized to the land (land costs) and reducing its DPGR by 
those land costs plus a percentage. Under the small business simplified 
overall method, a taxpayer's CGS and deductions are apportioned between 
DPGR and other receipts based on relative gross receipts. Commentators 
have questioned whether a taxpayer that uses the small business 
simplified overall method would have to reallocate land costs using the 
allocation formula provided by that method even though such costs have 
already been allocated in accordance with the land safe harbor. The 
final regulations clarify that a taxpayer that uses the land safe 
harbor to allocate gross receipts between real property constructed by 
the taxpayer and land does not take into account under the small 
business simplified overall method provided in Sec.  1.199-4(f) the 
costs that have already been taken into account for purposes of section 
199 pursuant to the land safe harbor.

Expanded Affiliated Groups

    The proposed regulations provide generally that if a member of an 
EAG (the disposing member) derives gross receipts from the lease, 
rental, license, sale, exchange, or other disposition of QPP, a 
qualified film, or utilities MPGE or produced by another member or 
members of the same EAG, the disposing member is treated as conducting 
the activities conducted by each other member of the EAG with respect 
to the QPP, qualified film, or utilities in determining whether its 
gross receipts are DPGR. A question arose as to when the determination 
of whether corporations are members of the same EAG for purposes of the 
attribution of activities is to be made. The final regulations clarify 
that attribution of activities between members of the same EAG is 
tested at the time that the disposing member disposes of the QPP, 
qualified film, or utilities. Examples are provided to illustrate this 
provision.
    Section 1.199-1(d) of the proposed regulations provides a de 
minimis rule that allows a taxpayer to treat all of its gross receipts 
as DPGR if less than 5 percent of the taxpayer's total gross receipts 
are non-DPGR. The proposed regulations provide that the 5 percent 
threshold is determined at the corporation level, rather than at the 
EAG or consolidated group level. Several commentators requested that 
the IRS and Treasury Department reconsider this position and apply the 
threshold at the EAG or consolidated group level.
    The de minimis rule is intended to eliminate the burden to a 
taxpayer of allocating gross receipts between DPGR and non-DPGR when 
less than 5 percent of its total gross receipts are non-DPGR. Applying 
this de minimis rule at the EAG level would create many burdensome 
issues for the EAG and its

[[Page 31279]]

members, including additional information reporting and circularity 
problems that could require members to compute QPAI twice and, thus, 
would not further the policy goals of providing de minimis rules to 
ease a taxpayer's administrative burdens. As a result, the IRS and 
Treasury Department continue to believe that, with respect to a 
corporation that is a member of an EAG but not a member of a 
consolidated group, the application of this threshold at the EAG member 
level is appropriate.
    However, with respect to a consolidated group, Sec.  1.1502-
13(c)(1)(i) and (c)(4) requires that the separate entity attributes of 
a company's intercompany items or corresponding items must be 
redetermined to the extent necessary to produce the effect as if the 
consolidated group members engaged in an intercompany transaction were 
divisions of a single corporation. If the de minimis rule were applied 
at the consolidated group member level, then a different result could 
apply to the consolidated group than would apply if the consolidated 
group members were divisions of a single corporation. Accordingly, with 
respect to a consolidated group, the final regulations provide that the 
de minimis rule is applied at the consolidated group level, rather than 
at the consolidated group member level.
    Similarly, with respect to a corporation that is a member of an EAG 
but not a member of a consolidated group, the new de minimis rule that 
allows a taxpayer to treat all of its gross receipts as non-DPGR if 
less than 5 percent of the taxpayer's total gross receipts are DPGR is 
determined at the EAG member level, rather than at the EAG group level. 
However, with respect to a consolidated group, the final regulations 
provide that this de minimis rule is applied at the consolidated group 
level, rather than at the consolidated group member level.

Consolidated Groups

    A commentator was concerned that the license of an intangible asset 
between members of a consolidated group could reduce the section 199 
deduction available to the members of a consolidated group, because the 
licensee member's royalty expense would reduce the group's QPAI, but 
the licensor member's royalty income from the license would not 
increase the group's QPAI. The commentator requested that language be 
added to the final regulations to provide that the intercompany 
transaction rules of Sec.  1.1502-13 shall be taken into account for 
purposes of determining the QPAI and DPGR of a consolidated group.
    As specifically noted in the preamble to the proposed regulations, 
the regulations under Sec.  1.1502-13(c) already ensure that the 
section 199 deduction cannot be reduced on account of an intercompany 
transaction. As discussed above concerning the application of the de 
minimis rules that allow treatment of gross receipts as DPGR or non-
DPGR, Sec.  1.1502-13(c)(1)(i) and (c)(4) requires that the separate 
entity attributes of a company's intercompany items or corresponding 
items must be redetermined to the extent necessary to produce the 
effect as if the consolidated group members engaged in an intercompany 
transaction were divisions of a single corporation. There is nothing in 
the proposed regulations that would prevent this rule from applying. In 
fact, several examples specifically illustrate the application of these 
rules. An additional example concerning the license of an intangible 
between members of a consolidated group has been added to the final 
regulations.
    Another commentator requested clarification of the application of 
Sec.  1.199-7(b)(2) of the proposed regulations where the EAG is 
comprised of more than one consolidated group. Section 1.199-7(b)(2) of 
the proposed regulations (Sec.  1.199-7(b)(3) of the final regulations) 
provides that, in determining the taxable income of an EAG, if a member 
of an EAG has an NOL carryback or carryover to the taxable year, then 
the amount of the NOL used to offset taxable income cannot exceed the 
taxable income of that member. The final regulations continue to treat 
a consolidated group as a single member of the EAG. Accordingly, if a 
consolidated group has a consolidated NOL (CNOL) carryback or 
carryover, the amount of the CNOL used to offset taxable income cannot 
exceed the consolidated group's taxable income, and may not be used to 
offset taxable income of other members of the EAG, whether separate 
corporations or consolidated groups. An example has been provided to 
illustrate this provision.

Trade or Business Requirement

    Pursuant to section 199(d)(5), Sec. Sec.  1.199-1 through 1.199-9 
are applied by taking into account only items that are attributable to 
the actual conduct of a trade or business. An individual engaged in the 
actual conduct of a trade or business must apply Sec. Sec.  1.199-1 
through 1.199-9 by taking into account in computing QPAI only items 
that are attributable to that trade or business (or trades or 
businesses) and any items allocated from a pass-thru entity engaged in 
a trade or business. Compensation received by an individual employee 
for services performed as an employee is not considered gross receipts 
for purposes of computing QPAI under Sec. Sec.  1.199-1 through 1.199-
9. Similarly, any costs or expenses paid or incurred by an individual 
employee with respect to those services performed as an employee are 
not considered CGS or deductions of that employee for purposes of 
computing QPAI under Sec. Sec.  1.199-1 through 1.199-9. For purposes 
of the trade-or-business requirement, a trust or estate is treated as 
an individual.

Pass-Thru Entities

    As noted above, section 514(b) of TIPRA amended section 
199(d)(1)(A)(iii) with respect to a partner's or shareholder's share of 
W-2 wages from a partnership or S corporation for taxable years 
beginning after May 17, 2006. Section 1.199-9 of the final regulations 
contains guidance for pass-thru entities with taxable years beginning 
on or before May 17, 2006. A taxpayer must apply Sec.  1.199-9 to a 
taxable year beginning on or before May 17, 2006, if that taxpayer 
applies Sec. Sec.  1.199-1 through 1.199-8 to the taxable year. The 
portions of Sec.  1.199-3 relating to qualifying in-kind partnerships 
and EAG partnerships, and all of Sec.  1.199-5 relating to pass-thru 
entities, in the final regulations are reserved for taxable years 
beginning after May 17, 2006. The IRS and Treasury Department intend to 
issue regulations that take into account the amendments made to section 
199(d)(1)(A)(iii) for pass-thru entities.
    Section 199 applies at the owner level in a manner consistent with 
the economic arrangement of the owners of the pass-thru entity. Under 
the proposed regulations, each owner computes its section 199 deduction 
by taking into account its distributive or proportionate share of the 
pass-thru entity's items (including items of income and gain, as well 
as items of loss and deduction not otherwise disallowed by the Code), 
CGS allocated to such items of income, and gross receipts included in 
such items of income. Generally, section 199 is applied at the 
shareholder, partner, or similar level. For a non-grantor trust or 
estate, this level may refer to one or more beneficiaries, the trust or 
estate, or both.
    Section 199(d)(1)(A)(iii), however, limits the amount of W-2 wages 
from a partnership or S corporation that may be used by each partner or 
shareholder to compute the partner's or shareholder's section 199 
deduction. Pursuant to the authority granted in section

[[Page 31280]]

199(d)(1)(C), the final regulations provide that this wage limitation 
will apply to non-grantor trusts and estates in the same way it applies 
to partnerships and S corporations. Thus, for all purposes of this wage 
limitation, references in the final regulations to pass-thru entities 
include not only partnerships and S corporations, but also all non-
grantor trusts and estates.
    The final regulations clarify that the section 199 deduction has no 
effect on a shareholder's adjusted basis in the stock of an S 
corporation or a partner's adjusted basis in an interest in a 
partnership because the section 199 deduction is not described in 
section 1367(a) or section 705(a). However, the shareholder's or 
partner's proportionate or distributive share of the S corporation or 
partnership items that are included in computing the shareholder's or 
partner's section 199 deduction will affect the shareholder's or 
partner's adjusted basis under the rules of section 1367(a) or section 
705(a).
    The proposed regulations provide that deductions of a partnership 
that otherwise would be taken into account in computing the partner's 
section 199 deduction are taken into account only if and to the extent 
the partner's distributive share of those deductions from all of the 
partnership's activities is not disallowed by section 465, 469, or 
704(d), or any other provision of the Code. If only a portion of the 
partner's distributive share of the losses or deductions is allowed for 
a taxable year, a proportionate share of those allowable losses or 
deductions that are allocated to the partner's share of the 
partnership's qualified production activities, determined in a manner 
consistent with sections 465, 469, and 704(d), and any other applicable 
provision of the Code (disallowed losses), is taken into account in 
computing the section 199 deduction for that taxable year. To the 
extent that any of the disallowed losses are allowed in a later taxable 
year, the partner takes into account a proportionate share of those 
losses in computing its QPAI for that later taxable year.
    In response to comments received, the IRS and Treasury Department 
intend to issue separate guidance by publication in the Internal 
Revenue Bulletin regarding the treatment of disallowed losses in 
determining a taxpayer's section 199 deduction. As a matter of 
administrative convenience and to reduce complexity for taxpayers, the 
final regulations clarify that disallowed losses of the taxpayer that 
are disallowed for taxable years beginning on or before December 31, 
2004, are not taken into account in a later taxable year for purposes 
of computing the taxpayer's QPAI for that later taxable year regardless 
of whether the disallowed losses are allowed for other purposes. The 
final regulations provide that similar rules concerning disallowed 
losses apply to taxpayers that are not partners or S corporation 
shareholders. See Sec.  1.199-8(h).
    Generally, in the case of a pass-thru entity, the calculations 
required to determine QPAI (that is, the allocation or apportionment of 
gross receipts, CGS, or deductions) are performed at the owner level. 
Notice 2005-14 and the proposed regulations provide that a partnership 
or S corporation that is a qualifying small taxpayer may use the small 
business simplified overall method to apportion CGS and deductions 
between DPGR and non-DPGR. This rule is not included in the final 
regulations, except that Sec.  1.199-9(k) permits a partnership or S 
corporation that is a qualifying small taxpayer to use the small 
business simplified overall method to apportion CGS and deductions 
between DPGR and non-DPGR at the entity level under Sec.  1.199-4(f) of 
the proposed regulations. In addition, Sec.  1.199-9(b)(1)(ii) and 
(c)(1)(ii) of the final regulations provides that the Secretary may, by 
publication in the Internal Revenue Bulletin, permit a partnership or S 
corporation to calculate a partner's or shareholder's share of QPAI at 
the entity level.
    If a partnership or S corporation calculates a partner's or 
shareholder's share of QPAI at the entity level, the owner's share of 
QPAI and W-2 wages from the partnership or S corporation are combined 
with the owner's QPAI and W-2 wages from other sources. The final 
regulations also clarify that, if a pass-thru entity calculates QPAI at 
the entity level, then generally the owner of the pass-thru entity is 
not permitted to use another cost allocation method to reallocate the 
costs of the pass-thru entity regardless of the method used by the 
pass-thru entity's owner to allocate or apportion costs. A taxpayer 
that receives QPAI from a partnership or S corporation does not take 
into account any gross receipts, income, assets, deductions, or other 
items of the partnership or S corporation when the taxpayer allocates 
and apportions deductions to determine the taxpayer's QPAI from other 
sources.
    Regarding the rule allowing partnerships that extract, refine, or 
process oil or natural gas to attribute these activities to their 
partners, some commentators requested that the rule be expanded to 
other industries that operate in a substantially similar manner. The 
exception for the oil and gas industry was provided in the proposed 
regulations to prevent a clearly qualifying activity from being 
disqualified under section 199 because of several decades-long industry 
practices. Among the historical industry practices taken into account 
by the IRS and Treasury Department in establishing the oil and gas 
exception was the fact that for decades the oil and gas industry 
generally has operated in a business model in which a partnership 
produces qualifying property and distributes such property in-kind to 
its partners (generally engaged themselves in the production of oil and 
gas), generally the partnership does not derive any gross receipts from 
the produced property, the property is marketed and sold exclusively 
and separately by each partner as competitors, and generally there is 
no marketing or sale by the partnership of the produced property, and 
no joint marketing or sale of the distributed property by any of the 
partners. In addition, the partnership typically qualifies to elect out 
of subchapter K.
    In response to the requests that this attribution rule be expanded 
to industries that historically have operated in a manner substantially 
similar to the oil and gas industry, the final regulations provide 
that, if a partnership that MPGE or produces property is a qualifying 
in-kind partnership (as defined later), then each partner may be 
treated as MPGE or producing the property MPGE or produced by the 
partnership that is distributed to that partner. If a partner of a 
qualifying in-kind partnership derives gross receipts from the lease, 
rental, license, sale, exchange, or other disposition of the property 
that was MPGE or produced by the qualifying in-kind partnership, then, 
provided such partner is a partner of the qualifying in-kind 
partnership at the time the partner disposes of the property, the 
partner is treated as conducting the MPGE or production activities 
previously conducted by the qualifying in-kind partnership with respect 
to that property. For this purpose, a qualifying in-kind partnership is 
defined in Sec.  1.199-9(i)(2) of the final regulations to include only 
certain partnerships operating solely in a designated industry: oil and 
gas, petrochemical, or electricity generation. Partnerships in other 
industries with substantially similar historical industry practices may 
be designated by the IRS and Treasury Department as qualifying in-kind 
partnerships by publication in the Internal Revenue Bulletin.
    The proposed regulations provide that, if an EAG partnership (as 
defined

[[Page 31281]]

in Sec.  1.199-9(j)(2) of the final regulations) MPGE or produces 
property and distributes, leases, rents, licenses, sells, exchanges, or 
otherwise disposes of that property to a member of an EAG of which the 
partners of the EAG partnership are members, then the MPGE or 
production activity conducted by the EAG partnership will be treated as 
having been conducted by the disposing member of the EAG. Similarly, if 
one or more members of an EAG of which the partners of an EAG 
partnership are members MPGE or produces property and contributes, 
leases, rents, licenses, sells, exchanges, or otherwise disposes of 
that property to the EAG partnership, then the MPGE or production 
activity conducted by the EAG member (or members) will be treated as 
having been conducted by the EAG partnership. A question arose as to 
when a corporation needs to be a member of an EAG of which the partners 
of the EAG partnership are members (and vice versa) for attribution of 
MPGE or production activities to take place. The final regulations 
clarify that attribution of such activities between an EAG partnership 
and members of the EAG of which the partners of the EAG partnership are 
members is determined at the time that the EAG partnership disposes of 
the property (in the case of property MPGE or produced by an EAG member 
or members) or at the time that the member or members of the EAG of 
which the partners of the EAG partnership are members dispose of the 
property (in the case of property MPGE or produced by the EAG 
partnership). Attribution is effective only for those taxable years 
that the disposing or producing member is a member of the EAG of which 
the partners of the EAG partnership are members for the entire taxable 
year of the EAG partnership. The final regulations also clarify that 
EAG partnerships, the partners of which are members of the same EAG, 
may attribute their production activities between themselves on a 
similar basis, provided that the producing EAG partnership and the 
disposing EAG partnership are owned by members of the same EAG for the 
entire taxable year of the respective EAG partnership that includes the 
date on which the disposing EAG partnership disposes of the property.
    Because the sale of an interest in a pass-thru entity does not 
reflect the realization of DPGR by that entity, DPGR generally does not 
include gain or loss recognized on the sale, exchange or other 
disposition of an interest in the entity. However, consistent with 
Notice 2005-14 and the proposed regulations, if section 751(a) or (b) 
applies, then gain or loss attributable to partnership assets giving 
rise to ordinary income under section 751(a) or (b), the sale, 
exchange, or other disposition of which would give rise to an item of 
DPGR, is taken into account in computing the partner's section 199 
deduction.
    One commentator stated that many commercial real estate developers 
dispose of commercial real property by selling interests in special 
purpose partnerships that hold commercial real property. Because a 
sale, exchange or other disposition of the commercial real property may 
result in section 1231 gain rather than ordinary income, the 
commentator suggested that the definition of inventory items be 
expanded for purposes of Sec.  1.199-9(e) by treating section 751(d) as 
not containing the words ``and other than property described in section 
1231.'' As a result, a sale or exchange of an interest in a partnership 
that holds commercial real property would generate DPGR if a sale or 
exchange of the commercial real property would generate DPGR regardless 
of whether the sale or exchange would result in ordinary income. The 
final regulations do not include the commentator's suggestion because 
the rule in Sec.  1.199-9(e) applies aggregate treatment to a sale or 
exchange of a partnership interest only to the extent section 751 
specifically allows such treatment. Modifying the explicit terms of 
section 751(d) as suggested would be inconsistent with the purposes of 
section 751 and section 199.

Statistical Sampling

    In the preamble to the proposed regulations, the IRS and Treasury 
Department invited taxpayers to submit comments on issues relating to 
section 199 including whether taxpayers can apply statistical sampling 
to section 199, what specific areas of section 199 statistical sampling 
could be applied to, and whether application of statistical sampling 
should be limited to specific areas of section 199. Comments were 
received on statistical sampling and the IRS and Treasury Department 
are considering those comments and intend to issue subsequent guidance 
addressing the application of statistical sampling for purposes of 
section 199.

Elections Under the Section 861 Regulations

    The preamble to the proposed regulations states that, because the 
provisions of section 199 may cause taxpayers to reconsider previously 
made elections under Sec. Sec.  1.861-8 through 1.861-17 and Sec. Sec.  
1.861-8T through 1.861-14T (the section 861 regulations), the IRS and 
Treasury Department intend to issue a revenue procedure granting 
taxpayers automatic consent to change certain of those elections. In 
the proposed regulations, the IRS and Treasury Department requested 
comments on which elections should be included in such a revenue 
procedure and the appropriate time period during which the automatic 
consent should apply. Several commentators urged promulgation of such a 
revenue procedure, and several comments specifically requested that the 
revenue procedure provide taxpayers automatic consent for more than one 
taxable year to change previously made elections.
    The IRS and Treasury Department intend to issue a revenue procedure 
that provides taxpayers automatic consent to change certain elections 
relating to the apportionment of interest expense and research and 
experimental expenditures under the section 861 regulations. It is 
intended that the automatic consent afforded under the revenue 
procedure will provide taxpayers the consent required by Sec. Sec.  
1.861-8T(c)(2) and 1.861-9(i)(2), with respect to the apportionment of 
interest expense, and by Sec.  1.861-17(e), with respect to the 
apportionment of research and experimental expenditures, to change an 
election, effective for a taxpayer's first taxable year beginning after 
December 31, 2004 (the taxpayer's 2005 taxable year). In addition, it 
is intended that the revenue procedure will provide taxpayers the 
consent required by those regulations for a taxpayer's taxable year 
immediately following the taxpayer's 2005 taxable year, but, in such 
case, a taxpayer would not be provided automatic consent to change any 
election that first took effect with respect to the taxpayer's 2005 
taxable year.

Financial and Administrative Burden

    Several commentators objected to the complexity of the proposed 
regulations, and to the financial and administrative burden that the 
commentators believe the regulations will impose on taxpayers 
(particularly on small businesses). The complexity and burden of the 
regulations are a function of the statutory language and framework of 
section 199, which are complex and contain many requirements. For 
example, with the exception of a few specific services (namely, 
construction, architecture, and engineering) only gross receipts 
derived from certain dispositions of certain property qualify under the 
statute. In addition, in the case of manufacturing activities, the 
property must be manufactured by the taxpayer in whole or in 
significant part

[[Page 31282]]

within the United States. Also, under section 199, costs must be 
allocated between qualifying and nonqualifying gross receipts. All of 
these statutory requirements (and others) potentially necessitate that 
taxpayers obtain information, make determinations and computations, and 
retain records that might not otherwise be required for business 
purposes. In the case of partnerships and S corporations, the statute 
requires that the deduction be computed at the owner level, 
necessitating the sharing between entity and owner of information that 
might not be needed for purposes other than section 199. Both the 
proposed and the final regulations provide a number of safe harbors and 
de minimis rules that are intended to balance the need for compliance 
with these statutory requirements against the burden imposed on 
taxpayers.
    In the preamble to the proposed regulations, the IRS and Treasury 
Department certify that the collection of information required under 
the proposed regulations (relating to information to be provided by 
cooperatives to their patrons) will not have a significant economic 
impact on a substantial number of small entities, and therefore that a 
Regulatory Flexibility Analysis is not required by the Regulatory 
Flexibility Act (RFA). One commentator asserted that the certification 
did not provide sufficient information for small entities to determine 
the impact the regulations will have on their businesses. The 
commentator also contended that the IRS and Treasury Department, in 
making the certification, failed to consider burdens imposed by the 
proposed regulations on other small entities, such as partnerships and 
S corporations, that are required under the regulations to provide 
certain information to their owners.
    The IRS and Treasury Department believe that the certification for 
the proposed regulations, as well as for these final regulations, is 
appropriate and complies with the requirements of the RFA. With respect 
to cooperatives, the regulations provide cooperatives with specific 
rules about the information they must provide to patrons under section 
199. The IRS and Treasury Department believe that cooperatives have the 
necessary information to comply with this requirement. The IRS and 
Treasury Department continue to believe that this requirement is the 
only collection of information in the regulations that is within the 
scope of the RFA. Certain other recordkeeping and reporting 
requirements of the regulations relating to information sharing between 
pass-thru entities (partnerships and S corporations) and their owners 
are subsumed within other existing income tax regulations that 
currently require that such entities report to their owners all 
information that is necessary for the owners to determine their tax 
liability.

Effective Date

    Section 199 applies to taxable years beginning after December 31, 
2004. Sections 1.199-1 through 1.199-8 are applicable for taxable years 
beginning on or after June 1, 2006. For a taxable year beginning on or 
before May 17, 2006, the enactment date of TIPRA, a taxpayer may apply 
Sec. Sec.  1.199-1 through 1.199-9 provided that the taxpayer applies 
all provisions in Sec. Sec.  1.199-1 through 1.199-9 to the taxable 
year. For a taxable year beginning after May 17, 2006, and before June 
1, 2006, a taxpayer may apply Sec. Sec.  1.199-1 through 1.199-8 
provided that the taxpayer applies all provisions in Sec. Sec.  1.199-1 
through 1.199-8 to the taxable year. Section 1.199-9 may not be applied 
to a taxable year that begins after May 17, 2006.
    For a taxpayer who chooses not to rely on these final regulations 
for a taxable year beginning before June 1, 2006, the guidance on 
section 199 that applies to such taxable year is contained in Notice 
2005-14 (2005-1 C.B. 498). In addition, a taxpayer also may rely on the 
provisions of REG-105847-05 (2005-47 I.R.B. 987) (see Sec.  
601.601(d)(2) of this chapter) for a taxable year beginning before June 
1, 2006. If Notice 2005-14 and REG-105847-05 include different rules 
for the same particular issue, then a taxpayer may rely on either the 
rule set forth in Notice 2005-14 or the rule set forth in REG-105847-
05. However, if REG-105847-05 includes a rule that was not included in 
Notice 2005-14, then a taxpayer is not permitted to rely on the absence 
of a rule to apply a rule contrary to REG-105847-05. For taxable years 
beginning after May 17, 2006, and before June 1, 2006, a taxpayer may 
not apply Notice 2005-14, REG-105847-05, or any other guidance under 
section 199 in a manner inconsistent with amendments made to section 
199 by section 514 of TIPRA. 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). Members of an EAG that 
are not members of a consolidated group may each apply the effective 
date rules without regard to how other members of the EAG apply the 
effective date rules.

Effect on Other Documents

    Notice 2005-14 (2005-1 C.B. 498) is obsolete for taxable years 
beginning on or after June 1, 2006.

Special Analyses

    It has been determined that this Treasury decision is not a 
significant regulatory action as defined in Executive Order 12866. 
Therefore, a regulatory assessment is not required. It is hereby 
certified that the collection of information in this regulation will 
not have a significant economic impact on a substantial number of small 
entities. This certification is based upon the fact that any burden on 
cooperatives is minimal. Accordingly, a Regulatory Flexibility Analysis 
under the Regulatory Flexibility Act (5 U.S.C. chapter 6) is not 
required. Pursuant to section 7805(f) of the Code, the notice of 
proposed rulemaking was submitted to the Chief Counsel for Advocacy of 
the Small Business Administration for comment on its impact on small 
business.

Drafting Information

    The principal authors of these regulations are Paul Handleman and 
Lauren Ross Taylor, 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

26 CFR Part I

    Income taxes, Reporting and recordkeeping requirements.

26 CFR Part 602

    Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

0
Accordingly, 26 CFR parts 1 and 602 are amended as follows:

PART 1--INCOME TAXES

0
Paragraph 1. The authority citation for part 1 is amended by adding 
entries to read, in part, as follows:

    Authority: 26 U.S.C. 7805 * * *
    Section 1.199-1 also issued under 26 U.S.C. 199(d).
    Section 1.199-2 also issued under 26 U.S.C. 199(d).
    Section 1.199-3 also issued under 26 U.S.C. 199(d).
    Section 1.199-4 also issued under 26 U.S.C. 199(d).
    Section 1.199-5 also issued under 26 U.S.C. 199(d).
    Section 1.199-6 also issued under 26 U.S.C. 199(d).

[[Page 31283]]

    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).
    Section 1.199-9 also issued under 26 U.S.C. 199(d). * * *


0
Par. 2. Sections 1.199-0 through 1.199-9 are added to read as follows:


Sec.  1.199-0  Table of contents.

    This section lists the section headings that appear in Sec. Sec.  
1.199-1 through 1.199-9.


Sec.  1.199-1  Income attributable to domestic production activities.

    (a) In general.
    (b) Taxable income and adjusted gross income.
    (1) In general.
    (2) Examples.
    (c) Qualified production activities income.
    (d) Allocation of gross receipts.
    (1) In general.
    (2) Reasonable method of allocation.
    (3) De minimis rules.
    (i) DPGR.
    (ii) Non-DPGR.
    (4) Example.
    (e) Certain multiple-year transactions.
    (1) Use of historical data.
    (2) Percentage of completion method.
    (3) Examples.


Sec.  1.199-2  Wage limitation.

    (a) Rules of application.
    (1) In general.
    (2) Wages paid by entity other than common law employer.
    (3) Requirement that wages must be reported on return filed with 
the Social Security Administration.
    (i) In general.
    (ii) Corrected return filed to correct a return that was filed 
within 60 days of the due date.
    (iii) Corrected return filed to correct a return that was filed 
later than 60 days after the due date.
    (4) Joint return.
    (b) Application in the case of a taxpayer with a short taxable 
year.
    (c) Acquisition or disposition of a trade or business (or major 
portion).
    (d) Non-duplication rule.
    (e) Definition of W-2 wages.
    (1) In general.
    (2) Limitation on W-2 wages for taxable years beginning after 
May 17, 2006, the enactment date of the Tax Increase Prevention and 
Reconciliation Act of 2005. [Reserved].
    (3) Methods for calculating W-2 wages.


Sec.  1.199-3  Domestic production gross receipts.

    (a) In general.
    (b) Related persons.
    (1) In general.
    (2) Exceptions.
    (c) Definition of gross receipts.
    (d) Determining domestic production gross receipts.
    (1) In general.
    (2) Special rules.
    (3) Exception.
    (4) Examples.
    (e) Definition of manufactured, produced, grown, or extracted.
    (1) In general.
    (2) Packaging, repackaging, labeling, or minor assembly.
    (3) Installing.
    (4) Consistency with section 263A.
    (5) Examples.
    (f) Definition of by the taxpayer.
    (1) In general.
    (2) Special rule for certain government contracts.
    (3) Subcontractor.
    (4) Examples.
    (g) Definition of in whole or in significant part.
    (1) In general.
    (2) Substantial in nature.
    (3) Safe harbor.
    (i) In general.
    (ii) Unadjusted depreciable basis.
    (iii) Computer software and sound recordings.
    (4) Special rules.
    (i) Contract with unrelated persons.
    (ii) Aggregation.
    (5) Examples.
    (h) Definition of United States.
    (i) Derived from the lease, rental, license, sale, exchange, or 
other disposition.
    (1) In general.
    (i) Definition.
    (ii) Lease income.
    (iii) Income substitutes.
    (iv) Exchange of property.
    (A) Taxable exchanges.
    (B) Safe harbor.
    (C) Eligible property.
    (2) Examples.
    (3) Hedging transactions.
    (i) In general.
    (ii) Currency fluctuations.
    (iii) Effect of identification and nonidentification.
    (iv) Other rules.
    (4) Allocation of gross receipts.
    (i) Embedded services and non-qualified property.
    (A) In general.
    (B) Exceptions.
    (ii) Non-DPGR.
    (iii) Examples.
    (5) Advertising income.
    (i) Tangible personal property.
    (ii) Qualified film.
    (iii) Examples.
    (6) Computer software.
    (i) In general.
    (ii) through (v) [Reserved].
    (7) Qualifying in-kind partnership for taxable years beginning 
after May 17, 2006, the enactment date of the Tax Increase 
Prevention and Reconciliation Act of 2005. [Reserved].
    (8) Partnerships owned by members of a single expanded 
affiliated group for taxable years beginning after May 17, 2006, the 
enactment date of the Tax Increase Prevention and Reconciliation Act 
of 2005. [Reserved].
    (9) Non-operating mineral interests.
    (j) Definition of qualifying production property.
    (1) In general.
    (2) Tangible personal property.
    (i) In general.
    (ii) Local law.
    (iii) Intangible property.
    (3) Computer software.
    (i) In general.
    (ii) Incidental and ancillary rights.
    (iii) Exceptions.
    (4) Sound recordings.
    (i) In general.
    (ii) Exception.
    (5) Tangible personal property with computer software or sound 
recordings.
    (i) Computer software and sound recordings.
    (ii) Tangible personal property.
    (k) Definition of qualified film.
    (1) In general.
    (2) Tangible personal property with a film.
    (i) Film not produced by a taxpayer.
    (ii) Film produced by a taxpayer.
    (A) Qualified film.
    (B) Nonqualified film.
    (3) Derived from a qualified film.
    (i) In general.
    (ii) Exceptions.
    (4) Compensation for services.
    (5) Determination of 50 percent.
    (6) Exception.
    (7) Examples.
    (l) Electricity, natural gas, or potable water.
    (1) In general.
    (2) Natural gas.
    (3) Potable water.
    (4) Exceptions.
    (i) Electricity.
    (ii) Natural gas.
    (iii) Potable water.
    (iv) De minimis exception.
    (A) DPGR.
    (B) Non-DPGR.
    (5) Example.
    (m) Definition of construction performed in the United States.
    (1) Construction of real property.
    (i) In general.
    (ii) Regular and ongoing basis.
    (A) In general.
    (B) New trade or business.
    (iii) De minimis exception.
    (A) DPGR.
    (B) Non-DPGR.
    (2) Activities constituting construction.
    (i) In general.
    (ii) Tangential services.
    (iii) Other construction activities.
    (iv) Administrative support services.
    (v) Exceptions.
    (3) Definition of real property.
    (4) Definition of infrastructure.
    (5) Definition of substantial renovation.
    (6) Derived from construction.
    (i) In general.
    (ii) Qualified construction warranty.
    (iii) Exceptions.
    (iv) Land safe harbor.
    (A) In general.
    (B) Determining gross receipts and costs.
    (v) Examples.
    (n) Definition of engineering and architectural services.
    (1) In general.
    (2) Engineering services.
    (3) Architectural services.
    (4) Administrative support services.
    (5) Exceptions.

[[Page 31284]]

    (6) De minimis exception for performance of services in the 
United States.
    (i) DPGR.
    (ii) Non-DPGR.
    (7) Example.
    (o) Sales of certain food and beverages.
    (1) In general.
    (2) De minimis exception.
    (3) Examples.
    (p) Guaranteed payments.


Sec.  1.199-4  Costs allocable to domestic production gross receipts.

    (a) In general.
    (b) Cost of goods sold allocable to domestic production gross 
receipts.
    (1) In general.
    (2) Allocating cost of goods sold.
    (i) In general.
    (ii) Gross receipts recognized in an earlier taxable year.
    (3) Special rules for imported items or services.
    (4) Rules for inventories valued at market or bona fide selling 
prices.
    (5) Rules applicable to inventories accounted for under the 
last-in, first-out (LIFO) inventory method.
    (i) In general.
    (ii) LIFO/FIFO ratio method.
    (iii) Change in relative base-year cost method.
    (6) Taxpayers using the simplified production method or 
simplified resale method for additional section 263A costs.
    (7) Examples.
    (c) Other deductions properly allocable to domestic production 
gross receipts or gross income attributable to domestic production 
gross receipts.
    (1) In general.
    (2) Treatment of net operating losses.
    (3) W-2 wages.
    (d) Section 861 method.
    (1) In general.
    (2) Deductions for charitable contributions.
    (3) Research and experimental expenditures.
    (4) Deductions allocated or apportioned to gross receipts 
treated as domestic production gross receipts.
    (5) Treatment of items from a pass-thru entity reporting 
qualified production activities income.
    (6) Examples.
    (e) Simplified deduction method.
    (1) In general.
    (2) Eligible taxpayer.
    (3) Total assets.
    (i) In general.
    (ii) Members of an expanded affiliated group.
    (4) Members of an expanded affiliated group.
    (i) In general.
    (ii) Exception.
    (iii) Examples.
    (f) Small business simplified overall method.
    (1) In general.
    (2) Qualifying small taxpayer.
    (3) Total costs for the current taxable year.
    (i) In general.
    (ii) Land safe harbor.
    (4) Members of an expanded affiliated group.
    (i) In general.
    (ii) Exception.
    (iii) Examples.
    (5) Trusts and estates.
    (g) Average annual gross receipts.
    (1) In general.
    (2) Members of an expanded affiliated group.


Sec.  1.199-5  Application of section 199 to pass-thru entities for 
taxable years beginning after May 17, 2006, the enactment date of the 
Tax Increase Prevention and Reconciliation Act of 2005. [Reserved].


Sec.  1.199-6  Agricultural and horticultural cooperatives.

    (a) In general.
    (b) Cooperative denied section 1382 deduction for portion of 
qualified payments.
    (c) Determining cooperative's taxable income.
    (d) Special rule for marketing cooperatives.
    (e) Qualified payment.
    (f) Specified agricultural or horticultural cooperative.
    (g) Written notice to patrons.
    (h) Additional rules relating to passthrough of section 199 
deduction.
    (i) W-2 wages.
    (j) Recapture of section 199 deduction.
    (k) Section is exclusive.
    (l) No double counting.
    (m) Examples.


Sec.  1.199-7  Expanded affiliated groups.

    (a) In general.
    (1) Definition of expanded affiliated group.
    (2) Identification of members of an expanded affiliated group.
    (i) In general.
    (ii) Becoming or ceasing to be a member of an expanded 
affiliated group.
    (3) Attribution of activities.
    (i) In general.
    (ii) Special rule.
    (4) Examples.
    (5) Anti-avoidance rule.
    (b) Computation of expanded affiliated group's section 199 
deduction.
    (1) In general.
    (2) Example.
    (3) Net operating loss carrybacks and carryovers.
    (c) Allocation of an expanded affiliated group's section 199 
deduction among members of the expanded affiliated group.
    (1) In general.
    (2) Use of section 199 deduction to create or increase a net 
operating loss.
    (d) Special rules for members of the same consolidated group.
    (1) Intercompany transactions.
    (2) Attribution of activities in the construction of real 
property and the performance of engineering and architectural 
services.
    (3) Application of the simplified deduction method and the small 
business simplified overall method.
    (4) Determining the section 199 deduction.
    (i) Expanded affiliated group consists of consolidated group and 
non-consolidated group members.
    (ii) Expanded affiliated group consists only of members of a 
single consolidated group.
    (5) Allocation of the section 199 deduction of a consolidated 
group among its members.
    (e) Examples.
    (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.
    (i) Pro rata allocation method.
    (ii) Section 199 closing of the books method.
    (iii) Making the section 199 closing of the books election.
    (2) Coordination with rules relating to the allocation of income 
under Sec.  1.1502-76(b).
    (g) Total section 199 deduction for a corporation that is a 
member of an expanded affiliated group for some or all of its 
taxable year.
    (1) Member of the same expanded affiliated group for the entire 
taxable year.
    (2) Member of the expanded affiliated group for a portion of the 
taxable year.
    (3) Example.
    (h) Computation of section 199 deduction for members of an 
expanded affiliated group with different taxable years.
    (1) In general.
    (2) Example.


Sec.  1.199-8  Other rules.

    (a) In general.
    (b) Individuals.
    (c) Trade or business requirement.
    (1) In general.
    (2) Individuals.
    (3) Trusts and estates.
    (d) Coordination with alternative minimum tax.
    (e) Nonrecognition transactions.
    (1) In general.
    (i) Sections 351, 721, and 731.
    (ii) Exceptions.
    (A) Section 708(b)(1)(B).
    (B) Transfers by reason of death.
    (2) Section 1031 exchanges.
    (3) Section 381 transactions.
    (f) Taxpayers with a 52-53 week taxable year.
    (g) Section 481(a) adjustments.
    (h) Disallowed losses or deductions.
    (i) Effective dates.
    (1) In general.
    (2) Pass-thru entities.
    (3) Non-consolidated EAG members.
    (4) Computer software provided to customers over the Internet. 
[Reserved].


Sec.  1.199-9  Application of section 199 to pass-thru entities for 
taxable years beginning on or before May 17, 2006, the enactment date 
of the Tax Increase Prevention and Reconciliation Act of 2005.

    (a) In general.
    (b) Partnerships.
    (1) In general.
    (i) Determination at partner level.
    (ii) Determination at entity level.
    (2) Disallowed losses or deductions.
    (3) Partner's share of W-2 wages.
    (4) Transition percentage rule for W-2 wages.
    (5) Partnerships electing out of subchapter K.
    (6) Examples.
    (c) S corporations.
    (1) In general.

[[Page 31285]]

    (i) Determination at shareholder level.
    (ii) Determination at entity level.
    (2) Disallowed losses or deductions.
    (3) Shareholder's share of W-2 wages.
    (4) Transition percentage rule for W-2 wages.
    (d) Grantor trusts.
    (e) Non-grantor trusts and estates.
    (1) Allocation of costs.
    (2) Allocation among trust or estate and beneficiaries.
    (i) In general.
    (ii) Treatment of items from a trust or estate reporting 
qualified production activities income.
    (3) Beneficiary's share of W-2 wages.
    (4) Transition percentage rule for W-2 wages.
    (5) Example.
    (f) Gain or loss from the disposition of an interest in a pass-
thru entity.
    (g) Section 199(d)(1)(A)(iii) wage limitation and tiered 
structures.
    (1) In general.
    (2) Share of W-2 wages.
    (3) Example.
    (h) No attribution of qualified activities.
    (i) Qualifying in-kind partnership.
    (1) In general.
    (2) Definition of qualifying in-kind partnership.
    (3) Special rules for distributions.
    (4) Other rules.
    (5) Example.
    (j) Partnerships owned by members of a single expanded 
affiliated group.
    (1) In general.
    (2) Attribution of activities.
    (i) In general.
    (ii) Attribution between EAG partnerships.
    (iii) Exception to attribution.
    (3) Special rules for distributions.
    (4) Other rules.
    (5) Examples.
    (k) Effective dates.


Sec.  1.199-1  Income attributable to domestic production activities.

    (a) In general. A taxpayer may deduct an amount 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 the taxpayer's qualified production activities 
income (QPAI) (as defined in paragraph (c) of this section) for the 
taxable year, or the taxpayer's taxable income for the taxable year 
(or, in the case of an individual, adjusted gross income). The amount 
of the deduction allowable under this paragraph (a) for any taxable 
year cannot exceed 50 percent of the W-2 wages of the employer for the 
taxable year (as determined under Sec.  1.199-2). The provisions of 
this section apply solely for purposes of section 199 of the Internal 
Revenue Code.
    (b) Taxable income and adjusted gross income--(1) In general. For 
purposes of paragraph (a) of this section, the definition of taxable 
income under section 63 applies, except that taxable income is 
determined without regard to section 199 and without regard to any 
amount excluded from gross income pursuant to section 114 or pursuant 
to section 101(d) of the American Jobs Creation Act of 2004, Public Law 
108-357, 118 Stat. 1418 (Act). In the case of individuals, adjusted 
gross income for the taxable year is determined after applying sections 
86, 135, 137, 219, 221, 222, and 469, and without regard to section 199 
and without regard to any amount excluded from gross income pursuant to 
section 114 or pursuant to section 101(d) of the Act. For purposes of 
determining the tax imposed by section 511, paragraph (a) of this 
section is applied using unrelated business taxable income. Except as 
provided in Sec.  1.199-7(c)(2), the deduction under section 199 is not 
taken into account in computing any net operating loss or the amount of 
any net operating loss carryback or carryover.
    (2) Examples. The following examples illustrate the application of 
this paragraph (b):

    Example 1.  X, a corporation that is not part of an expanded 
affiliated group (EAG) (as defined in Sec.  1.199-7), engages in 
production activities that generate QPAI and taxable income (without 
taking into account the deduction under this section and an NOL 
deduction) of $600 in 2010. During 2010, X incurs W-2 wages as 
defined in Sec.  1.199-2(e) of $300. X has an NOL carryover to 2010 
of $500. X's deduction under this section for 2010 is $9 (.09 x 
(lesser of QPAI of $600 and taxable income of $100 ($600 taxable 
income--$500 NOL)). Because the wage limitation is $150 (50% x 
$300), X's deduction is not limited.
    Example 2.  (i) Facts. X, a corporation that is not part of an 
EAG, engages in production activities that generate QPAI and taxable 
income (without taking into account the deduction under this section 
and an NOL deduction) of $100 in 2010. X has an NOL carryover to 
2010 of $500 that reduces its taxable income for 2010 to $0. X's 
deduction under this section for 2010 is $0 (.09 x (lesser of QPAI 
of $100 and taxable income of $0)).
    (ii) Carryover to 2011. X's taxable income for purposes of 
determining its NOL carryover to 2011 is $100. Accordingly, X's NOL 
carryover to 2011 is $400 ($500 NOL carryover to 2010--$100 NOL used 
in 2010).

    (c) Qualified production activities income. QPAI for any taxable 
year is an amount equal to the excess (if any) of the taxpayer's 
domestic production gross receipts (DPGR) (as defined in Sec.  1.199-3) 
over the sum of--
    (1) The cost of goods sold (CGS) that is allocable to such 
receipts; and
    (2) Other expenses, losses, or deductions (other than the deduction 
allowed under this section) that are properly allocable to such 
receipts. See Sec. Sec.  1.199-3 and 1.199-4.
    (d) Allocation of gross receipts--(1) In general. A taxpayer must 
determine the portion of its gross receipts for the taxable year that 
is DPGR and the portion of its gross receipts that is non-DPGR. 
Applicable Federal income tax principles apply to determine whether a 
transaction is, in substance, a lease, rental, license, sale, exchange, 
or other disposition the gross receipts of which may constitute DPGR 
(assuming all the other requirements of Sec.  1.199-3 are met), whether 
it is a service the gross receipts of which may constitute non-DPGR, or 
some combination thereof. For example, if a taxpayer leases qualifying 
production property (QPP) (as defined in Sec.  1.199-3(j)(1)) and in 
connection with that lease, also provides services, the taxpayer must 
allocate its gross receipts from the transaction using any reasonable 
method that is satisfactory to the Secretary based on all of the facts 
and circumstances and that accurately identifies the gross receipts 
that constitute DPGR and non-DPGR.
    (2) Reasonable method of allocation. Factors taken into 
consideration in determining whether the taxpayer's method of 
allocating gross receipts between DPGR and non-DPGR is reasonable 
include whether the taxpayer uses the most accurate information 
available; the relationship between the gross receipts and the method 
used; the accuracy of the method chosen as compared with other possible 
methods; whether the method is used by the taxpayer for internal 
management or other business purposes; whether the method is used for 
other Federal or state income tax purposes; the time, burden, and cost 
of using alternative methods; and whether the taxpayer applies the 
method consistently from year to year. Thus, if a taxpayer has the 
information readily available and can, without undue burden or expense, 
specifically identify whether the gross receipts derived from an item 
are DPGR, then the taxpayer must use that specific identification to 
determine DPGR. If a taxpayer does not have information readily 
available to specifically identify whether the gross receipts derived 
from an item are DPGR or cannot, without undue burden or expense, 
specifically identify whether the gross receipts derived from an item 
are DPGR, then the taxpayer is not required to use a method that 
specifically identifies whether the gross receipts derived from an item 
are DPGR.
    (3) De minimis rules--(i) DPGR. All of a taxpayer's gross receipts 
may be treated as DPGR if less than 5 percent of the taxpayer's total 
gross receipts are non-DPGR (after application of the exceptions 
provided in Sec.  1.199-

[[Page 31286]]

3(i)(4)(i)(B), (l)(4)(iv)(A), (m)(1)(iii)(A), (n)(6)(i), and (o)(2) 
that may result in gross receipts being treated as DPGR). If the amount 
of the taxpayer's gross receipts that are non-DPGR equals or exceeds 5 
percent of the taxpayer's total gross receipts, then, except as 
provided in paragraph (d)(3)(ii) of this section, the taxpayer is 
required to allocate all gross receipts between DPGR and non-DPGR in 
accordance with paragraph (d)(1) of this section. If a corporation is a 
member of an EAG, but is not a member of a consolidated group, then the 
determination of whether less than 5 percent of the taxpayer's total 
gross receipts are non-DPGR is made at the corporation level. If a 
corporation is a member of a consolidated group, then the determination 
of whether less than 5 percent of the taxpayer's total gross receipts 
are non-DPGR is made at the consolidated group level. In the case of an 
S corporation, partnership, trust (to the extent not described in Sec.  
1.199-9(d)) or estate, or other pass-thru entity, the determination of 
whether less than 5 percent of the pass-thru entity's total gross 
receipts are non-DPGR is made at the pass-thru entity level. In the 
case of an owner of a pass-thru entity, the determination of whether 
less than 5 percent of the owner's total gross receipts are non-DPGR is 
made at the owner level, taking into account all gross receipts of the 
owner from its other trade or business activities and the owner's share 
of the gross receipts of the pass-thru entity.
    (ii) Non-DPGR. All of a taxpayer's gross receipts may be treated as 
non-DPGR if less than 5 percent of the taxpayer's total gross receipts 
are DPGR (after application of the exceptions provided in Sec.  1.199-
3(i)(4)(ii), (l)(4)(iv)(B), (m)(1)(iii)(B), and (n)(6)(ii) that may 
result in gross receipts being treated as non-DPGR). If a corporation 
is a member of an EAG, but is not a member of a consolidated group, 
then the determination of whether less than 5 percent of the taxpayer's 
total gross receipts are DPGR is made at the corporation level. If a 
corporation is a member of a consolidated group, then the determination 
of whether less than 5 percent of the taxpayer's total gross receipts 
are DPGR is made at the consolidated group level. In the case of an S 
corporation, partnership, trust (to the extent not described in Sec.  
1.199-9(d)) or estate, or other pass-thru entity, the determination of 
whether less than 5 percent of the pass-thru entity's total gross 
receipts are DPGR is made at the pass-thru entity level. In the case of 
an owner of a pass-thru entity, the determination of whether less than 
5 percent of the owner's total gross receipts are DPGR is made at the 
owner level, taking into account all gross receipts of the owner from 
its other trade or business activities and the owner's share of the 
gross receipts of the pass-thru entity.
    (4) Example. The following example illustrates the application of 
this paragraph (d):

    Example. X derives its gross receipts from the sale of gasoline 
refined by X within the United States and the sale of refined 
gasoline that X acquired by purchase from an unrelated person. If at 
least 5% of X's gross receipts are derived from gasoline refined by 
X within the United States (that qualify as DPGR if all the other 
requirements of Sec.  1.199-3 are met) and at least 5% of X's gross 
receipts are derived from the resale of the acquired gasoline (that 
do not qualify as DPGR), then X does not qualify for the de minimis 
rules under paragraphs (d)(3)(i) and (ii) of this section, and X 
must allocate its gross receipts between the gross receipts derived 
from the sale of gasoline refined by X within the United States and 
the gross receipts derived from the resale of the acquired gasoline. 
If less than 5% of X's gross receipts are derived from the resale of 
the acquired gasoline, then, X may either allocate its gross 
receipts between the gross receipts derived from the gasoline 
refined by X within the United States and the gross receipts derived 
from the resale of the acquired gasoline, or, pursuant to paragraph 
(d)(3)(i) of this section, X may treat all of its gross receipts 
derived from the sale of the refined gasoline as DPGR. If X's gross 
receipts attributable to the gasoline refined by X within the United 
States constitute less than 5% of X's total gross receipts, then, X 
may either allocate its gross receipts between the gross receipts 
derived from the gasoline refined by X within the United States and 
the gross receipts derived from the resale of the acquired gasoline, 
or, pursuant to paragraph (d)(3)(ii) of this section, X may treat 
all of its gross receipts derived from the sale of the refined 
gasoline as non-DPGR.

    (e) Certain multiple-year transactions--(1) Use of historical data. 
If a taxpayer recognizes and reports gross receipts from advance 
payments or other similar payments on a Federal income tax return for a 
taxable year, then the taxpayer's use of historical data in making an 
allocation of gross receipts from the transaction between DPGR and non-
DPGR may constitute a reasonable method. 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.
    (2) Percentage of completion method. A taxpayer using a percentage 
of completion method under section 460 must determine the ratio of DPGR 
and non-DPGR using a reasonable method that is satisfactory to the 
Secretary based on all of the facts and circumstances that accurately 
identifies the gross receipts that constitute DPGR. See paragraph 
(d)(2) of this section for the factors taken into consideration in 
determining whether the taxpayer's method is reasonable.
    (3) Examples. The following examples illustrate the application of 
this paragraph (e):

    Example 1. On December 1, 2007, X, a calendar year accrual 
method taxpayer, sells for $100 a one-year computer software 
maintenance agreement that provides for (i) computer software 
updates that X expects to produce in the United States, and (ii) 
customer support services. At the end of 2007, X uses a reasonable 
method that is satisfactory to the Secretary based on all of the 
facts and circumstances to allocate 60% of the gross receipts ($60) 
to the computer software updates and 40% ($40) to the customer 
support services. X treats the $60 as DPGR in 2007. At the 
expiration of the one-year agreement on November 30, 2008, no 
computer software updates are provided by X. Pursuant to paragraph 
(e)(1) of this section, because X used a reasonable method that is 
satisfactory to the Secretary based on all of the facts and 
circumstances to identify gross receipts as DPGR, X is not required 
to make any adjustments to its 2007 Federal income tax return (for 
example, by amended return) or in 2008 for the $60 that was properly 
treated as DPGR in 2007, even though no computer software updates 
were provided under the contract.
    Example 2. X manufactures automobiles within the United States 
and sells 5-year extended warranties to customers. The sales price 
of the warranty is based on historical data that determines what 
repairs and services are performed on an automobile during the 5-
year period. X sells the 5-year warranty to Y for $1,000 in 2007. 
Under X's method of accounting, X recognizes warranty revenue when 
received. Using historical data, X concludes that 60% of the gross 
receipts attributable to a 5-year warranty will be derived from the 
sale of parts (QPP) that X manufactures within the United States, 
and 40% will be derived from the sale of purchased parts X did not 
manufacture and non-qualifying services. X's method of allocating 
its gross receipts with respect to the 5-year warranty between DPGR 
and non-DPGR is a reasonable method that is satisfactory to the 
Secretary based on all of the facts and circumstances. Therefore, X 
properly treats $600 as DPGR in 2007.
    Example 3. The facts are the same as in Example 2 except that in 
2009 X updates its historical data. The updated historical data show 
that 50% of the gross receipts attributable to a 5-year warranty 
will be derived from the sale of parts (QPP) that X manufactures 
within the United States and 50% will be derived from the sale of 
purchased parts X did not manufacture and non-qualifying services. 
In 2009, X sells a 5-year warranty for $1,000 to Z. Under all of the 
facts and circumstances, X's method of allocation is still a 
reasonable method. Relying on its updated historical data, X 
properly treats $500 as DPGR in 2009.

[[Page 31287]]

    Example 4. The facts are the same as in Example 2 except that Y 
pays for the 5-year warranty over time ($200 a year for 5 years). 
Under X's method of accounting, X recognizes each $200 payment as it 
is received. In 2009, X updates its historical data and the updated 
historical data show that 50% of the gross receipts attributable to 
a 5-year warranty will be derived from the sale of QPP that X 
manufactures within the United States and 50% will be derived from 
the sale of purchased parts X did not manufacture and non-qualifying 
services. Under all of the facts and circumstances, X's method of 
allocation is still a reasonable method. When Y makes its $200 
payment for 2009, X, relying on its updated historical data, 
properly treats $100 as DPGR in 2009.


Sec.  1.199-2  Wage limitation.

    (a) Rules of application--(1) In general. The provisions of this 
section apply solely for purposes of section 199 of the Internal 
Revenue Code. The amount of the deduction allowable under Sec.  1.199-
1(a) (section 199 deduction) to a taxpayer for any taxable year shall 
not exceed 50 percent of the W-2 wages (as defined in paragraph (e) of 
this section) of the taxpayer. For this purpose, except as provided in 
paragraph (a)(3) of this section and paragraph (b) of this section, the 
Forms W-2, ``Wage and Tax Statement,'' used in determining the amount 
of W-2 wages are those issued for the calendar year ending during the 
taxpayer's taxable year for wages paid to employees (or former 
employees) of the taxpayer for employment by the taxpayer. For purposes 
of this section, employees of the taxpayer are limited to employees of 
the taxpayer as defined in section 3121(d)(1) and (2) (that is, 
officers of a corporate taxpayer and employees of the taxpayer under 
the common law rules). See paragraph (a)(3) of this section for the 
requirement that W-2 wages must have been included in a return filed 
with the Social Security Administration (SSA) within 60 days after the 
due date (including extensions) of the return.
    (2) Wages paid by entity other than common law employer. In 
determining W-2 wages, a taxpayer may take into account any wages paid 
by another entity and reported by the other entity on Forms W-2 with 
the other entity as the employer listed in Box c of the Forms W-2, 
provided that the wages were paid to employees of the taxpayer for 
employment by the taxpayer. If the taxpayer is treated as an employer 
described in section 3401(d)(1) because of control of the payment of 
wages (that is, the taxpayer is not the common law employer of the 
payee of the wages), the payment of wages may not be included in 
determining W-2 wages of the taxpayer. If the taxpayer is paying wages 
as an agent of another entity to individuals who are not employees of 
the taxpayer, the wages may not be included in determining the W-2 
wages of the taxpayer.
    (3) Requirement that wages must be reported on return filed with 
the Social Security Administration--(i) In general. The term W-2 wages 
shall not include any amount that is not properly included in a return 
filed with SSA on or before the 60th day after the due date (including 
extensions) for such return. Under Sec.  31.6051-2 of this chapter, 
each Form W-2 and the transmittal Form W-3, ``Transmittal of Wage and 
Tax Statements,'' together constitute an information return to be filed 
with SSA. Similarly, each Form W-2c, ``Corrected Wage and Tax 
Statement,'' and the transmittal Form W-3 or W-3c, ``Transmittal of 
Corrected Wage and Tax Statements,'' together constitute an information 
return to be filed with SSA. In determining whether any amount has been 
properly included in a return filed with SSA on or before the 60th day 
after the due date (including extensions) for such return, each Form W-
2 together with its accompanying Form W-3 shall be considered a 
separate information return and each Form W-2c together with its 
accompanying Form W-3 or Form W-3c shall be considered a separate 
information return. Section 31.6071(a)-1(a)(3) of this chapter provides 
that each information return in respect of wages as defined in the 
Federal Insurance Contributions Act or of income tax withheld from 
wages which is required to be made under Sec.  31.6051-2 of this 
chapter shall be filed on or before the last day of February (March 31 
if filed electronically) of the year following the calendar year for 
which it is made, except that if a tax return under Sec.  31.6011(a)-
5(a) of this chapter is filed as a final return for a period ending 
prior to December 31, the information statement shall be filed on or 
before the last day of the second calendar month following the period 
for which the tax return is filed. Corrected Forms W-2 are required to 
be filed with SSA on or before the last day of February (March 31 if 
filed electronically) of the year following the year in which the 
correction is made, except that if a tax return under Sec.  31.6011(a)-
5(a) is filed as a final return for a period ending prior to December 
31 for the period in which the correction is made, the corrected Forms 
W-2 are required to be filed by the last day of the second calendar 
month following the period for which the final return is filed.
    (ii) Corrected return filed to correct a return that was filed 
within 60 days of the due date. If a corrected information return 
(Return B) is filed with SSA on or before the 60th day after the due 
date (including extensions) of Return B to correct an information 
return (Return A) that was filed with SSA on or before the 60th day 
after the due date (including extensions) of the information return 
(Return A) and paragraph (a)(3)(ii) of this section does not apply, 
then the wage information on Return B must be included in determining 
W-2 wages. If a corrected information return (Return D) is filed with 
SSA later than the 60th day after the due date (including extensions) 
of Return D to correct an information return (Return C) that was filed 
with SSA on or before the 60th day after the due date (including 
extensions) of the information return (Return C), then if Return D 
reports an increase (or increases) in wages included in determining W-2 
wages from the wage amounts reported on Return C, then such increase 
(or increases) on Return D shall be disregarded in determining W-2 
wages (and only the wage amounts on Return C may be included in 
determining W-2 wages). If Return D reports a decrease (or decreases) 
in wages included in determining W-2 wages from the amounts reported on 
Return C, then, in determining W-2 wages, the wages reported on Return 
C must be reduced by the decrease (or decreases) reflected on Return D.
    (iii) Corrected return filed to correct a return that was filed 
later than 60 days after the due date. If an information return (Return 
F) is filed to correct an information return (Return E) that was not 
filed with SSA on or before the 60th day after the due date (including 
extensions) of Return E, then Return F (and any subsequent information 
returns filed with respect to Return E) will not be considered filed on 
or before the 60th day after the due date (including extensions) of 
Return F (or the subsequent corrected information return). Thus, if a 
Form W-2c (or corrected Form W-2) is filed to correct a Form W-2 that 
was not filed with SSA on or before the 60th day after the due date 
(including extensions) of the information return including the Form W-2 
(or to correct a Form W-2c relating to an information return including 
a Form W-2 that had not been filed with SSA on or before the 60th day 
after the due date (including extensions) of the information return 
including the Form W-2), then the information return including this 
Form W-2c (or corrected Form W-2) shall not be considered to have been 
filed with SSA on or before the 60th day after the due date (including 
extensions) for this

[[Page 31288]]

information return including the Form W-2c (or corrected Form W-2), 
regardless of when the information return including the Form W-2c (or 
corrected Form W-2) is filed.
    (4) Joint return. An individual and his or her spouse are 
considered one taxpayer for purposes of determining the amount of W-2 
wages for a taxable year, provided that they file a joint return for 
the taxable year. Thus, an individual filing as part of a joint return 
may include the wages of employees of his or her spouse in determining 
W-2 wages, provided the employees are employed in a trade or business 
of the spouse and the other requirements of this section are met. 
However, a married taxpayer filing a separate return from his or her 
spouse for the taxable year may not include the wages of employees of 
the taxpayer's spouse in determining the taxpayer's W-2 wages for the 
taxable year.
    (b) Application in the case of a taxpayer with a short taxable 
year. In the case of a taxpayer with a short taxable year, subject to 
the rules of paragraph (a) of this section, the W-2 wages of the 
taxpayer for the short taxable year shall include only those wages paid 
during the short taxable year to employees of the taxpayer, only those 
elective deferrals (within the meaning of section 402(g)(3)) made 
during the short taxable year by employees of the taxpayer and only 
compensation actually deferred under section 457 during the short 
taxable year with respect to employees of the taxpayer. The Secretary 
shall have the authority to issue published guidance setting forth the 
method that is used to calculate W-2 wages in case of a taxpayer with a 
short taxable year. See paragraph (e)(3) of this section.
    (c) Acquisition or disposition of a trade or business (or major 
portion). If a taxpayer (a successor) acquires a trade or business, the 
major portion of a trade or business, or the major portion of a 
separate unit of a trade or business from another taxpayer (a 
predecessor), then, for purposes of computing the respective section 
199 deduction of the successor and of the predecessor, the W-2 wages 
paid for that calendar year shall be allocated between the successor 
and the predecessor based on whether the wages are for employment by 
the successor or for employment by the predecessor. Thus, in this 
situation, the W-2 wages are allocated based on whether the wages are 
for employment for a period during which the employee was employed by 
the predecessor or for employment for a period during which the 
employee was employed by the successor, regardless of which permissible 
method for Form W-2 reporting is used.
    (d) Non-duplication rule. Amounts that are treated as W-2 wages for 
a taxable year under any method shall not be treated as W-2 wages of 
any other taxable year. Also, an amount shall not be treated as W-2 
wages by more than one taxpayer.
    (e) Definition of W-2 wages--(1) In general. Under section 
199(b)(2), the term W-2 wages means, 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. Thus, the term W-2 wages includes the total 
amount of wages as defined in section 3401(a); the total amount of 
elective deferrals (within the meaning of section 402(g)(3)); the 
compensation deferred under section 457; and for taxable years 
beginning after December 31, 2005, the amount of designated Roth 
contributions (as defined in section 402A).
    (2) Limitation on W-2 wages for taxable years beginning after May 
17, 2006, the enactment date of the Tax Increase Prevention and 
Reconciliation Act of 2005. [Reserved].
    (3) Methods for calculating W-2 wages. The Secretary may provide by 
publication in the Internal Revenue Bulletin (see Sec.  
601.601(d)(2)(ii)(b) of this chapter) for methods to be used in 
calculating W-2 wages, including W-2 wages for short taxable years. For 
example, see Rev. Proc. 2006-22 (2006-22 I.R.B.) (see Sec.  
601.601(d)(2) of this chapter).


Sec.  1.199-3  Domestic production gross receipts.

    (a) In general. The provisions of this section apply solely for 
purposes of section 199 of the Internal Revenue Code (Code). Domestic 
production gross receipts (DPGR) are the gross receipts (as defined in 
paragraph (c) of this section) of the taxpayer that are--
    (1) Derived from any lease, rental, license, sale, exchange, or 
other disposition (as defined in paragraph (i) of this section) of--
    (i) Qualifying production property (QPP) (as defined in paragraph 
(j)(1) of this section) that is manufactured, produced, grown, or 
extracted (MPGE) (as defined in paragraph (e) of this section) by the 
taxpayer (as defined in paragraph (f) of this section) in whole or in 
significant part (as defined in paragraph (g) of this section) within 
the United States (as defined in paragraph (h) of this section);
    (ii) Any qualified film (as defined in paragraph (k) of this 
section) produced by the taxpayer; or
    (iii) Electricity, natural gas, or potable water (as defined in 
paragraph (l) of this section) (collectively, utilities) produced by 
the taxpayer in the United States;
    (2) Derived from, in the case of a taxpayer engaged in the active 
conduct of a construction trade or business, construction of real 
property (as defined in paragraph (m) of this section) performed in the 
United States by the taxpayer in the ordinary course of such trade or 
business; or
    (3) Derived from, in the case of a taxpayer engaged in the active 
conduct of an engineering or architectural services trade or business, 
engineering or architectural services (as defined in paragraph (n) of 
this section) 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.
    (b) Related persons--(1) In general. 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. 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). Any other person is an 
unrelated person for purposes of Sec. Sec.  1.199-1 through 1.199-9.
    (2) Exceptions. Notwithstanding paragraph (b)(1) of this section, 
gross receipts derived from any QPP or qualified film leased or rented 
by the taxpayer to a related person may qualify as DPGR if the QPP or 
qualified film is held for sublease or rent, or is subleased or rented, 
by the related person to an unrelated person for the ultimate use of 
the unrelated person. Similarly, notwithstanding paragraph (b)(1) of 
this section, gross receipts derived from the license of QPP or a 
qualified film to a related person for reproduction and sale, exchange, 
lease, rental, or sublicense to an unrelated person for the ultimate 
use of the unrelated person may qualify as DPGR.
    (c) Definition of gross receipts. The term gross receipts means the 
taxpayer's receipts for the taxable year that are recognized under the 
taxpayer's methods of accounting used for Federal income tax purposes 
for the taxable year. If the gross receipts are recognized in an 
intercompany transaction within the meaning of Sec.  1.1502-13, see 
also Sec.  1.199-7(d). For this purpose, gross receipts include total 
sales (net of returns and allowances) and all amounts

[[Page 31289]]

received for services. In addition, gross receipts include any income 
from investments and from incidental or outside sources. For example, 
gross receipts include interest (including original issue discount and 
tax-exempt interest within the meaning of section 103), dividends, 
rents, royalties, and annuities, regardless of whether the amounts are 
derived in the ordinary course of the taxpayer's trade of business. 
Gross receipts are not reduced by cost of goods sold (CGS) or by the 
cost of property sold if such property is described in section 
1221(a)(1), (2), (3), (4), or (5). Gross receipts do not include the 
amounts received in repayment of a loan or similar instrument (for 
example, a repayment of the principal amount of a loan held by a 
commercial lender) and, except to the extent of gain recognized, do not 
include gross receipts derived from a non-recognition transaction, such 
as a section 1031 exchange. Finally, gross receipts do not include 
amounts received by the taxpayer with respect to sales tax or other 
similar state and local taxes if, under the applicable state or local 
law, the tax is legally imposed on the purchaser of the good or service 
and the taxpayer merely collects and remits the tax to the taxing 
authority. If, in contrast, the tax is imposed on the taxpayer under 
the applicable law, then gross receipts include the amounts received 
that are allocable to the payment of such tax.
    (d) Determining domestic production gross receipts--(1) In general. 
For purposes of Sec. Sec.  1.199-1 through 1.199-9, a taxpayer 
determines, 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 (and not, for 
example, on a division-by-division, product line-by-product line, or 
transaction-by-transaction basis).
    (i) The term item means the property offered by the taxpayer in the 
normal course of the taxpayer's business for lease, rental, license, 
sale, exchange, or other disposition (for purposes of this paragraph 
(d), collectively referred to as disposition) to customers, if the 
gross receipts from the disposition of such property qualify as DPGR; 
or
    (ii) If paragraph (d)(1)(i) of this section does not apply to the 
property, then any component of the property described in paragraph 
(d)(1)(i) of this section is treated as the item, provided that the 
gross receipts from the disposition of the property described in 
paragraph (d)(1)(i) of this section that are attributable to such 
component qualify as DPGR. Each component that meets the requirements 
under this paragraph (d)(1)(ii) must be treated as a separate item and 
a component that meets the requirements under this paragraph (d)(1)(ii) 
may not be combined with a component that does not meet these 
requirements.
    (2) Special rules. The following special rules apply for purposes 
of paragraph (d)(1) of this section:
    (i) For purposes of paragraph (d)(1)(i) of this section, in no 
event may a single item consist of two or more properties unless those 
properties are offered for disposition, in the normal course of the 
taxpayer's business, as a single item (regardless of how the properties 
are packaged).
    (ii) In the case of property customarily sold by weight or by 
volume, the item is determined using the custom of the industry (for 
example, barrels of oil).
    (iii) In the case of construction activities and services or 
engineering and architectural services, a taxpayer may use any 
reasonable method that is satisfactory to the Secretary based on all of 
the facts and circumstances to determine what construction activities 
and services or engineering or architectural services constitute an 
item.
    (3) Exception. If a taxpayer MPGE QPP within the United States or 
produces a qualified film or produces utilities in the United States 
that it disposes of, and the taxpayer leases, rents, licenses, 
purchases, or otherwise acquires property that contains or may contain 
the QPP, qualified film, or the utilities (or a portion thereof), and 
the taxpayer cannot reasonably determine, without undue burden and 
expense, whether the acquired property contains any of the original 
QPP, qualified film, or utilities MPGE or produced by the taxpayer, 
then the taxpayer is not required to determine whether any portion of 
the acquired property qualifies as an item for purposes of paragraph 
(d)(1) of this section. Therefore, the gross receipts derived from the 
disposition of the acquired property may be treated as non-DPGR. 
Similarly, the preceding sentences shall apply if the taxpayer can 
reasonably determine that the acquired property contains QPP, a 
qualified film, or utilities (or a portion thereof) MPGE or produced by 
the taxpayer, but cannot reasonably determine, without undue burden or 
expense, how much, or what type, grade, etc., of the QPP, qualified 
film, or utilities MPGE or produced by the taxpayer the acquired 
property contains.
    (4) Examples. The following examples illustrate the application of 
paragraph (d) of this section:

    Example 1. Q manufactures leather and rubber shoe soles in the 
United States. Q imports shoe uppers, which are the parts of the 
shoe above the sole. Q manufactures shoes for sale by sewing or 
otherwise attaching the soles to the imported uppers. Q offers the 
shoes for sale to customers in the normal course of Q's business. If 
the gross receipts derived from the sale of the shoes do not qualify 
as DPGR under this section, then under paragraph (d)(1)(ii) of this 
section, Q must treat the sole as the item if the gross receipts 
derived from the sale of the sole qualify as DPGR under this 
section.
    Example 2. The facts are the same as in Example 1 except that Q 
also buys some finished shoes from unrelated persons and resells 
them to retail shoe stores. Q offers all shoes (manufactured and 
purchased) for sale to customers, in the normal course of Q's 
business, in individual pairs, and requires no minimum quantity 
order. Q ships the shoes in boxes, each box containing as many as 50 
pairs of shoes. A full, or partially full, box may contain some 
shoes that Q manufactured, and some that Q purchased. Under 
paragraph (d)(2)(i) of this section, Q cannot treat a box of 50 (or 
fewer) pairs of shoes as an item, because Q offers the shoes for 
sale in the normal course of Q's business in individual pairs.
    Example 3. R manufactures toy cars in the United States. R also 
purchases cars that were manufactured by unrelated persons. R offers 
the cars for sale to customers, in the normal course of R's 
business, in sets of three, and requires no minimum quantity order. 
R sells the three-car sets to toy stores. A three-car set may 
contain some cars manufactured by R and some cars purchased by R. If 
the gross receipts derived from the sale of the three-car sets do 
not qualify as DPGR under this section, then, under paragraph 
(d)(1)(ii) of this section, R must treat a toy car in the three-car 
set as the item, provided the gross receipts derived from the sale 
of the toy car qualify as DPGR under this section.
    Example 4. The facts are the same as Example 3 except that R 
offers the toy cars for sale individually to customers in the normal 
course of R's business, rather than in sets of three. R's customers 
resell the individual toy cars at three for $10. Frequently, this 
results in retail customers purchasing three individual cars in one 
transaction. In determining R's DPGR, under paragraph (d)(2)(i) of 
this section, each toy car is an item and R cannot treat three 
individual toy cars as one item, because the individual toy cars are 
not offered for sale in sets of three by R in the normal course of 
R's business.
    Example 5. The facts are the same as in Example 3 except that R 
offers the toy cars for sale to customers in the normal course of 
R's business both individually and in sets of three. The results are 
the same as Example 3 with respect to the three-car sets. The 
results are the same as in Example 4 with respect to the individual 
toy cars that are not included in the three-car sets and offered for 
sale individually. Thus, R has two items, an individual toy car and 
a set of three toy cars.
    Example 6. S produces television sets in the United States. S 
also produces the same

[[Page 31290]]

model of television set outside the United States. In both cases, S 
packages the sets one to a box. S sells the television sets to large 
retail consumer electronics stores. S requires that its customers 
purchase a minimum of 100 television sets per order. With respect to 
a particular order by a customer of 100 television sets, some were 
manufactured by S in the United States, and some were manufactured 
by S outside the United States. Under paragraph (d)(2)(i) of this 
section, a minimum order of 100 television sets is the item provided 
that the gross receipts derived from the sale of the 100 television 
sets qualify as DPGR.
    Example 7. T produces in bulk form in the United States the 
active ingredient for a pharmaceutical product. T sells the active 
ingredient in bulk form to FX, a foreign corporation. This sale 
qualifies as DPGR assuming all the other requirements of this 
section are met. FX uses the active ingredient to produce the 
finished dosage form drug. FX sells the drug in finished dosage to 
T, which sells the drug to customers. Assume that T knows how much 
of the active ingredient is in the finished dosage. Under paragraph 
(d)(1)(ii) of this section, if T's gross receipts derived from the 
sale of the finished dosage do not qualify as DPGR under this 
section, then T must treat the active ingredient component as the 
item because the gross receipts attributable to the active 
ingredient qualify as DPGR under this section. The exception in 
paragraph (d)(3) of this section does not apply because T can 
reasonably determine without undue burden or expense that the 
finished dosage contains the active ingredient and the quantity of 
the active ingredient in the finished dosage.
    Example 8. U produces steel within the United States and sells 
its steel to a variety of customers, including V, an unrelated 
person, who uses the steel for the manufacture of equipment. V also 
purchases steel from other steel producers. For its steel 
operations, U purchases equipment from V that may contain steel 
produced by U. U sells the equipment after 5 years. If U cannot 
reasonably determine without undue burden and expense whether the 
equipment contains any steel produced by U, then, under paragraph 
(d)(3) of this section, U may treat the gross receipts derived from 
sale of the equipment as non-DPGR.
    Example 9. The facts are the same as in Example 8 except that U 
knows that the equipment purchased from V does contain some amount 
of steel produced by U. If U cannot reasonably determine without 
undue burden and expense how much steel produced by U the equipment 
contains, then, under paragraph (d)(3) of this section, U may treat 
the gross receipts derived from sale of the equipment as non-DPGR.
    Example 10. W manufactures sunroofs, stereos, and tires within 
the United States. W purchases automobiles from unrelated persons 
and installs the manufactured components in the automobiles. W, in 
the normal course of W's business, sells the automobiles with the 
components to customers. If the gross receipts derived from the sale 
of the automobiles with the components do not qualify as DPGR under 
this section, then under paragraph (d)(1)(ii) of this section, W 
must treat each component (sunroofs, stereos, and tires) that it 
manufactures as a separate item if the gross receipts derived from 
the sale of each component qualify as DPGR under this section.
    Example 11. X manufacturers leather soles within the United 
States. X purchases shoe uppers, metal eyelets, and laces. X 
manufactures shoes by sewing or otherwise attaching the soles to the 
uppers; attaching the metal eyelets to the shoes; and threading the 
laces through the eyelets. X, in the normal course of X's business, 
sells the shoes to customers. If the gross receipts derived from the 
sale of the shoes do not qualify as DPGR under this section, then 
under paragraph (d)(1)(ii) of this section, X must treat the sole as 
the item if the gross receipts derived from the sale of the sole 
qualify as DPGR under this section. X may not treat the shoe upper, 
metal eyelets or laces as part of the item because under paragraph 
(d)(1)(ii) of this section the sole is the component that is treated 
as the item.
    Example 12. Y manufactures glass windshields for automobiles 
within the United States. Y purchases automobiles from unrelated 
persons and installs the windshields in the automobiles. Y, in the 
normal course of Y's business, sells the automobiles with the 
windshields to customers. If the automobiles with the windshields do 
not meet the requirements for being an item, then, under paragraph 
(d)(1)(ii) of this section, Y must treat each windshield that it 
manufactures as an item if the gross receipts derived from the sale 
of the windshield qualify as DPGR under this section. Y may not 
treat any other portion of the automobile as part of the item 
because under paragraph (d)(1)(ii) of this section the windshield is 
the component.

    (e) Definition of manufactured, produced, grown, or extracted--(1) 
In general. Except as provided in paragraphs (e)(2) and (3) of this 
section, the term MPGE includes manufacturing, producing, growing, 
extracting, installing, developing, improving, and creating QPP; making 
QPP out of scrap, salvage, or junk material as well as from new or raw 
material by processing, manipulating, refining, or changing the form of 
an article, or by combining or assembling two or more articles; 
cultivating soil, raising livestock, fishing, and mining minerals. The 
term MPGE also includes storage, handling, or other processing 
activities (other than transportation activities) within the United 
States related to the sale, exchange, or other disposition of 
agricultural products, provided the products are consumed in connection 
with or incorporated into the MPGE of QPP, whether or not by the 
taxpayer. Pursuant to paragraph (f)(1) of this section, the taxpayer 
must have the benefits and burdens of ownership of the QPP under 
Federal income tax principles during the period the MPGE activity 
occurs in order for gross receipts derived from the MPGE of QPP to 
qualify as DPGR.
    (2) Packaging, repackaging, labeling, or minor assembly. If a 
taxpayer packages, repackages, labels, or performs minor assembly of 
QPP and the taxpayer engages in no other MPGE activity with respect to 
that QPP, the taxpayer's packaging, repackaging, labeling, or minor 
assembly does not qualify as MPGE with respect to that QPP.
    (3) Installing. If a taxpayer installs QPP and engages in no other 
MPGE activity with respect to the QPP, the taxpayer's installing 
activity does not qualify as an MPGE activity. Notwithstanding 
paragraph (i)(4)(i)(B)(4) of this section, if the taxpayer installs QPP 
MPGE by the taxpayer and, except as provided in paragraph (f)(2) of 
this section, the taxpayer has the benefits and burdens of ownership of 
the QPP under Federal income tax principles during the period the 
installing activity occurs, then the portion of the installing activity 
that relates to the QPP is an MPGE activity.
    (4) Consistency with section 263A. A taxpayer that has MPGE QPP for 
the taxable year should treat itself as a producer under section 263A 
with respect to the QPP unless the taxpayer is not subject to section 
263A. A taxpayer that currently is not properly accounting for its 
production activities under section 263A, and wishes to change its 
method of accounting to comply with the producer requirements of 
section 263A, must follow the applicable administrative procedures 
issued under Sec.  1.446-1(e)(3)(ii) for obtaining the Commissioner's 
consent to a change in accounting method (for further guidance, for 
example, see Rev. Proc. 97-27 (1997-1 C.B. 680), or Rev. Proc. 2002-9 
(2002-1 C.B. 327), whichever applies (see Sec.  601.601(d)(2) of this 
chapter)).
    (5) Examples. The following examples illustrate the application of 
this paragraph (e):

    Example 1. A, B, and C are unrelated persons and are not 
cooperatives to which Part I of subchapter T of the Code applies. B 
grows agricultural products in the United States and sells them to 
A, who owns agricultural storage bins in the United States. A stores 
the agricultural products and has the benefits and burdens of 
ownership under Federal income tax principles of the agricultural 
products while they are being stored. A sells the agricultural 
products to C, who processes them into refined agricultural products 
in the United States. The gross receipts from A's, B's, and C's 
activities are DPGR from the MPGE of QPP.
    Example 2. The facts are the same as in Example 1 except that B 
grows the agricultural products outside the United

[[Page 31291]]

States and C processes them into refined agricultural products 
outside the United States. Pursuant to paragraph (e)(1) of this 
section, the gross receipts derived by A from its sale of the 
agricultural products to C are DPGR from the MPGE of QPP within the 
United States. B's and C's respective MPGE activities occur outside 
the United States and, therefore, their respective gross receipts 
are non-DPGR.
    Example 3. Y is hired to reconstruct and refurbish unrelated 
customers' tangible personal property. As part of the reconstruction 
and refurbishment, Y installs purchased replacement parts that 
constitute QPP in the customers' property. Y's installation of 
purchased replacement parts does not qualify as MPGE pursuant to 
paragraph (e)(3) of this section because Y did not MPGE the 
replacement parts.
    Example 4. The facts are the same as in Example 3 except that Y 
manufactures the replacement parts it uses for the reconstruction 
and refurbishment of customers' tangible personal property. Y has 
the benefits and burdens of ownership under Federal income tax 
principles of the replacement parts during the reconstruction and 
refurbishment activity and while installing the parts. Y's gross 
receipts derived from the MPGE of the replacement parts and Y's 
gross receipts derived from the installation of the replacement 
parts, which is an MPGE activity pursuant to paragraph (e)(3) of 
this section, are DPGR (assuming all the other requirements of this 
section are met).
    Example 5. Z MPGE QPP within the United States. The following 
activities are performed by Z as part of the MPGE of the QPP while Z 
has the benefits and burdens of ownership under Federal income tax 
principles: materials analysis and selection, subcontractor 
inspections and qualifications, testing of component parts, 
assisting customers in their review and approval of the QPP, routine 
production inspections, product documentation, diagnosis and 
correction of system failure, and packaging for shipment to 
customers. Because Z MPGE the QPP, these activities performed by Z 
are part of the MPGE of the QPP.
    Example 6. X purchases automobiles from unrelated persons and 
customizes them by adding ground effects, spoilers, custom wheels, 
specialized paint and decals, sunroofs, roof racks, and similar 
accessories. X does not manufacture any of the accessories. X's 
activity is minor assembly under paragraph (e)(2) of this section 
which is not an MPGE activity.
    Example 7. Y manufactures furniture in the United States that it 
sells to unrelated persons. Y also engraves customers' names on pens 
and pencils purchased from unrelated persons and sells the pens and 
pencils to such customers. Although Y's sales of furniture qualify 
as DPGR if all the other requirements of this section are met, Y 
must determine whether its gross receipts derived from the sale of 
the pens and pencils qualify as DPGR. Y's status as a manufacturer 
of furniture in the United States does not carry over to its other 
activities.
    Example 8. X produces computer software within the United 
States. In 2007, X enters into an agreement with Y, an unrelated 
person, under which X will manage Y's networks using computer 
software that X produced. Pursuant to the terms of the agreement, X 
also provides to Y for Y's use on Y's own hardware computer software 
that X produced (additional computer software). Assume that, based 
on all of the facts and circumstances, the transaction between X and 
Y relating to the additional computer software is a lease or sale of 
the additional computer software. Y pays X monthly fees of $100 
under the agreement during 2007. No separate charge for the 
additional computer software is stated in the agreement or in the 
monthly invoices that X provides to Y. The portion of X's gross 
receipts that is derived from the lease or sale of the additional 
computer software is DPGR (assuming all the other requirements of 
this section are met).

    (f) Definition of by the taxpayer--(1) In general. With the 
exception of the rules applicable to an expanded affiliated group (EAG) 
under Sec.  1.199-7, qualifying in-kind partnerships under Sec.  1.199-
9(i), EAG partnerships under Sec.  1.199-9(j), and government contracts 
under paragraph (f)(2) of this section, only one taxpayer may claim the 
deduction under Sec.  1.199-1(a) with respect to any qualifying 
activity under paragraphs (e)(1), (k)(1), and (l)(1) of this section 
performed in connection with the same QPP, or the production of a 
qualified film or utilities. If one taxpayer performs a qualifying 
activity under paragraph (e)(1), (k)(1), or (l)(1) of this section 
pursuant to a contract with another party, then only the taxpayer that 
has the benefits and burdens of ownership of the QPP, qualified film, 
or utilities under Federal income tax principles during the period in 
which the qualifying activity occurs is treated as engaging in the 
qualifying activity.
    (2) Special rule for certain government contracts. Gross receipts 
derived from the MPGE of QPP in whole or in significant part within the 
United States will be treated as gross receipts derived from the lease, 
rental, license, sale, exchange, or other disposition of QPP MPGE by 
the taxpayer in whole or in significant part within the United States 
notwithstanding the requirements of paragraph (f)(1) of this section 
if--
    (i) The QPP is MPGE by the taxpayer within the United States 
pursuant to a contract with the Federal government; and
    (ii) The Federal Acquisition Regulation (Title 48, Code of Federal 
Regulations) requires that title or risk of loss with respect to the 
QPP be transferred to the Federal government before the MPGE of the QPP 
is completed.
    (3) Subcontractor. If a taxpayer (subcontractor) enters into a 
contract or agreement to MPGE QPP on behalf of a taxpayer to which 
paragraph (f)(2) of this section applies, and the QPP under the 
contract or agreement is subject to paragraph (f)(2)(ii) of this 
section, then, notwithstanding the requirements of paragraph (f)(1) of 
this section, the subcontractor's gross receipts derived from the MPGE 
of the QPP in whole or in significant part within the United States 
will be treated as gross receipts derived from the lease, rental, 
license, sale, exchange, or other disposition of QPP MPGE by the 
subcontractor in whole or in significant part within the United States.
    (4) Examples. The following examples illustrate the application of 
this paragraph (f):

    Example 1. X designs machines that it uses in its trade or 
business. X contracts with Y, an unrelated person, for the 
manufacture of the machines. The contract between X and Y is a 
fixed-price contract. The contract specifies that the machines will 
be manufactured in the United States using X's design. X owns the 
intellectual property attributable to the design and provides it to 
Y with a restriction that Y may only use it during the manufacturing 
process and has no right to exploit the intellectual property. The 
contract specifies that Y controls the details of the manufacturing 
process while the machines are being produced; Y bears the risk of 
loss or damage during manufacturing of the machines; and Y has the 
economic loss or gain upon the sale of the machines based on the 
difference between Y's costs and the fixed price. Y has legal title 
during the manufacturing process and legal title to the machines is 
not transferred to X until final manufacturing of the machines has 
been completed. Based on all of the facts and circumstances, 
pursuant to paragraph (f)(1) of this section Y has the benefits and 
burdens of ownership of the machines under Federal income tax 
principles during the period the manufacturing occurs and, as a 
result, Y is treated as the manufacturer of the machines.
    Example 2. X designs and engineers machines that it sells to 
customers. X contracts with Y, an unrelated person, for the 
manufacture of the machines. The contract between X and Y is a cost-
reimbursable type contract. Assume that X has the benefits and 
burdens of ownership of the machines under Federal income tax 
principles during the period the manufacturing occurs except that 
legal title to the machines is not transferred to X until final 
manufacturing of the machines is completed. Based on all of the 
facts and circumstances, X is treated as the manufacturer of the 
machines under paragraph (f)(1) of this section.
    Example 3. X manufactures machines within the United States 
pursuant to a contract with the Federal government and the Federal 
Acquisition Regulation requires that the title or risk of loss with 
respect to the machines be transferred to the Federal government 
before X completes manufacture of the machines. X subcontracts with 
Y, an unrelated person, for the manufacture of components for the 
machines that Y manufactures within the United States.

[[Page 31292]]

Assume that the machines manufactured by X, and the components for 
the machines manufactured by Y, are QPP. Both the machines and 
components are subject to the Federal Acquisition Regulation that 
requires title or risk of loss with respect to the machines and 
components be transferred to the Federal government before 
manufacturing of the machines and components are complete. Under 
paragraph (f)(2) of this section, the gross receipts derived by X 
from the manufacture within the United States of the machines for 
the Federal government are treated as having been derived from the 
lease, rental, license, sale, exchange, or other disposition of the 
machines manufactured by X in whole or in significant part within 
the United States. Under paragraph (f)(3) of this section, the gross 
receipts derived by Y from the manufacture within the United States 
of the components for X are also treated as having been derived from 
the lease, rental, license, sale, exchange, or other disposition of 
the components manufactured by Y in whole or in significant part 
within the United States.

    (g) Definition of in whole or in significant part--(1) In general. 
QPP must be MPGE in whole or in significant part by the taxpayer and in 
whole or in significant part within the United States to qualify under 
section 199(c)(4)(A)(i)(I). If a taxpayer enters into a contract with 
an unrelated person for the unrelated person to MPGE QPP for the 
taxpayer and the taxpayer has the benefits and burdens of ownership of 
the QPP under applicable Federal income tax principles during the 
period the MPGE activity occurs, then, pursuant to paragraph (f)(1) of 
this section, the taxpayer is considered to MPGE the QPP under this 
section. The unrelated person must perform the MPGE activity on behalf 
of the taxpayer in whole or in significant part within the United 
States in order for the taxpayer to satisfy the requirements of this 
paragraph (g)(1).
    (2) Substantial in nature. QPP will be treated as MPGE in 
significant part by the taxpayer within the United States for purposes 
of paragraph (g)(1) of this section 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 QPP, and the nature of the 
MPGE activity that the taxpayer performs within the United States. The 
MPGE of a key component of QPP does not, in itself, meet the 
substantial-in-nature requirement with respect to the QPP under this 
paragraph (g)(2). In the case of tangible personal property (as defined 
in paragraph (j)(2) of this section), research and experimental 
activities under section 174 and the creation of intangible assets are 
not taken into account in determining whether the MPGE of QPP is 
substantial in nature for any QPP other than computer software (as 
defined in paragraph (j)(3) of this section) and sound recordings (as 
defined in paragraph (j)(4) of this section). Thus, for example, a 
taxpayer may take into account its design and development activities 
when determining whether its MPGE of computer software is substantial 
in nature.
    (3) Safe harbor--(i) In general. A taxpayer will be treated as 
having MPGE QPP in whole or in significant part within the United 
States for purposes of paragraph (g)(1) of this section if, in 
connection with the QPP, the direct labor and overhead of such taxpayer 
to MPGE the QPP within the United States account for 20 percent or more 
of the taxpayer's CGS of the QPP, 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 paragraph 
(g)(3)(ii) of this section) in the QPP. 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. Research and 
experimental expenditures under section 174 and the costs of creating 
intangible assets are not taken into account in determining direct 
labor or overhead for any tangible personal property. However, for a 
special rule regarding computer software and sound recordings, see 
paragraph (g)(3)(iii) of this section. In the case of tangible personal 
property (as defined in paragraph (j)(2) of this section), research and 
experimental expenditures under section 174 and any other costs 
incurred in the creation of intangible assets may be excluded from CGS 
or unadjusted depreciable basis for purposes of determining whether the 
taxpayer meets the safe harbor under this paragraph (g)(3).
    (ii) Unadjusted depreciable basis. The term unadjusted depreciable 
basis means the basis of property for purposes of section 1011 without 
regard to any adjustments described in section 1016(a)(2) and (3). This 
basis does not reflect the reduction in basis for--
    (A) Any portion of the basis the taxpayer properly elects to treat 
as an expense under section 179 or 179C; or
    (B) Any adjustments to basis provided by other provisions of the 
Code and the regulations under the Code (for example, a reduction in 
basis by the amount of the disabled access credit pursuant to section 
44(d)(7)).
    (iii) Computer software and sound recordings. In determining direct 
labor and overhead under paragraph (g)(3)(i) of this section, the costs 
of direct labor and overhead for developing computer software as 
described in Rev. Proc. 2000-50 (2000-1 C.B. 601) (see Sec.  
601.601(d)(2) of this chapter), research and experimental expenditures 
under section 174, and any other costs of creating intangible assets 
for computer software and sound recordings are treated as direct labor 
and overhead. These costs must be included in the taxpayer's CGS or 
unadjusted depreciable basis of computer software and sound recordings 
for purposes of determining whether the taxpayer meets the safe harbor 
under paragraph (g)(3)(i) of this section. If the taxpayer expects to 
lease, rent, license, sell, exchange, or otherwise dispose of computer 
software or sound recordings over more than one taxable year, the costs 
of developing computer software as described in Rev. Proc. 2000-50 
(2000-1 C.B. 601), research and experimental expenditures under section 
174, and any other costs of creating intangible assets for computer 
software and sound recordings must be allocated over the estimated 
number of units that the taxpayer expects to lease, rent, license, 
sell, exchange, or otherwise dispose of.
    (4) Special rules--(i) Contract with an unrelated person. If a 
taxpayer enters into a contract with an unrelated person for the 
unrelated person to MPGE QPP within the United States for the taxpayer, 
and the taxpayer is considered to MPGE the QPP pursuant to paragraph 
(f)(1) of this section, then, for purposes of the substantial-in-nature 
requirement under paragraph (g)(2) of this section and the safe harbor 
under paragraph (g)(3)(i) of this section, the taxpayer's MPGE or 
production activities or direct labor and overhead shall include both 
the taxpayer's MPGE or production activities or direct labor and 
overhead to MPGE the QPP within the United States as well as the MPGE 
or production activities or direct labor and overhead of the unrelated 
person to MPGE the QPP within the United States under the contract.
    (ii) Aggregation. In determining whether the substantial-in-nature 
requirement under paragraph (g)(2) of this section or the safe harbor 
under

[[Page 31293]]

paragraph (g)(3)(i) of this section is met at the time the taxpayer 
disposes of an item of QPP--
    (A) An EAG member must take into account all of the previous MPGE 
or production activities or direct labor and overhead of the other 
members of the EAG;
    (B) An EAG partnership (as defined in Sec.  1.199-9(j)) must take 
into account all of the previous MPGE or production activities or 
direct labor and overhead of all members of the EAG in which the 
partners of the EAG partnership are members (as well as the previous 
MPGE or production activities of any other EAG partnerships owned by 
members of the same EAG);
    (C) A member of an EAG in which the partners of an EAG partnership 
are members must take into account all of the previous MPGE or 
production activities or direct labor and overhead of the EAG 
partnership (as well as those of any other members of the EAG and any 
previous MPGE or production activities of any other EAG partnerships 
owned by members of the same EAG); and
    (D) A partner of a qualifying in-kind partnership (as defined in 
Sec.  1.199-9(i)) must take into account all of the previous MPGE or 
production activities or direct labor and overhead of the qualifying 
in-kind partnership.
    (5) Examples. The following examples illustrate the application of 
this paragraph (g):

    Example 1. X purchases from Y, an unrelated person, unrefined 
oil extracted outside the United States. X refines the oil in the 
United States. The refining of the oil by X is an MPGE activity that 
is substantial in nature.
    Example 2. X purchases gemstones and precious metal from outside 
the United States and then uses these materials to produce jewelry 
within the United States by cutting and polishing the gemstones, 
melting and shaping the metal, and combining the finished materials. 
X's MPGE activities are substantial in nature under paragraph (g)(2) 
of this section. Therefore, X has MPGE the jewelry in significant 
part within the United States.
    Example 3.  (i) Facts. X operates an automobile assembly plant 
in the United States. In connection with such activity, X purchases 
assembled engines, transmissions, and certain other components from 
Y, an unrelated person, and X assembles all of the component parts 
into an automobile. X also conducts stamping, machining, and 
subassembly operations, and X uses tools, jigs, welding equipment, 
and other machinery and equipment in the assembly of automobiles. On 
a per-unit basis, X 's selling price and costs of such automobiles 
are as follows:
Selling price: $ 2,500
Cost of goods sold:
    Material--Acquired from Y: $ 1,475
    Direct labor and overhead: $325
    Total cost of goods sold: $1,800
Gross profit: $700
Administrative and selling expenses: $300
Taxable income: $400
    (ii) Analysis. Although X's direct labor and overhead are less 
than 20% of total CGS ($325/$1,800, or 18%) and X is not within the 
safe harbor under paragraph (g)(3)(i) of this section, the 
activities conducted by X in connection with the assembly of an 
automobile are substantial in nature under paragraph (g)(2) of this 
section taking into account the nature of X's activity and the 
relative value of X's activity. Therefore, X's automobiles will be 
treated as MPGE in significant part by X within the United States 
for purposes of paragraph (g)(1) of this section.
    Example 4. X imports into the United States QPP that is 
partially manufactured. Assume that X completes the manufacture of 
the QPP within the United States and X's completion of the 
manufacturing of the QPP within the United States satisfies the in-
whole-or-in-significant-part requirement under paragraph (g)(1) of 
this section. Therefore, X's gross receipts from the lease, rental, 
license, sale, exchange, or other disposition of the QPP qualify as 
DPGR if all other applicable requirements under this section are 
met.
    Example 5. X manufactures QPP in significant part within the 
United States and exports the QPP for further manufacture outside 
the United States. X retains title to the QPP while the QPP is being 
further manufactured outside the United States. Assuming X meets all 
the requirements under this section for the QPP after the further 
manufacturing, X's gross receipts derived from the lease, rental, 
license, sale, exchange, or other disposition of the QPP will be 
considered DPGR, regardless of whether the QPP is imported back into 
the United States prior to the lease, rental, license, sale, 
exchange, or other disposition of the QPP.
    Example 6. X is a retailer within the United States that sells 
cigars and pipe tobacco that X purchases from an unrelated person. 
While being displayed and offered for sale by X, the cigars and pipe 
tobacco age on X's shelves in a room with controlled temperature and 
humidity. Although X's cigars and pipe tobacco may become more 
valuable as they age, the gross receipts derived by X from the sale 
of the cigars and pipe tobacco are non-DPGR because the aging of the 
cigars and pipe tobacco while being displayed and offered for sale 
by X does not qualify as an MPGE activity that is substantial in 
nature.
    Example 7. X incurs $1,000,000 in computer software development 
costs in direct labor and overhead to develop computer software. X 
begins producing the computer software and expects to license one 
million copies of the computer software. In determining its direct 
labor and overhead for the computer software under paragraph 
(g)(3)(i) of this section, X must allocate under paragraph 
(g)(3)(iii) of this section the $1,000,000 to the computer software 
X expects to produce. Thus, for each copy of the computer software 
produced by X, $1 ($1,000,000 in computer software development 
costs/one million estimated number of units to be licensed) in 
computer software development costs are treated as direct labor and 
overhead.
    Example 8. X creates computer software for microwave ovens. X 
also manufactures the electric motors used in the ovens. X purchases 
the other components of the microwave ovens from unrelated persons. 
X sells each microwave oven individually to customers. Assume that 
X's assembly of the finished microwave ovens is not minor assembly. 
To determine whether the manufacture of the microwave ovens 
satisfies the safe harbor under paragraph (g)(3)(i) of this section, 
X's direct labor and overhead include X's direct labor and overhead 
for creating the computer software, manufacturing the electric 
motors, and assembling the finished microwave ovens that are offered 
for sale.
    Example 9. X designs shirts within the United States, but X cuts 
and sews the shirts outside of the United States. Because X's design 
activity is the creation of an intangible, its design activity is 
not taken into account in determining whether the manufacture of the 
shirts is substantial in nature under paragraph (g)(2) of this 
section, and the costs X incurs in creating the design of the shirts 
are not direct labor or overhead under paragraph (g)(3)(i) of this 
section. Therefore, X has not MPGE the shirts in significant part 
within the United States.
    Example 10. 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. The computer chips are 
key components of the computers and the computers will not operate 
without them. The manufacture of the computer chips is not, in 
itself, substantial in nature with respect to the finished 
computers. Therefore, the taxpayer's MPGE activities must meet 
either the substantial-in-nature requirement under paragraph (g)(2) 
of this section, or the safe harbor under paragraph (g)(3) of this 
section, in order to qualify with respect to the finished computers.

    (h) Definition of United States. For purposes of this section, the 
term United States includes the 50 states, the District of Columbia, 
the territorial waters of the United States, and the seabed and subsoil 
of those submarine areas that are adjacent to the territorial waters of 
the United States and over which the United States has exclusive 
rights, in accordance with international law, with respect to the 
exploration and exploitation of natural resources. The term United 
States does not include possessions and territories of the United 
States or the airspace or space over the United States and these areas.
    (i) Derived from the lease, rental, license, sale, exchange, or 
other disposition--(1) In general--(i) Definition. The term derived 
from the lease, rental, license, sale, exchange, or other disposition 
is defined as, and limited to, the gross receipts directly

[[Page 31294]]

derived from the lease, rental, license, sale, exchange, or other 
disposition of QPP, a qualified film, or utilities, even if the 
taxpayer has already recognized gross receipts from a previous lease, 
rental, license, sale, exchange, or other disposition of the same QPP, 
qualified film, or utilities. Applicable Federal income tax principles 
apply to determine whether a transaction is, in substance, a lease, 
rental, license, sale, exchange, or other disposition, whether it is a 
service, or whether it is some combination thereof.
    (ii) Lease income. The financing and interest components of a lease 
of QPP or a qualified film are considered to be derived from the lease 
of such QPP or qualified film. However, any portion of the lease income 
that is attributable to services or non-qualified property as defined 
in paragraph (i)(4) of this section is not derived from the lease of 
QPP or a qualified film.
    (iii) Income substitutes. The proceeds from business interruption 
insurance, governmental subsidies, and governmental payments not to 
produce are treated as gross receipts derived from the lease, rental, 
license, sale, exchange, or other disposition to the extent that they 
are substitutes for gross receipts that would qualify as DPGR.
    (iv) Exchange of property--(A) Taxable exchanges. Except as 
provided in paragraph (i)(1)(iv)(B) of this section, the value of 
property received by a taxpayer in a taxable exchange of QPP MPGE in 
whole or in significant part by the taxpayer within the United States, 
a qualified film produced by the taxpayer, or utilities produced by the 
taxpayer within the United States is DPGR for the taxpayer (assuming 
all the other requirements of this section are met). However, unless 
the taxpayer meets all of the requirements under this section 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.
    (B) Safe harbor. For purposes of paragraph (i)(1)(iv)(A) of this 
section, the gross receipts derived by the taxpayer from the sale of 
eligible property (as defined in paragraph (i)(1)(iv)(C) of this 
section) received in a taxable exchange, net of any adjustments between 
the parties 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. For purposes 
of the preceding sentence, the taxable exchange is deemed to occur on 
the date of the sale of the eligible property received in the taxable 
exchange by the taxpayer, to the extent 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. 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 paragraph (g)(1) of this section with respect to the 
property sold, for purposes of this paragraph (i)(1)(iv)(B), the 
taxpayer must also value the property sold without taking into account 
the gross receipts attributable to the further MPGE or production 
activity.
    (C) Eligible property. For purposes of paragraph (i)(1)(iv)(B) of 
this section, eligible property is--
    (1) Oil, natural gas (as described in paragraph (l)(2) of this 
section), or petrochemicals, or products derived from oil, natural gas, 
or petrochemicals; or
    (2) Any other property or product designated by publication in the 
Internal Revenue Bulletin (see Sec.  601.601(d)(2)(ii)(b) of this 
chapter).
    (2) Examples. The following examples illustrate the application of 
paragraph (i)(1) of this section:

    Example 1. X MPGE QPP in whole or in significant part within the 
United States and uses the QPP in its business. After several years 
X sells the QPP that it MPGE to Y. The gross receipts derived from 
the sale of the QPP to Y are DPGR (assuming all the other 
requirements of this section are met).
    Example 2. X MPGE QPP within the United States and sells the QPP 
to Y, an unrelated person. Y leases the QPP for 3 years to Z, a 
taxpayer unrelated to both X and Y, and shortly after Y enters into 
the lease with Z, X repurchases the QPP from Y subject to the lease. 
At the end of the lease term, Z purchases the QPP from X. X's 
proceeds derived from the sale of the QPP to Y, from the lease to Z 
(including any financing and interest components of the lease), and 
from the sale of the QPP to Z all qualify as DPGR (assuming all the 
other requirements of this section are met).
    Example 3. X MPGE QPP within the United States and sells the QPP 
to Y, an unrelated person, for $25,000. X finances Y's purchase of 
the QPP and receives total payments of $35,000, of which $10,000 
relates to interest and finance charges. The $25,000 qualifies as 
DPGR, but the $10,000 in interest and finance charges do not qualify 
as DPGR because the $10,000 is not derived from the MPGE of QPP 
within the United States, but rather from X's lending activity.
    Example 4. Cable company X charges subscribers $15 a month for 
its basic cable television. Y, an unrelated person, produces a 
qualified film within the meaning of paragraph (k)(1) of this 
section that it licenses to X for $.10 per subscriber per month. The 
gross receipts derived by Y are derived from the license of a 
qualified film produced by Y and are DPGR (assuming all the other 
requirements of this section are met).
    Example 5. X manufactures cars within the United States. X also 
manufactures replacement parts within the United States. The 
replacement parts are QPP under paragraph (j)(1) of this section. X 
offers extended warranties to its customers. X sells a car to Y. Y 
purchases an extended warranty and brings the car to X's service 
department for maintenance. X repairs the car and replaces damaged 
parts with replacement parts that X manufactured within the United 
States. The portion of X's gross receipts derived from the sale of 
the extended warranty relating to the manufactured parts are DPGR.

    (3) Hedging transactions--(i) In general. For purposes of this 
section, provided that the risk being hedged relates to QPP described 
in section 1221(a)(1) or relates to property described in section 
1221(a)(8) consumed in an activity giving rise to DPGR, and provided 
that the transaction is a hedging transaction within the meaning of 
section 1221(b)(2)(A) and Sec.  1.1221-2(b) and is properly identified 
as a hedging transaction in accordance with Sec.  1.1221-2(f), then--
    (A) In the case of a hedge of purchases of property described in 
section 1221(a)(1), gain or loss on the hedging transaction must be 
taken into account in determining CGS;
    (B) In the case of a hedge of sales of property described in 
section 1221(a)(1), gain or loss on the hedging transaction must be 
taken into account in determining DPGR; and
    (C) In the case of a hedge of purchases of property described in 
section 1221(a)(8), gain or loss on the hedging transaction must be 
taken into account in determining DPGR.
    (ii) Currency fluctuations. For purposes of this section, in the 
case of a transaction that manages the risk of currency fluctuations, 
the determination of whether the transaction is a hedging transaction 
within the meaning of Sec.  1.1221-2(b) is made without regard to 
whether the transaction is a section 988 transaction. See Sec.  1.1221-
2(a)(4). The preceding sentence applies only to the extent that Sec.  
1.988-5(b) does not apply.
    (iii) Effect of identification and nonidentification. If a taxpayer 
does not make an identification that satisfies all of the requirements 
of Sec.  1.1221-2(f) but

[[Page 31295]]

the taxpayer has no reasonable grounds for treating the transaction as 
other than a hedging transaction, then a loss from the transaction is 
taken into account under this paragraph (i)(3). If the inadvertent 
identification rule of Sec.  1.1221-2(g)(1)(ii) or the inadvertent 
error rule of Sec.  1.1221-2(g)(2)(ii) applies, then the taxpayer is 
treated as not having identified the transaction as a hedging 
transaction or as having identified the transaction as a hedging 
transaction, as the case may be. If a taxpayer identifies a transaction 
as a hedging transaction in accordance with Sec.  1.1221-2(f)(1), 
then--
    (A) That identification is binding with respect to loss for 
purposes of this paragraph (i)(3), whether or not all of the 
requirements of Sec.  1.1221-2(f) are satisfied and whether or not the 
transaction is in fact a hedging transaction within the meaning of 
section 1221(b)(2)(A) and Sec.  1.1221-2(b), and
    (B) This paragraph (i)(3) does not apply to require gain to be 
taken into account in determining CGS or DPGR, if the transaction is 
not in fact a hedging transaction within the meaning of section 
1221(b)(2)(A) and Sec.  1.1221-2(b).
    (iv) Other rules. See Sec.  1.1221-2(e) for rules applicable to 
hedging by members of a consolidated group and Sec.  1.446-4 for rules 
regarding the timing of income, deductions, gains, or losses with 
respect to hedging transactions.
    (4) Allocation of gross receipts--(i) Embedded services and non-
qualified property--(A) In general. Except as otherwise provided in 
paragraph (i)(4)(i)(B), paragraph (m) (relating to construction), and 
paragraph (n) (relating to engineering and architectural services) of 
this section, gross receipts derived from the performance of services 
do not qualify as DPGR. In the case of an embedded service, that is, a 
service the price of which, in the normal course of the taxpayer's 
business, is not separately stated from the amount charged for the 
lease, rental, license, sale, exchange, or other disposition of QPP, a 
qualified film, or utilities, DPGR include only the gross receipts 
derived from the lease, rental, license, sale, exchange, or other 
disposition of QPP, a qualified film, or utilities (assuming all the 
other requirements of this section are met) and not any receipts 
attributable to the embedded service. In addition, DPGR does not 
include the gross receipts derived from the lease, rental, license, 
sale, exchange, or other disposition of property that does not meet all 
of the requirements under this section (non-qualified property). The 
allocation of the gross receipts attributable to the embedded services 
or non-qualified property will be deemed to be reasonable if the 
allocation reflects the fair market value of the embedded services or 
non-qualified property. For example, gross receipts derived from the 
lease, rental, license, sale, exchange, or other disposition of a 
replacement part that is non-qualified property does not qualify as 
DPGR. In addition, see Sec.  1.199-1(e) for other instances when an 
allocation of gross receipts attributable to embedded services or non-
qualified property will be deemed reasonable.
    (B) Exceptions. There are six exceptions to the rules under 
paragraph (i)(4)(i)(A) of this section regarding embedded services and 
non-qualified property. A taxpayer may include in DPGR, if all the 
other requirements of this section are met with respect to the 
underlying item of QPP, qualified films, or utilities to which the 
embedded services or non-qualified property relate, the gross receipts 
derived from--
    (1) A qualified warranty, that is, a warranty (other than a 
computer software maintenance agreement described in paragraph 
(i)(4)(i)(B)(5) of this section) that is provided in connection with 
the lease, rental, license, sale, exchange, or other disposition of 
QPP, a qualified film, or utilities if, in the normal course of the 
taxpayer's business--
    (i) The price for the warranty is not separately stated from the 
amount charged for the lease, rental, license, sale, exchange, or other 
disposition of the QPP, qualified film, or utilities; and
    (ii) The warranty is neither separately offered by the taxpayer nor 
separately bargained for with customers (that is, a customer cannot 
purchase the QPP, qualified film, or utilities without the warranty);
    (2) A qualified delivery, that is, a delivery or distribution 
service that is provided in connection with the lease, rental, license, 
sale, exchange, or other disposition of QPP if, in the normal course of 
the taxpayer's business--
    (i) The price for the delivery or distribution service is not 
separately stated from the amount charged for the lease, rental, 
license, sale, exchange, or other disposition of the QPP; and
    (ii) The delivery or distribution service is neither separately 
offered by the taxpayer nor separately bargained for with customers 
(that is, a customer cannot purchase the QPP without the delivery or 
distribution service);
    (3) A qualified operating manual, that is, a manual of instructions 
(including electronic instructions) that is provided in connection with 
the lease, rental, license, sale, exchange, or other disposition of 
QPP, a qualified film or utilities if, in the normal course of the 
taxpayer's business--
    (i) The price for the manual is not separately stated from the 
amount charged for the lease, rental, license, sale, exchange, or other 
disposition of the QPP, qualified film, or utilities;
    (ii) The manual is neither separately offered by the taxpayer nor 
separately bargained for with customers (that is, a customer cannot 
purchase the QPP, qualified film, or utilities without the manual); and
    (iii) The manual is not provided in connection with a training 
course for customers;
    (4) A qualified installation, that is, an installation service 
(including minor assembly) for tangible personal property that is 
provided in connection with the lease, rental, license, sale, exchange, 
or other disposition of the tangible personal property if, in the 
normal course of the taxpayer's business--
    (i) The price for the installation service is not separately stated 
from the amount charged for the lease, rental, license, sale, exchange, 
or other disposition of the tangible personal property; and
    (ii) The installation is neither separately offered by the taxpayer 
nor separately bargained for with customers (that is, a customer cannot 
purchase the tangible personal property without the installation 
service);
    (5) Services performed pursuant to a qualified computer software 
maintenance agreement. A qualified computer software maintenance 
agreement is an agreement provided in connection with the lease, 
rental, license, sale, exchange, or other disposition of the computer 
software that entitles the customer to receive future updates, cyclical 
releases, rewrites of the underlying software, or customer support 
services for the computer software if, in the normal course of the 
taxpayer's business--
    (i) The price for the agreement is not separately stated from the 
amount charged for the lease, rental, license, sale, exchange, or other 
disposition of the computer software; and
    (ii) The agreement is neither separately offered by the taxpayer 
nor separately bargained for with customers (that is, a customer cannot 
purchase the computer software without the agreement); and
    (6) A de minimis amount of gross receipts from embedded services 
and non-qualified property for each item of QPP, qualified films, or 
utilities. For purposes of the preceding sentence, a de minimis amount 
of gross receipts from embedded services and non-qualified property is 
less than 5 percent of the

[[Page 31296]]

total gross receipts derived from the lease, rental, license, sale, 
exchange, or other disposition of each item of QPP, qualified films, or 
utilities. In the case of gross receipts derived from the lease, 
rental, license, sale, exchange, or other disposition of QPP, a 
qualified film, or utilities that are received over a period of time 
(for example, a multi-year lease or installment sale), this de minimis 
exception is applied by taking into account the total gross receipts 
for the entire period derived (and to be derived) from the lease, 
rental, license, sale, exchange, or other disposition of the item of 
QPP, qualified films, or utilities. For purposes of the preceding 
sentence, if a taxpayer treats gross receipts as DPGR under this de 
minimis exception, then the taxpayer must treat the gross receipts 
recognized in each taxable year consistently as DPGR. The gross 
receipts that the taxpayer treats as DPGR under paragraphs 
(i)(4)(i)(B)(1), (2), (3), (4), and (5) and (l)(4)(iv)(A) of this 
section are treated as DPGR for purposes of applying this de minimis 
exception. This de minimis exception does not apply if the price of a 
service or non-qualified property is separately stated by the taxpayer, 
or if the service or non-qualified property is separately offered or 
separately bargained for with the customer (that is, the customer can 
purchase the QPP, qualified film, or utilities without the service or 
non-qualified property).
    (ii) Non-DPGR. All of a taxpayer's gross receipts derived from the 
lease, rental, license, sale, exchange or other disposition of an item 
of QPP, qualified films, or utilities may be treated as non-DPGR if 
less than 5 percent of the taxpayer's total gross receipts derived from 
the lease, rental, license, sale, exchange or other disposition of that 
item are DPGR. In the case of gross receipts derived from the lease, 
rental, license, sale, exchange, or other disposition of QPP, a 
qualified film, and utilities that are received over a period of time 
(for example, a multi-year lease or installment sale), this paragraph 
(i)(4)(ii) is applied by taking into account the total gross receipts 
for the entire period derived (and to be derived) from the lease, 
rental, license, sale, exchange, or other disposition of the item of 
QPP, qualified films, or utilities. For purposes of the preceding 
sentence, if a taxpayer treats gross receipts as non-DPGR under this de 
minimis exception, then the taxpayer must treat the gross receipts 
recognized in each taxable year consistently as non-DPGR.
    (iii) Examples. The following examples illustrate the application 
of this paragraph (i)(4):

    Example 1. X MPGE QPP within the United States. As part of the 
sale of the QPP to Z, X trains Z's employees on how to use and 
operate the QPP. No other services or property are provided to Z in 
connection with the sale of the QPP to Z. In the normal course of 
X's business, the QPP and training services are separately stated in 
the sales contract. Because, in the normal course of the X's 
business, the training services are separately stated, the training 
services are not treated as embedded services under the de minimis 
exception in paragraph (i)(4)(i)(B)(6) of this section.
    Example 2. The facts are the same as in Example 1 except that, 
in the normal course of X's business, the training services are not 
separately stated in the sales contract and the customer cannot 
purchase the QPP without the training services. If the gross 
receipts for the embedded training services are less than 5% of the 
gross receipts derived from the sale of X's QPP to Z, after applying 
the exceptions under paragraphs (i)(4)(i)(B)(1) through (5) of this 
section, then the gross receipts may be included in DPGR under the 
de minimis exception in paragraph (i)(4)(i)(B)(6) of this section.
    Example 3. X MPGE QPP within the United States. As part of the 
sale of the QPP to retailers, X charges a fee for delivering the 
QPP. In the normal course of X's business, the price of the QPP and 
the delivery fee are separately stated in X's sales contracts. 
Because, in the normal course of X's business, the delivery fee is 
separately stated, the delivery fee does not qualify as DPGR under 
the qualified delivery exception in paragraph (i)(4)(i)(B)(2) of 
this section or the de minimis exception under paragraph 
(i)(4)(i)(B)(6) of this section. The result would be the same even 
if the retailer's customers cannot purchase the QPP without paying 
the delivery fee.
    Example 4. (i) Facts. X manufactures industrial sewing machines 
within the United States that X offers for sale individually to 
customers. X enters into a single, lump-sum priced contract with Y, 
an unrelated person, and the contract has the following terms: X 
will manufacture industrial sewing machines within the United States 
for Y; X will deliver the industrial sewing machines to Y; X will 
provide a one-year warranty on the industrial sewing machines; X 
will provide operating manuals with the industrial sewing machines; 
X will provide 100 hours of training and training manuals to Y's 
employees on the use and maintenance of the industrial sewing 
machines; X will provide purchased spare parts for the industrial 
sewing machines; and X will provide a 3-year service agreement for 
the industrial sewing machines. In the normal course of X's 
business, none of the services or property described above are 
separately stated, separately offered or separately bargained for.
    (ii) Analysis. The receipts for the manufacture of the 
industrial sewing machines are DPGR under paragraphs (e)(1) and (g) 
of this section (assuming all the other requirements of this section 
are met). X may include in DPGR the gross receipts derived from 
delivering the industrial sewing machines, which is a qualified 
delivery under paragraph (i)(4)(i)(B)(2) of this section; the gross 
receipts derived from the one-year warranty, which is a qualified 
warranty under paragraph (i)(4)(i)(B)(1) of this section; and the 
gross receipts derived from the operating manuals, which is a 
qualified operating manual under paragraph (i)(4)(i)(B)(3) of this 
section. If the gross receipts allocable to each industrial sewing 
machine for the embedded services consisting of the employee 
training and 3-year service agreement, and for the non-qualified 
property consisting of the purchased spare parts and the employee 
training manuals, which are not qualified operating manuals, are in 
total less than 5% of the gross receipts derived from the sale of 
each industrial sewing machine to Y (after applying the exceptions 
under paragraphs (i)(4)(i)(B)(1) through (5) of this section), then 
those gross receipts may be included in DPGR under the de minimis 
exception in paragraph (i)(4)(i)(B)(6) of this section. If, however, 
the gross receipts allocable to each industrial sewing machine for 
the embedded services and non-qualified property consisting of 
employee training, the 3-year service agreement, purchased spare 
parts, and employee training manuals equal or exceed, in total, 5% 
of the gross receipts derived from the sale of each industrial 
sewing machine to Y (after applying the exceptions under paragraphs 
(i)(4)(i)(B)(1) through (5) of this section), then those gross 
receipts do not qualify as DPGR under the de minimis exception in 
paragraph (i)(4)(i)(B)(6) of this section (and X must allocate gross 
receipts between DPGR and non-DPGR under Sec.  1.199-1(d)(1)).

    (5) Advertising income--(i) Tangible personal property. A 
taxpayer's gross receipts that are derived from the lease, rental, 
license, sale, exchange, or other disposition of newspapers, magazines, 
telephone directories, periodicals, and other similar printed 
publications that are MPGE in whole or in significant part within the 
United States include advertising income from advertisements placed in 
those media, but only if the gross receipts, if any, derived from the 
lease, rental, license, sale, exchange, or other disposition of the 
newspapers, magazines, telephone directories, or periodicals are (or 
would be) DPGR.
    (ii) Qualified film. A taxpayer's gross receipts that are derived 
from the lease, rental, license, sale, exchange, or other disposition 
of a qualified film include advertising income and product-placement 
income with respect to that qualified film, that is, compensation for 
placing or integrating advertising or a product into the qualified 
film, but only if the gross receipts, if any, derived from the 
qualified film are (or would be) DPGR.
    (iii) Examples. The following examples illustrate the application 
of this paragraph (i)(5):

    Example 1. X MPGE, and sells, newspapers within the United 
States. X's gross receipts

[[Page 31297]]

from the newspapers include gross receipts derived from the sale of 
newspapers to customers and payments from advertisers to publish 
display advertising or classified advertisements in X's newspapers. 
X's gross receipts described above are DPGR derived from the sale of 
X's newspapers.
    Example 2. The facts are the same as in Example 1 except that X 
disposes of the newspapers free of charge to customers, rather than 
selling them. X's gross receipts from the display advertising or 
classified advertisements are DPGR.
    Example 3. X produces two live television programs that are 
qualified films. X licenses the first television program to Y's 
television station and X licenses the second television program to 
Z's television station. Z broadcasts the second television program 
on its station. Both television programs contain product placements 
and advertising for which X received compensation. X and Y are 
unrelated persons. X and Z are non-consolidated members of an EAG. 
The gross receipts derived by X from licensing the first television 
program to Y are DPGR. As a result, pursuant to paragraph (i)(5)(ii) 
of this section, all of X's product placement and advertising income 
for the first television program is treated as gross receipts that 
are derived from the license of the qualified film. The gross 
receipts derived by X from licensing the second television program 
to Z are non-DPGR under paragraph (b)(1) of this section. Paragraph 
(b)(2) of this section does not apply because Z's broadcast of the 
second television program on Z's television station is not a lease, 
rental, license, sale, exchange, or other disposition of the second 
television program. As a result, pursuant to paragraph (i)(5)(ii) of 
this section, none of X's product placement and advertising income 
for the second television program is treated as gross receipts 
derived from the qualified film.
    Example 4. The facts are the same as in Example 3 except that Z 
sublicenses to an unrelated person the television program instead of 
broadcasting the television program on its station. The gross 
receipts derived by X from licensing the television program to Z are 
DPGR under paragraph (b)(2) of this section. As a result, pursuant 
to paragraph (i)(5)(ii) of this section, X's product placement and 
advertising income for the television program licensed to Z is 
treated as gross receipts derived from the qualified film. In 
addition, Z's receipts from the sublicense of the qualified film are 
DPGR under Sec.  1.199-7(a)(3)(i).
    Example 5. X produces television programs that are qualified 
films. X licenses the qualified films to Y, an unrelated person, and 
the license agreement provides that X will receive advertising time 
slots as part of its payments from Y under the license agreement. 
X's gross receipts derived from the license of the qualified films 
to Y include income attributable to the advertising time slots and 
are DPGR under paragraph (b)(2) of this section.

    (6) Computer software--(i) In general. DPGR include the gross 
receipts of the taxpayer that are derived from the lease, rental, 
license, sale, exchange, or other disposition of computer software MPGE 
by the taxpayer in whole or in significant part within the United 
States. Such gross receipts qualify as DPGR even if the customer 
provides the computer software to its employees or others over the 
Internet.
    (ii) through (v). [Reserved]. For further guidance see Sec.  1.199-
3T(i)(6)(ii) through (v).
    (7) Qualifying in-kind partnership for taxable years beginning 
after May 17, 2006, the enactment date of the Tax Increase Prevention 
and Reconciliation Act of 2005. [Reserved].
    (8) Partnerships owned by members of a single expanded affiliated 
group for taxable years beginning after May 17, 2006, the enactment 
date of the Tax Increase Prevention and Reconciliation Act of 2005. 
[Reserved].
    (9) Non-operating mineral interests. DPGR does not include gross 
receipts derived from non-operating mineral interests (for example, 
interests other than operating mineral interests within the meaning of 
Sec.  1.614-2(b)).
    (j) Definition of qualifying production property--(1) In general. 
QPP means--
    (i) Tangible personal property (as defined in paragraph (j)(2) of 
this section);
    (ii) Computer software (as defined in paragraph (j)(3) of this 
section); and
    (iii) Sound recordings (as defined in paragraph (j)(4) of this 
section).
    (2) Tangible personal property--(i) In general. The term tangible 
personal property is any tangible property other than land, real 
property described in paragraph (m)(3) of this section, and any 
property described in paragraph (j)(3), (j)(4), (k)(1), or (l) of this 
section. For purposes of the preceding sentence, tangible personal 
property also includes any gas (other than natural gas described in 
paragraph (l)(2) of this section), chemical, and similar property, for 
example, steam, oxygen, hydrogen, and nitrogen. Property such as 
machinery, printing presses, transportation and office equipment, 
refrigerators, grocery counters, testing equipment, display racks and 
shelves, and neon and other signs that are contained in or attached to 
a building constitutes tangible personal property for purposes of this 
paragraph (j)(2)(i). Except as provided in paragraphs (j)(5)(ii) and 
(k)(2)(i) of this section, computer software, sound recordings, and 
qualified films are not treated as tangible personal property 
regardless of whether they are affixed to a tangible medium. However, 
the tangible medium to which such property may be affixed (for example, 
a videocassette, a computer diskette, or other similar tangible item) 
is tangible personal property.
    (ii) Local law. In determining whether property is tangible 
personal property, local law is not controlling.
    (iii) Intangible property. The term tangible personal property does 
not include property in a form other than in a tangible medium. For 
example, mass-produced books are tangible personal property, but 
neither the rights to the underlying manuscript nor an online version 
of the book is tangible personal property.
    (3) Computer software--(i) In general. The term computer software 
means any program or routine or any sequence of machine-readable code 
that is designed to cause a computer to perform a desired function or 
set of functions, and the documentation required to describe and 
maintain that program or routine. Thus, for example, an electronic book 
available online or for download is not computer software. For purposes 
of this paragraph (j)(3), computer software also includes the machine-
readable code for video games and similar programs, for equipment that 
is an integral part of other property, and for typewriters, 
calculators, adding and accounting machines, copiers, duplicating 
equipment, and similar equipment, regardless of whether the code is 
designed to operate on a computer (as defined in section 168(i)(2)(B)). 
Computer programs of all classes, for example, operating systems, 
executive systems, monitors, compilers and translators, assembly 
routines, and utility programs, as well as application programs, are 
included. Except as provided in paragraph (j)(5) of this section, if 
the medium in which the software is contained, whether written, 
magnetic, or otherwise, is tangible, then such medium is considered 
tangible personal property for purposes of this section.
    (ii) Incidental and ancillary rights. Computer software also 
includes any incidental and ancillary rights that are necessary to 
effect the acquisition of the title to, the ownership of, or the right 
to use the computer software, and that are used only in connection with 
that specific computer software. Such incidental and ancillary rights 
are not included in the definition of trademark or trade name under 
Sec.  1.197-2(b)(10)(i). For example, a trademark or trade name that is 
ancillary to the ownership or use of a specific computer software 
program in the taxpayer's trade or business and is not acquired for the 
purpose of marketing the computer software is included in the 
definition of computer software and is not included in the definition 
of trademark or trade name.
    (iii) Exceptions. Computer software does not include any data or

[[Page 31298]]

information base unless the data or information base is in the public 
domain and is incidental to a computer program. For this purpose, a 
copyrighted or proprietary data or information base is treated as in 
the public domain if its availability through the computer program does 
not contribute significantly to the cost of the program. For example, 
if a word-processing program includes a dictionary feature that may be 
used to spell-check a document or any portion thereof, then the entire 
program (including the dictionary feature) is computer software 
regardless of the form in which the dictionary feature is maintained or 
stored.
    (4) Sound recordings--(i) In general. The term sound recordings 
means any works that result from the fixation of a series of musical, 
spoken, or other sounds under section 168(f)(4). The definition of 
sound recordings is limited to the master copy of the recordings (or 
other copy from which the holder is licensed to make and produce 
copies), and, except as provided in paragraph (j)(5) of this section, 
if the medium (such as compact discs, tapes, or other phonorecordings) 
in which the sounds may be embodied is tangible, then the medium is 
considered tangible personal property for purposes of paragraph (j)(2) 
of this section.
    (ii) Exception. The term sound recordings does not include the 
creation of copyrighted material in a form other than a sound 
recording, such as lyrics or music composition.
    (5) Tangible personal property with computer software or sound 
recordings--(i) Computer software and sound recordings. If a taxpayer 
MPGE in whole or in significant part computer software or sound 
recordings within the United States that is affixed or added to 
tangible personal property (for example, a computer diskette, or an 
appliance), whether or not the taxpayer MPGE such tangible personal 
property in whole or in significant part within the United States, then 
for purposes of this section--
    (A) The computer software and the tangible personal property may be 
treated by the taxpayer as computer software. If the taxpayer treats 
the computer software and the tangible personal property as computer 
software, activities the cost of which are described in Rev. Proc. 
2000-50 (2000-1 C.B. 601), activities giving rise to research and 
experimental expenditures under section 174, and the creation of 
intangible assets for computer software are considered in determining 
whether the taxpayer's MPGE activity is substantial in nature under 
paragraph (g)(2) of this section. In determining direct labor and 
overhead under paragraph (g)(3)(i) of this section, the costs of direct 
labor and overhead for developing the computer software as described in 
Rev. Proc. 2000-50 (2000-1 C.B. 601), research and experimental 
expenditures under section 174, and any other costs of creating 
intangible assets for the computer software are treated as direct labor 
and overhead. These costs must be included in the taxpayer's CGS of the 
computer software for purposes of determining whether the taxpayer 
meets the safe harbor under paragraph (g)(3)(i) of this section. 
However, any costs under section 174, and the costs to create 
intangible assets, attributable to the tangible personal property are 
not considered in determining whether the taxpayer's activity is 
substantial in nature under paragraph (g)(2) of this section and are 
not direct labor and overhead under paragraph (g)(3)(i) of this 
section; and
    (B) The sound recordings and the tangible personal property with 
the sound recordings may be treated by the taxpayer as sound 
recordings. If the taxpayer treats the sound recordings and the 
tangible personal property as sound recordings, activities giving rise 
to research and experimental expenditures under section 174 and the 
creation of intangible assets for sound recordings are considered in 
determining whether the taxpayer's MPGE activity is substantial in 
nature under paragraph (g)(2) of this section. In determining direct 
labor and overhead under paragraph (g)(3)(i) of this section, research 
and experimental expenditures under section 174 and any other costs of 
creating intangible assets for sound recordings are treated as direct 
labor and overhead. These costs must be included in the taxpayer's CGS 
of sound recordings for purposes of determining whether the taxpayer 
meets the safe harbor under paragraph (g)(3)(i) of this section. 
However, any costs under section 174, and the costs to create 
intangible assets, attributable to the tangible personal property are 
not considered in determining whether the taxpayer's activity is 
substantial in nature under paragraph (g)(2) of this section and are 
not direct labor and overhead under paragraph (g)(3)(i) of this 
section.
    (ii) Tangible personal property. If a taxpayer MPGE tangible 
personal property (for example, a computer diskette or an appliance) in 
whole or in significant part within the United States but not the 
computer software or sound recordings that is affixed or added to such 
tangible personal property, then for purposes of this section the 
tangible personal property with the computer software or sound 
recordings may be treated by the taxpayer as tangible personal property 
under paragraph (j)(2) of this section. Any costs under section 174, 
and the costs to create intangible assets, attributable to the tangible 
personal property are not considered in determining whether the 
taxpayer's activity is substantial in nature under paragraph (g)(2) of 
this section and are not direct labor or overhead under paragraph 
(g)(3)(i) of this section. For purposes of paragraph (g)(3) of this 
section, the taxpayer's CGS (or unadjusted depreciable basis, if 
applicable) for each item of tangible personal property includes the 
taxpayer's cost of leasing, renting, licensing, buying, or otherwise 
acquiring the computer software or sound recordings.
    (k) Definition of qualified film--(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, if not 
less than 50 percent of the total compensation paid to actors, 
production personnel, directors, and producers relating to the 
production of the motion picture film, video tape, or television 
programming is compensation paid by the taxpayer for services relating 
to the production of the film performed in the United States by those 
individuals. For purposes of this paragraph (k), actors include 
players, newscasters, or any other persons performing in a qualified 
film. The term production personnel includes, for example, writers, 
choreographers and composers providing services during the production 
of a film, casting agents, camera operators, set designers, lighting 
technicians, make-up artists, and others whose activities are directly 
related to the production of the film. Except as provided in paragraph 
(k)(2) of this section, the definition of qualified film does not 
include tangible personal property embodying the qualified film, such 
as DVDs or videocassettes.
    (2) Tangible personal property with a film--(i) Film not produced 
by a taxpayer. If a taxpayer MPGE tangible personal property (for 
example, a DVD) in whole or in significant part in the United States 
and a film not produced by a taxpayer is affixed to the tangible 
personal property, then the taxpayer may treat the tangible personal 
property with the affixed film as tangible personal property, 
regardless of whether the film is a qualified film. The determination 
of whether the gross receipts of such a taxpayer derived from the 
lease, rental, license, sale, exchange, or other disposition of the 
tangible

[[Page 31299]]

personal property with the affixed film are DPGR is made under the 
rules of this section. For purposes of paragraph (g)(2) of this 
section, in determining whether the taxpayer's MPGE activity is 
substantial in nature, the taxpayer must consider the value of the 
licensed film. For purposes of paragraph (g)(3) of this section, the 
taxpayer's CGS (or unadjusted depreciable basis, as applicable) for 
each item of tangible personal property includes the taxpayer's cost of 
leasing, renting, licensing, buying, or otherwise acquiring the film.
    (ii) Film produced by a taxpayer. If a taxpayer produces a film and 
the film is affixed to tangible personal property (for example, a DVD), 
then for purposes of this section--
    (A) Qualified film. If the film is a qualified film, the taxpayer 
may treat the tangible personal property, whether or not the taxpayer 
MPGE such tangible personal property, to which the qualified film is 
affixed as part of the qualified film; and
    (B) Nonqualified film. If the film is not a qualified film 
(nonqualified film), a taxpayer cannot treat the tangible personal 
property to which the nonqualified film is affixed as part of the 
nonqualified film.
    (3) Derived from a qualified film--(i) In general. DPGR include the 
gross receipts of a taxpayer that are derived from any lease, rental, 
license, sale, exchange, or other disposition of any qualified film 
produced by such taxpayer.
    (ii) Exceptions. The showing of a qualified film (for example, in a 
movie theater or by broadcast on a television station) by a taxpayer is 
not a lease, rental, license, sale, exchange, or other disposition of 
the qualified film by such taxpayer. Ticket sales for viewing a 
qualified film do not constitute DPGR because the gross receipts are 
not derived from the lease, rental, license, sale, exchange, or other 
disposition of a qualified film. Because a taxpayer that merely writes 
a screenplay or other similar material is not considered to have 
produced a qualified film under paragraph (k)(1) of this section, the 
amounts that the taxpayer receives from the sale of the script or 
screenplay, even if the script is developed into a qualified film, are 
not gross receipts derived from a qualified film. In addition, revenue 
from the sale of film-themed merchandise is revenue from the sale of 
tangible personal property and not gross receipts derived from a 
qualified film. Gross receipts derived from a license of the right to 
use or exploit the film characters are not gross receipts derived from 
a qualified film.
    (4) Compensation for services. The term compensation for services 
means all payments for services performed by actors (as described in 
paragraph (k)(1) of this section), production personnel, directors, and 
producers, including participations and residuals. 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 for services performed by actors, 
production personnel, directors, and producers for purposes of this 
section. 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 determine the compensation expected 
to be paid for services performed by actors, production personnel, 
directors, and producers as participations and residuals based on the 
total forecasted income used in determining income forecast 
depreciation. 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). 
Compensation for services is not limited to W-2 wages and includes 
compensation paid to independent contractors.
    (5) Determination of 50 percent. 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 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. 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 
by actors (as described in paragraph (k)(1) of this section), 
production personnel, directors, and producers, and the total 
compensation paid to those individuals for services relating to the 
production of the film. 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.
    (6) Exception. A qualified film does not include property with 
respect to which records are required to be maintained under 18 U.S.C. 
2257. Section 2257 of Title 18 requires maintenance of certain records 
with respect to any book, magazine, periodical, film, videotape, or 
other matter that--
    (i) Contains one or more visual depictions made after November 1, 
1990, of actual sexually explicit conduct; and
    (ii) Is produced in whole or in part with materials that have been 
mailed or shipped in interstate or foreign commerce, or is shipped or 
transported or is intended for shipment or transportation in interstate 
or foreign commerce.
    (7) Examples. The following examples illustrate the application of 
this paragraph (k):

    Example 1. X produces a qualified film and duplicates the film 
onto purchased DVDs. X sells the DVDs with the qualified film to 
customers. Under paragraph (k)(2)(ii)(A) of this section, X treats 
the DVD with the qualified film as a qualified film. Accordingly, 
X's gross receipts derived from the sale of the qualified film to 
customers are DPGR (assuming all the other requirements of this 
section are met).
    Example 2. The facts are the same as in Example 1 except that 
the film is a nonqualified film because the film does not satisfy 
the not-less-than-50-percent-of-the-total-compensation requirement 
under (k)(1) of this section and X manufactures the DVDs in the 
United States. Under paragraph (k)(2)(ii)(B) of this section, X 
cannot treat the DVD as part of the nonqualified film. X's gross 
receipts (not including the gross receipts attributable to the 
nonqualified film) derived from the sale of the tangible personal 
property are DPGR (assuming all the other requirements of this 
section are met).
    Example 3. X produces live television programs that are 
qualified films. X shows the programs on its own television station. 
X sells advertising time slots to advertisers for the television 
programs. Because showing a qualified film on a television station 
is not a lease, rental, license, sale, exchange, or other 
disposition pursuant to paragraph (k)(3)(ii) of this section, the 
advertising income X receives from advertisers is not derived from 
the lease, rental, license, sale, exchange, or other disposition of 
the qualified films and is non-DPGR.
    Example 4. The facts are the same as in Example 3 except that X 
also licenses the qualified films to Y, an unrelated cable company 
that broadcasts X's qualified films. As part of the license 
agreement, X can sell

[[Page 31300]]

advertising time slots. Because X's gross receipts from Y are 
derived from the licensing of qualified films pursuant to paragraph 
(k)(3)(i) of this section, X's gross receipts derived from licensing 
the qualified film are DPGR. In addition, the gross receipts derived 
from the advertising income X receives that is related to the 
qualified films licensed to Y is DPGR pursuant to paragraph 
(i)(5)(ii) of this section. Because showing a qualified film on a 
television station is not a lease, rental, license, sale, exchange, 
or other disposition pursuant to paragraph (k)(3)(ii) of this 
section, the portion of the advertising income X derives from 
advertisers for the qualified films it broadcasts on its own 
television station is not derived from the lease, rental, license, 
sale, exchange, or other disposition of the qualified films and is 
non-DPGR.
    Example 5. X produces a qualified film and contracts with Y, an 
unrelated person, to duplicate the film onto DVDs. Y manufactures 
blank DVDs within the United States, duplicates X's film onto the 
DVDs in the United States, and sells the DVDs with the qualified 
film to X who then sells them to customers. Y has all of the 
benefits and burdens of ownership under Federal income tax 
principles of the DVDs during the MPGE and duplication process. 
Assume Y's activities relating to manufacture of the blank DVDs and 
duplicating the film onto the DVDs collectively satisfy the safe 
harbor under paragraph (g)(3) of this section. Y's gross receipts 
from manufacturing the DVDs and duplicating the film onto the DVDs 
are DPGR (assuming all the other requirements of this section are 
met). X's gross receipts from the sale of the DVDs to customers are 
DPGR (assuming all the other requirements of this section are met).
    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 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 paid by X to 
actors, production personnel, directors, and producers for 
production services performed in the United States, and the 
denominator is the sum of the total compensation paid by X to such 
individuals regardless of where the production services are 
performed and the total compensation paid by Y and Z to actors, 
production personnel, directors, and producers relating to the 
production of the films licensed by X (regardless of where the 
services 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.

    (l) Electricity, natural gas, or potable water--(1) In general. 
DPGR include gross receipts derived from any lease, rental, license, 
sale, exchange, or other disposition of utilities produced by the 
taxpayer in the United States if all other requirements of this section 
are met. In the case of an integrated producer that both produces and 
delivers utilities, see paragraph (l)(4) of this section that describes 
certain gross receipts that do not qualify as DPGR.
    (2) Natural gas. The term natural gas includes only natural gas 
extracted from a natural deposit and does not include, for example, 
methane gas extracted from a landfill. In the case of natural gas, 
production activities include all activities involved in extracting 
natural gas from the ground and processing the gas into pipeline 
quality gas.
    (3) Potable water. The term potable water means unbottled drinking 
water. In the case of potable water, production activities include the 
acquisition, collection, and storage of raw water (untreated water), 
transportation of raw water to a water treatment facility, and 
treatment of raw water at such a facility. Gross receipts attributable 
to any of these activities are included in DPGR if all other 
requirements of this section are met.
    (4) Exceptions--(i) Electricity. Gross receipts attributable to the 
transmission of electricity from the generating facility to a point of 
local distribution and gross receipts attributable to the distribution 
of electricity to customers are non-DPGR.
    (ii) Natural gas. Gross receipts attributable to the transmission 
of pipeline quality gas from a natural gas field (or, if treatment at a 
natural gas processing plant is necessary to produce pipeline quality 
gas, from a natural gas processing plant) to a local distribution 
company's citygate (or to another customer) are non-DPGR. Likewise, 
gross receipts of a local gas distribution company attributable to 
distribution from the citygate to the local customers are non-DPGR.
    (iii) Potable water. Gross receipts attributable to the storage of 
potable water after completion of treatment of the potable water, as 
well as gross receipts attributable to the transmission and 
distribution of potable water, are non-DPGR.
    (iv) De minimis exception--(A) DPGR. Notwithstanding paragraphs 
(l)(4)(i), (ii), and (iii) of this section, if less than 5 percent of a 
taxpayer's gross receipts derived from a sale, exchange, or other 
disposition of utilities are attributable to the transmission or 
distribution of the utilities and the storage of portable water after 
completion of treatment of the potable water, then the gross receipts 
derived from the lease, rental, license, sale, exchange, or other 
disposition of the utilities that are attributable to the transmission 
and distribution of the utilities and the storage of portable water 
after completion of treatment of the potable water may be treated as 
being DPGR (assuming all other requirements of this section are met). 
In the case of gross receipts derived from the lease, rental, license, 
sale, exchange, or other disposition of utilities that are received 
over a period of time (for example, a multi-year lease or installment 
sale), this de minimis exception is applied by taking into account the 
total gross receipts for the entire period derived (and to be derived) 
from the lease, rental, license, sale, exchange, or other disposition 
of the utilities. For purposes of the preceding sentence, if a taxpayer 
treats gross receipts as DPGR under this de minimis exception, then the 
taxpayer must treat the gross receipts recognized in each taxable year 
consistently as DPGR.
    (B) Non-DPGR. If less than 5 percent of a taxpayer's gross receipts 
derived from a sale, exchange, or other disposition of utilities are 
DPGR, then the gross receipts derived from the sale, exchange, or other 
disposition of the utilities may be treated as non-DPGR. In the case of 
gross receipts derived from the lease, rental, license, sale, exchange, 
or other disposition of utilities that are received over a period of 
time (for example, a multi-year lease or installment sale), this de 
minimis exception is applied by taking into account the total gross 
receipts for the entire period derived (and to be derived) from the 
lease, rental, license, sale, exchange, or other disposition of the 
utilities. For purposes of the preceding sentence, if a taxpayer treats 
gross receipts as non-DPGR under this de minimis exception, then the 
taxpayer must treat the gross receipts recognized in each taxable year 
consistently as non-DPGR.
    (5) Example. The following example illustrates the application of 
this paragraph (l):

    Example. X owns a wind turbine in the United States that 
generates electricity and Y owns a high voltage transmission line 
that passes near X's wind turbine and ends near the system of local 
distribution lines of Z. X sells the electricity produced at the 
wind turbine to Z and contracts with Y to transmit the electricity 
produced at the wind turbine to Z who sells the electricity to 
customers using Z's distribution network. The gross receipts 
received by X from the sale of electricity produced at the wind 
turbine are DPGR. The gross receipts of Y derived from transporting 
X's electricity to Z are non-

[[Page 31301]]

DPGR under paragraph (l)(4)(i) of this section. Likewise, the gross 
receipts of Z derived from distributing the electricity are non-DPGR 
under paragraph (l)(4)(i) of this section. If X made direct sales of 
electricity to customers in Z's service area and Z receives 
remuneration for the distribution of electricity, the gross receipts 
of Z are non-DPGR under paragraph (l)(4)(i) of this section. If X, 
Y, and Z are related persons (as defined in paragraph (b) of this 
section), then X, Y, and Z must allocate gross receipts among the 
production activities (that are DPGR), and the transmission and 
distribution activities (that are non-DPGR).

    (m) Definition of construction performed in the United States--(1) 
Construction of real property--(i) In general. The term construction 
means activities and services relating to the construction or erection 
of real property (as defined in paragraph (m)(3) of this section) in 
the United States by a taxpayer that, at the time the taxpayer 
constructs the real property, is engaged in a trade or business (but 
not necessarily its primary, or only, trade or business) that is 
considered construction for purposes of the North American Industry 
Classification System (NAICS) on a regular and ongoing basis. A trade 
or business that is considered construction under the NAICS means a 
construction activity under the two-digit NAICS code of 23 and any 
other construction activity in any other NAICS code provided the 
construction activity relates to the construction of real property such 
as NAICS code 213111 (drilling oil and gas wells) and 213112 (support 
activities for oil and gas operations). For purposes of this paragraph 
(m), the term construction project means the construction activities 
and services treated as the item under paragraph (d)(2)(iii) of this 
section. Tangible personal property (for example, appliances, 
furniture, and fixtures) that is sold as part of a construction project 
is not considered real property for purposes of this paragraph 
(m)(1)(i). In determining whether property is real property, the fact 
that property is real property under local law is not controlling. 
Conversely, property may be real property for purposes of this 
paragraph (m)(1)(i) even though under local law the property is 
considered tangible personal property.
    (ii) Regular and ongoing basis--(A) In general. For purposes of 
paragraph (m)(1)(i) of this section, a taxpayer engaged in a 
construction trade or business will be considered to be engaged in such 
trade or business on a regular and ongoing basis if the taxpayer 
derives gross receipts from an unrelated person by selling or 
exchanging the constructed real property described in paragraph (m)(3) 
of this section within 60 months of the date on which construction is 
complete (for example, on the date a certificate of occupancy is issued 
for the property).
    (B) New trade or business. In the case of a newly-formed trade or 
business or a taxpayer in its first taxable year, the taxpayer is 
considered to be engaged in a trade or business on a regular and 
ongoing basis if the taxpayer reasonably expects that it will engage in 
a trade or business on a regular and ongoing basis.
    (iii) De minimis exception--(A) DPGR. For purposes of paragraph 
(m)(1)(i) of this section, if less than 5 percent of the total gross 
receipts derived by a taxpayer from a construction project (as 
described in paragraph (m)(1)(i) of this section) are derived from 
activities other than the construction of real property in the United 
States (for example, from non-construction activities or the sale of 
tangible personal property or land), then the total gross receipts 
derived by the taxpayer from the project may be treated as DPGR from 
construction. If a taxpayer applies the land safe harbor under 
paragraph (m)(6)(iv) of this section, for a construction project (as 
described in paragraph (m)(1)(i) of this section), then the gross 
receipts excluded under the land safe harbor are excluded in 
determining total gross receipts under this paragraph (m)(1)(iii)(A). 
If a taxpayer does not apply the land safe harbor and uses any 
reasonable method (for example, an appraisal of the land) to allocate 
gross receipts attributable to the land to non-DPGR, then a taxpayer 
applies this paragraph (m)(1)(iii)(A) by excluding such gross receipts 
derived from the sale, exchange, or other disposition of the land from 
total gross receipts. In the case of gross receipts derived from 
construction that are received over a period of time (for example, an 
installment sale), this de minimis exception is applied by taking into 
account the total gross receipts for the entire period derived (and to 
be derived) from construction. For purposes of the preceding sentence, 
if a taxpayer treats gross receipts as DPGR under this de minimis 
exception, then the taxpayer must treat the gross receipts recognized 
in each taxable year consistently as DPGR.
    (B) Non-DPGR. For purposes of paragraph (m)(1)(i) of this section, 
if less than 5 percent of the total gross receipts derived by a 
taxpayer from a construction project qualify as DPGR, then the total 
gross receipts derived by the taxpayer from the construction project 
may be treated as non-DPGR. In the case of gross receipts derived from 
construction that are received over a period of time (for example, an 
installment sale), this de minimis exception is applied by taking into 
account the total gross receipts for the entire period derived (and to 
be derived) from construction. For purposes of the preceding sentence, 
if a taxpayer treats gross receipts as non-DPGR under this de minimis 
exception, then the taxpayer must treat the gross receipts recognized 
in each taxable year consistently as non-DPGR.
    (2) Activities constituting construction--(i) In general.
    Activities constituting construction are activities performed in 
connection with a project to erect or substantially renovate real 
property, including activities performed by a general contractor or 
that constitute activities typically performed by a general contractor, 
for example, activities relating to management and oversight of the 
construction process such as approvals, periodic inspection of the 
progress of the construction project, and required job modifications.
    (ii) Tangential services. Activities constituting construction do 
not include tangential services such as hauling trash and debris, and 
delivering materials, even if the tangential services are essential for 
construction. However, if the taxpayer performing construction also, in 
connection with the construction project, provides tangential services 
such as delivering materials to the construction site and removing its 
construction debris, then the gross receipts derived from the 
tangential services are DPGR.
    (iii) Other construction activities. Improvements to land that are 
not capitalizable to the land (for example, landscaping) and painting 
are activities constituting construction only if these activities are 
performed in connection with other activities (whether or not by the 
same taxpayer) that constitute the erection or substantial renovation 
of real property and provided the taxpayer meets the requirements under 
paragraph (m)(1) of this section. Services such as grading, demolition 
(including demolition of structures under section 280B), clearing, 
excavating, and any other activities that physically transform the land 
are activities constituting construction only if these services are 
performed in connection with other activities (whether or not by the 
same taxpayer) that constitute the erection or substantial renovation 
of real property and provided the taxpayer meets the requirements under 
paragraph (m)(1) of this section. A taxpayer engaged in these 
activities must make a reasonable inquiry or a reasonable determination 
as to whether the activity relates to the

[[Page 31302]]

erection or substantial renovation of real property in the United 
States. Construction activities also include activities relating to 
drilling an oil or gas well and mining and include any activities the 
cost of which are intangible drilling and development costs within the 
meaning of Sec.  1.612-4 or development expenditures for a mine or 
natural deposit under section 616.
    (iv) Administrative support services. If the taxpayer performing 
construction activities also provides, in connection with the 
construction project, administrative support services (for example, 
billing and secretarial services) incidental and necessary to such 
construction project, then these administrative support services are 
considered construction activities.
    (v) Exceptions. The lease, license, or rental of equipment, for 
example, bulldozers, generators, or computers, for use in the 
construction of real property is not a construction activity under this 
paragraph (m)(2). The term construction does not include any activity 
that is within the definition of engineering and architectural services 
under paragraph (n) of this section.
    (3) Definition of real property. The term real property means 
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 
paragraph (m)(4) of this section). For purposes of the preceding 
sentence, an entire utility plant including both the shell and the 
interior will be treated as an inherently permanent structure. Property 
produced by a taxpayer that is not real property in the hands of that 
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). For purposes of 
this paragraph (m)(3), structural components of buildings and 
inherently permanent structures include property such as walls, 
partitions, doors, wiring, plumbing, central air conditioning and 
heating systems, pipes and ducts, elevators and escalators, and other 
similar property.
    (4) Definition of infrastructure. The term infrastructure includes 
roads, power lines, water systems, railroad spurs, communications 
facilities, sewers, sidewalks, cable, and wiring. The term also 
includes inherently permanent oil and gas platforms.
    (5) Definition of substantial renovation. The term substantial 
renovation means the renovation of a major component or substantial 
structural part of real property that materially increases the value of 
the property, substantially prolongs the useful life of the property, 
or adapts the property to a new or different use.
    (6) Derived from construction--(i) In general. Assuming all the 
requirements of this section are met, DPGR derived from the 
construction of real property performed in the United States includes 
the proceeds from the sale, exchange, or other disposition of real 
property constructed by the taxpayer in the United States (whether or 
not the property is sold immediately after construction is completed 
and whether or not the construction project is completed). DPGR derived 
from the construction of real property includes compensation for the 
performance of construction services by the taxpayer in the United 
States. DPGR derived from the construction of real property includes 
gross receipts derived from materials and supplies consumed in the 
construction project or that become part of the constructed real 
property, assuming all the requirements of this section are met.
    (ii) Qualified construction warranty. DPGR derived from the 
construction of real property includes gross receipts from any 
qualified construction warranty, that is, a warranty that is provided 
in connection with the constructed real property if, in the normal 
course of the taxpayer's business--
    (A) The price for the construction warranty is not separately 
stated from the amount charged for the constructed real property; and
    (B) The construction warranty is neither separately offered by the 
taxpayer nor separately bargained for with customers (that is, the 
customer cannot purchase the constructed real property without the 
construction warranty).
    (iii) Exceptions. DPGR derived from the construction of real 
property performed in the United States does not include gross receipts 
derived from the sale, exchange, or other disposition of real property 
acquired by the taxpayer even if the taxpayer originally constructed 
the property. In addition, DPGR derived from the construction of real 
property does not include gross receipts from the lease or rental of 
real property constructed by the taxpayer or, except as provided in 
paragraph (m)(2)(iii) of this section, gross receipts derived from the 
sale or other disposition of land (including zoning, planning, 
entitlement costs, and other costs capitalized to the land).
    (iv) Land safe harbor--(A) In general. For purposes of paragraph 
(m)(6)(i) of this section, a taxpayer may allocate gross receipts 
between the gross receipts derived from the sale, exchange, or other 
disposition of real property constructed by the taxpayer and the gross 
receipts derived from the sale, exchange, or other disposition of land 
by reducing its costs related to DPGR under Sec.  1.199-4 by the costs 
of the land and any other costs capitalized to the land (collectively, 
land costs) (including zoning, planning, entitlement costs, and other 
costs capitalized to the land (except costs for activities listed in 
paragraph (m)(2)(iii) of this section) and land costs in any common 
improvements as defined in section 2.01 of Rev. Proc. 92-29 (1992-1 
C.B. 748) (see Sec.  601.601(d)(2) of this chapter)) and by reducing 
its DPGR by those land costs plus a percentage. Generally, the 
percentage is based on the number of months that elapse between the 
date the taxpayer acquires the land (not including any options to 
acquire the land) and ends on the date the taxpayer sells each item of 
real property on the land. However, a taxpayer will be deemed, for 
purposes of this paragraph (m)(6)(iv)(A), to acquire the land on the 
date the taxpayer entered into an option agreement to acquire the land 
if the taxpayer acquired the land pursuant to such option agreement and 
the purchase price of the land under the option agreement does not 
approximate the fair market value of the land. In the case of a sale or 
disposition of land between related persons (as defined in paragraph 
(b)(1) of this section) for less than fair market value, for purposes 
of determining the percentage, the purchaser or transferee of the land 
must include the months during which the land was held by the seller or 
transferor. The percentage is 5 percent for land held not more than 60 
months, 10 percent for land held more than 60 months but not more than 
120 months, and 15 percent for land held more than 120 months but not 
more than 180 months. Land held by a taxpayer for more than 180 months 
is not eligible for the safe harbor under this paragraph (m)(6)(iv)(A).
    (B) Determining gross receipts and costs. In the case of a taxpayer 
that uses the small business simplified overall method of cost 
allocation under Sec.  1.199-4(f), gross receipts derived from the 
sale, exchange, or other disposition of land, and costs attributable to 
the land, pursuant to the land safe harbor under

[[Page 31303]]

paragraph (m)(6)(iv)(A) of this section, are not taken into account for 
purposes of computing QPAI under Sec. Sec.  1.199-1 through 1.199-9 
except that the gross receipts are taken into account for determining 
eligibility for that method of cost allocation. All other taxpayers 
must treat the gross receipts derived from the sale, exchange, or other 
disposition of land, pursuant to the land safe harbor under paragraph 
(m)(6)(iv)(A) of this section, as non-DPGR. In the case of a pass-thru 
entity, if the pass-thru entity would be eligible to use the small 
business simplified overall method of cost allocation if the method 
were applied at the pass-thru entity level, then the gross receipts 
derived from the sale, exchange, or other disposition of land, and 
costs allocated to the land, pursuant to the land safe harbor under 
paragraph (m)(6)(iv)(A) of this section, are not taken into account by 
the pass-thru entity or its owner or owners for purposes of computing 
QPAI under Sec. Sec.  1.199-1 through 1.199-9. For purposes of the 
preceding sentence, in determining whether the pass-thru entity would 
be eligible for the small business simplified overall method of cost 
allocation, the gross receipts excluded pursuant to the land safe 
harbor under paragraph (m)(6)(iv)(A) of this section are taken into 
account for determining eligibility for that method of cost allocation. 
All other pass-thru entities (including all trusts and estates 
described in Sec.  1.199-9(e)) must treat the gross receipts 
attributable to the sale, exchange, or other disposition of land, 
pursuant to the land safe harbor under paragraph (m)(6)(iv)(A) of this 
section, as non-DPGR.
    (v) Examples. The following examples illustrate the application of 
this paragraph (m)(6):

    Example 1. A, who is in the trade or business of construction 
under NAICS code 23 on a regular and ongoing basis, purchases a 
building in the United States and retains B, an unrelated person, to 
oversee a substantial renovation of the building (within the meaning 
of paragraph (m)(5) of this section). Although not licensed as a 
general contractor, B performs general contractor level work and 
activities relating to management and oversight of the construction 
process such as approvals, periodic inspection of the progress of 
the construction project, and required job modifications. B retains 
C (a general contractor) to oversee day-to-day operations and hire 
subcontractors. C hires D (a subcontractor) to install a new 
electrical system in the building as part of that substantial 
renovation. The amounts that B receives from A for construction 
services, the amounts that C receives from B for construction 
services, and the amounts that D receives from C for construction 
services qualify as DPGR under paragraph (m)(6)(i) of this section 
provided B, C, and D meet all of the requirements of paragraph 
(m)(1) of this section. The gross receipts that A receives from the 
subsequent sale of the building do not qualify as DPGR because A did 
not engage in any activity constituting construction under paragraph 
(m)(2) of this section even though A is in the trade or business of 
construction. The results would be the same if A, B, C, and D were 
members of the same EAG under Sec.  1.199-7(a). However, if A, B, C, 
and D were members of the same consolidated group, see Sec.  1.199-
7(d)(2).
    Example 2. X is engaged as an electrical contractor under NAICS 
code 238210 on a regular and ongoing basis. X purchases the wires, 
conduits, and other electrical materials that it installs in 
construction projects in the United States. In a particular 
construction project, all of the wires, conduits, and other 
electrical materials installed by X for the operation of that 
building are considered structural components of the building. X's 
gross receipts derived from installing that property are derived 
from the construction of real property under paragraph (m)(1) of 
this section. In addition, pursuant to paragraph (m)(6)(i) of this 
section, X's gross receipts derived from the purchased materials 
qualify as DPGR because the wires, conduits, and other electrical 
materials are consumed during the construction of the building or 
become structural components of the building.
    Example 3. X is engaged in a trade or business on a regular and 
ongoing basis that is considered construction under the two-digit 
NAICS code of 23. X buys unimproved land in the United States. X 
gets the land zoned for residential housing through an entitlement 
process. X grades the land and sells the land to home builders who 
construct houses on the land. The gross receipts that X derives from 
the sale of the land that are attributable to the grading qualify as 
DPGR under paragraphs (m)(2)(iii) and (6)(i) of this section because 
those services are undertaken in connection with a construction 
project in the United States. X's gross receipts derived from the 
land including capitalized costs of entitlements (including zoning) 
do not qualify as DPGR under paragraph (m)(6)(i) of this section 
because the gross receipts are not derived from the construction of 
real property.
    Example 4. The facts are the same as in Example 3 except that X 
constructs roads, sewers, and sidewalks, and installs power and 
water lines on the land. X conveys the roads, sewers, sidewalks, and 
power and water lines to the local government and utilities. The 
gross receipts that X derives from the sale of lots that are 
attributable to grading, and the construction of the roads, sewers, 
sidewalks, and power and water lines (that qualify as infrastructure 
under paragraph (m)(4) of this section) are DPGR. X's gross receipts 
derived from the land including capitalized costs of entitlements 
(including zoning) do not qualify as DPGR under paragraph (m)(6)(i) 
of this section because the gross receipts are not derived from the 
construction of real property.
    Example 5. (i) Facts. X, who is engaged in the trade or business 
of construction under NAICS code 23 on a regular and ongoing basis, 
constructs housing that is real property under paragraph (m)(3) of 
this section. On June 1, 2007, X pays $50,000,000 and acquires 1,000 
acres of land that X will develop as a new housing development. In 
November 2007, after the expenditure of $10,000,000 for entitlement 
costs, X receives permits to begin construction. After this 
expenditure, X's land costs total $60,000,000. The development 
consists of 1,000 houses to be built on half-acre lots over 5 years. 
On January 31, 2012, the first house is sold for $300,000. 
Construction costs for each house are $170,000. Common improvements 
consisting of streets, sidewalks, sewer lines, playgrounds, 
clubhouses, tennis courts, and swimming pools that X is 
contractually obligated or required by law to provide cost $55,000 
per lot. The common improvements of $55,000 per lot include $30,000 
in land costs underlying the common improvements.
    (ii) Land safe harbor. Pursuant to the land safe harbor under 
paragraph (m)(6)(iv) of this section, X calculates the basis for 
each house sold as $195,000 (total costs of $255,000 ($170,000 in 
construction costs plus $55,000 in common improvements (including 
$30,000 in land costs) plus $30,000 in land costs for the lot), 
which are reduced by land costs of $60,000). X calculates the DPGR 
for each house sold by taking the gross receipts of $300,000 and 
reducing that amount by land costs of $60,000 plus a percentage of 
$60,000. As X acquired the land on June 1, 2007, for each house sold 
on the land between January 31, 2012, and June 1, 2012, the 
percentage reduction for X is 5% because X has held the land for not 
more than 60 months from the date of acquisition. Thus, X's DPGR for 
each house is $237,000 ($300,000-$60,000-$3,000) with costs for each 
house of $195,000 ($255,000-$60,000). For each house sold on the 
land between June 2, 2012 and June 1, 2017, the percentage reduction 
for X is 10% because X has held the land for more than 60 months but 
not more than 120 months from the date of acquisition. Thus, of the 
$300,000 of gross receipts, X's DPGR for each house is $234,000 
($300,000-$60,000-$6,000) with costs for each house of $195,000 
($255,000-$60,000).
    Example 6. The facts are the same as in Example 5 except that on 
December 31, 2007, after X received the permits to begin 
construction, X sold the entitled land to Y, an unrelated 
corporation, for $75,000,000. Y is engaged in a trade or business on 
a regular and ongoing basis that is considered construction under 
NAICS code 23. Y subsequently incurred the construction costs and 
the costs of the common improvements, and Y sold the houses. Because 
X did not perform any construction activities, none of X's 
$75,000,000 in gross receipts derived from Y are DPGR and none of 
X's costs are allocable to DPGR. Pursuant to the land safe harbor 
under paragraph (m)(6)(iv) of this section, Y calculates the basis 
for each house sold as $195,000 (total costs of $270,000 ($170,000 
in construction costs plus $62,500 in common improvements (including 
$37,500 in land costs) plus $37,500 in land costs for the lot), 
which are reduced by land costs of $75,000). Y calculates the DPGR 
for

[[Page 31304]]

each house sold by taking the gross receipts of $300,000 and 
reducing that amount by land costs of $75,000 plus a percentage of 
$75,000. As Y acquired the land on December 31, 2007, for the houses 
sold on the land between January 31, 2012, and December 31, 2012, 
the percentage reduction for Y is 5% because Y held the land for not 
more than 60 months from the date of acquisition. Thus, of the 
$300,000 of gross receipts, the DPGR for each house is $221,250 
($300,000-$75,000-$3,750) with costs for each house of $195,000. For 
the houses sold on the land between January 1, 2013, and December 
31, 2017, the percentage reduction for Y is 10% because Y held the 
land for more than 60 months but not more than 120 months from the 
date of acquisition. Thus, of the $300,000 of gross receipts, the 
DPGR for each house is $217,500 ($300,000-$75,000-$7,500) with costs 
for each house of $195,000. The results would be the same if X and Y 
were members of the same EAG, provided X and Y were not members of 
the same consolidated group.
    Example 7. The facts are the same as in Example 6 except that Y 
is a member of the same consolidated group as X. Pursuant to Sec.  
1.1502-13(c)(1)(ii), Y's holding period in the land includes the 
period of time X held the land. In order to produce the same effect 
as if X and Y were divisions of a single corporation (see Sec.  
1.1502-13(c)(1)(i)), for each house sold between January 31, 2012, 
and June 1, 2012, Y's DPGR are redetermined to be $237,000, the same 
as X's DPGR for houses sold between January 31, 2012, and June 1, 
2012, in Example 5. Y's costs for each house do not have to be 
redetermined because Y's costs are $195,000, the same as the costs 
would be if X and Y were divisions of a single corporation. For each 
house sold between June 2, 2012, and June 1, 2017, Y's DPGR are 
redetermined to be $234,000, the same as X's DPGR for each house 
sold between June 2, 2012, and June 1, 2017, in Example 5. Y's costs 
for each house do not have to be redetermined because Y's costs are 
$195,000, the same as the costs would be if X and Y were divisions 
of a single corporation.
    Example 8. X, who is engaged in the trade or business of 
construction under NAICS code 23 on a regular and ongoing basis, 
purchases land for development and builds an office building on the 
land. Y enters into a contract with X to purchase the office 
building. As part of the contract, X is required to furnish the 
office space with desks, chairs, and lamps. Upon completion of the 
sale of the building, X uses the land safe harbor under paragraph 
(m)(6)(iv) of this section to account for the land. After 
application of the land safe harbor, X uses the de minimis exception 
under paragraph (m)(1)(iii)(A) of this section in determining 
whether the gross receipts derived from the sale of the desks, 
chairs, and lamps qualify as DPGR. If the gross receipts derived 
from the sale of the desks, chairs, and lamps are less than 5% of 
the total gross receipts derived by X from the sale of the furnished 
office building (excluding any gross receipts taken into account 
under the land safe harbor pursuant to paragraph (m)(6)(iv)(B) of 
this section), then all of the gross receipts derived from the sale 
of the furnished office building, after the reduction under the land 
safe harbor, may be treated as DPGR.

    (n) Definition of engineering and architectural services--(1) In 
general. DPGR include gross receipts derived from engineering or 
architectural services performed in the United States for a 
construction project described in paragraph (m)(1)(i) of this section. 
At the time the taxpayer performs the engineering or architectural 
services, the taxpayer must be engaged in a trade or business (but not 
necessarily its primary, or only, trade or business) that is considered 
engineering or architectural services for purposes of the NAICS, for 
example NAICS codes 541330 (engineering services) or 541310 
(architectural services), on a regular and ongoing basis. In the case 
of a newly-formed trade or business or a taxpayer in its first taxable 
year, a taxpayer is considered to be engaged in a trade or business on 
a regular and ongoing basis if the taxpayer reasonably expects that it 
will engage in a trade or business on a regular and ongoing basis. DPGR 
include gross receipts derived from engineering or architectural 
services, including feasibility studies for a construction project in 
the United States, even if the planned construction project is not 
undertaken or is not completed.
    (2) Engineering services. Engineering services in connection with 
any construction project include any professional services requiring 
engineering education, training, and experience and the application of 
special knowledge of the mathematical, physical, or engineering 
sciences to those professional services such as consultation, 
investigation, evaluation, planning, design, or responsible supervision 
of construction (for the purpose of assuring compliance with plans, 
specifications, and design) or erection, in connection with any 
construction project.
    (3) Architectural services. Architectural services in connection 
with any construction project include the offering or furnishing of any 
professional services such as consultation, planning, aesthetic and 
structural design, drawings and specifications, or responsible 
supervision of construction (for the purpose of assuring compliance 
with plans, specifications, and design) or erection, in connection with 
any construction project.
    (4) Administrative support services. If the taxpayer performing 
engineering or architectural services also provides administrative 
support services (for example, billing and secretarial services) 
incidental and necessary to such engineering or architectural services, 
then these administrative support services are considered engineering 
or architectural services.
    (5) Exceptions. Engineering or architectural services do not 
include post-construction services such as annual audits and 
inspections.
    (6) De minimis exception for performance of services in the United 
States--(i) DPGR. If less than 5 percent of the total gross receipts 
derived by a taxpayer from engineering or architectural services 
performed in the United States for a construction project (described in 
paragraph (m)(1)(i) of this section) are derived from services not 
relating to a construction project (for example, the services are 
performed outside the United States or in connection with property 
other than real property), then the total gross receipts derived by the 
taxpayer may be treated as DPGR from engineering or architectural 
services performed in the United States for the construction project. 
In the case of gross receipts derived from engineering or architectural 
services that are received over a period of time (for example, an 
installment sale), this de minimis exception is applied by taking into 
account the total gross receipts for the entire period derived (and to 
be derived) from engineering or architectural services. For purposes of 
the preceding sentence, if a taxpayer treats gross receipts as DPGR 
under this de minimis exception, then the taxpayer must treat the gross 
receipts recognized in each taxable year consistently as DPGR.
    (ii) Non-DPGR. If less than 5 percent of the total gross receipts 
derived by a taxpayer from engineering or architectural services 
performed in the United States for a construction project qualify as 
DPGR, then the total gross receipts derived by the taxpayer from 
engineering or architectural services performed in the United States 
for the construction project may be treated as non-DPGR. In the case of 
gross receipts derived from engineering or architectural services that 
are received over a period of time (for example, an installment sale), 
this de minimis exception is applied by taking into account the total 
gross receipts for the entire period derived (and to be derived) from 
engineering or architectural services. For purposes of the preceding 
sentence, if a taxpayer treats gross receipts as non-DPGR under this de 
minimis exception, then the taxpayer must treat the gross receipts 
recognized in each taxable year consistently as non-DPGR.

[[Page 31305]]

    (7) Example. The following example illustrates the application of 
this paragraph (n):

    Example. X is engaged in the trade or business of providing 
engineering services under NAICS code 541330 on a regular and 
ongoing basis. Y buys unimproved land. Y hires X to provide 
engineering services for roads, sewers, sidewalks, and power and 
water lines that qualify as infrastructure under paragraph (m)(4) of 
this section and that will be constructed on Y's land. X's gross 
receipts from engineering services for the infrastructure are DPGR. 
X's gross receipts from engineering services relating to land 
(except as provided in paragraph (m)(2)(iii) of this section) do not 
qualify as DPGR under paragraph (n)(1) of this section because the 
gross receipts are not derived from engineering services for a 
construction project described in paragraph (m)(1)(i) of this 
section.

    (o) Sales of certain food and beverages--(1) In general. DPGR does 
not include gross receipts of the taxpayer that are derived from the 
sale of food or beverages prepared by the taxpayer at a retail 
establishment. A retail establishment is defined as tangible property 
(both real and personal) owned, leased, occupied, or otherwise used by 
the taxpayer in its trade or business of selling food or beverages to 
the public at which retail sales are made. In addition, a facility that 
prepares food and beverages for take out service or delivery is a 
retail establishment (for example, a caterer). If a taxpayer's facility 
is a retail establishment, then, for purposes of this section, the 
taxpayer may allocate its gross receipts between the gross receipts 
derived from the retail sale of the food and beverages prepared and 
sold at the retail establishment (that are non-DPGR) and gross receipts 
derived from the wholesale sale of the food and beverages prepared and 
sold at the retail establishment (that are DPGR assuming all the other 
requirements of section 199 are met). Wholesale sales are defined as 
food and beverages held for resale by the purchaser. The exception for 
sales of certain food and beverages also applies to food and beverages 
for non-human consumption. A retail establishment does not include the 
bonded premises of a distilled spirits plant or wine cellar, or the 
premises of a brewery (other than a tavern on the brewery premises). 
See Chapter 51 of Title 26 of the United States Code and the 
implementing regulations thereunder.
    (2) De minimis exception. A taxpayer may treat a facility at which 
food or beverages are prepared as not being a retail establishment if 
less than 5 percent of the gross receipts derived from the sale of food 
or beverages at that facility during the taxable year are attributable 
to retail sales.
    (3) Examples. The following examples illustrate the application of 
this paragraph (o):

    Example 1. X buys coffee beans and roasts those beans at a 
facility in the United States, the only activity of which is the 
roasting and packaging of coffee beans. X sells the roasted coffee 
beans through a variety of unrelated third-party vendors and also 
sells roasted coffee beans at X's retail establishments. At X's 
retail establishments, X prepares brewed coffee and other foods. To 
the extent that the gross receipts of X's retail establishments are 
derived from the sale of coffee beans roasted at the facility, the 
receipts are DPGR (assuming all the other requirements of this 
section are met). To the extent the gross receipts of X's retail 
establishments are derived from the retail sale of brewed coffee or 
food prepared at the retail establishments, the receipts are non-
DPGR. However, pursuant to Sec.  1.199-1(d)(1)(ii), X must allocate 
part of the receipts from the retail sale of the brewed coffee as 
DPGR to the extent of the value of the coffee beans that were 
roasted at the facility and that were used to brew coffee.
    Example 2. Y operates a bonded winery within the United States. 
Bottles of wine produced by Y at the bonded winery are sold to 
consumers at the taxpaid premises. Pursuant to paragraph (o)(1) of 
this section, the bonded premises is not considered a retail 
establishment and is treated as separate and apart from the taxpaid 
premises, which is considered a retail establishment for purposes of 
paragraph (o)(1) of this section. Accordingly, the wine produced by 
Y in the bonded premises and sold by Y from the taxpaid premises is 
not considered to have been produced at a retail establishment, and 
the gross receipts derived from the sales of the wine are DPGR 
(assuming all the other requirements of this section are met).

    (p) Guaranteed payments. DPGR does not include guaranteed payments 
under section 707(c). Thus, partners, including partners in 
partnerships described in Sec.  1.199-9(i) and (j), may not treat 
guaranteed payments as DPGR. See Sec.  1.199-9(b)(6) Example 5.


Sec.  1.199-4  Costs allocable to domestic production gross receipts.

    (a) In general. The provisions of this section apply solely for 
purposes of section 199 of the Internal Revenue Code (Code). To 
determine its qualified production activities income (QPAI) (as defined 
in Sec.  1.199-1(c)) for a taxable year, a taxpayer must subtract from 
its domestic production gross receipts (DPGR) (as defined in Sec.  
1.199-3(a)) the cost of goods sold (CGS) allocable to DPGR and other 
expenses, losses, or deductions (deductions), other than the deduction 
allowed under section 199, that are properly allocable to such 
receipts. Paragraph (b) of this section provides rules for determining 
CGS allocable to DPGR. Paragraph (c) of this section provides rules for 
determining the deductions that are properly allocable to DPGR. 
Paragraph (d) of this section provides that a taxpayer generally must 
determine deductions allocable to DPGR or to gross income attributable 
to DPGR using Sec. Sec.  1.861-8 through 1.861-17 and Sec. Sec.  1.861-
8T through 1.861-14T (the section 861 regulations), subject to the 
rules in paragraph (d) of this section (the section 861 method). 
Paragraph (e) of this section provides that certain taxpayers may 
apportion deductions to DPGR using the simplified deduction method. 
Paragraph (f) of this section provides a small business simplified 
overall method that a qualifying small taxpayer may use to apportion 
CGS and deductions to DPGR.
    (b) Cost of goods sold allocable to domestic production gross 
receipts--(1) In general. When determining its QPAI, a taxpayer must 
subtract from DPGR the CGS allocable to DPGR. A taxpayer determines its 
CGS allocable to DPGR in accordance with this paragraph (b) or, if 
applicable, paragraph (f) of this section. In the case of a sale, 
exchange, or other disposition of inventory, CGS is equal to beginning 
inventory plus purchases and production costs incurred during the 
taxable year and included in inventory costs, less ending inventory. 
CGS is determined under the methods of accounting that the taxpayer 
uses to compute taxable income. See sections 263A, 471, and 472. If 
section 263A requires a taxpayer to include additional section 263A 
costs (as defined in Sec.  1.263A-1(d)(3)) in inventory, additional 
section 263A costs must be included in determining CGS. CGS allocable 
to DPGR also includes inventory valuation adjustments such as 
writedowns under the lower of cost or market method. In the case of a 
sale, exchange, or other disposition (including, for example, theft, 
casualty, or abandonment) of non-inventory property, CGS for purposes 
of this section includes the adjusted basis of the property. CGS 
allocable to DPGR for a taxable year may include the inventory cost and 
adjusted basis of qualifying production property (QPP) (as defined in 
Sec.  1.199-3(j)(1)), a qualified film (as defined in Sec.  1.199-
3(k)(1)), or electricity, natural gas, and potable water (as defined in 
Sec.  1.199-3(l)) (collectively, utilities) that will generate (or have 
generated) DPGR notwithstanding that the gross receipts attributable to 
the sale, lease, rental, license, exchange, or other disposition of the 
QPP, qualified film, or utilities will be, or have been, included in 
the

[[Page 31306]]

computation of gross income for a different taxable year. For example, 
advance payments that are DPGR may be included in gross income under 
Sec.  1.451-5(b)(1)(i) in a different taxable year than the related CGS 
allocable to that DPGR. If gross receipts are treated as DPGR pursuant 
to Sec.  1.199-1(d)(3)(i) or Sec.  1.199-3(i)(4)(i)(B)(6), 
(l)(4)(iv)(A), (m)(1)(iii)(A), (n)(6)(i), or (o)(2), then CGS must be 
allocated to such DPGR. Similarly, if gross receipts are treated as 
non-DPGR pursuant to Sec.  1.199-1(d)(3)(ii) or Sec.  1.199-
3(i)(4)(ii), (l)(4)(iv)(B), (m)(1)(iii)(B), or (n)(6)(ii), then CGS 
must be allocated to such non-DPGR. See Sec.  1.199-3(m)(6)(iv) for 
rules relating to treatment of certain costs in the case of a taxpayer 
that uses the land safe harbor under that paragraph.
    (2) Allocating cost of goods sold--(i) In general. A taxpayer must 
use a reasonable method that is satisfactory to the Secretary based on 
all of the facts and circumstances to allocate CGS between DPGR and 
non-DPGR. Whether an allocation method is reasonable is based on all of 
the facts and circumstances including whether the taxpayer uses the 
most accurate information available; the relationship between CGS and 
the method used; the accuracy of the method chosen as compared with 
other possible methods; whether the method is used by the taxpayer for 
internal management or other business purposes; whether the method is 
used for other Federal or state income tax purposes; the availability 
of costing information; the time, burden, and cost of using alternative 
methods; and whether the taxpayer applies the method consistently from 
year to year. Depending on the facts and circumstances, reasonable 
methods may include methods based on gross receipts, number of units 
sold, number of units produced, or total production costs. Ordinarily, 
if a taxpayer uses a method to allocate gross receipts between DPGR and 
non-DPGR, then the use of a different method to allocate CGS that is 
not demonstrably more accurate than the method used to allocate gross 
receipts will not be considered reasonable. However, if a taxpayer has 
information readily available to specifically identify CGS allocable to 
DPGR and can specifically identify that amount without undue burden or 
expense, CGS allocable to DPGR is that amount irrespective of whether 
the taxpayer uses another allocation method to allocate gross receipts 
between DPGR and non-DPGR. A taxpayer that does not have information 
readily available to specifically identify CGS allocable to DPGR and 
that cannot, without undue burden or expense, specifically identify 
that amount is not required to use a method that specifically 
identifies CGS allocable to DPGR.
    (ii) Gross receipts recognized in an earlier taxable year. If a 
taxpayer (other than a taxpayer that uses the small business simplified 
overall method of paragraph (f) of this section) recognizes and reports 
gross receipts on a Federal income tax return for a taxable year, and 
incurs CGS related to such gross receipts in a subsequent taxable year, 
then regardless of whether the gross receipts ultimately qualify as 
DPGR, the taxpayer must allocate the CGS to--
    (A) DPGR if the taxpayer identified the related gross receipts as 
DPGR in the prior taxable year; or
    (B) Non-DPGR if the taxpayer identified the related gross receipts 
as non-DPGR in the prior taxable year or if the taxpayer recognized 
under the taxpayer's methods of accounting those gross receipts in a 
taxable year to which section 199 does not apply.
    (3) Special rules for imported items or services. The cost of any 
item or service brought into the United States (as defined in Sec.  
1.199-3(h)) without an arm's length transfer price may not be treated 
as less than its value immediately after it entered the United States 
for purposes of determining the CGS to be used in the computation of 
QPAI. Similarly, the adjusted basis of leased or rented property that 
gives rise to DPGR that has been brought into the United States (as 
defined in Sec.  1.199-3(h)) without an arm's length transfer price may 
not be treated as less than its value immediately after it entered the 
United States. When an item or service is imported into the United 
States that had been exported by the taxpayer for further manufacture, 
the increase in cost may not exceed the difference between the value of 
the property when exported and the value of the property when imported 
back into the United States after further manufacture. For this 
purpose, the value of property is its customs value as defined in 
section 1059A(b)(1).
    (4) Rules for inventories valued at market or bona fide selling 
prices. If part of CGS is attributable to inventory valuation 
adjustments, then CGS allocable to DPGR includes inventory adjustments 
to QPP that is 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. Accordingly, taxpayers 
that value inventory under Sec.  1.471-4 (inventories at cost or 
market, whichever is lower) or Sec.  1.471-2(c) (subnormal goods at 
bona fide selling prices) must allocate a proper share of such 
adjustments (for example, writedowns) to DPGR based on a reasonable 
method that is satisfactory to the Secretary based on all of the facts 
and circumstances. Factors taken into account in determining whether 
the method is reasonable include whether the taxpayer uses the most 
accurate information available; the relationship between the adjustment 
and the allocation base chosen; the accuracy of the method chosen as 
compared with other possible methods; whether the method is used by the 
taxpayer for internal management or other business purposes; whether 
the method is used for other Federal or state income tax purposes; the 
time, burden, and cost of using alternative methods; and whether the 
taxpayer applies the method consistently from year to year. If a 
taxpayer has information readily available to specifically identify the 
proper amount of inventory valuation adjustments allocable to DPGR, 
then the taxpayer must allocate that amount to DPGR. A taxpayer that 
does not have information readily available to specifically identify 
the proper amount of inventory valuation adjustments allocable to DPGR 
and that cannot, without undue burden or expense, specifically identify 
the proper amount of inventory valuation adjustments allocable to DPGR, 
is not required to use a method that specifically identifies inventory 
valuations adjustments to DPGR.
    (5) Rules applicable to inventories accounted for under the last-
in, first-out (LIFO) inventory method--(i) In general. This paragraph 
applies to inventories accounted for using the specific goods last-in, 
first-out (LIFO) method or the dollar-value LIFO method. Whenever a 
specific goods grouping or a dollar-value pool contains QPP, qualified 
films, or utilities that produces DPGR and goods that do not, the 
taxpayer must allocate CGS attributable to that grouping or pool 
between DPGR and non-DPGR using a reasonable method that is 
satisfactory to the Secretary based on all of the facts and 
circumstances. Whether a method of allocating CGS between DPGR and non-
DPGR is reasonable must be determined in accordance with paragraph 
(b)(2) of this section. In addition, this paragraph (b)(5) provides 
methods that a taxpayer may use to allocate CGS for inventories 
accounted for using the LIFO method. If a taxpayer uses the LIFO/FIFO 
ratio method provided in paragraph (b)(5)(ii) of this section or the 
change in relative base-year cost method provided in paragraph 
(b)(5)(iii) of this section, then

[[Page 31307]]

the taxpayer must use that method for all inventory accounted for under 
the LIFO method.
    (ii) LIFO/FIFO ratio method. A taxpayer using the specific goods 
LIFO method or the dollar-value LIFO method may use the LIFO/FIFO ratio 
method. The LIFO/FIFO ratio method is applied with respect to all LIFO 
inventory of a taxpayer on a grouping-by-grouping or pool-by-pool 
basis. Under the LIFO/FIFO ratio method, a taxpayer computes the CGS of 
a grouping or pool allocable to DPGR by multiplying the CGS of QPP, 
qualified films, or utilities in the grouping or pool that produced 
DPGR computed using the first-in, first-out (FIFO) method by the LIFO/
FIFO ratio of the grouping or pool. The LIFO/FIFO ratio of a grouping 
or pool is equal to the total CGS of the grouping or pool computed 
using the LIFO method over the total CGS of the grouping or pool 
computed using the FIFO method.
    (iii) Change in relative base-year cost method. A taxpayer using 
the dollar-value LIFO method may use the change in relative base-year 
cost method. The change in relative base-year cost method is applied 
with respect to all LIFO inventory of a taxpayer on a pool-by-pool 
basis. The change in relative base-year cost method determines the CGS 
allocable to DPGR by increasing or decreasing the total production 
costs (section 471 costs and additional section 263A costs) of QPP, a 
qualified film, or utilities that generate DPGR by a portion of any 
increment or liquidation of the dollar-value pool. The portion of an 
increment or liquidation allocable to DPGR is determined by multiplying 
the LIFO value of the increment or liquidation (expressed as a positive 
number) by the ratio of the change in total base-year cost (expressed 
as a positive number) of the QPP, qualified film, or utilities that 
will generate DPGR in ending inventory to the change in total base-year 
cost (expressed as a positive number) of all goods in the ending 
inventory. The portion of an increment or liquidation allocable to DPGR 
may be zero but cannot exceed the amount of the increment or 
liquidation. Thus, a ratio in excess of 1.0 must be treated as 1.0.
    (6) Taxpayers using the simplified production method or simplified 
resale method for additional section 263A costs. A taxpayer that uses 
the simplified production method or simplified resale method to 
allocate additional section 263A costs, as defined in Sec.  1.263A-
1(d)(3), to ending inventory must follow the rules in paragraph (b)(2) 
of this section to determine the amount of additional section 263A 
costs allocable to DPGR. Allocable additional section 263A costs 
include additional section 263A costs included in beginning inventory 
as well as additional section 263A costs incurred during the taxable 
year. Ordinarily, if a taxpayer uses the simplified production method 
or the simplified resale method, the additional section 263A costs 
should be allocated in the same proportion as section 471 costs are 
allocated.
    (7) Examples. The following examples illustrate the application of 
this paragraph (b) and assume that the taxpayer does not use the small 
business simplified overall method provided in paragraph (f) of this 
section:

    Example 1. Advance payments. T, a calendar year taxpayer, is a 
manufacturer of furniture in the United States. Under its method of 
accounting, T includes advance payments and other gross receipts 
derived from the sale of furniture in gross income when the payments 
are received. In December 2007, T receives an advance payment of 
$5,000 from X with respect to an order of furniture to be 
manufactured for a total price of $20,000. In 2008, T produces and 
sells the furniture to X. In 2008, T incurs $14,000 of section 471 
and additional section 263A costs to produce the furniture ordered 
by X. T receives the remaining $15,000 of the contract price from X 
in 2008. Assuming that in 2007, T can reasonably determine that all 
the requirements of Sec. Sec.  1.199-1 and 1.199-3 will be met with 
respect to the furniture, the advance payment qualifies as DPGR in 
2007. Assuming further that all the requirements of Sec. Sec.  
1.199-1 and 1.199-3 are met with respect to the furniture in 2008, 
the remaining $15,000 of the contract price must be included in 
income and DPGR when received by T in 2008. T must include the 
$14,000 it incurred to produce the furniture in CGS and CGS 
allocable to DPGR in 2008. See Sec.  1.199-4(b)(2)(ii) for rules 
regarding gross receipts and costs recognized in different taxable 
years.
    Example 2. Use of standard cost method. X, a calendar year 
taxpayer, manufactures item A in a factory located in the United 
States and item B in a factory located in Country Y. Item A is 
produced by X within the United States and the sale of A generates 
DPGR. X uses the FIFO inventory method to account for its inventory 
and determines the cost of item A using a standard cost method. At 
the beginning of its 2007 taxable year, X's inventory contains 2,000 
units of item A at a standard cost of $5 per unit. X did not incur 
significant cost variances in previous taxable years. During the 
2007 taxable year, X produces 8,000 units of item A at a standard 
cost of $6 per unit. X determines that with regard to its production 
of item A it has incurred a significant cost variance. When X 
reallocates the cost variance to the units of item A that it has 
produced, the production cost of item A is $7 per unit. X sells 
7,000 units of item A during the taxable year. X can identify from 
its books and records that CGS related to the sales of item A during 
the taxable year are $45,000 ((2,000 x $5) + (5,000 x $7)). 
Accordingly, X has CGS allocable to DPGR of $45,000.
    Example 3. Change in relative base-year cost method. (i) Y 
elects, beginning with the calendar year 2007, to compute its 
inventories using the dollar-value, LIFO method under section 472. Y 
establishes a pool for items A and B. Y produces item A within the 
United States and the sales of item A generate DPGR. Y does not 
produce item B within the United States and the sale of item B does 
not generate DPGR. The composition of the inventory for the pool at 
the base date, January 1, 2007, is as follows:

----------------------------------------------------------------------------------------------------------------
                              Item                                     Unit          Unit cost      Total cost
----------------------------------------------------------------------------------------------------------------
A...............................................................           2,000           $5.00         $10,000
B...............................................................           1,250            4.00           5,000
 
    Total.......................................................  ..............  ..............          15,000
----------------------------------------------------------------------------------------------------------------

    (ii) Y uses a standard cost method to allocate all direct and 
indirect costs (section 471 and additional section 263A costs) to the 
units of item A and item B that it produces. During 2007, Y incurs 
$52,500 of section 471 costs and additional section 263A costs to 
produce 10,000 units of item A and $114,000 of section 471 costs and 
additional section 263A costs to produce 20,000 units of item B.
    (iii) The closing inventory of the pool at December 31, 2007, 
contains 3,000 units of item A and 2,500 units of item B. The closing 
inventory of the pool at December 31, 2007, shown at base-year and 
current-year cost is as follows:

[[Page 31308]]



----------------------------------------------------------------------------------------------------------------
                                                                                   Current-year
              Item                   Quantity     Base-year cost      Amount           cost           Amount
----------------------------------------------------------------------------------------------------------------
A...............................           3,000           $5.00         $15,000           $5.25         $15,750
B...............................           2,500            4.00          10,000            5.70          14,250
                                 -------------------------------------------------------------------------------
    Totals......................  ..............  ..............          25,000  ..............          30,000
----------------------------------------------------------------------------------------------------------------

    (iv) The base-year cost of the closing LIFO inventory at December 
31, 2007, amounts to $25,000, and exceeds the $15,000 base-year cost of 
the opening inventory for the taxable year by $10,000 (the increment 
stated at base-year cost). The increment valued at current-year cost is 
computed by multiplying the increment stated at base-year cost by the 
ratio of the current-year cost of the pool to total base-year cost of 
the pool (that is, $30,000/$25,000, or 120%). The increment stated at 
current-year cost is $12,000 ($10,000 x 120%).
    (v) The change in relative base-year cost of item A is $5,000 
($15,000-$10,000). The change in relative base-year cost (the increment 
stated at base-year cost) of the total inventory is $10,000 ($25,000-
$15,000). The ratio of the change in base-year cost of item A to the 
change in base-year cost of the total inventory is 50% ($5,000/
$10,000).
    (vi) CGS allocable to DPGR is $46,500, computed as follows:

------------------------------------------------------------------------
 
------------------------------------------------------------------------
Current-year production costs related    ..............         $52,500
 to DPGR...............................
Less:
    Increment stated at current-year            $12,000  ...............
     cost..............................
    Ratio..............................             50%  ...............
    Total..............................  ..............          (6,000)
                                        --------------------------------
        Total..........................  ..............          46,500
------------------------------------------------------------------------

    Example 4. Change in relative base-year cost method. (i) The 
facts are the same as in Example 3 except that, during the calendar 
year 2008, Y experiences an inventory decrement. During 2008, Y 
incurs $66,000 of section 471 costs and additional section 263A 
costs to produce 12,000 units of item A and $150,000 of section 471 
costs and additional section 263A costs to produce 25,000 units of 
item B.
    (ii) The closing inventory of the pool at December 31, 2008, 
contains 2,000 units of item A and 2,500 units of item B. The 
closing inventory of the pool at December 31, 2008, shown at base-
year and current-year cost is as follows:

----------------------------------------------------------------------------------------------------------------
                                                                                   Current-year
              Item                   Quantity     Base-year cost      Amount           cost           Amount
----------------------------------------------------------------------------------------------------------------
A...............................           2,000           $5.00         $10,000           $5.50         $11,000
B...............................           2,500            4.00          10,000            6.00          15,000
                                 -------------------------------------------------------------------------------
    Totals......................  ..............  ..............          20,000  ..............          26,000
----------------------------------------------------------------------------------------------------------------

    (iii) The base-year cost of the closing LIFO inventory at December 
31, 2008, amounts to $20,000, and is less than the $25,000 base-year 
cost of the opening inventory for that taxable year by $5,000 (the 
decrement stated at base-year cost). This liquidation is reflected by 
reducing the most recent layer of increment. The LIFO value of the 
inventory at December 31, 2008 is:

----------------------------------------------------------------------------------------------------------------
                                                                     Base cost         Index        LIFO value
----------------------------------------------------------------------------------------------------------------
January 1, 2008, base cost......................................         $15,000            1.00         $15,000
December 31, 2008, increment....................................           5,000            1.20           6,000
                                                                 -----------------------------------------------
    Total.......................................................  ..............  ..............          21,000
----------------------------------------------------------------------------------------------------------------

    (iv) The change in relative base-year cost of item A is $5,000 
($15,000-$10,000). The change in relative base-year cost of the total 
inventory is $5,000 ($25,000-$20,000). The ratio of the change in base-
year cost of item A to the change in base-year cost of the total 
inventory is 100% ($5,000/$5,000).
    (v) CGS allocable to DPGR is $72,000, computed as follows:

------------------------------------------------------------------------
 
------------------------------------------------------------------------
Current-year production costs related to  ..............         $66,000
 DPGR...................................
Plus:
    LIFO value of decrement.............          $6,000  ..............
    Ratio...............................            100%  ..............
    Total...............................  ..............           6,000
                                         -------------------------------
        Total...........................  ..............          72,000
------------------------------------------------------------------------


[[Page 31309]]

    Example 5. LIFO/FIFO ratio method. (i) The facts are the same as 
in Example 3 except that Y uses the LIFO/FIFO ratio method to 
determine its CGS allocable to DPGR.
    (ii) Y's CGS related to item A on a FIFO basis is $46,750 
((2,000 units at $5) + (7,000 units at $5.25)).
    (iii) Y's total CGS computed on a LIFO basis is $154,500 
(beginning inventory of $15,000 plus total production costs of 
$166,500 less ending inventory of $27,000).
    (iv) Y's total CGS computed on a FIFO basis is $151,500 
(beginning inventory of $15,000 plus total production costs of 
$166,500 less ending inventory of $30,000).
    (v) The ratio of Y's CGS computed using the LIFO method to its 
CGS computed using the FIFO method is 102% ($154,500/$151,500). Y's 
CGS related to DPGR computed using the LIFO/FIFO ratio method is 
$47,685 ($46,750 x 102%).
    Example 6. LIFO/FIFO ratio method. (i) The facts are the same as 
in Example 4 except that Y uses the LIFO/FIFO ratio method to 
compute CGS allocable to DPGR.
    (ii) Y's CGS related to item A on a FIFO basis is $70,750 
((3,000 units at $5.25) + (10,000 units at $5.50)).
    (iii) Y's total CGS computed on a LIFO basis is $222,000 
(beginning inventory of $27,000 plus total production costs of 
$216,000 less ending inventory of $21,000).
    (iv) Y's total CGS computed on a FIFO basis is $220,000 
(beginning inventory of $30,000 plus total production costs of 
$216,000 less ending inventory of $26,000).
    (v) The ratio of Y's CGS computed using the LIFO method to its 
CGS computed using the FIFO method is 101% ($222,000/$220,000). Y's 
CGS related to DPGR computed using the LIFO/FIFO ratio method is 
$71,457 ($70,750 x 101%).

    (c) Other deductions properly allocable to domestic production 
gross receipts or gross income attributable to domestic production 
gross receipts--(1) In general. In determining its QPAI, a taxpayer 
must subtract from its DPGR, in addition to its CGS allocable to DPGR, 
the deductions that are properly allocable to DPGR. A taxpayer 
generally must allocate and apportion these deductions using the rules 
of the section 861 method. In lieu of the section 861 method, certain 
taxpayers may apportion these deductions using the simplified deduction 
method provided in paragraph (e) of this section. Paragraph (f) of this 
section provides a small business simplified overall method that may be 
used by a qualifying small taxpayer, as defined in that paragraph. A 
taxpayer using the simplified deduction method or the small business 
simplified overall method must use that method for all deductions. A 
taxpayer eligible to use the small business simplified overall method 
may choose at any time for any taxable year to use the small business 
simplified overall method, the simplified deduction method, or the 
section 861 method for a taxable year. A taxpayer eligible to use the 
simplified deduction method may choose at any time for any taxable year 
to use the simplified deduction method or the section 861 method for a 
taxable year.
    (2) Treatment of net operating losses. A deduction under section 
172 for a net operating loss is not allocated or apportioned to DPGR or 
gross income attributable to DPGR.
    (3) W-2 wages. Although only W-2 wages as described in Sec.  1.199-
2 are taken into account in computing the W-2 wage limitation, all 
wages paid (or incurred in the case of an accrual method taxpayer) in a 
taxpayer's trade or business during the taxable year are taken into 
account in computing QPAI for that taxable year.
    (d) Section 861 method--(1) In general. Under the section 861 
method, a taxpayer must allocate and apportion its deductions using the 
allocation and apportionment rules provided under the section 861 
regulations under which section 199 is treated as an operative section 
described in Sec.  1.861-8(f). Accordingly, the taxpayer applies the 
rules of the section 861 regulations to allocate and apportion 
deductions (including, if applicable, its distributive share of 
deductions from pass-thru entities) to gross income attributable to 
DPGR. Gross receipts that are allocable to land under the safe harbor 
provided in Sec.  1.199-3(m)(6)(iv) are treated as non-DPGR. See Sec.  
1.199-3(m)(6)(iv)(B). If the taxpayer applies the allocation and 
apportionment rules of the section 861 regulations for section 199 and 
another operative section, then the taxpayer must use the same method 
of allocation and the same principles of apportionment for purposes of 
all operative sections (subject to the rules provided in paragraphs 
(c)(2) and (d)(2) and (3) of this section). See Sec.  1.861-8(f)(2)(i).
    (2) Deductions for charitable contributions. Deductions for 
charitable contributions (as allowed under section 170 and section 
873(b)(2) or 882(c)(1)(B)) must be ratably apportioned between gross 
income attributable to DPGR and gross income attributable to non-DPGR 
based on the relative amounts of gross income.
    (3) Research and experimental expenditures. Research and 
experimental expenditures must be allocated and apportioned in 
accordance with Sec.  1.861-17 without taking into account the 
exclusive apportionment rule of Sec.  1.861-17(b).
    (4) Deductions allocated or apportioned to gross receipts treated 
as domestic production gross receipts. If gross receipts are treated as 
DPGR pursuant to Sec.  1.199-1(d)(3)(i) or Sec.  1.199-
3(i)(4)(i)(B)(6), (l)(4)(iv)(A), (m)(1)(iii)(A), (n)(6)(i), or (o)(2), 
then deductions must be allocated or apportioned to the gross income 
attributable to such DPGR. Similarly, if gross receipts are treated as 
non-DPGR pursuant to Sec.  1.199-1(d)(3)(ii) or Sec.  1.199-
3(i)(4)(ii), (l)(4)(iv)(B), (m)(1)(iii)(B), or (n)(6)(ii), then 
deductions must be allocated or apportioned to the gross income 
attributable to such non-DPGR.
    (5) Treatment of items from a pass-thru entity reporting qualified 
production activities income. If, pursuant to Sec.  1.199-9(e)(2) or to 
the authority granted in Sec.  1.199-9(b)(1)(ii) or (c)(1)(ii), a 
taxpayer must combine QPAI and W-2 wages from a partnership, S 
corporation, trust (to the extent not described in Sec.  1.199-9(d)) or 
estate with the taxpayer's total QPAI and W-2 wages from other sources, 
then for purposes of apportioning the taxpayer's interest expense under 
this paragraph Sec.  1.199-4(d), the taxpayer's interest in such 
partnership (and, where relevant in apportioning the taxpayer's 
interest expense, the partnership's assets), the taxpayer's shares in 
such S corporation, or the taxpayer's interest in such trust shall be 
disregarded.
    (6) Examples. The following examples illustrate the operation of 
the section 861 method. Assume in the following examples that all 
corporations are calendar year taxpayers, that all taxpayers have 
sufficient W-2 wages as defined in Sec.  1.199-2(e) so that the section 
199 deduction is not limited under section 199(b)(1), and that, with 
respect to the allocation and apportionment of interest expense, Sec.  
1.861-10T does not apply.

    Example 1. Section 861 method and no EAG. (i) Facts. X, a United 
States corporation that is not a member of an expanded affiliated 
group (EAG) (as defined in Sec.  1.199-7), engages in activities 
that generate both DPGR and non-DPGR. All of X's production 
activities that generate DPGR are within Standard Industrial 
Classification (SIC) Industry Group AAA (SIC AAA). All of X's 
production activities that generate non-DPGR are within SIC Industry 
Group BBB (SIC BBB). X is able to identify from its books and 
records CGS allocable to DPGR and to non-DPGR. X incurs $900 of 
research and experimentation expenses (R&E) that are deductible 
under section 174, $300 of which are performed with respect to SIC 
AAA and $600 of which are performed with respect to SIC BBB. None of 
the R&E is legally mandated R&E as described in Sec.  1.861-17(a)(4) 
and none of the R&E is included in CGS. X incurs section 162 selling 
expenses that are not includible in CGS and not properly allocable 
to any gross income. For 2010, the adjusted basis of X's assets is 
$5,000, $4,000 of which generates gross

[[Page 31310]]

income attributable to DPGR and $1,000 of which generates gross 
income attributable to non-DPGR. For 2010, X's taxable income is 
$1,380 based on the following Federal income tax items:

------------------------------------------------------------------------
 
------------------------------------------------------------------------
DPGR (all from sales of products within SIC AAA).......          $3,000
Non-DPGR (all from sales of products within SIC BBB)...           3,000
CGS allocable to DPGR..................................            (600)
CGS allocable to non-DPGR..............................          (1,800)
Section 162 selling expenses...........................            (840)
Section 174 R&E-SIC AAA................................            (300)
Section 174 R&E-SIC BBB................................            (600)
Interest expense (not included in CGS).................            (300)
Charitable contributions...............................            (180)
                                                        ----------------
X's taxable income.....................................           1,380
------------------------------------------------------------------------

    (ii) X's QPAI. X allocates and apportions its deductions to 
gross income attributable to DPGR under the section 861 method of 
this paragraph (d). In this case, the section 162 selling expenses 
are definitely related to all of X's gross income. Based on the 
facts and circumstances of this specific case, apportionment of 
those expenses between DPGR and non-DPGR on the basis of X's gross 
receipts is appropriate. For purposes of apportioning R&E, X elects 
to use the sales method as described in Sec.  1.861-17(c). X elects 
to apportion interest expense under the tax book value method of 
Sec.  1.861-9T(g). X has $2,400 of gross income attributable to DPGR 
(DPGR of $3,000--CGS of $600 allocated based on X's books and 
records). X's QPAI for 2010 is $1,320, as shown below:

------------------------------------------------------------------------
 
------------------------------------------------------------------------
DPGR (all from sales of products within SIC AAA).......          $3,000
CGS allocable to DPGR..................................            (600)
Section 162 selling expenses ($840 x ($3,000 DPGR/                 (420)
 $6,000 total gross receipts)).........................
Interest expense (not included in CGS) ($300 x ($4,000             (240)
 (X's DPGR assets)/ $5,000 (X's total assets)))........
Charitable contributions (not included in CGS) ($180 x             (120)
 ($2,400 gross income attributable to DPGR/$3,600 total
 gross income))........................................
Section 174 R&E-SIC AAA................................            (300)
                                                        ----------------
    X's QPAI...........................................           1,320
------------------------------------------------------------------------

    (iii) Section 199 deduction determination. X's tentative 
deduction under Sec.  1.199-1(a) is $119 (.09 x (lesser of QPAI of 
$1,320 and taxable income of $1,380)). Because the facts of this 
example assume that X's W-2 wages as defined in Sec.  1.199-2(e) are 
sufficient to avoid a limitation on the section 199 deduction, X's 
section 199 deduction for 2010 is $119.
    Example 2. Section 861 method and EAG. (i) Facts. The facts are 
the same as in Example 1 except that X owns stock in Y, a United 
States corporation, equal to 75% of the total voting power of stock 
of Y and 80% of the total value of stock of Y. X and Y are not 
members of an affiliated group as defined in section 1504(a). 
Accordingly, the rules of Sec.  1.861-14T do not apply to X's and 
Y's selling expenses, R&E, and charitable contributions. X and Y 
are, however, members of an affiliated group for purposes of 
allocating and apportioning interest expense (see Sec.  1.861-
11T(d)(6)) and are also members of an EAG. For 2010, the adjusted 
basis of Y's assets is $45,000, $21,000 of which generates gross 
income attributable to DPGR and $24,000 of which generates gross 
income attributable to non-DPGR. All of Y's activities that generate 
DPGR are within SIC Industry Group AAA (SIC AAA). All of Y's 
activities that generate non-DPGR are within SIC Industry Group BBB 
(SIC BBB). None of X's and Y's sales are to each other. Y is not 
able to identify from its books and records CGS allocable to DPGR 
and non-DPGR. In this case, because CGS is definitely related under 
the facts and circumstances to all of Y's gross receipts, 
apportionment of CGS between DPGR and non-DPGR based on gross 
receipts is appropriate. For 2010, Y's taxable income is $1,910 
based on the following Federal income tax items:

------------------------------------------------------------------------
 
------------------------------------------------------------------------
DPGR (all from sales of products within SIC AAA).......          $3,000
Non-DPGR (all from sales of products within SIC BBB)...           3,000
CGS allocated to DPGR..................................          (1,200)
CGS allocated to non-DPGR..............................          (1,200)
Section 162 selling expenses...........................            (840)
Section 174 R&E-SIC AAA................................            (100)
Section 174 R&E-SIC BBB................................            (200)
Interest expense (not included in CGS and not subject              (500)
 to Sec.   1.861-10T)..................................
Charitable contributions...............................             (50)
                                                        ----------------
    Y's taxable income.................................           1,910
------------------------------------------------------------------------

    (ii) QPAI. (A) X's QPAI. Determination of X's QPAI is the same 
as in Example 1 except that interest is apportioned to gross income 
attributable to DPGR based on the combined adjusted bases of X's and 
Y's assets. See Sec.  1.861-11T(c). Accordingly, X's QPAI for 2010 
is $1,410, as shown below:

------------------------------------------------------------------------
 
------------------------------------------------------------------------
DPGR (all from sales of products within SIC AAA).......          $3,000
CGS allocated to DPGR..................................            (600)
Section 162 selling expenses ($840 x ($3,000 DPGR/                 (420)
 $6,000 total gross receipts)).........................
Interest expense (not included in CGS and not subject              (150)
 to Sec.   1.861-10T) ($300 x ($25,000 (tax book value
 of X's and Y's DPGR assets)/$50,000 (tax book value of
 X's and Y's total assets)))...........................
Charitable contributions (not included in CGS) ($180 x             (120)
 ($2,400 gross income attributable to DPGR/$3,600 total
 gross income))........................................

[[Page 31311]]

 
Section 174 R&E-SIC AAA................................            (300)
                                                        ----------------
    X's QPAI...........................................           1,410
------------------------------------------------------------------------

    (B) Y's QPAI. Y makes the same elections under the section 861 
method as does X. Y has $1,800 of gross income attributable to DPGR 
(DPGR of $3,000--CGS of $1,200 allocated based on Y's gross 
receipts). Y's QPAI for 2010 is $1,005, as shown below:

------------------------------------------------------------------------
 
------------------------------------------------------------------------
DPGR (all from sales of products within SIC AAA).......          $3,000
CGS allocated to DPGR..................................          (1,200)
Section 162 selling expenses ($840 x ($3,000 DPGR/                 (420)
 $6,000 total gross receipts)).........................
Interest expense (not included in CGS and not subject              (250)
 to Sec.   1.861-10T) ($500 x ($25,000 (tax book value
 of X's and Y's DPGR assets)/$50,000 (tax book value of
 X's and Y's total assets)))...........................
Charitable contributions (not included in CGS) ($50 x               (25)
 ($1,800 gross income attributable to DPGR/$3,600 total
 gross income))........................................
Section 174 R&E-SIC AAA................................            (100)
                                                        ----------------
    Y's QPAI...........................................          $1,005
------------------------------------------------------------------------

    (iii) Section 199 deduction determination. The section 199 
deduction of the X and Y EAG is determined by aggregating the 
separately determined QPAI, taxable income, and W-2 wages of X and 
Y. See Sec.  1.199-7(b). Accordingly, the X and Y EAG's tentative 
section 199 deduction is $217 (.09 x (lesser of combined taxable 
incomes of X and Y of $3,290 (X's taxable income of $1,380 plus Y's 
taxable income of $1,910) and combined QPAI of $2,415 (X's QPAI of 
$1,410 plus Y's QPAI of $1,005)). Because the facts of this example 
assume that the W-2 wages of X and Y are sufficient to avoid a 
limitation on the section 199 deduction, X and Y EAG's section 199 
deduction for 2010 is $217. The $217 is allocated to X and Y in 
proportion to their QPAI. See Sec.  1.199-7(c).

    (e) Simplified deduction method--(1) In general. An eligible 
taxpayer may use the simplified deduction method to apportion 
deductions between DPGR and non-DPGR. The simplified deduction method 
does not apply to CGS. Under the simplified deduction method, a 
taxpayer's deductions (except the net operating loss deduction as 
provided in paragraph (c)(2) of this section) are ratably apportioned 
between DPGR and non-DPGR based on relative gross receipts. 
Accordingly, the amount of deductions for the current taxable year 
apportioned to DPGR is equal to the same proportion of the total 
deductions for the current taxable year that the amount of DPGR bears 
to total gross receipts. Gross receipts that are allocable to land 
under the safe harbor provided in Sec.  1.199-3(m)(6)(iv) are treated 
as non-DPGR. See Sec.  1.199-3(m)(6)(iv)(B). Whether a trust (to the 
extent not described in Sec.  1.199-9(d)) or an estate may use the 
simplified deduction method is determined at the trust or estate level. 
If a trust or estate qualifies to use the simplified deduction method, 
the simplified deduction method must be applied at the trust or estate 
level, taking into account the trust's or estate's DPGR, non-DPGR, and 
other items from all sources, including its distributive or allocable 
share of those items of any lower-tier entity, prior to any charitable 
or distribution deduction. Whether the owner of a pass-thru entity may 
use the simplified deduction method is determined at the level of the 
entity's owner. If the owner of a pass-thru entity qualifies and uses 
the simplified deduction method, then the simplified deduction method 
is applied at the level of the owner of the pass-thru entity taking 
into account the owner's DPGR, non-DPGR, and other items from all 
sources including its distributive or allocable share of those items of 
the pass-thru entity.
    (2) Eligible taxpayer. For purposes of this paragraph (e), an 
eligible taxpayer is--
    (i) A taxpayer that has average annual gross receipts (as defined 
in paragraph (g) of this section) of $100,000,000 or less; or
    (ii) A taxpayer that has total assets (as defined in paragraph 
(e)(3) of this section) of $10,000,000 or less.
    (3) Total assets--(i) In general. For purposes of the simplified 
deduction method, total assets means the total assets the taxpayer has 
at the end of the taxable year. In the case of a C corporation, the 
corporation's total assets at the end of the taxable year is the amount 
required to be reported on Schedule L of Form 1120, ``United States 
Corporation Income Tax Return,'' in accordance with the Form 1120 
instructions.
    (ii) Members of an expanded affiliated group. To compute the total 
assets of an EAG, the total assets at the end of the taxable year of 
each corporation that is a member of the EAG at the end of the taxable 
year that ends with or within the taxable year of the computing member 
(as described in Sec.  1.199-7(h)) are aggregated. For purposes of this 
paragraph, a consolidated group is treated as one member of the EAG.
    (4) Members of an expanded affiliated group--(i) In general. 
Whether the members of an EAG may use the simplified deduction method 
is determined by reference to all the members of the EAG. If the 
average annual gross receipts of the EAG are less than or equal to 
$100,000,000 or the total assets of the EAG are less than or equal to 
$10,000,000, then each member of the EAG may individually determine 
whether to use the simplified deduction method, regardless of the cost 
allocation method used by the other members.
    (ii) Exception. Notwithstanding paragraph (e)(4)(i) of this 
section, all members of the same consolidated group must use the same 
cost allocation method.
    (iii) Examples. The following examples illustrate the application 
of paragraph (e) of this section:

    Example 1. Corporations X, Y, and Z are the only three members 
of an EAG. Neither X, Y, nor Z is a member of a consolidated group. 
X, Y, and Z have average annual gross receipts of $20,000,000, 
$70,000,000, and $5,000,000, respectively. X, Y, and Z each have 
total assets at the end of the taxable year of $5,000,000. Because 
the average annual gross receipts of the EAG are less than or equal 
to $100,000,000, each of X, Y, and Z may use either the simplified 
deduction method or the section 861 method.
    Example 2. The facts are the same as in Example 1 except that X 
and Y are members of the same consolidated group. X, Y, and Z may 
use either the simplified deduction method or the section 861 
method. However, X and Y must use the same cost allocation method.
    Example 3. The facts are the same as in Example 1 except that 
Z's average annual gross receipts are $15,000,000. Because the 
average annual gross receipts of the EAG are greater than 
$100,000,000 and the total assets of the EAG at the end of the 
taxable year are greater than $10,000,000, X, Y, and Z must each use 
the section 861 method.

    (f) Small business simplified overall method--(1) In general. A 
qualifying small taxpayer may use the small business simplified overall 
method to apportion CGS and deductions between

[[Page 31312]]

DPGR and non-DPGR. Under the small business simplified overall method, 
a taxpayer's total costs for the current taxable year (as defined in 
paragraph (f)(3) of this section) are apportioned between DPGR and non-
DPGR based on relative gross receipts. Accordingly, the amount of total 
costs for the current taxable year apportioned to DPGR is equal to the 
same proportion of total costs for the current taxable year that the 
amount of DPGR bears to total gross receipts. Total gross receipts for 
this purpose do not include gross receipts that are allocated to land 
under the land safe harbor provided in Sec.  1.199-3(m)(6)(iv). See 
Sec.  1.199-3(m)(6)(iv)(B).
    (2) Qualifying small taxpayer. Except as provided in paragraph 
(f)(5), for purposes of this paragraph (f), a qualifying small taxpayer 
is--
    (i) A taxpayer that has average annual gross receipts (as defined 
in paragraph (g) of this section) of $5,000,000 or less;
    (ii) A taxpayer that is engaged in the trade or business of farming 
that is not required to use the accrual method of accounting under 
section 447; or
    (iii) A taxpayer that is eligible to use the cash method as 
provided in Rev. Proc. 2002-28 (2002-1 C.B. 815) (that is, certain 
taxpayers with average annual gross receipts of $10,000,000 or less 
that are not prohibited from using the cash method under section 448, 
including partnerships, S corporations, C corporations, or 
individuals). See Sec.  601.601(d)(2) of this chapter.
    (3) Total costs for the current taxable year--(i) In general. For 
purposes of the small business simplified overall method, total costs 
for the current taxable year means the total CGS and deductions 
(excluding the net operating loss deduction as provided in paragraph 
(c)(2) of this section) for the current taxable year. Total costs for 
the current taxable year are determined under the methods of accounting 
that the taxpayer uses to compute taxable income.
    (ii) Land safe harbor. A taxpayer that uses the land safe harbor 
provided in Sec.  1.199-3(m)(6)(iv) must reduce total costs for the 
current taxable year by the costs of land and any other costs 
capitalized to the land (except costs for activities listed in Sec.  
1.199-3(m)(2)(iii)) prior to applying the small business simplified 
overall method. See Sec.  1.199-3(m)(6)(iv)(B). For example, if a 
taxpayer has $1,000 of total costs for the current taxable year and 
$600 of such costs is attributable to land under the land safe harbor, 
then only $400 of such costs is apportioned between DPGR and non-DPGR 
under the small business simplified overall method.
    (4) Members of an expanded affiliated group--(i) In general. 
Whether the members of an EAG may use the small business simplified 
overall method is determined by reference to all the members of the 
EAG. If the average annual gross receipts of the EAG are less than or 
equal to $5,000,000, the EAG (viewed as a single corporation) is 
engaged in the trade or business of farming that is not required to use 
the accrual method of accounting under section 447, or the EAG (viewed 
as a single corporation) is eligible to use the cash method as provided 
in Rev. Proc. 2002-28, then each member of the EAG may individually 
determine whether to use the small business simplified overall method, 
regardless of the cost allocation method used by the other members.
    (ii) Exception. Notwithstanding paragraph (f)(4)(i) of this 
section, all members of the same consolidated group must use the same 
cost allocation method.
    (iii) Examples. The following examples illustrate the application 
of paragraph (f) of this section:

    Example 1. Corporations L, M, and N are the only three members 
of an EAG. Neither L, M, nor N is a member of a consolidated group. 
L, M, and N have average annual gross receipts for the current 
taxable year of $1,000,000, $1,500,000, and $2,000,000, 
respectively. Because the average annual gross receipts of the EAG 
are less than or equal to $5,000,000, each of L, M, and N may use 
the small business simplified overall method, the simplified 
deduction method, or the section 861 method.
    Example 2. The facts are the same as in Example 1 except that M 
and N are members of the same consolidated group. L, M, and N may 
use the small business simplified overall method, the simplified 
deduction method, or the section 861 method. However, M and N must 
use the same cost allocation method.
    Example 3. The facts are the same as in Example 1 except that N 
has average annual gross receipts of $4,000,000. Unless the EAG, 
viewed as a single corporation, is engaged in the trade or business 
of farming that is not required to use the accrual method of 
accounting under section 447, or the EAG, viewed as a single 
corporation, is eligible to use the cash method as provided in Rev. 
Proc. 2002-28, because the average annual gross receipts of the EAG 
are greater than $5,000,000, L, M, and N are all ineligible to use 
the small business simplified overall method.

    (5) Trusts and estates. Trusts and estates under Sec.  1.199-9(e) 
may not use the small business simplified overall method.
    (g) Average annual gross receipts--(1) In general. For purposes of 
the simplified deduction method and the small business simplified 
overall method, average annual gross receipts means the average annual 
gross receipts of the taxpayer (including gross receipts attributable 
to the sale, exchange, or other disposition of land under the land safe 
harbor provided in Sec.  1.199-3(m)(6)(iv)) for the 3 taxable years 
(or, if fewer, the taxable years during which the taxpayer was in 
existence) preceding the current taxable year, even if one or more of 
such taxable years began before the effective date of section 199. In 
the case of any taxable year of less than 12 months (a short taxable 
year), the gross receipts shall be annualized by multiplying the gross 
receipts for the short period by 12 and dividing the result by the 
number of months in the short period.
    (2) Members of an expanded affiliated group. To compute the average 
annual gross receipts of an EAG, the gross receipts, for the entire 
taxable year, of each corporation that is a member of the EAG at the 
end of its taxable year that ends with or within the taxable year of 
the computing member are aggregated. For purposes of this paragraph, a 
consolidated group is treated as one member of the EAG.


Sec.  1.199-5  Application of section 199 to pass-thru entities for 
taxable years beginning after May 17, 2006, the enactment date of the 
Tax Increase Prevention and Reconciliation Act of 2005. [Reserved].


Sec.  1.199-6  Agricultural and horticultural cooperatives.

    (a) In general. A patron who receives a qualified payment (as 
defined in paragraph (e) of this section) from a specified agricultural 
or horticultural cooperative (cooperative) (as defined in paragraph (f) 
of this section) is allowed a deduction under Sec.  1.199-1(a) (section 
199 deduction) for the taxable year the qualified payment is received 
for the portion of the cooperative's section 199 deduction passed 
through to the patron and identified by the cooperative in a written 
notice mailed to the person during the payment period described in 
section 1382(d). The provisions of this section apply solely for 
purposes of section 199 of the Internal Revenue Code (Code).
    (b) Cooperative denied section 1382 deduction for portion of 
qualified payments. A cooperative must reduce its section 1382 
deduction by an amount equal to the portion of any qualified payment 
that is attributable to the cooperative's section 199 deduction passed 
through to the patron.
    (c) Determining cooperative's taxable income. For purposes of 
determining its section 199 deduction, the cooperative's taxable income 
is computed without taking into account any deduction allowable under 
section 1382(b) or (c) (relating to patronage dividends, per-

[[Page 31313]]

unit retain allocations, and nonpatronage distributions).
    (d) Special rule for marketing cooperatives. In the case of a 
cooperative engaged in the marketing of agricultural and/or 
horticultural products described in paragraph (f) of this section, the 
cooperative is treated as having manufactured, produced, grown, or 
extracted (MPGE) (as defined in Sec.  1.199-3(e)) in whole or in 
significant part (as defined in Sec.  1.199-3(g)) within the United 
States (as defined in Sec.  1.199-3(h)) any agricultural or 
horticultural products marketed by the cooperative that its patrons 
have MPGE.
    (e) Qualified payment. The term qualified payment means any amount 
of a patronage dividend or per-unit retain allocation, as described in 
section 1385(a)(1) or (3) received by a patron from a cooperative, that 
is attributable to the portion of the cooperative's qualified 
production activities income (QPAI) (as defined in Sec.  1.199-1(c)), 
for which the cooperative is allowed a section 199 deduction. For this 
purpose, patronage dividends and per-unit retain allocations include 
any advances on patronage and per-unit retains paid in money during the 
taxable year.
    (f) Specified agricultural or horticultural cooperative. A 
specified agricultural or horticultural cooperative means a cooperative 
to which Part I of subchapter T of the Code applies and the cooperative 
has MPGE in whole or significant part within the United States any 
agricultural or horticultural product, or has marketed agricultural or 
horticultural products. For this purpose, agricultural or horticultural 
products also include fertilizer, diesel fuel, and other supplies used 
in agricultural or horticultural production.
    (g) Written notice to patrons. In order for a patron to qualify for 
the section 199 deduction, paragraph (a) of this section requires that 
the cooperative identify in a written notice the patron's portion of 
the section 199 deduction that is attributable to the portion of the 
cooperative's QPAI for which the cooperative is allowed a section 199 
deduction. This written notice must be mailed by the cooperative to its 
patrons no later than the 15th day of the ninth month following the 
close of the taxable year. The cooperative may use the same written 
notice, if any, that it uses to notify patrons of their respective 
allocations of patronage dividends, or may use a separate timely 
written notice(s) to comply with this section. The cooperative must 
report the amount of the patron's section 199 deduction on Form 1099-
PATR, ``Taxable Distributions Received From Cooperative,'' issued to 
the patron.
    (h) Additional rules relating to passthrough of section 199 
deduction. The cooperative may, at its discretion, pass through all, 
some, or none of the section 199 deduction to its patrons. However, the 
cooperative may not apply section 199(d)(3) and this section to any 
portion of the section 199 deduction that is not passed through to its 
patrons. A cooperative member of a federated cooperative may pass 
through the section 199 deduction it receives from the federated 
cooperative to its member patrons. Patrons may claim the section 199 
deduction for the taxable year in which they receive the written notice 
from the cooperative informing them of the section 199 amount without 
regard to the taxable income limitation under Sec.  1.199-1(a) and (b).
    (i) W-2 wages. The W-2 wage limitation described in Sec.  1.199-2 
shall be applied at the cooperative level whether or not the 
cooperative chooses to pass through some or all of the section 199 
deduction. Any section 199 deduction that has been passed through by a 
cooperative to its patrons is not subject to the W-2 wage limitation a 
second time at the patron level.
    (j) Recapture of section 199 deduction. If the amount of the 
section 199 deduction that was passed through to patrons exceeds the 
amount allowable as a section 199 deduction as determined on audit or 
reported on an amended return, then recapture of the excess will occur 
at the cooperative level in the taxable year the cooperative took the 
excess section 199 deduction amount into account.
    (k) Section is exclusive. This section is the exclusive method for 
cooperatives and their patrons to compute the amount of the section 199 
deduction. Thus, a patron may not deduct any amount with respect to a 
patronage dividend or a per-unit retain allocation unless the 
requirements of this section are satisfied.
    (l) No double counting. To the extent a cooperative passes through 
the section 199 deduction to a patron, a qualified payment received by 
the patron of the cooperative is not taken in account for purposes of 
section 199.
    (m) Examples. The following examples illustrate the application of 
this section:

    Example 1. (i) Cooperative X markets corn grown by its members 
within the United States for sale to retail grocers. For its 
calendar year ended December 31, 2007, Cooperative X has gross 
receipts of $1,500,000, all derived from the sale of corn grown by 
its members within the United States. Cooperative X pays $370,000 
for its members' corn and its W-2 wages (as defined in Sec.  1.199-
2(e)) for 2007 total $130,000. Cooperative X has no other costs. 
Patron A is a member of Cooperative X. Patron A is a cash basis 
taxpayer and files Federal income tax returns on a calendar year 
basis. All corn grown by Patron A in 2007 is sold through 
Cooperative X and Patron A is eligible to share in patronage 
dividends paid by Cooperative X for that year.
    (ii) Cooperative X is a cooperative described in paragraph (f) 
of this section. Accordingly, this section applies to Cooperative X 
and its patrons and all of Cooperative X's gross receipts from the 
sale of its patrons' corn qualify as domestic production gross 
receipts (as defined Sec.  1.199-3(a)). Cooperative X's QPAI is 
$1,000,000. Cooperative X's section 199 deduction for its taxable 
year 2007 is $60,000 (.06 x $1,000,000). Because this amount is less 
than 50% of Cooperative X's W-2 wages, the entire amount is allowed 
as a section 199 deduction subject to the rules of section 199(d)(3) 
and this section.
    Example 2. (i) The facts are the same as in Example 1 except 
that Cooperative X decides to pass its entire section 199 deduction 
through to its members. Cooperative X declares a patronage dividend 
for its 2007 taxable year of $1,000,000, which it pays on March 15, 
2008. Pursuant to paragraph (g) of this section, Cooperative X 
notifies members in written notices that accompany the patronage 
dividend notification that it is allocating to them the section 199 
deduction it is entitled to claim in the taxable year 2007. On March 
15, 2008, Patron A receives a $10,000 patronage dividend that is a 
qualified payment under paragraph (e) of this section from 
Cooperative X. In the notice that accompanies the patronage 
dividend, Patron A is designated a $600 section 199 deduction. Under 
paragraph (a) of this section, Patron A must claim a $600 section 
199 deduction for the taxable year ending December 31, 2008, without 
regard to the taxable income limitation under Sec.  1.199-1(a) and 
(b). Cooperative X must report the amount of Patron A's section 199 
deduction on Form 1099-PATR, ``Taxable Distributions Received From 
Cooperative,'' issued to Patron A for the calendar year 2008.
    (ii) Under paragraph (b) of this section, Cooperative X is 
required to reduce its patronage dividend deduction of $1,000,000 by 
the $60,000 section 199 deduction passed through to members (whether 
or not Cooperative X pays patronage on book or Federal income tax 
net earnings). As a consequence, Cooperative X is entitled to a 
patronage dividend deduction for the taxable year ending December 
31, 2007, in the amount of $940,000 ($1,000,000 - $60,000) and to a 
section 199 deduction in the amount of $60,000 ($1,000,000 x .06). 
Its taxable income for 2007 is $0.
    Example 3. (i) The facts are the same as in Example 1 except 
that Cooperative X paid out $500,000 to its patrons as advances on 
expected patronage net earnings. In 2007, Cooperative X pays its 
patrons a $500,000 ($1,000,000-$500,000 already paid) patronage 
dividend in cash or a combination of cash and qualified written 
notices of allocation. Under paragraph (b) of this section and 
section 1382, Cooperative X is allowed a patronage dividend 
deduction of

[[Page 31314]]

$440,000 ($500,000-$60,000 section 199 deduction), whether patronage 
net earnings are distributed on book or Federal income tax net 
earnings.
    (ii) The patrons will have received a gross amount of $1,000,000 
in qualified payments under paragraph (e) of this section from 
Cooperative X ($500,000 paid during the taxable year as advances and 
the additional $500,000 paid as patronage dividends). If Cooperative 
X passes through its entire section 199 deduction to its members by 
providing the notice required by paragraph (g) of this section, then 
the patrons will be allowed a $60,000 section 199 deduction, 
resulting in a net $940,000 taxable distribution from Cooperative X. 
Pursuant to paragraph (l) of this section, the $1,000,000 received 
by the patrons from Cooperative X is not taken into account for 
purposes of section 199 in the hands of the patrons.


Sec.  1.199-7  Expanded affiliated groups.

    (a) In general. The provisions of this section apply solely for 
purposes of section 199 of the Internal Revenue Code (Code). All 
members of an expanded affiliated group (EAG) are treated as a single 
corporation for purposes of section 199. Notwithstanding the preceding 
sentence, except as otherwise provided in the Code and regulations 
(see, for example, sections 199(c)(7) and 267, Sec.  1.199-3(b), 
paragraph (a)(3) of this section, and the consolidated return 
regulations), each member of an EAG is a separate taxpayer that 
computes its own taxable income or loss, qualified production 
activities income (QPAI) (as defined in Sec.  1.199-1(c)), and W-2 
wages (as defined in Sec.  1.199-2(e)). If members of an EAG are also 
members of a consolidated group, see paragraph (d) of this section.
    (1) Definition of expanded affiliated group. 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).
    (2) Identification of members of an expanded affiliated group--(i) 
In general. A corporation must determine if it is a member of an EAG on 
a daily basis.
    (ii) Becoming or ceasing to be a member of an expanded affiliated 
group. If a corporation becomes or ceases to be a member of an EAG, the 
corporation is treated as becoming or ceasing to be a member of the EAG 
at the end of the day on which its status as a member changes.
    (3) Attribution of activities--(i) In general. If a member of an 
EAG (the disposing member) derives gross receipts (as defined in Sec.  
1.199-3(c)) from the lease, rental, license, sale, exchange, or other 
disposition (as defined in Sec.  1.199-3(i)) of qualifying production 
property (QPP) (as defined in Sec.  1.199-3(j)) that was manufactured, 
produced, grown or extracted (MPGE) (as defined in Sec.  1.199-3(e)), 
in whole or in significant part (as defined in Sec.  1.199-3(g)) in the 
United States (as defined in Sec.  1.199-3(h)), a qualified film (as 
defined in Sec.  1.199-3(k)), or electricity, natural gas, or potable 
water (as defined in Sec.  1.199-3(l)) (collectively, utilities) that 
was produced in the United States, such property was MPGE or produced 
by another corporation (or corporations), and the disposing member is a 
member of the same EAG as the other corporation (or corporations) at 
the time that the disposing member disposes of the QPP, qualified film, 
or utilities, then the disposing member is treated as conducting the 
previous activities conducted by such other corporation (or 
corporations) with respect to the QPP, qualified film, or utilities in 
determining whether its gross receipts are domestic production gross 
receipts (DPGR) (as defined in Sec.  1.199-3(a)). With respect to a 
lease, rental, or license, the disposing member is treated as having 
disposed of the QPP, qualified film, or utilities on the date or dates 
on which it takes into account the gross receipts derived from the 
lease, rental, or license under its methods of accounting. With respect 
to a sale, exchange, or other disposition, the disposing member is 
treated as having disposed of the QPP, qualified film, or utilities on 
the date on which it ceases to own the QPP, qualified film, or 
utilities for Federal income tax purposes, even if no gain or loss is 
taken into account.
    (ii) Special rule. Attribution of activities does not apply for 
purposes of the construction of real property under Sec.  1.199-3(m) or 
the performance of engineering and architectural services under Sec.  
1.199-3(n). A member of an EAG must engage in a construction activity 
under Sec.  1.199-3(m)(2), provide engineering services under Sec.  
1.199-3(n)(2), or provide architectural services under Sec.  1.199-
3(n)(3) in order for the member's gross receipts to be derived from 
construction, engineering, or architectural services.
    (4) Examples. The following examples illustrate the application of 
paragraph (a)(3) of this section. Assume that all taxpayers are 
calendar year taxpayers. The examples are as follows:

    Example 1. Corporations M and N are members of the same EAG. M 
is engaged solely in the trade or business of manufacturing 
furniture in the United States that it sells to unrelated persons. N 
is engaged solely in the trade or business of engraving companies' 
names on pens and pencils purchased from unrelated persons and then 
selling the pens and pencils to such companies. For purposes of this 
example, assume that if N was not a member of an EAG, its activities 
would not qualify as MPGE. Accordingly, although M's sales of the 
furniture qualify as DPGR (assuming all the other requirements of 
Sec.  1.199-3 are met), N's sales of the engraved pens and pencils 
do not qualify as DPGR because neither N nor another member of the 
EAG MPGE the pens and pencils.
    Example 2. For the entire 2007 year, Corporations A and B are 
members of the same EAG. A is engaged solely in the trade or 
business of MPGE machinery in the United States. A and B each own 
45% of partnership C and unrelated persons own the remaining 10%. C 
is engaged solely in the trade or business of MPGE the same type of 
machinery in the United States as A. In 2007, B purchases and then 
resells the machinery MPGE in 2007 by A and C. B also resells 
machinery it purchases from unrelated persons. If only B's 
activities were considered, B would not qualify for the deduction 
under Sec.  1.199-1(a) (section 199 deduction). However, because at 
the time B disposes of the machinery B is a member of the EAG that 
includes A, B is Treated as conducting A's previous MPGE activities 
in determining whether B's gross receipts from the sale of the 
machinery MPGE by A are DPGR. C is not a member of the EAG and thus 
C's MPGE activities are not attributed to B in determining whether 
B's gross receipts from the sale of the machinery MPGE by C are 
DPGR. Accordingly, B's gross receipts attributable to its sale of 
the machinery it purchases from A are DPGR (assuming all the other 
requirements of Sec.  1.199-3 are met). B's gross receipts 
attributable to its sale of the machinery it purchases from C and 
from the unrelated persons are non-DPGR because no member of the EAG 
MPGE the machinery and because C does not qualify as an EAG 
partnership.
    Example 3. The facts are the same as in Example 2 except that 
rather than reselling the machinery, B rents the machinery it 
acquired from A to unrelated persons and B takes the gross receipts 
attributable to the rental of the machinery into account under its 
methods of accounting in 2007, 2008, and 2009. In addition, as of 
the close of business on December 31, 2008, A and B cease to be 
members of the same EAG. With respect to the machinery acquired from 
C and the unrelated persons, B's gross receipts attributable to the 
rental of the machinery in 2007, 2008, and 2009 are non-DPGR because 
no member of the EAG MPGE the machinery and because C does not 
qualify as an EAG partnership. With respect to machinery acquired 
from A, B's gross receipts in 2007 and 2008 attributable to the 
rental of the machinery are DPGR because at the time B takes into 
account the gross receipts derived from the rental of the machinery 
into account under its methods of accounting, B is a member of the 
same EAG as A and B is treated as conducting A's previous MPGE 
activities. However, with respect to the rental receipts in 2009, 
because A and B are not members of the same EAG in 2009, B's rental 
receipts are non-DPGR.

[[Page 31315]]

    Example 4. For the entire 2007 year, Corporation P owns over 50% 
of the stock of Corporation S. In 2007, P MPGE QPP in the United 
States and transfers the QPP to S. On February 28, 2008, P disposes 
of stock of S, reducing P's ownership of S below 50% and P and S 
cease to be members of the same EAG. On June 30, 2008, S sells the 
QPP to an unrelated person. Unless P's transfer of the QPP to S took 
place in a transaction to which section 381(a) applies (see Sec.  
1.199-8(e)(3)), because S is not a member of the same EAG as P on 
June 30, 2008, S is not treated as conducting the activities 
conducted by P in determining if S's receipts are DPGR, 
notwithstanding that P and S were members of the same EAG when P 
MPGE the QPP and when P transferred the QPP to S.
    Example 5. For the entire 2007 year, Corporations X and Y are 
unrelated corporations. In 2007, X MPGE QPP in the United States and 
sells the QPP to Y. On August 31, 2008, X acquires over 50% of the 
stock of Y, thus making X and Y members of the same EAG. On November 
30, 2008, Y sells the QPP to an unrelated person. Because X and Y 
are members of the same EAG on November 30, 2008, Y is treated as 
conducting the activities conducted by X in 2007 in determining if 
Y's receipts are DPGR, notwithstanding that X and Y were not members 
of the same EAG when X MPGE the QPP nor when X sold the QPP to Y.

    (5) Anti-avoidance rule. If a transaction between members of an EAG 
is engaged in or structured with a principal purpose of qualifying for, 
or increasing the amount of, the section 199 deduction of the EAG or 
the portion of the section 199 deduction allocated to one or more 
members of the EAG, adjustments must be made to eliminate the effect of 
the transaction on the computation of the section 199 deduction.
    (b) Computation of expanded affiliated group's section 199 
deduction--(1) In general. The section 199 deduction for an EAG is 
determined by the EAG by aggregating each member's taxable income or 
loss, QPAI, and W-2 wages, if any. For purposes of this determination, 
a member's QPAI may be positive or negative. A member's taxable income 
or loss and QPAI shall be determined by reference to the member's 
methods of accounting.
    (2) Example. The following example illustrates the application of 
paragraph (b)(1) of this section:

    Example. Corporations X, Y, and Z, calendar year taxpayers, are 
the only members of an EAG and are not members of a consolidated 
group. X has taxable income of $50,000, QPAI of $15,000, and W-2 
wages of $1,000. Y has taxable income of ($20,000), QPAI of 
($1,000), and W-2 wages of $750. Z has $0 taxable income and $0 
QPAI, but has W-2 wages of $2,000. In determining the EAG's section 
199 deduction, the EAG aggregates each member's taxable income or 
loss, QPAI, and W-2 wages. Accordingly, the EAG has taxable income 
of $30,000 ($50,000 + ($20,000) + $0), QPAI of $14,000 ($15,000 + 
($1,000) + $0), and W-2 wages of $3,750 ($1,000 + $750 + $2,000).

    (3) Net operating loss carrybacks and carryovers. In determining 
the taxable income of an EAG, if a member of an EAG has a net operating 
loss (NOL) carryback or carryover to the taxable year, then the amount 
of the NOL used to offset taxable income cannot exceed the taxable 
income of that member.
    (c) Allocation of an expanded affiliated group's section 199 
deduction among members of the expanded affiliated group--(1) In 
general. An EAG's section 199 deduction as determined in paragraph 
(b)(1) of this section is allocated among the members of the EAG in 
proportion to each member's QPAI, regardless of whether the EAG member 
has taxable income or loss or W-2 wages for the taxable year. For this 
purpose, if a member has negative QPAI, the QPAI of the member shall be 
treated as zero.
    (2) Use of section 199 deduction to create or increase a net 
operating loss. Notwithstanding Sec.  1.199-1(b), if a member of an EAG 
has some or all of the EAG's section 199 deduction allocated to it 
under paragraph (c)(1) of this section and the amount allocated exceeds 
the member's taxable income (determined prior to allocation of the 
section 199 deduction), the section 199 deduction will create an NOL 
for the member. Similarly, if a member of an EAG, prior to the 
allocation of some or all of the EAG's section 199 deduction to the 
member, has an NOL for the taxable year, the portion of the EAG's 
section 199 deduction allocated to the member will increase the 
member's NOL.
    (d) Special rules for members of the same consolidated group--(1) 
Intercompany transactions. In the case of an intercompany transaction 
between consolidated group members S and B (as the terms intercompany 
transaction, S, and B are defined in Sec.  1.1502-13(b)(1)), S takes 
the intercompany transaction into account in computing the section 199 
deduction at the same time and in the same proportion as S takes into 
account the income, gain, deduction, or loss from the intercompany 
transaction under Sec.  1.1502-13.
    (2) Attribution of activities in the construction of real property 
and the performance of engineering and architectural services. 
Notwithstanding paragraph (a)(3)(ii) of this section, a disposing 
member (as described in paragraph (a)(3)(i) of this section) is treated 
as conducting the previous activities conducted by each other member of 
its consolidated group with respect to the construction of real 
property under Sec.  1.199-3(m) and the performance of engineering and 
architectural services under Sec.  1.199-3(n), but only with respect to 
activities performed during the period of consolidation.
    (3) Application of the simplified deduction method and the small 
business simplified overall method. For purposes of applying the 
simplified deduction method under Sec.  1.199-4(e) and the small 
business simplified overall method under Sec.  1.199-4(f), a 
consolidated group determines its QPAI using its members' DPGR, non-
DPGR, cost of goods sold (CGS), and all other deductions, expenses, or 
losses (deductions), determined after application of Sec.  1.1502-13.
    (4) Determining the section 199 deduction--(i) Expanded affiliated 
group consists of consolidated group and non-consolidated group 
members. In determining the section 199 deduction, if an EAG includes 
corporations that are members of the same consolidated group and 
corporations that are not members of the same consolidated group, the 
consolidated taxable income or loss, QPAI, and W-2 wages, if any, of 
the consolidated group (and not the separate taxable income or loss, 
QPAI, and W-2 wages of the members of the consolidated group), are 
aggregated with the taxable income or loss, QPAI, and W-2 wages, if 
any, of the non-consolidated group members. For example, if A, B, C, 
S1, and S2 are members of the same EAG, and A, S1, and S2 are members 
of the same consolidated group (the A consolidated group), then the A 
consolidated group is treated as one member of the EAG. Accordingly, 
the EAG is considered to have three members, the A consolidated group, 
B, and C. The consolidated taxable income or loss, QPAI, and W-2 wages, 
if any, of the A consolidated group are aggregated with the taxable 
income or loss, QPAI, and W-2 wages, if any, of B and C in determining 
the EAG's section 199 deduction.
    (ii) Expanded affiliated group consists only of members of a single 
consolidated group. If all the members of an EAG are members of the 
same consolidated group, the consolidated group's section 199 deduction 
is determined using the consolidated group's consolidated taxable 
income or loss, QPAI, and W-2 wages, rather than the separate taxable 
income or loss, QPAI, and W-2 wages of its members.
    (5) Allocation of the section 199 deduction of a consolidated group 
among its members. The section 199 deduction of a consolidated group 
(or

[[Page 31316]]

the section 199 deduction allocated to a consolidated group that is a 
member of an EAG) is allocated to the members of the consolidated group 
in proportion to each consolidated group member's QPAI, regardless of 
whether the consolidated group member has separate taxable income or 
loss or W-2 wages for the taxable year. In allocating the section 199 
deduction of a consolidated group among its members, any 
redetermination of a corporation's receipts, CGS, or other deductions 
from an intercompany transaction under Sec.  1.1502-13(c)(1)(i) or 
(c)(4) for purposes of section 199 is not taken into account. Also, for 
purposes of this allocation, if a consolidated group member has 
negative QPAI, the QPAI of the member shall be treated as zero.
    (e) Examples. The following examples illustrate the application of 
paragraphs (a) through (d) of this section:

    Example 1. Corporations X and Y are members of the same EAG but 
are not members of a consolidated group. All the activities 
described in this example take place during the same taxable year. X 
and Y each use the section 861 method described in Sec.  1.199-4(d) 
for allocating and apportioning their deductions. X incurs $5,000 in 
costs in manufacturing a machine, all of which are capitalized. X is 
entitled to a $1,000 depreciation deduction for the machine in the 
current taxable year. X rents the machine to Y for $1,500. Y uses 
the machine in manufacturing QPP within the United States. Y incurs 
$1,400 of CGS in manufacturing the QPP. Y sells the QPP to unrelated 
persons for $7,500. Pursuant to section 199(c)(7) and Sec.  1.199-
3(b), X's rental income is non-DPGR (and its related costs are not 
attributable to DPGR). Accordingly, Y has $4,600 of QPAI (Y's $7,500 
DPGR received from unrelated persons-Y's $1,400 CGS allocable to 
such receipts-Y's $1,500 of rental expense), X has $0 of QPAI, and 
the EAG has $4,600 of QPAI.
    Example 2.  The facts are the same as in Example 1 except that X 
and Y are members of the same consolidated group. Pursuant to 
section 199(c)(7) and Sec.  1.199-3(b), X's rental income ordinarily 
would not be DPGR (and its related costs would not be allocable to 
DPGR). However, because X and Y are members of the same consolidated 
group, Sec.  1.1502-13(c)(1)(i) provides that the separate entity 
attributes of X's intercompany items or Y's corresponding items, or 
both, may be redetermined in order to produce the same effect as if 
X and Y were divisions of a single corporation. If X and Y were 
divisions of a single corporation, X and Y would have QPAI of $5,100 
($7,500 DPGR received from unrelated persons-$1,400 CGS allocable to 
such receipts-$1,000 depreciation deduction). To obtain this same 
result for the consolidated group, X's rental income is redetermined 
as DPGR, which results in the consolidated group having $9,000 of 
DPGR (the sum of Y's DPGR of $7,500 + X's DPGR of $1,500) and $3,900 
of costs allocable to DPGR (the sum of Y's $1,400 CGS + Y's $1,500 
rental expense + X's $1,000 depreciation expense). For purposes of 
determining how much of the consolidated group's section 199 
deduction is allocated to X and Y, pursuant to paragraph (d)(5) of 
this section, the redetermination of X's rental income as DPGR under 
Sec.  1.1502-13(c)(1)(i) is not taken into account (X's costs are 
considered to be allocable to DPGR because they are allocable to the 
consolidated group deriving DPGR). Accordingly, for this purpose, X 
is deemed to have ($1,000) of QPAI (X's $0 DPGR-X's $1,000 
depreciation deduction). Because X is deemed to have negative QPAI, 
also pursuant to paragraph (d)(5) of this section, X's QPAI is 
treated as zero. Y has $4,600 of QPAI (Y's $7,500 DPGR-Y's $1,400 
CGS allocable to such receipts-Y's $1,500 of rental expense). 
Accordingly, X is allocated $0/($0 + $4,600) of the consolidated 
group's section 199 deduction and Y is allocated $4,600/($0 + 
$4,600) of the consolidated group's section 199 deduction.
    Example 3.  Corporations P and S are members of the same EAG but 
are not members of a consolidated group. P and S each use the 
section 861 method for allocating and apportioning their deductions 
and are both calendar year taxpayers. In 2007, P incurs $1,000 in 
research and development expenses in creating an intangible asset 
and deducts these expenses in 2007. P anticipates that it will 
license the intangible asset to S. On January 1, 2008, P licenses 
the intangible asset to S for $2,500. S uses the intangible asset in 
manufacturing QPP within the United States. S incurs $2,000 of 
additional costs in manufacturing the QPP. On December 31, 2008, S 
sells the QPP to unrelated persons for $10,000. Because on December 
31, 2007, P anticipates that it will license the intangible asset to 
S, a related person, and also because the intangible asset is not 
QPP, P's license receipts from S will be non-DPGR. Accordingly, P's 
research and development expenses in 2007 are not attributable to 
DPGR. In 2008, S has $5,500 of QPAI (S's $10,000 DPGR received from 
unrelated persons-S's $2,000 additional costs in manufacturing the 
QPP-S's $2,500 of license expense), P has $0 of QPAI, and the EAG 
has $5,500 of QPAI.
    Example 4. (i) Determination of consolidated group's QPAI. The 
facts are the same as in Example 3 except that P and S are members 
of the same consolidated group. Pursuant to section 199(c)(7) and 
Sec.  1.199-3(b), and also because the intangible asset is not QPP, 
P's license income ordinarily would not be DPGR (and its related 
costs would not be allocable to DPGR). However, because P and S are 
members of the same consolidated group, Sec.  1.1502-13(c)(1)(i) 
provides that the separate entity attributes of P's intercompany 
items or S's corresponding items, or both, may be redetermined in 
order to produce the same effect as if P and S were divisions of a 
single corporation. If P and S were divisions of a single 
corporation, in 2007 the single corporation would have $1,000 of 
expenses allocable to the anticipated DPGR from the sale of the QPP 
to unrelated persons, resulting in a negative QPAI (from this 
individual item) of $1,000. In 2008, the single corporation would 
have QPAI of $8,000 ($10,000 DPGR received from unrelated persons-
$2,000 additional costs in manufacturing the QPP). To obtain this 
same result for the consolidated group, P's license income from S is 
redetermined as DPGR. P's research and development expenses are 
allocable to DPGR. This results in the consolidated group having 
negative QPAI in 2007 (from the research and development expense) of 
$1,000. In 2008, the consolidated group has $12,500 of DPGR (the sum 
of S's DPGR of $10,000 + P's DPGR of $2,500) and $4,500 of costs 
allocable to DPGR (the sum of S's $2,000 additional costs + S's 
$2,500 license expense), resulting in $8,000 of QPAI in 2008.
    (ii) Allocation of deduction. Since the consolidated group has 
no QPAI in 2007, there is no section 199 deduction to be allocated 
between P and S in 2007. In 2008, the consolidated group has $8,000 
of QPAI and, assuming that the group has positive taxable income and 
W-2 wages, the consolidated group will have a section 199 deduction. 
For purposes of determining how much of the consolidated group's 
section 199 deduction is allocated to P and S, pursuant to paragraph 
(d)(5) of this section, the redetermination of P's license income as 
DPGR under Sec.  1.1502-13(c)(1)(i) is not taken into account. 
Accordingly, for purposes of allocating the consolidated group's 
section 199 deduction between P and S, P is deemed to have $0 DPGR 
and $0 QPAI in 2008. S has $5,500 of QPAI (S's $10,000 DPGR - S's 
$2,000 in additional costs allocable to such receipts - S's $2,500 
of license expense). Accordingly, P is allocated $0/($0 + $5,500) of 
the consolidated group's section 199 deduction in 2008 and S is 
allocated $5,500/($0 + $5,500) of the consolidated group's section 
199 deduction.
    Example 5. (i) Facts. Corporations A and B are the only two 
members of an EAG but are not members of a consolidated group. A and 
B each file Federal income tax returns on a calendar year basis. The 
average annual gross receipts of the EAG are less than or equal to 
$100,000,000 and A and B each use the simplified deduction method 
under Sec.  1.199-4(e). In 2007, A MPGE televisions within the 
United States. A has $10,000,000 of DPGR from sales of televisions 
to unrelated persons and $2,000,000 of DPGR from sales of 
televisions to B. In addition, A has gross receipts from computer 
consulting services with unrelated persons of $3,000,000. A has CGS 
of $6,000,000. A is able to determine from its books and records 
that $4,500,000 of its CGS are attributable to televisions sold to 
unrelated persons and $1,500,000 are attributable to televisions 
sold to B (see Sec.  1.199-4(b)(2)). A has other deductions of 
$4,000,000. A has no other items of income, gain, or deductions. In 
2007, B sells the televisions it purchased from A to unrelated 
persons for $4,100,000. B also pays $100,000 for administrative 
services performed in 2007. B has no other items of income, gain, or 
deductions.
    (ii) QPAI. (A) A's QPAI. In order to determine A's QPAI, A 
subtracts its $6,000,000 CGS from its $12,000,000 DPGR. Under the 
simplified deduction method, A then apportions its remaining 
$4,000,000 of deductions to DPGR in proportion to the ratio

[[Page 31317]]

of its DPGR to total gross receipts. Thus, of A's $4,000,000 of 
deductions, $3,200,000 is apportioned to DPGR ($4,000,000 x 
$12,000,000/$15,000,000). Accordingly, A's QPAI is $2,800,000 
($12,000,000 DPGR-$6,000,000 CGS-$3,200,000 deductions apportioned 
to its DPGR).
    (B) B's QPAI. Although B did not MPGE the televisions it sold, 
pursuant to paragraph (a)(3) of this section, B is treated as 
conducting A's MPGE of the televisions in determining whether B's 
gross receipts are DPGR. Thus, B has $4,100,000 of DPGR. In order to 
determine B's QPAI, B subtracts its $2,000,000 CGS from its 
$4,100,000 DPGR. Under the simplified deduction method, B then 
apportions its remaining $100,000 of deductions to DPGR in 
proportion to the ratio of its DPGR to total gross receipts. Thus, 
because B has no other gross receipts, all of B's $100,000 of 
deductions is apportioned to DPGR ($100,000 x $4,100,000/
$4,100,000). Accordingly, B's QPAI is $2,000,000 ($4,100,000 DPGR-
$2,000,000 CGS-$100,000 deductions apportioned to its DPGR).
    Example 6. (i) Facts. The facts are the same as in Example 5 
except that A and B are members of the same consolidated group, B 
does not sell the televisions purchased from A until 2008, and B's 
$100,000 paid for administrative services are paid in 2008 for 
services performed in 2008. In addition, in 2008, A has $3,000,000 
in gross receipts from computer consulting services with unrelated 
persons and $1,000,000 in related deductions.
    (ii) Consolidated group's 2007 QPAI. The consolidated group's 
DPGR and total gross receipts in 2007 are $10,000,000 and 
$13,000,000, respectively, because, pursuant to paragraph (d)(1) of 
this section and Sec.  1.1502-13, the sale of the televisions from A 
to B is not taken into account in 2007. In order to determine the 
consolidated group's QPAI, the consolidated group subtracts its 
$4,500,000 CGS from the televisions sold to unrelated persons from 
its $10,000,000 DPGR. Under the simplified deduction method, the 
consolidated group apportions its remaining $4,000,000 of deductions 
to DPGR in proportion to the ratio of its DPGR to total gross 
receipts. Thus, $3,076,923 ($4,000,000 x $10,000,000/$13,000,000) is 
allocated to DPGR. Accordingly, the consolidated group's QPAI for 
2007 is $2,423,077 ($10,000,000 DPGR-$4,500,000 CGS-$3,076,923 
deductions apportioned to its DPGR).
    (iii) Allocation of consolidated group's 2007 section 199 
deduction to its members. Because B's only activity during 2007 is 
the purchase of televisions from A, B has no DPGR or deductions and 
thus, no QPAI, in 2007. Accordingly, the entire section 199 
deduction in 2007 for the consolidated group will be allocated to A.
    (iv) Consolidated group's 2008 QPAI. Pursuant to paragraph 
(d)(1) of this section and Sec.  1.1502-13(c), A's sale of 
televisions to B in 2007 is taken into account in 2008 when B sells 
the televisions to unrelated persons. However, because A and B are 
members of a consolidated group, Sec.  1.1502-13(c)(1)(i) provides 
that the separate entity attributes of A's intercompany items or B's 
corresponding items, or both, may be redetermined in order to 
produce the same effect as if A and B were divisions of a single 
corporation. Accordingly, A's $2,000,000 of gross receipts are 
redetermined to be non-DPGR and as not being gross receipts for 
purposes of allocating costs between DPGR and non-DPGR, and B's 
$2,000,000 CGS are redetermined to be not allocable to DPGR. 
Notwithstanding that A's receipts are redetermined to be non-DPGR 
and as not being gross receipts for purposes of allocating costs 
between DPGR and non-DPGR, A's CGS are still considered to be 
allocable to DPGR because they are allocable to the consolidated 
group deriving DPGR. Accordingly, the consolidated group's DPGR in 
2008 is $4,100,000 from B's sales of televisions, and its total 
receipts are $7,100,000 ($4,100,000 DPGR plus $3,000,000 non-DPGR 
from A's computer consulting services). To determine the 
consolidated group's QPAI, the consolidated group subtracts A's 
$1,500,000 CGS from the televisions sold to B from its $4,100,000 
DPGR. Under the simplified deduction method, the consolidated group 
apportions its remaining $1,100,000 of deductions ($1,000,000 from A 
and $100,000 from B) to DPGR in proportion to the consolidated 
group's ratio of its DPGR to total gross receipts. Thus, $635,211 
($1,100,000 x $4,100,000/$7,100,000) is allocated to DPGR. 
Accordingly, the consolidated group's QPAI for 2008 is $1,964,789 
($4,100,000 DPGR-$1,500,000 CGS-$635,211 deductions apportioned to 
its DPGR), the same QPAI that would result if A and B were divisions 
of a single corporation.
    (v) Allocation of consolidated group's 2008 section 199 
deduction to its members. (A) A's QPAI. For purposes of allocating 
the consolidated group's section 199 deduction to its members, 
pursuant to paragraph (d)(5) of this section, the redetermination of 
A's $2,000,000 in receipts is disregarded. Accordingly, for this 
purpose, A's DPGR are $2,000,000 (receipts from the sale of 
televisions to B taken into account in 2008) and its total receipts 
are $5,000,000 ($2,000,000 DPGR + $3,000,000 non-DPGR from its 
computer consulting services). In determining A's QPAI, A subtracts 
its $1,500,000 CGS from the televisions sold to B from its 
$2,000,000 DPGR. Under the simplified deduction method, A apportions 
its remaining $1,000,000 of deductions in proportion to the ratio of 
its DPGR to total receipts. Thus, $400,000 ($1,000,000 x $2,000,000/
$5,000,000) is allocated to DPGR. Thus, A's QPAI is $100,000 
($2,000,000 DPGR-$1,500,000 CGS-$400,000 deductions allocated to its 
DPGR).
    (B) B's QPAI. B's DPGR and its total gross receipts are each 
$4,100,000. For purposes of allocating the consolidated group's 
section 199 deduction to its members, pursuant to paragraph (d)(5) 
of this section, the redetermination of B's $2,000,000 CGS as not 
allocable to DPGR is disregarded. In determining B's QPAI, B 
subtracts its $2,000,000 CGS from the televisions purchased from A 
from its $4,100,000 DPGR. Under the simplified deduction method, B 
apportions its remaining $100,000 deductions in proportion to the 
ratio of its DPGR to total receipts. Thus, all $100,000 ($100,000 x 
$4,100,000/$4,100,000) is allocated to DPGR. Thus, B's QPAI is 
$2,000,000 ($4,100,000 DPGR-$2,000,000 CGS-$100,000 deductions 
allocated to its DPGR).
    (C) Allocation to A and B. Pursuant to paragraph (d)(5) of this 
section, the consolidated group's section 199 deduction for 2008 is 
allocated $100,000/($100,000 + $2,000,000) to A and $2,000,000/
($100,000 + $2,000,000) to B.
    Example 7. Corporations S and B are members of the same 
consolidated group that files its Federal income tax returns on a 
calendar year basis. In 2007, S manufactures office furniture for B 
to use in B's corporate headquarters and S sells the office 
furniture to B. S and B have no other activities in the taxable 
year. If S and B were not members of a consolidated group, S's gross 
receipts from the sale of the office furniture to B would be DPGR 
(assuming all the other requirements of Sec.  1.199-3 are met) and 
S's CGS or other deductions, expenses, or losses from the sale to B 
would be allocable to S's DPGR. However, because S and B are members 
of a consolidated group, the separate entity attributes of S's 
intercompany items or B's corresponding items, or both, may be 
redetermined under Sec.  1.1502-13(c)(1)(i) or (c)(4) in order to 
produce the same effect as if S and B were divisions of a single 
corporation. If S and B were divisions of a single corporation, 
there would be no DPGR with respect to the office furniture because 
there would be no lease, rental, license, sale, exchange, or other 
disposition of the furniture by the single corporation (and no CGS 
or other deductions allocable to DPGR). Thus, in order to produce 
the same effect as if S and B were divisions of a single 
corporation, S's gross receipts are redetermined as non-DPGR. 
Accordingly, the consolidated group has no DPGR (and no CGS or other 
deductions allocated or apportioned to DPGR) and receives no section 
199 deduction in 2007.
    Example 8. (i) Facts. A and B are members of the same 
consolidated group that files its Federal income tax returns on a 
calendar year basis. On January 1, 2007, A MPGE QPP which is 10-year 
recovery property for $100 and depreciates it under the straight-
line method. On January 1, 2009, A sells the property to B for $130. 
Under section 168(i)(7), B is treated as A for purposes of section 
168 to the extent B's $130 basis does not exceed A's adjusted basis 
at the time of the sale. B's additional basis is treated as new 10-
year recovery property for which B elects the straight-line method 
of recovery. (To simplify the example, the half-year convention is 
disregarded.)
    (ii) Depreciation; intercompany gain. A claims $10 of 
depreciation for each taxable year 2007 and 2008 and has an $80 
basis at the time of the sale to B. Thus, A has a $50 intercompany 
gain from its sale to B. For each taxable year 2009 through 2016, B 
has $10 of depreciation with respect to $80 of its basis (the 
portion of its $130 basis not exceeding A's adjusted basis) and $5 
of depreciation with respect to the $50 of its additional basis that 
exceeds A's adjusted basis. For each taxable year 2017 and 2018, B 
has $5 of depreciation with respect to the

[[Page 31318]]

$50 of its additional basis that exceeds A's adjusted basis.
    (iii) Timing. A's $50 gain is taken into account to reflect the 
difference for each consolidated return year between B's 
depreciation taken into account with respect to the property and the 
depreciation that would have been taken into account if A and B were 
divisions of a single corporation. For each taxable year 2009 
through 2016, B takes into account $15 of depreciation rather than 
the $10 of depreciation that would have been taken into account if A 
and B were divisions of a single corporation. For each taxable year 
2017 and 2018, B takes into account $5 of depreciation rather than 
the $0 of depreciation that would have been taken into account if A 
and B were divisions of a single corporation (the QPP would have 
been fully depreciated after the 2016 taxable year if A and B were 
divisions of a single corporation). Thus, A takes $5 of gain into 
account in each of the 2009 through 2018 taxable years (10% of its 
$50 gain). Pursuant to Sec.  1.199-7(d)(1), A takes its sale to B 
into account in computing the section 199 deduction at the same time 
and in the same proportion as A takes into account the income, gain, 
deduction, or loss from the intercompany transaction under Sec.  
1.1502-13. Thus, in each taxable year 2009 through 2018, A takes 
into account $13 of gross receipts (10% of its $130 gross receipts) 
from the sale to B. The group's income in each taxable year 2009 
through 2016 is a $10 loss ($5 gain-$15 depreciation), the same net 
amount it would have been if A and B were divisions of a single 
corporation. The group's income in each taxable year 2017 and 2018 
is $0 ($5 gain-$5 depreciation), the same net amount it would have 
been if A and B were divisions of a single corporation.
    (iv) Attributes. If A and B were not members of a consolidated 
group, A's gross receipts on the sale of the QPP to B would be DPGR 
(assuming all the other requirements of Sec.  1.199-3 are met). 
However, because A and B are members of a consolidated group, the 
separate entity attributes of A's DPGR may be redetermined under 
Sec.  1.1502-13(c)(1)(i) or (c)(4) in order to produce the same 
effect as if A and B were divisions of a single corporation. If A 
and B were divisions of a single corporation, there would be no DPGR 
with respect to the QPP because there would be no lease, rental, 
license, sale, exchange, or other disposition of the QPP by the 
single corporation (and no CGS or other deductions allocable to 
DPGR). Thus, in order to produce the same effect as if A and B were 
divisions of a single corporation, A's $13 of gross receipts taken 
into account in each year is redetermined as non-DPGR. Accordingly, 
the consolidated group has no DPGR (and no CGS or other deductions 
allocable or apportioned to DPGR) and receives no section 199 
deduction.
    Example 9.  Corporations X, Y, and Z are members of the same EAG 
but are not members of a consolidated group. X, Y, and Z each files 
Federal income tax returns on a calendar year basis. Assume that the 
EAG has W-2 wages in excess of the section 199(b) wage limitation. 
Prior to 2007, X had no taxable income or loss. In 2007, X has $0 of 
taxable income and $2,000 of QPAI, Y has $4,000 of taxable income 
and $3,000 of QPAI, and Z has $4,000 of taxable income and $5,000 of 
QPAI. Accordingly, the EAG has taxable income of $8,000, the sum of 
X's taxable income of $0, Y's taxable income of $4,000, and Z's 
taxable income of $4,000. The EAG has QPAI of $10,000, the sum of 
X's QPAI of $2,000, Y's QPAI of $3,000, and Z's QPAI of $5,000. 
Because X's, Y's, and Z's taxable years all began in 2007, the 
transition percentage under section 199(a)(2) is 6%. Thus, the EAG's 
section 199 deduction for 2007 is $480 (6% of the lesser of the 
EAG's taxable income of $8,000 or the EAG's QPAI of $10,000). 
Pursuant to paragraph (c)(1) of this section, the $480 section 199 
deduction is allocated to X, Y, and Z in proportion to their 
respective amounts of QPAI, that is $96 to X ($480 x $2,000/
$10,000), $144 to Y ($480 x $3,000/$10,000), and $240 to Z ($480 x 
$5,000/$10,000). Although X's taxable income for 2007 determined 
prior to allocation of a portion of the EAG's section 199 deduction 
to it was $0, pursuant to paragraph (c)(2) of this section X will 
have an NOL for 2007 equal to $96. Because X's NOL for 2007 cannot 
be carried back to a previous taxable year, X's NOL carryover to 
2008 will be $96.
    Example 10. (i) Facts. Corporation P owns all of the stock of 
Corporations S and T and P, S, and T file a consolidated Federal 
income tax return on a calendar year basis. In 2007, P MPGE QPP in 
the United States at a cost of $1,000. On November 30, 2007, P sells 
the QPP to S for $2,500. On February 28, 2008, P disposes of 60% of 
the stock of S. On June 30, 2008, S sells the QPP to an unrelated 
person for $3,000.
    (ii) Analysis. Because P and S are members of a consolidated 
group in 2007, pursuant to Sec.  1.199-7(d)(1) and Sec.  1.1502-13, 
neither P's $1,500 of gain on the sale of QPP to S nor P's $2,500 
gross receipts from the sale are taken into account in 2007. Under 
Sec.  1.1502-13(d), P takes the intercompany transaction into 
account immediately before S becomes a non-member of the 
consolidated group. In order to produce the same effect as if P and 
S were divisions of a single corporation, P's gross receipts from 
the sale of the QPP to S are redetermined under Sec.  1.1502-
13(c)(1)(i) as non-DPGR. Further, because P and S are not members of 
the same EAG when S sells the QPP to the unrelated person, and 
because P's transfer of the QPP to S did not take place in a 
transaction to which section 381(a) applies, S is not treated as 
conducting the activities conducted by P in determining if S's 
receipts are DPGR, notwithstanding that P and S were members of the 
same EAG when P MPGE the QPP and when P sold the QPP to S. 
Accordingly, neither the P consolidated group nor S will have DPGR 
with respect to the QPP.
    Example 11. Corporation X is the common parent of a consolidated 
group, consisting of X and Y, which has filed a consolidated Federal 
income tax return for many years. Corporation P is the common parent 
of a consolidated group, consisting of P and S, which has filed a 
consolidated Federal income tax return for many years. The X and P 
consolidated groups each file their consolidated Federal income tax 
returns on a calendar year basis. X, Y, P and S are members of the 
same EAG in 2008. In 2007, the X consolidated group incurred a 
consolidated net operating loss (CNOL) of $25,000, none of which was 
carried back and used to offset taxable income of prior taxable 
years. Neither P nor S (nor the P consolidated group) has ever 
incurred an NOL. In 2008, the X consolidated group has (prior to the 
deduction under section 172) taxable income of $8,000 and the P 
consolidated group has taxable income of $20,000. The X consolidated 
group uses $8,000 of its CNOL from 2007 to offset the X consolidated 
group's taxable income in 2008. None of the X consolidated group's 
remaining CNOL may be used to offset taxable income of the P 
consolidated group under paragraph (b)(3) of this section. 
Accordingly, for purposes of determining the EAG's section 199 
deduction, the EAG has taxable income of $20,000 (the X consolidated 
group's taxable income (after the deduction under section 172) of $0 
plus the P consolidated group's taxable income of $20,000).

    (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. In general, this allocation of items is made by 
using the pro rata allocation method described in paragraph (f)(1)(i) 
of this section. However, a corporation may elect to use the section 
199 closing of the books method described in paragraph (f)(1)(ii) of 
this section. Neither the pro rata allocation method nor the section 
199 closing of the books method is a method of accounting.
    (i) Pro rata allocation method. 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.
    (ii) Section 199 closing of the books method. Under the section 199 
closing of the books method, a corporation's taxable income or loss, 
QPAI, and W-2 wages for the period during which the corporation was a 
member of an EAG are computed by treating the corporation's 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.

[[Page 31319]]

    (iii) Making the section 199 closing of the books election. A 
corporation makes the section 199 closing of the books election by 
making the following statement: ``The section 199 closing of the books 
election is hereby made with respect to [insert name of corporation and 
its employer identification number] with respect to the following 
periods [insert dates of the two periods between which items are 
allocated pursuant to the closing of the books method].'' The statement 
must be filed with the corporation's timely filed (including 
extensions) Federal income tax return for the taxable year that 
includes the periods that are subject to the election. Once made, a 
section 199 closing of the books election is irrevocable.
    (2) Coordination with rules relating to the allocation of income 
under Sec.  1.1502-76(b). If Sec.  1.1502-76(b) (relating to items 
included in a consolidated return) applies to a corporation that is a 
member of an EAG, then any allocation of items required under this 
paragraph (f) is made only after the allocation of the corporation's 
items pursuant to Sec.  1.1502-76(b).
    (g) Total section 199 deduction for a corporation that is a member 
of an expanded affiliated group for some or all of its taxable year--
(1) Member of the same expanded affiliated group for the entire taxable 
year. If a corporation is a member of the same EAG for its entire 
taxable year, the corporation's section 199 deduction for the taxable 
year is the amount of the section 199 deduction allocated to the 
corporation by the EAG under paragraph (c)(1) of this section.
    (2) Member of the expanded affiliated group for a portion of the 
taxable year. If a corporation is a member of an EAG only for a portion 
of its taxable year and is either not a member of any EAG or is a 
member of another EAG, or both, for another portion of the taxable 
year, the corporation's section 199 deduction for the taxable year is 
the sum of its section 199 deductions for each portion of the taxable 
year.
    (3) Example. The following example illustrates the application of 
paragraphs (f) and (g) of this section:

    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. Taking 
into account Z's taxable income, QPAI, and W-2 wages allocated to 
the first half of 2007 pursuant to the section 199 closing of the 
books election, the EAG has positive taxable income and QPAI for 
2007 and W-2 wages in excess of the section 199(b) wage limitation. 
Because the EAG has both positive taxable income and QPAI and 
sufficient W-2 wages, and because Z has positive QPAI for the first 
half of 2007, a portion of the EAG's section 199 deduction is 
allocated to Z. Because Z has negative QPAI for the second half of 
2007, Z is allowed no section 199 deduction for the second half of 
2007. Thus, despite the fact that Z has a $70 taxable loss and 
($100) of QPAI for the entire 2007 taxable year, Z is entitled to a 
section 199 deduction for 2007 equal to the section 199 deduction 
allocated to Z as a member of the EAG.

    (h) Computation of section 199 deduction for members of an expanded 
affiliated group with different taxable years--(1) In general. If 
members of an EAG have different taxable years, in determining the 
section 199 deduction of a member (the computing member), the computing 
member is required to take into account the taxable income or loss, 
determined without regard to the section 199 deduction, QPAI, and W-2 
wages of each other group member that are both--
    (i) Attributable to the period that each other member of the EAG 
and the computing member are members of the EAG; and
    (ii) Taken into account in a taxable year that begins after the 
effective date of section 199 and such taxable year ends with or within 
the taxable year of the computing member with respect to which the 
section 199 deduction is computed.
    (2) Example. The following example illustrates the application of 
this paragraph (h):

    Example. (i) Corporations X, Y, and Z are members of the same 
EAG. Neither X, Y, nor Z is a member of a consolidated group. X and 
Y are calendar year taxpayers and Z is a June 30 fiscal year 
taxpayer. Z came into existence on July 1, 2007. Each corporation 
has taxable income that exceeds its QPAI and has sufficient W-2 
wages to avoid the limitation under section 199(b). For the taxable 
year ending December 31, 2007, X's QPAI is $8,000 and Y's QPAI is 
($6,000). For its taxable year ending June 30, 2008, Z's QPAI is 
$2,000.
    (ii) In computing X's and Y's respective section 199 deductions 
for their taxable years ending December 31, 2007, X's and Y's 
taxable income, QPAI, and W-2 wages from their respective taxable 
years ending December 31, 2007, are aggregated. The EAG's QPAI for 
this purpose is $2,000 (X's QPAI of $8,000 + Y's QPAI of ($6,000)). 
Because the taxable years of the computing members, X and Y, began 
in 2007, the transition percentage under section 199(a)(2) is 6%. 
Accordingly, the EAG's section 199 deduction is $120 ($2,000 x .06). 
The $120 deduction is allocated to each of X and Y in proportion to 
their respective QPAI as a percentage of the QPAI of each member of 
the EAG that was taken into account in computing the EAG's section 
199 deduction. Pursuant to paragraph (c)(1) of this section, in 
allocating the section 199 deduction between X and Y, because Y's 
QPAI is negative, Y's QPAI is treated as being $0. Accordingly, X's 
section 199 deduction for its taxable year ending December 31, 2007, 
is $120 ($120 x $8,000/($8,000 + $0)). Y's section 199 deduction for 
its taxable year ending December 31, 2007, is $0 ($120 x $0/($8,000 
+ $0)).
    (iii) In computing Z's section 199 deduction for its taxable 
year ending June 30, 2008, X's and Y's items from their respective 
taxable years ending December 31, 2007, are taken into account. 
Therefore, X's and Y's taxable income or loss, determined without 
regard to the section 199 deduction, QPAI, and W-2 wages from their 
taxable years ending December 31, 2007, are aggregated with Z's 
taxable income or loss, QPAI, and W-2 wages from its taxable year 
ending June 30, 2008. The EAG's QPAI is $4,000 (X's QPAI of $8,000 + 
Y's QPAI of ($6,000) + Z's QPAI of $2,000). Because the taxable year 
of the computing member, Z, began in 2007, the transition percentage 
under section 199(a)(2) is 6%. Accordingly, the EAG's section 199 
deduction is $240 ($4,000 x .06). A portion of the $240 deduction is 
allocated to Z in proportion to its QPAI as a percentage of the QPAI 
of each member of the EAG that was taken into account in computing 
the EAG's section 199 deduction. Pursuant to paragraph (c)(1) of 
this section, in allocating a portion of the $240 deduction to Z, 
because Y's QPAI is negative, Y's QPAI is treated as being $0. Z's 
section 199 deduction for its taxable year ending June 30, 2008, is 
$48 ($240 x $2,000/($8,000 + $0 + $2,000)).


Sec.  1.199-8  Other rules.

    (a) In general. The provisions of this section apply solely for 
purposes of section 199 of the Internal Revenue Code (Code). When 
calculating the deduction under Sec.  1.199-1(a) (section 199 
deduction), taxpayers are required to make numerous allocations under 
Sec. Sec.  1.199-1 through 1.199-9. In making these allocations, 
taxpayers may use any reasonable method that is satisfactory to the 
Secretary based on all of the facts and circumstances, unless the 
regulations under Sec. Sec.  1.199-1 through 1.199-9 specify a method. 
A change in a taxpayer's method of allocating or apportioning gross 
receipts, cost of goods sold (CGS), expenses, losses, or deductions 
(deductions) does not constitute a change in method of accounting to 
which the provisions of sections 446 and 481 and the regulations 
thereunder apply.
    (b) Individuals. In the case of an individual, the section 199 
deduction is equal to the applicable percentage of the

[[Page 31320]]

lesser of the taxpayer's qualified production activities income (QPAI) 
(as defined in Sec.  1.199-1(c)) for the taxable year, or adjusted 
gross income (AGI) for the taxable year determined after applying 
sections 86, 135, 137, 219, 221, 222, and 469, and without regard to 
section 199.
    (c) Trade or business requirement--(1) In general. Sections 1.199-1 
through 1.199-9 are applied by taking into account only items that are 
attributable to the actual conduct of a trade or business.
    (2) Individuals. An individual engaged in the actual conduct of a 
trade or business must apply Sec. Sec.  1.199-1 through 1.199-9 by 
taking into account in computing QPAI only items that are attributable 
to that trade or business (or trades or businesses) and any items 
allocated from a pass-thru entity engaged in a trade or business. 
Compensation received by an individual employee for services performed 
as an employee is not considered gross receipts for purposes of 
computing QPAI under Sec. Sec.  1.199-1 through 1.199-9. Similarly, any 
costs or expenses paid or incurred by an individual employee with 
respect to those services performed as an employee are not considered 
CGS or deductions of that employee for purposes of computing QPAI under 
Sec. Sec.  1.199-1 through 1.199-9.
    (3) Trusts and estates. For purposes of this paragraph (c), a trust 
or estate is treated as an individual.
    (d) Coordination with alternative minimum tax. For purposes of 
determining alternative minimum taxable income (AMTI) under section 55, 
a taxpayer that is not a corporation must deduct an amount 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 the taxpayer's QPAI for the taxable 
year, or the taxpayer's taxable income for the taxable year, determined 
without regard to the section 199 deduction (or in the case of an 
individual, AGI). For purposes of determining AMTI in the case of a 
corporation (including a corporation subject to tax under section 
511(a)), a taxpayer must deduct an amount 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 the taxpayer's QPAI for the taxable year, or the taxpayer's 
AMTI for the taxable year, determined without regard to the section 199 
deduction. For purposes of computing AMTI, QPAI is determined without 
regard to any adjustments under sections 56 through 59. In the case of 
an individual or a non-grantor trust or estate, AGI and taxable income 
are also determined without regard to any adjustments under sections 56 
through 59. The amount of the deduction allowable under this paragraph 
(d) for any taxable year cannot exceed 50 percent of the W-2 wages of 
the employer for the taxable year (as determined under Sec.  1.199-2). 
The section 199 deduction is not taken into account in determining the 
amount of the alternative tax net operating loss deduction (ATNOL) 
allowed under section 56(a)(4). For example, assume that for the 
calendar year 2007, a corporation has both AMTI (before the NOL 
deduction and before the section 199 deduction) and QPAI of $1,000,000, 
and has an ATNOL carryover to 2007 of $5,000,000. Assume that the 
taxpayer has W-2 wages in excess of the section 199(b) wage limitation. 
Under section 56(d), the ATNOL deduction for 2007 is $900,000 (90 
percent of $1,000,000), reducing AMTI to $100,000. The taxpayer must 
then further reduce the AMTI by the section 199 deduction of $6,000 
(six percent of the lesser of $1,000,000 or $100,000) to $94,000. The 
ATNOL carryover to 2008 is $4,100,000.
    (e) Nonrecognition transactions--(1) In general--(i) Sections 351, 
721, and 731. Except as provided for an EAG partnership (as defined in 
Sec.  1.199-9(j)) and an expanded affiliated group (EAG) (as defined in 
Sec.  1.199-7), if property is transferred by the taxpayer to an entity 
in a transaction to which section 351 or 721 applies, then whether the 
gross receipts derived by the entity are domestic production gross 
receipts (DPGR) (as defined in Sec.  1.199-3) shall be determined based 
solely on the activities performed by the entity without regard to the 
activities performed by the taxpayer prior to the contribution of the 
property to the entity. Except as provided for a qualifying in-kind 
partnership (as defined in Sec.  1.199-9(i)) and an EAG partnership, if 
property is transferred by a partnership to a partner in a transaction 
to which section 731 applies, then whether gross receipts derived by 
the partner are DPGR shall be determined based on the activities 
performed by the partner without regard to the activities performed by 
the partnership before the distribution of the property to the partner.
    (ii) Exceptions--(A) Section 708(b)(1)(B). If property is deemed to 
be contributed by a partnership (transferor partnership) to another 
partnership (transferee partnership) as a result of a termination under 
section 708(b)(1)(B), then the transferee partnership shall be treated 
as performing those activities performed by the transferor partnership 
with respect to the transferred property of the transferor partnership.
    (B) Transfers by reason of death. If property is transferred upon 
or by reason of the death of an individual (decedent), then the 
decedent's successor(s) in interest shall be treated as having 
performed those activities performed by or deemed to have been 
performed (pursuant to Sec.  1.199-9(i)) by the decedent with respect 
to the transferred property. For this purpose, a transfer shall include 
without limitation the passing of the property by bequest, contractual 
provision, beneficiary designation, or operation of law, and successor 
in interest shall include without limitation the decedent's heirs or 
legatees, the decedent's estate or trust, or the beneficiary or 
beneficiaries of the decedent's estate or trust.
    (2) Section 1031 exchanges. If a taxpayer exchanges property for 
replacement property in a transaction to which section 1031 applies, 
then whether the gross receipts derived from the lease, rental, 
license, sale, exchange, or other disposition of the replacement 
property are DPGR shall be determined based solely on the activities 
performed by the taxpayer with respect to the replacement property.
    (3) Section 381 transactions. If a corporation (the acquiring 
corporation) acquires the assets of another corporation (the target 
corporation) in a transaction to which section 381(a) applies, then the 
acquiring corporation shall be treated as performing those activities 
of the target corporation with respect to the acquired assets of the 
target corporation. Therefore, to the extent that the acquired assets 
of the target corporation would have given rise to DPGR if leased, 
rented, licensed, sold, exchanged, or otherwise disposed of by the 
target corporation, such assets will give rise to DPGR if leased, 
rented, licensed, sold, exchanged, or otherwise disposed of by the 
acquiring corporation (assuming all the other requirements of Sec.  
1.199-3 are met).
    (f) Taxpayers with a 52-53 week taxable year. For purposes of 
applying Sec.  1.441-2(c)(1) in the case of a taxpayer using a 52-53 
week taxable year, any reference in section 199(a)(2) (the phase-in 
rule), Sec. Sec.  1.199-1 through 1.199-9 to a taxable year beginning 
after a particular calendar year means a taxable year beginning after 
December 31st of that year. Similarly, any reference to a taxable year 
beginning in a particular calendar year means a taxable year beginning 
after December 31st of the preceding calendar year. For example, a 52-
53 week taxable year that begins on December 26, 2006, is deemed to 
begin

[[Page 31321]]

on January 1, 2007, and the transition percentage for that taxable year 
is 6 percent.
    (g) Section 481(a) adjustments. For purposes of determining QPAI, a 
section 481(a) adjustment, whether positive or negative, taken into 
account by a taxpayer during the taxable year that is solely 
attributable to either the taxpayer's gross receipts, CGS, or 
deductions must be allocated or apportioned between DPGR and non-DPGR 
using the methods used by a taxpayer to allocate or apportion gross 
receipts, CGS, and deductions between DPGR and non-DPGR for the current 
taxable year. See Sec. Sec.  1.199-1 and 1.199-4 for rules related to 
the allocation and apportionment of gross receipts, CGS, and 
deductions, respectively. For example, if a taxpayer changes its method 
of accounting for inventories from the last-in, first-out (LIFO) method 
to the first-in, first-out (FIFO) method and the taxpayer uses the 
small business simplified overall method to apportion CGS between DPGR 
and non-DPGR, the taxpayer is required to apportion the resulting 
section 481(a) adjustment, whether positive or negative, between DPGR 
and non-DPGR using the small business simplified overall method. If a 
section 481(a) adjustment is not solely attributable to either gross 
receipts, CGS, or deductions (for example, the taxpayer changes its 
overall method of accounting from an accrual method to the cash method) 
and the section 481(a) adjustment cannot be specifically identified 
with either gross receipts, CGS, or deductions, then the section 481(a) 
adjustment, whether positive or negative, must be attributed to, or 
among, gross receipts, CGS, or deductions using any reasonable method 
that is satisfactory to the Secretary based on all of the facts and 
circumstances, and then allocated or apportioned between DPGR and non-
DPGR using the same methods the taxpayer uses to allocate or apportion 
gross receipts, CGS, or deductions between DPGR and non-DPGR for the 
taxable year or taxable years that the section 481(a) adjustment is 
taken into account. Factors taken into consideration in determining 
whether the method is reasonable include whether the taxpayer uses the 
most accurate information available; the relationship between the 
section 481(a) adjustment and the apportionment base chosen; the 
accuracy of the method chosen as compared with other possible methods; 
and the time, burden, and cost of using alternative methods. If a 
section 481(a) adjustment is spread over more than one taxable year, 
then a taxpayer must attribute the section 481(a) adjustment among 
gross receipts, CGS, or deductions, as applicable, in the same amount 
for each taxable year within the spread period. For example, if a 
taxpayer, using a reasonable method that is satisfactory to the 
Secretary based on all of the facts and circumstances, determines that 
a section 481(a) adjustment that is required to be spread over four 
taxable years should be attributed half to gross receipts and half to 
deductions, then the taxpayer must attribute the section 481(a) 
adjustment half to gross receipts and half to deductions in each of the 
four taxable years of the spread period. Further, if such taxpayer uses 
the simplified deduction method to apportion deductions between DPGR 
and non-DPGR in the first taxable year of the spread period, then the 
taxpayer must use the simplified deduction method to apportion half the 
section 481(a) adjustment for that taxable year between DPGR and non-
DPGR for that taxable year. Similarly, if in the second taxable year of 
the spread period the taxpayer uses the section 861 method to apportion 
and allocate costs between DPGR and non-DPGR, then the taxpayer must 
use the section 861 method to allocate and apportion half the section 
481(a) adjustment for that taxable year between DPGR and non-DPGR for 
that taxable year.
    (h) Disallowed losses or deductions. Except as provided by 
publication in the Internal Revenue Bulletin (see Sec.  
601.601(d)(2)(ii)(b) of this chapter), losses or deductions of a 
taxpayer that otherwise would be taken into account in computing the 
taxpayer's section 199 deduction are taken into account only if and to 
the extent the deductions are not disallowed by section 465 or 469, or 
any other provision of the Code. If only a portion of the taxpayer's 
share of the losses or deductions is allowed for a taxable year, the 
proportionate share of those allowable losses or deductions that are 
allocated to the taxpayer's qualified production activities, determined 
in a manner consistent with section 465 and 469, and any other 
applicable provision of the Code, is taken into account in computing 
QPAI for purposes of the section 199 deduction for that taxable year. 
To the extent that any of the disallowed losses or deductions are 
allowed in a later taxable year, the taxpayer takes into account a 
proportionate share of those losses or deductions in computing its QPAI 
for that later taxable year. Losses or deductions of the taxpayer that 
are disallowed for taxable years beginning on or before December 31, 
2004, are not taken into account in a later taxable year for purposes 
of computing the taxpayer's QPAI and the wage limitation of section 
199(d)(1)(A)(iii) under Sec.  1.199-9 for that taxable year, regardless 
of whether the losses or deductions are allowed for other purposes. For 
taxpayers that are partners in partnerships, see Sec.  1.199-9(b)(2). 
For taxpayers that are shareholders in S corporations, see Sec.  1.199-
9(c)(2).
    (i) Effective dates--(1) In general. Section 199 applies to taxable 
years beginning after December 31, 2004. Sections 1.199-1 through 
1.199-8 are applicable for taxable years beginning on or after June 1, 
2006. For a taxable year beginning on or before May 17, 2006, the 
enactment date of the Tax Increase Prevention and Reconciliation Act of 
2005 (Pub. L. 109-222, 120 Stat. 345), a taxpayer may apply Sec. Sec.  
1.199-1 through 1.199-9 provided that the taxpayer applies all 
provisions in Sec. Sec.  1.199-1 through 1.199-9 to the taxable year. 
For a taxable year beginning after May 17, 2006, and before June 1, 
2006, a taxpayer may apply Sec. Sec.  1.199-1 through 1.199-8 provided 
that the taxpayer applies all provisions in Sec. Sec.  1.199-1 through 
1.199-8 to the taxable year. For a taxpayer who chooses not to rely on 
these final regulations for a taxable year beginning before June 1, 
2006, the guidance under section 199 that applies to such taxable year 
is contained in Notice 2005-14 (2005-1 C.B. 498) (see Sec.  
601.601(d)(2) of this chapter). In addition, a taxpayer also may rely 
on the provisions of REG-105847-05 (2005-47 I.R.B. 987) (see Sec.  
601.601(d)(2) of this chapter) for a taxable year beginning before June 
1, 2006. If Notice 2005-14 and REG-105847-05 include different rules 
for the same particular issue, then a taxpayer may rely on either the 
rule set forth in Notice 2005-14 or the rule set forth in REG-105847-
05. However, if REG-105847-05 includes a rule that was not included in 
Notice 2005-14, then a taxpayer is not permitted to rely on the absence 
of a rule in Notice 2005-14 to apply a rule contrary to REG-105847-05. 
For taxable years beginning after May 17, 2006, and before June 1, 
2006, a taxpayer may not apply Notice 2005-14, REG-105847-05, or any 
other guidance under section 199 in a manner inconsistent with 
amendments made to section 199 by section 514 of the Tax Increase 
Prevention and Reconciliation Act of 2005.
    (2) Pass-thru entities. 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,

[[Page 31322]]

shall not be taken into account for purposes of section 199(d)(1).
    (3) Non-consolidated EAG members. A member of an EAG that is not a 
member of a consolidated group may apply paragraph (i)(1) of this 
section without regard to how other members of the EAG apply paragraph 
(i)(1) of this section.
    (4) Computer software provided to customers over the Internet. 
[Reserved]. For further guidance, see Sec.  1.199-8T(i)(4).


Sec.  1.199-9  Application of section 199 to pass-thru entities for 
taxable years beginning on or before May 17, 2006, the enactment date 
of the Tax Increase Prevention and Reconciliation Act of 2005.

    (a) In general. The provisions of this section apply solely for 
purposes of section 199 of the Internal Revenue Code (Code).
    (b) Partnerships--(1) In general--(i) Determination at partner 
level. The deduction with respect to the qualified production 
activities of the partnership allowable under Sec.  1.199-1(a) (section 
199 deduction) is determined at the partner level. As a result, each 
partner must compute its deduction separately. The section 199 
deduction has no effect on the adjusted basis of the partner's interest 
in the partnership. Except as provided by publication pursuant to 
paragraph (b)(1)(ii) of this section, for purposes of this section, 
each partner is allocated, in accordance with sections 702 and 704, its 
share of partnership items (including items of income, gain, loss, and 
deduction), cost of goods sold (CGS) allocated to such items of income, 
and gross receipts that are included in such items of income, even if 
the partner's share of CGS and other deductions and losses exceeds 
domestic production gross receipts (DPGR) (as defined in Sec.  1.199-
3(a)) and regardless of the amount of the partner's share of W-2 wages 
(as defined in Sec.  1.199-2(e)) of the partnership for the taxable 
year. A partnership may specially allocate items of income, gain, loss, 
or deduction to its partners, subject to the rules of section 704(b) 
and the supporting regulations. Guaranteed payments under section 
707(c) are not considered allocations of partnership income for 
purposes of this section. Guaranteed payments under section 707(c) are 
deductions by the partnership that must be taken into account under the 
rules of Sec.  1.199-4. See Sec.  1.199-3(p) and paragraph (b)(6) 
Example 5 of this section. Except as provided in paragraph (b)(1)(ii) 
of this section, to determine its section 199 deduction for the taxable 
year, a partner aggregates its distributive share of such items, to the 
extent they are not otherwise disallowed by the Code, with those items 
it incurs outside the partnership (whether directly or indirectly) for 
purposes of allocating and apportioning deductions to DPGR and 
computing its qualified production activities income (QPAI) (as defined 
in Sec.  1.199-1(c)).
    (ii) Determination at entity level. The Secretary may, by 
publication in the Internal Revenue Bulletin (see Sec.  
601.601(d)(2)(ii)(b) of this chapter), permit a partnership to 
calculate a partner's share of QPAI at the entity level, instead of 
allocating, in accordance with sections 702 and 704, the partner's 
share of partnership items (including items of income, gain, loss, and 
deduction). If a partnership does calculate QPAI at the entity level--
    (A) The partner is allocated its share of QPAI and W-2 wages (as 
defined in Sec.  1.199-2(e)), which (subject to the limitations of 
paragraph (b)(2) of this section and section 199(d)(1)(A)(iii), 
respectively) are combined with the partner's QPAI and W-2 wages from 
other sources;
    (B) For purposes of computing QPAI under Sec. Sec.  1.199-1 through 
1.199-9, a partner does not take into account the items from such a 
partnership (for example, a partner does not take into account items 
from such a partnership in determining whether a threshold or de 
minimis rule applies or when the partner allocates and apportions 
deductions in calculating its QPAI from other sources);
    (C) A partner generally does not recompute its share of QPAI from 
the partnership using another method; however, the partner might have 
to adjust its share of QPAI from the partnership to take into account 
certain disallowed losses or deductions, or the allowance of suspended 
losses or deductions; and
    (D) A partner's distributive share of QPAI from a partnership may 
be less than zero.
    (2) Disallowed losses or deductions. Except as provided by 
publication in the Internal Revenue Bulletin (see Sec.  
601.601(d)(2)(ii)(b) of this chapter), losses or deductions of a 
partnership that otherwise would be taken into account in computing the 
partner's section 199 deduction for a taxable year are taken into 
account in that year only if and to the extent the partner's 
distributive share of those losses or deductions from all of the 
partnership's activities is not disallowed by section 465, 469, or 
704(d), or any other provision of the Code. If only a portion of the 
partner's distributive share of the losses or deductions is allowed for 
a taxable year, a proportionate share of those allowable losses or 
deductions that are allocated to the partnership's qualified production 
activities, determined in a manner consistent with sections 465, 469, 
and 704(d), and any other applicable provision of the Code, is taken 
into account in computing QPAI and the wage limitation of section 
199(d)(1)(A)(iii) for that taxable year. To the extent that any of the 
disallowed losses or deductions are allowed in a later taxable year, 
the partner takes into account a proportionate share of those losses or 
deductions in computing its QPAI for that later taxable year. Losses or 
deductions of the partnership that are disallowed for taxable years 
beginning on or before December 31, 2004, are not taken into account in 
a later taxable year for purposes of computing the partner's QPAI or 
the wage limitation of section 199(d)(1)(A)(iii) for that taxable year, 
regardless of whether the losses or deductions are allowed for other 
purposes.
    (3) Partner's share of W-2 wages. Under section 199(d)(1)(A)(iii), 
a partner's share of W-2 wages of a partnership for purposes of 
determining the partner's section 199(b) wage limitation is the lesser 
of the partner's allocable share of those wages (without regard to 
section 199(d)(1)(A)(iii)), or 2 times 3 percent of the QPAI computed 
by taking into account only the items of the partnership allocated to 
the partner for the taxable year of the partnership. Except as provided 
by publication in the Internal Revenue Bulletin (see Sec.  
601.601(d)(2)(ii)(b) of this chapter), this QPAI calculation is 
performed by the partner using the same cost allocation method that the 
partner uses in calculating the partner's section 199 deduction. The 
partnership must allocate W-2 wages (prior to the application of the 
wage limitation) among the partners in the same manner as wage expense. 
The partner must add the partner's share of the W-2 wages from the 
partnership, as limited by section 199(d)(1)(A)(iii), to the partner's 
W-2 wages from other sources, if any. If QPAI, computed by taking into 
account only the items of the partnership allocated to the partner for 
the taxable year (as required by the wage limitation of section 
199(d)(1)(A)(iii)) is not greater than zero, then the partner may not 
take into account any W-2 wages of the partnership in applying the wage 
limitation of Sec.  1.199-2 (but the partner will, nevertheless, 
aggregate its distributive share of partnership items including wage 
expense with those items not from the partnership in computing its QPAI 
when determining its section 199 deduction). See Sec.  1.199-

[[Page 31323]]

2 for the computation of W-2 wages, and paragraph (g) of this section 
for rules regarding pass-thru entities in a tiered structure.
    (4) Transition percentage rule for W-2 wages. With regard to 
partnerships, for purposes of section 199(d)(1)(A)(iii)(II) the 
transition percentages determined under section 199(a)(2) shall be 
determined by reference to the partnership's taxable year. Thus, if a 
partner uses a calendar year taxable year, and owns an interest in a 
partnership that has a taxable year ending on April 30, the partner's 
section 199(d)(1)(A)(iii) wage limitation for the partnership's taxable 
year beginning on May 1, 2006, would be calculated using 3 percent, 
even though the partner includes the partner's distributive share of 
partnership items from that taxable year on the partner's 2007 Federal 
income tax return.
    (5) Partnerships electing out of subchapter K. For purposes of 
Sec. Sec.  1.199-1 through 1.199-9, the rules of paragraph (b) of this 
section shall apply to all partnerships, including those partnerships 
electing under section 761(a) to be excluded, in whole or in part, from 
the application of subchapter K of chapter 1 of the Code.
    (6) Examples. The following examples illustrate the application of 
this paragraph (b). Assume that each partner has sufficient adjusted 
gross income or taxable income so that the section 199 deduction is not 
limited under section 199(a)(1)(B); that the partnership and each of 
its partners (whether individual or corporate) are calendar year 
taxpayers; and that the amount of the partnership's W-2 wages equals 
wage expense for each taxable year. The examples are as follows:

    Example 1. Section 861 method with interest expense. (i) 
Partnership Federal income tax items. X and Y, unrelated United 
States corporations, are each 50% partners in PRS, a partnership 
that engages in production activities that generate both DPGR and 
non-DPGR. X and Y share all items of income, gain, loss, deduction, 
and credit 50% each. Both X and Y are engaged in a trade or 
business. PRS is not able to identify from its books and records CGS 
allocable to DPGR and non-DPGR. In this case, because CGS is 
definitely related under the facts and circumstances to all of PRS's 
gross income, apportionment of CGS between DPGR and non-DPGR based 
on gross receipts is appropriate. For 2006, the adjusted basis of 
PRS's business assets is $5,000, $4,000 of which generate gross 
income attributable to DPGR and $1,000 of which generate gross 
income attributable to non-DPGR. For 2006, PRS has the following 
Federal income tax items:

------------------------------------------------------------------------
 
------------------------------------------------------------------------
DPGR....................................................          $3,000
Non-DPGR................................................           3,000
CGS (includes $200 of W-2 wages)........................           3,240
Section 162 selling expenses (includes $300 of W-2                 1,200
 wages).................................................
Interest expense (not included in CGS)..................             300
------------------------------------------------------------------------

    (ii) Allocation of PRS's items of income, gain, loss, deduction, 
or credit. X and Y each receive the following distributive share of 
PRS's items of income, gain, loss, deduction or credit, as 
determined under the principles of Sec.  1.704-1(b)(1)(vii):

------------------------------------------------------------------------
 
------------------------------------------------------------------------
Gross income attributable to DPGR ($1,500 (DPGR) - $810             $690
 (allocable CGS, includes $50 of W-2 wages))............
Gross income attributable to non-DPGR ($1,500 (non-DPGR)             690
 - $810 (allocable CGS, includes $50 of W-2 wages)).....
Section 162 selling expenses (includes $150 of W-2                   600
 wages).................................................
Interest expense (not included in CGS)..................             150
------------------------------------------------------------------------

    (iii) Determination of QPAI. (A) X's QPAI. Because the section 
199 deduction is determined at the partner level, X determines its 
QPAI by aggregating, to the extent necessary, its distributive share 
of PRS's Federal income tax items with all other such items from all 
other, non-PRS-related activities. For 2006, X does not have any 
other such items. For 2006, the adjusted basis of X's non-PRS 
assets, all of which are investment assets, is $10,000. X's only 
gross receipts for 2006 are those attributable to the allocation of 
gross income from PRS. X allocates and apportions its deductible 
items to gross income attributable to DPGR under the section 861 
method of Sec.  1.199-4(d). In this case, the section 162 selling 
expenses (including W-2 wages) are definitely related to all of 
PRS's gross receipts. Based on the facts and circumstances of this 
specific case, apportionment of those expenses between DPGR and non-
DPGR on the basis of PRS's gross receipts is appropriate. X elects 
to apportion its distributive share of interest expense under the 
tax book value method of Sec.  1.861-9T(g). X's QPAI for 2006 is 
$366, as shown below:

------------------------------------------------------------------------
 
------------------------------------------------------------------------
DPGR...................................................          $1,500
CGS allocable to DPGR (includes $50 of W-2 wages)......            (810)
Section 162 selling expenses (includes $75 of W-2                  (300)
 wages) ($600 x $1,500/$3,000).........................
Interest expense (not included in CGS) ($150 x $2,000               (24)
 (X's share of PRS's DPGR assets)/$12,500 (X's non-PRS
 assets ($10,000) and X's share of PRS assets
 ($2,500)))............................................
                                                        ----------------
X's QPAI...............................................             366
------------------------------------------------------------------------

    (B) Y's QPAI. (1) For 2006, in addition to the activities of 
PRS, Y engages in production activities that generate both DPGR and 
non-DPGR. Y is able to identify from its books and records CGS 
allocable to DPGR and to non-DPGR. For 2006, the adjusted basis of 
Y's non-PRS assets attributable to its production activities that 
generate DPGR is $8,000 and to other production activities that 
generate non-DPGR is $2,000. Y has no other assets. Y has the 
following Federal income tax items relating to its non-PRS 
activities:

------------------------------------------------------------------------
 
------------------------------------------------------------------------
Gross income attributable to DPGR ($1,500 (DPGR) - $900             $600
 (allocable CGS, includes $70 of W-2 wages))............
Gross income attributable to non-DPGR ($3,000 (other               1,380
 gross receipts) - $1,620 (allocable CGS, includes $150
 of W-2 wages)).........................................
Section 162 selling expenses (includes $30 of W-2 wages)             540
Interest expense (not included in CGS)..................              90
------------------------------------------------------------------------


[[Page 31324]]

    (2) Y determines its QPAI in the same general manner as X. 
However, because Y has other trade or business activities outside of 
PRS, Y must aggregate its distributive share of PRS's Federal income 
tax items with its own such items. Y allocates and apportions its 
deductible items to gross income attributable to DPGR under the 
section 861 method of Sec.  1.199-4(d). In this case, Y's 
distributive share of PRS's section 162 selling expenses (including 
W-2 wages), as well as those selling expenses from Y's non-PRS 
activities, are definitely related to all of its gross income. Based 
on the facts and circumstances of this specific case, apportionment 
of those expenses between DPGR and non-DPGR on the basis of Y's 
gross receipts is appropriate. Y elects to apportion its 
distributive share of interest expense under the tax book value 
method of Sec.  1.861-9T(g). Y has $1,290 of gross income 
attributable to DPGR ($3,000 DPGR ($1,500 from PRS and $1,500 from 
non-PRS activities) - $1,710 CGS ($810 from PRS and $900 from non-
PRS activities). Y's QPAI for 2006 is $642, as shown below:

------------------------------------------------------------------------
 
------------------------------------------------------------------------
DPGR ($1,500 from PRS and $1,500 from non-PRS                    $3,000
 activities)...........................................
CGS allocable to DPGR ($810 from PRS and $900 from non-          (1,710)
 PRS activities) (includes $120 of W-2 wages)..........
Section 162 selling expenses (includes $180 of W-2                 (456)
 wages) ($1,140 ($600 from PRS and $540 from non-PRS
 activities) x ($1,500 PRS DPGR + $1,500 non-PRS DPGR)/
 ($3,000 PRS total gross receipts + $4,500 non-PRS
 total gross receipts))................................
Interest expense (not included in CGS) ($240 ($150 from            (192)
 PRS and $90 from non-PRS activities) x $10,000 (Y's
 non-PRS DPGR assets ($8,000) and Y's share of PRS DPGR
 assets ($2,000))/$12,500 (Y's non-PRS assets ($10,000)
 and Y's share of PRS assets ($2,500)))................
                                                        ----------------
Y's QPAI...............................................             642
------------------------------------------------------------------------

    (iv) PRS W-2 wages allocated to X and Y under section 
199(d)(1)(A)(iii). Solely for purposes of calculating the PRS W-2 
wages that are allocated to them under section 199(d)(1)(A)(iii) for 
purposes of the wage limitation of section 199(b), X and Y must 
separately determine QPAI taking into account only the items of PRS 
allocated to them. X and Y must use the same methods of allocation 
and apportionment that they use to determine their QPAI in 
paragraphs (iii)(A) and (B) of this Example 1, respectively. 
Accordingly, X and Y must apportion deductible section 162 selling 
expenses that include W-2 wage expense on the basis of gross 
receipts, and must apportion interest expense according to the tax 
book value method of Sec.  1.861-9T(g).
    (A) QPAI of X and Y, solely for this purpose, is determined by 
allocating and apportioning each partner's share of PRS expenses to 
each partner's share of PRS gross income of $690 attributable to 
DPGR ($1,500 DPGR-$810 CGS, apportioned based on gross receipts). 
Thus, QPAI of X and Y solely for this purpose is $270, as shown 
below:

------------------------------------------------------------------------
 
------------------------------------------------------------------------
DPGR...................................................          $1,500
CGS allocable to DPGR..................................            (810)
Section 162 selling expenses (including W-2 wages)                 (300)
 ($600 x ($1,500/$3,000))..............................
Interest expense (not included in CGS) ($150 x $2,000              (120)
 (partner's share of adjusted basis of PRS's DPGR
 assets)/$2,500 (partner's share of adjusted basis of
 total PRS assets))....................................
                                                        ----------------
QPAI...................................................             270
------------------------------------------------------------------------

    (B) X's and Y's shares of PRS's W-2 wages determined under 
section 199(d)(1)(A)(iii) for purposes of the wage limitation of 
section 199(b) are$16, the lesser of $250 (partner's allocable share 
of PRS's W-2 wages ($100 included in total CGS, and $150 included in 
selling expenses) and $16 (2 x ($270 x .03)).
    (v) Section 199 deduction determination. (A) X's tentative 
section 199 deduction is $11 (.03 x $366 (that is, QPAI determined 
at partner level)) subject to the wage limitation of $8 (50% x $16). 
Accordingly, X's section 199 deduction for 2006 is $8.
    (B) Y's tentative section 199 deduction is $19 (.03 x $642 (that 
is, QPAI determined at the partner level) subject to the wage 
limitation of $133 (50% x ($16 from PRS and $250 from non-PRS 
activities)). Accordingly, Y's section 199 deduction for 2006 is 
$19.
    Example 2. Section 861 method with R&E expense. (i) Partnership 
items of income, gain, loss, deduction or credit. X and Y, unrelated 
United States corporations each of which is engaged in a trade or 
business, are partners in PRS, a partnership that engages in 
production activities that generate both DPGR and non-DPGR. Neither 
X nor Y is a member of an affiliated group. X and Y share all items 
of income, gain, loss, deduction, and credit 50% each. All of PRS's 
domestic production activities that generate DPGR are within 
Standard Industrial Classification (SIC) Industry Group AAA (SIC 
AAA). All of PRS's production activities that generate non-DPGR are 
within SIC Industry Group BBB (SIC BBB). PRS is not able to identify 
from its books and records CGS allocable to DPGR and to non-DPGR 
and, therefore, apportions CGS to DPGR and non-DPGR based on its 
gross receipts. PRS incurs $900 of research and experimentation 
expenses (R&E) that are deductible under section 174, $300 of which 
are performed with respect to SIC AAA and $600 of which are 
performed with respect to SIC BBB. None of the R&E is legally 
mandated R&E as described in Sec.  1.861-17(a)(4) and none is 
included in CGS. PRS incurs section 162 selling expenses (that 
include W-2 wage expense) that are not includible in CGS and not 
directly allocable to any gross income. For 2006, PRS has the 
following Federal income tax items:

------------------------------------------------------------------------
 
------------------------------------------------------------------------
DPGR (all from sales of products within SIC AAA)........          $3,000
Non-DPGR (all from sales of products within SIC BBB)....           3,000
CGS (includes $200 of W-2 wages)........................           2,400
Section 162 selling expenses (includes $100 of W-2                   840
 wages).................................................
Section 174 R&E-SIC AAA.................................             300
Section 174 R&E-SIC BBB.................................             600
------------------------------------------------------------------------

    (ii) Allocation of PRS's items of income, gain, loss, deduction, 
or credit. X and Y each receive the following distributive share of 
PRS's items of income, gain, loss, deduction, or credit, as 
determined under the principles of Sec.  1.704-1(b)(1)(vii):

------------------------------------------------------------------------
 
------------------------------------------------------------------------
Gross income attributable to DPGR ($1,500 (DPGR)-$600               $900
 (CGS, includes $50 of W-2 wages))......................
Gross income attributable to non-DPGR ($1,500 (other                 900
 gross receipts)-$600 (CGS, includes $50 of W-2 wages)).
Section 162 selling expenses (includes $50 of W-2 wages)             420
Section 174 R&E-SIC AAA.................................             150

[[Page 31325]]

 
Section 174 R&E-SIC BBB.................................             300
------------------------------------------------------------------------

    (iii) Determination of QPAI. (A) X's QPAI. Because the section 
199 deduction is determined at the partner level, X determines its 
QPAI by aggregating, to the extent necessary, its distributive 
shares of PRS's Federal income tax items with all other such items 
from all other, non-PRS-related activities. For 2006, X does not 
have any other such tax items. X's only gross receipts for 2006 are 
those attributable to the allocation of gross income from PRS. As 
stated, all of PRS's domestic production activities that generate 
DPGR are within SIC AAA. X allocates and apportions its deductible 
items to gross income attributable to DPGR under the section 861 
method of Sec.  1.199-4(d). In this case, the section 162 selling 
expenses (including W-2 wages) are definitely related to all of 
PRS's gross income. Based on the facts and circumstances of this 
specific case, apportionment of those expenses between DPGR and non-
DPGR on the basis of PRS's gross receipts is appropriate. For 
purposes of apportioning R&E, X elects to use the sales method as 
described in Sec.  1.861-17(c). Because X has no direct sales of 
products, and because all of PRS's SIC AAA sales attributable to X's 
share of PRS's gross income generate DPGR, all of X's share of PRS's 
section 174 R&E attributable to SIC AAA is taken into account for 
purposes of determining X's QPAI. Thus, X's total QPAI for 2006 is 
$540, as shown below:

------------------------------------------------------------------------
 
------------------------------------------------------------------------
DPGR (all from sales of products within SIC AAA).......          $1,500
CGS (includes $50 of W-2 wages)........................            (600)
Section 162 selling expenses (including W-2 wages)                 (210)
 ($420 x ($1,500 DPGR/$3,000 total gross receipts))....
Section 174 R&E-SIC AAA................................            (150)
                                                        ----------------
X's QPAI...............................................             540
------------------------------------------------------------------------

    (B) Y's QPAI. (1) For 2006, in addition to the activities of 
PRS, Y engages in domestic production activities that generate both 
DPGR and non-DPGR. With respect to those non-PRS activities, Y is 
not able to identify from its books and records CGS allocable to 
DPGR and to non-DPGR. In this case, because CGS is definitely 
related under the facts and circumstances to all of Y's non-PRS 
gross receipts, apportionment of CGS between DPGR and non-DPGR based 
on Y's non-PRS gross receipts is appropriate. For 2006, Y has the 
following non-PRS Federal income tax items:

------------------------------------------------------------------------
 
------------------------------------------------------------------------
DPGR (from sales of products within SIC AAA)............          $1,500
DPGR (from sales of products within SIC BBB)............           1,500
Non-DPGR (from sales of products within SIC BBB)........           3,000
CGS (allocated to DPGR within SIC AAA) (includes $56 of              750
 W-2 wages).............................................
CGS (allocated to DPGR within SIC BBB) (includes $56 of              750
 W-2 wages).............................................
CGS (allocated to non-DPGR within SIC BBB) (includes               1,500
 $113 of W-2 wages).....................................
Section 162 selling expenses (includes $30 of W-2 wages)             540
Section 174 R&E-SIC AAA.................................             300
Section 174 R&E-SIC BBB.................................             450
------------------------------------------------------------------------

    (2) Because Y has DPGR as a result of activities outside PRS, Y 
must aggregate its distributive share of PRS's Federal income tax 
items with such items from all its other, non-PRS-related 
activities. Y allocates and apportions its deductible items to gross 
income attributable to DPGR under the section 861 method of Sec.  
1.199-4(d). In this case, the section 162 selling expenses 
(including W-2 wages) are definitely related to all of Y's gross 
income. Based on the facts and circumstances of the specific case, 
apportionment of such expenses between DPGR and non-DPGR on the 
basis of Y's gross receipts is appropriate. For purposes of 
apportioning R&E, Y elects to use the sales method as described in 
Sec.  1.861-17(c).
    (3) With respect to sales that generate DPGR, Y has gross income 
of $2,400 ($4,500 DPGR ($1,500 from PRS and $3,000 from non-PRS 
activities) -$2,100 CGS ($600 from sales of products by PRS and 
$1,500 from non-PRS activities)). Because all of the sales in SIC 
AAA generate DPGR, all of Y's share of PRS's section 174 R&E 
attributable to SIC AAA and the section 174 R&E attributable to SIC 
AAA that Y incurs in its non-PRS activities are taken into account 
for purposes of determining Y's QPAI. Because only a portion of the 
sales within SIC BBB generate DPGR, only a portion of the section 
174 R&E attributable to SIC BBB is taken into account in determining 
Y's QPAI. Thus, Y's QPAI for 2006 is $1,282, as shown below:

------------------------------------------------------------------------
 
------------------------------------------------------------------------
DPGR ($4,500 DPGR ($1,500 from PRS and $3,000 from non-          $4,500
 PRS activities).......................................
CGS ($600 from sales of products by PRS and $1,500 from          (2,100)
 non-PRS activities)...................................
Section 162 selling expenses (including W-2 wages)                 (480)
 ($420 from PRS + $540 from non-PRS activities) x
 ($4,500 DPGR/$9,000 total gross receipts))............
Section 174 R&E-SIC AAA ($150 from PRS and $300 from               (450)
 non-PRS activities)...................................
Section 174 R&E-SIC BBB ($300 from PRS + $450 from non-            (188)
 PRS activities) x ($1,500 DPGR/$6,000 total gross
 receipts allocated to SIC BBB ($1,500 from PRS and
 $4,500 from non-PRS activities))......................
                                                        ----------------
Y's QPAI...............................................           1,282
------------------------------------------------------------------------

    (iv) PRS W-2 wages allocated to X and Y under section 
199(d)(1)(A)(iii). Solely for purposes of calculating the PRS W-2 
wages that are allocated to X and Y under section 199(d)(1)(A)(iii) 
for purposes of the wage limitation of section 199(b), X and Y must 
separately determine QPAI taking into account only the items of PRS 
allocated to them. X and Y must use the same methods of allocation 
and apportionment that they use to determine their QPAI in 
paragraphs (iii)(A) and (B) of this Example 2, respectively. 
Accordingly, X and Y must apportion section 162 selling expenses 
that include W-2 wage expense on the basis of gross receipts, and 
apportion section 174 R&E expense under the sales method as 
described in Sec.  1.861-17(c).
    (A) QPAI of X and Y, solely for this purpose, is determined by 
allocating and apportioning each partner's share of PRS expenses to 
each partner's share of PRS gross income of $900 attributable to 
DPGR ($1,500 DPGR--$600 CGS, allocated based on PRS's

[[Page 31326]]

gross receipts). Because all of PRS's SIC AAA sales generate DPGR, 
all of X's and Y's shares of PRS's section 174 R&E attributable to 
SIC AAA is taken into account for purposes of determining X's and 
Y's QPAI. None of PRS's section 174 R&E attributable to SIC BBB is 
taken into account because PRS has no DPGR within SIC BBB. Thus, X 
and Y each has QPAI, solely for this purpose, of $540, as shown 
below:

------------------------------------------------------------------------
 
------------------------------------------------------------------------
DPGR (all from sales of products within SIC AAA).......          $1,500
CGS (includes $50 of W-2 wages)........................            (600)
Section 162 selling expenses (including W-2 wages)                 (210)
 ($420 x $1,500/$3,000)................................
Section 174 R&E-SIC AAA................................            (150)
                                                        ----------------
QPAI...................................................             540
------------------------------------------------------------------------

    (B) X's and Y's shares of PRS's W-2 wages determined under 
section 199(d)(1)(A)(iii) for purposes of the wage limitation of 
section 199(b) are $32, the lesser of $150 (partner's allocable 
share of PRS's W-2 wages ($100 included in CGS, and $50 included in 
selling expenses)) and $32 (2 x ($540 x .03)).
    (v) Section 199 deduction determination. (A) X's tentative 
section 199 deduction is $16 (.03 x $540 (QPAI determined at partner 
level)) subject to the wage limitation of $16 (50% x $32). 
Accordingly, X's section 199 deduction for 2006 is $16.
    (B) Y's tentative section 199 deduction is $38 (.03 x $1,282 
(QPAI determined at partner level) subject to the wage limitation of 
$144 (50% x $287 ($32 from PRS + $255 from non-PRS activities)). 
Accordingly, Y's section 199 deduction for 2006 is $38.
    Example 3. Partnership with special allocations. (i) In general. 
X and Y are unrelated corporate partners in PRS and each is engaged 
in a trade or business. PRS is a partnership that engages in a 
domestic production activity and other activities. In general, X and 
Y share all partnership items of income, gain, loss, deduction, and 
credit equally, except that 80% of the wage expense of PRS and 20% 
of PRS's other expenses are specially allocated to X (substantial 
economic effect under section 704(b) is presumed). In the 2006 
taxable year, PRS's only wage expense is $2,000 for marketing, which 
is not included in CGS. PRS has $8,000 of gross receipts ($6,000 of 
which is DPGR), $4,000 of CGS ($3,500 of which is allocable to 
DPGR), and $3,000 of deductions (comprised of $2,000 of wages for 
marketing and $1,000 of other expenses). X qualifies for and uses 
the simplified deduction method under Sec.  1.199-4(e). Y does not 
qualify to use that method and, therefore, must use the section 861 
method under Sec.  1.199-4(d). In the 2006 taxable year, X has gross 
receipts attributable to non-partnership trade or business 
activities of $1,000 and wages of $200. None of X's non-PRS gross 
receipts is DPGR.
    (ii) Allocation and apportionment of costs. Under the 
partnership agreement, X's distributive share of the items of PRS is 
$1,250 of gross income attributable to DPGR ($3,000 DPGR x $1,750 
allocable CGS), $750 of gross income attributable to non-DPGR 
($1,000 non-DPGR x $250 allocable CGS), and $1,800 of deductions 
(comprised of X's special allocations of $1,600 of wage expense 
($2,000 x 80%) for marketing and $200 of other expenses ($1,000 x 
20%)). Under the simplified deduction method, X apportions $1,200 of 
other deductions to DPGR ($2,000 ($1,800 from the partnership and 
$200 from non-partnership activities) x ($3,000 DPGR/$5,000 total 
gross receipts)). Accordingly, X's QPAI is $50 ($3,000 DPGR x $1,750 
CGS x $1,200 of deductions). However, in determining the section 
199(d)(1)(A)(iii) wage limitation, QPAI is computed taking into 
account only the items of PRS allocated to X for the taxable year of 
PRS. Thus, X apportions $1,350 of deductions to DPGR ($1,800 x 
($3,000 DPGR/$4,000 total gross receipts from PRS)). Accordingly, 
X's QPAI for purposes of the section 199(d)(1)(A)(iii) wage 
limitation is $0 ($3,000 DPGR x $1,750 CGS x $1,350 of deductions). 
X's share of PRS's W-2 wages is $0, the lesser of $1,600 (X's 80% 
allocable share of $2,000 of wage expense for marketing) and $0 (2 x 
($0 QPAI x .03)). X's tentative deduction is $2 ($50 QPAI x .03), 
subject to the section 199(b)(1) wage limitation of $100 (50% x $200 
($0 of PRS-related W-2 wages + $200 of non-PRS W-2 wages)). 
Accordingly, X's section 199 deduction for the 2006 taxable year is 
$2.
    Example 4. Partnership with no W-2 wages. (i) Facts. A, an 
individual, and B, an individual, are partners in PRS. PRS is a 
partnership that engages in manufacturing activities that generate 
both DPGR and non-DPGR. A and B share all items of income, gain, 
loss, deduction, and credit equally. In the 2006 taxable year, PRS 
has total gross receipts of $2,000 ($1,000 of which is DPGR), CGS of 
$400 and deductions of $800. PRS has no W-2 wages. A and B each use 
the small business simplified overall method under Sec.  1.199-4(f). 
A has trade or business activities outside of PRS. With respect to 
those activities, A has total gross receipts of $1,000 ($500 of 
which is DPGR), CGS of $400 (including $50 of W-2 wages) and 
deductions of $200 for the 2006 taxable year. B has no trade or 
business activities outside of PRS and pays $0 of W-2 wages directly 
for the 2006 taxable year. A's distributive share of the items of 
the partnership is $500 DPGR, $500 non-DPGR, $200 CGS, and $400 of 
deductions.
    (ii) Section 199(d)(1)(A)(iii) wage limitation. A's CGS and 
deductions apportioned to DPGR from PRS equal $300 (($200 CGS + $400 
of other deductions) x ($500 DPGR/$1,000 total gross receipts)). 
Accordingly, for purposes of the wage limitation of section 
199(d)(1)(A)(iii), A's QPAI is $200 ($500 DPGR x $300 CGS and other 
deductions). A's share of partnership W-2 wages after application of 
the section 199(d)(1)(A)(iii) limitation is $0, the lesser of $0 
(A's 50% allocable share of PRS's $0 of W-2 wages) or $12 (2 x ($200 
QPAI x .03)). B's share of PRS's W-2 wages also is $0.
    (iii) Section 199 deduction computation. A's total CGS and 
deductions apportioned to DPGR equal $600 (($200 PRS CGS + $400 
outside trade or business CGS + $400 PRS deductions + $200 outside 
trade or business deductions) x ($1,000 total DPGR ($500 from PRS + 
$500 from outside trade or business)/$2,000 total gross receipts 
($1,000 from PRS + $1,000 from outside trade or business)). 
Accordingly, A's QPAI is $400 ($1,000 DPGR x $600 CGS and 
deductions). A's tentative deduction is $12 ($400 QPAI x .03), 
subject to the section 199(b)(1) wage limitation of $25 (50% x $50 
total W-2 wages). A's section 199 deduction for the 2006 taxable 
year is $12. B's total section 199 deduction for the 2006 taxable 
year is $0 because B has no W-2 wages for the 2006 taxable year.
    Example 5. Guaranteed payment. (i) Facts. The facts are the same 
as Example 4 except that in 2006 PRS also makes a guaranteed payment 
of $200 to A for services, and PRS pays $200 of W-2 wages to PRS 
employees, which is included within the $400 of CGS. See section 
707(c). This guaranteed payment is taxable to A as ordinary income 
and is properly deducted by PRS under section 162. Pursuant to Sec.  
1.199-3(p), A may not treat any part of this payment as DPGR. 
Accordingly, PRS has total gross receipts of $2,000 ($1,000 of which 
is DPGR), CGS of $400 (including $200 of W-2 wages) and deductions 
of $1,000 (including the $200 guaranteed payment) for the 2006 
taxable year. A's distributive share of the items of the partnership 
is $500 DPGR, $500 non-DPGR, $200 CGS, and $500 of deductions.
    (ii) Section 199(d)(1)(A)(iii) wage limitation. A's CGS and 
deductions apportioned to DPGR from PRS equal $350 (($200 CGS + $500 
of other deductions) x ($500 DPGR/$1,000 total gross receipts)). 
Accordingly, for purposes of the wage limitation of section 
199(d)(1)(A)(iii), A's QPAI is $150 ($500 DPGR x $350 CGS and other 
deductions). A's share of partnership W-2 wages after application of 
the section 199(d)(1)(A)(iii) limitation is $9, the lesser of $100 
(A's 50% allocable share of PRS's $200 of W-2 wages) or $9 (2 x 
($150 QPAI x .03)). B's share of PRS's W-2 wages after application 
of section 199(d)(1)(A)(iii) also is $9.
    (iii) A's section 199 deduction computation. A's total CGS and 
deductions apportioned to DPGR equal $591 (($200 PRS CGS + $400 
outside trade or business CGS + $500 PRS deductions + $200 outside 
trade or business deductions) x ($1,000 total DPGR ($500 from PRS + 
$500 from outside trade or business)/$2,200 total gross receipts 
($1,000 from PRS + $200 guaranteed payment + $1,000 from outside 
trade or business)). Accordingly, A's QPAI is $409 ($1,000 DPGR x 
$591 CGS and other deductions). A's tentative deduction is $12 ($409 
QPAI x .03),

[[Page 31327]]

subject to the section 199(b)(1) wage limitation of $30 (50% x $59 
($9 PRS W-2 wages $50 + W-2 wages from A's trade or business 
activities outside of PRS)). A's section 199 deduction for the 2006 
taxable year is $12.
    (iv) B's section 199 deduction computation. B's QPAI is $150 
($500 DPGR x $350 CGS and other deductions). B's tentative deduction 
is $5 ($150 QPAI x .03), subject to the section 199(b)(1) wage 
limitation of $5 (50% x $9). Assuming that B engages in no other 
activities generating DPGR, B's section 199 deduction for the 2006 
taxable year is $5.

    (c) S corporations--(1) In general--(i) Determination at 
shareholder level. The section 199 deduction with respect to the 
qualified production activities of an S corporation is determined at 
the shareholder level. As a result, each shareholder must compute its 
deduction separately. The section 199 deduction will have no effect on 
the basis of a shareholder's stock in an S corporation. Except as 
provided by publication pursuant to paragraph (c)(1)(ii) of this 
section, for purposes of this section, each shareholder is allocated, 
in accordance with section 1366, its pro rata share of S corporation 
items (including items of income, gain, loss, and deduction), CGS 
allocated to such items of income, and gross receipts included in such 
items of income, even if the shareholder's share of CGS and other 
deductions and losses exceeds DPGR, and regardless of the amount of the 
shareholder's share of the W-2 wages of the S corporation for the 
taxable year. Except as provided by publication under paragraph 
(c)(1)(ii) of this section, to determine its section 199 deduction for 
the taxable year, the shareholder aggregates its pro rata share of such 
items, to the extent they are not otherwise disallowed by the Code, 
with those items it incurs outside the S corporation (whether directly 
or indirectly) for purposes of allocating and apportioning deductions 
to DPGR and computing its QPAI.
    (ii) Determination at entity level. The Secretary may, by 
publication in the Internal Revenue Bulletin (see Sec.  
601.601(d)(2)(ii)(b) of this chapter), permit an S corporation to 
calculate a shareholder's share of QPAI at the entity level, instead of 
allocating, in accordance with section 1366, the shareholder's pro rata 
share of S corporation items (including items of income, gain, loss, 
and deduction). If an S corporation does calculate QPAI at the entity 
level--
    (A) Each shareholder is allocated its share of QPAI and W-2 wages, 
which (subject to the limitations under paragraph (c)(2) of this 
section and section 199(d)(1)(A)(iii), respectively) are combined with 
the shareholder's QPAI and W-2 wages from other sources;
    (B) For purposes of computing QPAI under Sec. Sec.  1.199-1 through 
1.199-9, a shareholder does not take into account the items from such 
an S corporation (for example, a shareholder does not take into account 
items from such an S corporation in determining whether a threshold or 
de minimis rule applies or when the shareholder allocates and 
apportions deductions in calculating its QPAI from other sources);
    (C) A shareholder generally does not recompute its share of QPAI 
from the S corporation using another method; however, the shareholder 
might have to adjust its share of QPAI from the S corporation to take 
into account certain disallowed losses or deductions, or the allowance 
of suspended losses or deductions; and
    (D) A shareholder's share of QPAI from an S corporation may be less 
than zero.
    (2) Disallowed losses or deductions. Except as provided by 
publication in the Internal Revenue Bulletin (see Sec.  
601.601(d)(2)(ii)(b) of this chapter), losses or deductions of the S 
corporation that otherwise would be taken into account in computing the 
shareholder's section 199 deduction for a taxable year are taken into 
account in that year only if and to the extent the shareholder's pro 
rata share of the losses or deductions from all of the S corporation's 
activities is not disallowed by section 465, 469, or 1366(d), or any 
other provision of the Code. If only a portion of the shareholder's 
share of the losses or deductions is allowed for a taxable year, a 
proportionate share of those allowable losses or deductions that are 
allocated to the S corporation's qualified production activities, 
determined in a manner consistent with sections 465, 469, and 1366(d), 
and any other applicable provision of the Code, is taken into account 
in computing the QPAI and the wage limitation of section 
199(d)(1)(A)(iii) for that taxable year. To the extent that any of the 
disallowed losses or deductions are allowed in a later taxable year, 
the shareholder takes into account a proportionate share of those 
losses or deductions in computing its QPAI for that later taxable year. 
Losses or deductions of the S corporation that are disallowed for 
taxable years beginning on or before December 31, 2004, are not taken 
into account in a later taxable year for purposes of computing the 
shareholder's QPAI or the wage limitation of section 199(d)(1)(A)(iii) 
for that taxable year, regardless of whether the losses or deductions 
are allowed for other purposes.
    (3) Shareholder's share of W-2 wages. Under section 
199(d)(1)(A)(iii), an S corporation shareholder's share of the W-2 
wages of the S corporation for purposes of determining the 
shareholder's section 199(b) limitation is the lesser of the 
shareholder's allocable share of those wages (without regard to section 
199(d)(1)(A)(iii)), or 2 times 3 percent of the QPAI computed by taking 
into account only the items of the S corporation allocated to the 
shareholder for the taxable year of the S corporation. Except as 
provided by publication in the Internal Revenue Bulletin (see Sec.  
601.601(d)(2)(ii)(b) of this chapter), this QPAI calculation is 
performed by the shareholder using the same cost allocation method that 
the shareholder uses in calculating the shareholder's section 199 
deduction. The S corporation must allocate W-2 wages (prior to the 
application of the wage limitation) among the shareholders in the same 
manner as wage expense. The shareholder must add the shareholder's 
share of W-2 wages from the S corporation, as limited by section 
199(d)(1)(A)(iii), to the shareholder's W-2 wages from other sources, 
if any. If QPAI, computed by taking into account only the items of the 
S corporation allocated to the shareholder for the taxable year (as 
required by the wage limitation of section 199(d)(1)(A)(iii)), is not 
greater than zero, then the shareholder may not take into account any 
W-2 wages of the S corporation in applying the wage limitation of Sec.  
1.199-2 (but the shareholder will, nevertheless, aggregate its 
distributive share of S corporation items including wage expense with 
those items not from the S corporation in computing its QPAI when 
determining its section 199 deduction). See Sec.  1.199-2 for the 
computation of W-2 wages, and paragraph (g) of this section for rules 
regarding pass-thru entities in a tiered structure.
    (4) Transition percentage rule for W-2 wages. With regard to S 
corporations, for purposes of section 199(d)(1)(A)(iii)(II) the 
transition percentages determined under section 199(a)(2) shall be 
determined by reference to the S corporation's taxable year. Thus, if 
an S corporation shareholder uses a calendar year taxable year, and 
owns stock in an S corporation that has a taxable year ending on April 
30, the shareholder's section 199(d)(1)(A)(iii) wage limitation for the 
S corporation's taxable year beginning on May 1, 2006, would be 
calculated using 3 percent, even though the shareholder includes the

[[Page 31328]]

shareholder's pro rata share of S corporation items from that taxable 
year on the shareholder's 2007 Federal income tax return.
    (d) Grantor trusts. To the extent that the grantor or another 
person is treated as owning all or part (the owned portion) of a trust 
under sections 671 through 679, such person (owner) computes its QPAI 
with respect to the owned portion of the trust as if that QPAI had been 
generated by activities performed directly by the owner. Similarly, for 
purposes of the section 199(b) wage limitation, the owner of the trust 
takes into account the owner's share of the W-2 wages of the trust that 
are attributable to the owned portion of the trust. The section 
199(d)(1)(A)(iii) wage limitation is not applicable to the owned 
portion of the trust. The provisions of paragraph (e) of this section 
do not apply to the owned portion of a trust.
    (e) Non-grantor trusts and estates--(1) Allocation of costs. The 
trust or estate calculates each beneficiary's share (as well as the 
trust's or estate's own share, if any) of QPAI and W-2 wages from the 
trust or estate at the trust or estate level. The beneficiary of a 
trust or estate is not permitted to use another cost allocation method 
to recompute its share of QPAI from the trust or estate or to 
reallocate the costs of the trust or estate. Except as provided in 
paragraph (d) of this section, the QPAI of a trust or estate must be 
computed by allocating expenses described in section 199(d)(5) in one 
of two ways, depending on the classification of those expenses under 
Sec.  1.652(b)-3. Specifically, directly attributable expenses within 
the meaning of Sec.  1.652(b)-3 are allocated pursuant to Sec.  
1.652(b)-3, and expenses not directly attributable within the meaning 
of Sec.  1.652(b)-3 (other expenses) are allocated under the simplified 
deduction method of Sec.  1.199-4(e) (unless the trust or estate does 
not qualify to use the simplified deduction method, in which case it 
must use the section 861 method of Sec.  1.199-4(d) with respect to 
such other expenses). For this purpose, depletion and depreciation 
deductions described in section 642(e) and amortization deductions 
described in section 642(f) are treated as other expenses described in 
section 199(d)(5). Also for this purpose, the trust's or estate's share 
of other expenses from a lower-tier pass-thru entity is not directly 
attributable to any class of income (whether or not those other 
expenses are directly attributable to the aggregate pass-thru gross 
income as a class for purposes other than section 199). A trust or 
estate may not use the small business simplified overall method for 
computing its QPAI. See Sec.  1.199-4(f)(5).
    (2) Allocation among trust or estate and beneficiaries--(i) In 
general. The QPAI of a trust or estate (which will be less than zero if 
the CGS and deductions allocated and apportioned to DPGR exceed the 
trust's or estate's DPGR) and W-2 wages of the trust or estate are 
allocated to each beneficiary and to the trust or estate based on the 
relative proportion of the trust's or estate's distributable net income 
(DNI), as defined by section 643(a), for the taxable year that is 
distributed or required to be distributed to the beneficiary or is 
retained by the trust or estate. To the extent that the trust or estate 
has no DNI for the taxable year, any QPAI and W-2 wages are allocated 
entirely to the trust or estate. A trust or estate is allowed the 
section 199 deduction in computing its taxable income to the extent 
that QPAI and W-2 wages are allocated to the trust or estate. A 
beneficiary of a trust or estate is allowed the section 199 deduction 
in computing its taxable income based on its share of QPAI and W-2 
wages from the trust or estate, which (subject to the wage limitation 
as described in paragraph (e)(3) of this section) are aggregated with 
the beneficiary's QPAI and W-2 wages from other sources.
    (ii) Treatment of items from a trust or estate reporting qualified 
production activities income. When, pursuant to this paragraph (e), a 
taxpayer must combine QPAI and W-2 wages from a trust or estate with 
the taxpayer's total QPAI and W-2 wages from other sources, the 
taxpayer, when applying Sec. Sec.  1.199-1 through 1.199-9 to determine 
the taxpayer's total QPAI and W-2 wages from such other sources, does 
not take into account the items from such trust or estate. Thus, for 
example, a beneficiary of an estate that receives QPAI from the estate 
does not take into account the beneficiary's distributive share of the 
estate's gross receipts, gross income, or deductions when the 
beneficiary determines whether a threshold or de minimis rule applies 
or when the beneficiary allocates and apportions deductions in 
calculating its QPAI from other sources.
    (3) Beneficiary's share of W-2 wages. The trust or estate must 
compute each beneficiary's share of W-2 wages from the trust or estate 
in accordance with section 199(d)(1)(A)(iii), as if the beneficiary 
were a partner in a partnership. The application of section 
199(d)(1)(A)(iii) to each trust and estate therefore means that if 
QPAI, computed by taking into account only the items of the trust or 
estate allocated to the beneficiary for the taxable year, is not 
greater than zero, then the beneficiary may not take into account any 
W-2 wages of the trust or estate in applying the wage limitation of 
Sec.  1.199-2 (but the beneficiary will, nevertheless, aggregate its 
QPAI from the trust or estate with its QPAI from other sources when 
determining the beneficiary's section 199 deduction). See paragraph (g) 
of this section for rules applicable to pass-thru entities in a tiered 
structure.
    (4) Transition percentage rule for W-2 wages. With regard to trusts 
and estates, for purposes of section 199(d)(1)(A)(iii)(II), the 
transition percentages determined under section 199(a)(2) shall be 
determined by reference to the taxable year of the trust or estate.
    (5) Example. The following example illustrates the application of 
this paragraph (e) and paragraph (g) of this section. Assume that the 
partnership, trust, and trust beneficiary all are calendar year 
taxpayers.

    Example. (i) Computation of DNI and inclusion and deduction 
amounts. (A) Trust's distributive share of partnership items. Trust, 
a complex trust, is a partner in PRS, a partnership that engages in 
activities that generate DPGR and non-DPGR. In 2006, PRS distributes 
$10,000 cash to Trust. Trust's distributive share of PRS items, 
which are properly included in Trust's DNI, is as follows:

------------------------------------------------------------------------
 
------------------------------------------------------------------------
Gross income attributable to DPGR ($15,000 DPGR - $5,000         $10,000
 CGS (including W-2 wages of $1,000))...................
Gross income attributable to non-DPGR ($5,000 other                5,000
 gross receipts - $0 CGS)...............................
Selling expenses (includes W-2 wages of $2,000).........           3,000
Other expenses (includes W-2 wages of $1,000)...........           2,000
------------------------------------------------------------------------

    (B) Trust's direct activities. In addition to its cash 
distribution in 2006 from PRS, Trust also directly has the following 
items which are properly included in Trust's DNI:

[[Page 31329]]



------------------------------------------------------------------------
 
------------------------------------------------------------------------
Dividends...............................................         $10,000
Tax-exempt interest.....................................          10,000
Rents from commercial real property operated by Trust as          10,000
 a business.............................................
Real estate taxes.......................................           1,000
Trustee commissions.....................................           3,000
State income and personal property taxes................           5,000
W-2 wages for rental business...........................           2,000
Other business expenses.................................           1,000
------------------------------------------------------------------------

    (C) Allocation of deductions under Sec.  1.652(b)-3--(1) 
Directly attributable expenses. In computing Trust's DNI for the 
taxable year, the distributive share of expenses of PRS are directly 
attributable under Sec.  1.652(b)-3(a) to the distributive share of 
income of PRS. Accordingly, the $5,000 of CGS, $3,000 of selling 
expenses, and $2,000 of other expenses are subtracted from the gross 
receipts from PRS ($20,000), resulting in net income from PRS of 
$10,000. With respect to the Trust's direct expenses, $1,000 of the 
trustee commissions, the $1,000 of real estate taxes, and the $2,000 
of W-2 wages are directly attributable under Sec.  1.652(b)-3(a) to 
the rental income.
    (2) Non-directly attributable expenses. Under Sec.  1.652(b)-
3(b), the trustee must allocate a portion of the sum of the balance 
of the trustee commissions ($2,000), state income and personal 
property taxes ($5,000), and the other business expenses ($1,000) to 
the $10,000 of tax-exempt interest. The portion to be attributed to 
tax-exempt interest is $2,222 ($8,000 x ($10,000 tax exempt 
interest/$36,000 gross receipts net of direct expenses)), resulting 
in $7,778 ($10,000 - $2,222) of net tax-exempt interest. Pursuant to 
its authority recognized under Sec.  1.652(b)-3(b), the trustee 
allocates the entire amount of the remaining $5,778 of trustee 
commissions, state income and personal property taxes, and other 
business expenses to the $6,000 of net rental income, resulting in 
$222 ($6,000 - $5,778) of net rental income.
    (D) Amounts included in taxable income. For 2006, Trust has DNI 
of $28,000 (net dividend income of $10,000 + net PRS income of 
$10,000 + net rental income of $222 + net tax-exempt income of 
$7,778). Pursuant to Trust's governing instrument, Trustee 
distributes 50%, or $14,000, of that DNI to B, an individual who is 
a discretionary beneficiary of Trust. Assume that there are no 
separate shares under Trust, and no distributions are made to any 
other beneficiary that year. Consequently, with respect to the 
$14,000 distribution B receives from Trust, B properly includes in 
B's gross income $5,000 of income from PRS, $111 of rents, and 
$5,000 of dividends, and properly excludes from B's gross income 
$3,889 of tax-exempt interest. Trust includes $20,222 in its 
adjusted total income and deducts $10,111 under section 661(a) in 
computing its taxable income.
    (ii) Section 199 deduction. (A) Simplified deduction method. For 
purposes of computing the section 199 deduction for the taxable 
year, assume Trust qualifies for the simplified deduction method 
under Sec.  1.199-4(e). The determination of Trust's QPAI under the 
simplified deduction method requires multiple steps to allocate 
costs. First, the Trust's expenses directly attributable to DPGR 
under Sec.  1.652(b)-3(a) are subtracted from the Trust's DPGR. In 
this step, the directly attributable $5,000 of CGS and selling 
expenses of $3,000 are subtracted from the $15,000 of DPGR from PRS. 
Next, Trust must identify its other trade or business expenses 
directly related to non-DPGR trade or business income. In this 
example, the portion of the trustee commissions not directly 
attributable to the rental operation ($2,000), as well as the 
portion of the state income and personal property taxes not directly 
attributable to either the PRS interests or the rental operation, 
are not trade or business expenses and, thus, are ignored in 
computing QPAI. The portion of the state income and personal 
property taxes that is treated as other trade or business expenses 
is $3,000 ($5,000 x $30,000 total trade or business gross receipts/
$50,000 total gross receipts). Trust then allocates its other trade 
or business expenses on the basis of its total gross receipts from 
the conduct of a trade or business ($20,000 from PRS + $10,000 
rental income). Trust then combines its non-directly attributable 
(other) business expenses ($2,000 from PRS + $4,000 ($1,000 of other 
expenses + $3,000 of income and property taxes) from its own 
activities) and then apportions this total between DPGR and other 
receipts on the basis of Trust's total trade or business gross 
receipts ($6,000 x $15,000 DPGR/$30,000 total trade or business 
gross receipts = $3,000). Thus, for purposes of computing Trust's 
and B's section 199 deduction, Trust's QPAI is $4,000 ($7,000 - 
$3,000). Because the distribution of Trust's DNI to B equals one-
half of Trust's DNI, Trust and B each has QPAI from PRS for purposes 
of the section 199 deduction of $2,000.
    (B) Section 199(d)(1)(A)(iii) wage limitation. The wage 
limitation under section 199(d)(1)(A)(iii) must be applied both at 
the Trust level and at B's level. After applying this limitation to 
the Trust's share of PRS's W-2 wages, Trust is allocated $330 of W-2 
wages from PRS (the lesser of Trust's allocable share of PRS's W-2 
wages ($4,000) or 2 x 3% of Trust's QPAI from PRS ($5,500)). Trust's 
QPAI from PRS for purposes of the section 199(d)(1)(A)(iii) 
limitation is determined by taking into account only the items of 
PRS allocated to Trust ($15,000 DPGR - ($5,000 of CGS + $3,000 
selling expenses + $1,500 of other expenses)). For this purpose, the 
$1,500 of other expenses is determined by multiplying $2,000 of 
other expenses from PRS by $15,000 of DPGR from PRS, divided by 
$20,000 of total gross receipts from PRS. Trust adds this $330 of W-
2 wages to Trust's own $2,000 of W-2 wages (thus, $2,330). Because 
the $14,000 Trust distribution to B equals one-half of Trust's DNI, 
Trust and B each has W-2 wages of $1,165. After applying the section 
199(d)(1)(A)(iii) wage limitation to B's share of the W-2 wages 
allocated from Trust, B has W-2 wages of $120 from Trust (lesser of 
$1,165 (allocable share of W-2 wages) or 2 x .03 x $2,000 (B's share 
of Trust's QPAI)). B has W-2 wages of $100 from non-Trust activities 
for a total of $220 of W-2 wages.
    (C) Section 199 deduction computation. (1) B's computation. B is 
eligible to use the small business simplified overall method. Assume 
that B has sufficient adjusted gross income so that the section 199 
deduction is not limited under section 199(a)(1)(B). B has $1,000 of 
QPAI from non-Trust activities that is added to the $2,000 QPAI from 
Trust for a total of $3,000 of QPAI. B's tentative deduction is $90 
(.03 x $3,000), but it is limited under section 199(b) to $110 (50% 
x $220 W-2 wages). Accordingly, B's section 199 deduction for 2006 
is $90.
    (2) Trust's computation. Trust has sufficient adjusted gross 
income so that the section 199 deduction is not limited under 
section 199(a)(1)(B). Trust's tentative deduction is $60 (.03 x 
$2,000 QPAI), but it is limited under section 199(b) to $583 (50% x 
$1,165 W-2 wages). Accordingly, Trust's section 199 deduction for 
2006 is $60.

    (f) Gain or loss from the disposition of an interest in a pass-thru 
entity. DPGR generally does not include gain or loss recognized on the 
sale, exchange, or other disposition of an interest in a pass-thru 
entity. However, with respect to a partnership, if section 751(a) or 
(b) applies, then gain or loss attributable to assets of the 
partnership giving rise to ordinary income under section 751(a) or (b), 
the sale, exchange, or other disposition of which would give rise to 
DPGR, is taken into account in computing the partner's section 199 
deduction. Accordingly, to the extent that cash or property received by 
a partner in a sale or exchange for all or part of its partnership 
interest is attributable to unrealized receivables or inventory items 
within the meaning of section 751(c) or (d), respectively, and the sale 
or exchange of the unrealized receivable or inventory items would give 
rise to DPGR if sold, exchanged, or otherwise disposed of by the 
partnership, the cash or property received by the partner is taken into 
account by the partner in determining its DPGR for the taxable year. 
Likewise, to the extent that a distribution of property to a partner is 
treated under

[[Page 31330]]

section 751(b) as a sale or exchange of property between the 
partnership and the distributee partner, and any property deemed sold 
or exchanged would give rise to DPGR if sold, exchanged, or otherwise 
disposed of by the partnership, the deemed sale or exchange of the 
property must be taken into account in determining the partnership's 
and distributee partner's DPGR to the extent not taken into account 
under the qualifying in-kind partnership rules. See Sec.  1.751-1(b) 
and paragraph (i) of this section.
    (g) Section 199(d)(1)(A)(iii) wage limitation and tiered 
structures--(1) In general. If a pass-thru entity owns an interest, 
directly or indirectly, in one or more pass-thru entities, then the 
wage limitation of section 199(d)(1)(A)(iii) must be applied at each 
tier (that is, separately for each entity). For purposes of this wage 
limitation, references to pass-thru entities includes partnerships, S 
corporations, trusts (to the extent not described in paragraph (d) of 
this section) and estates. Thus, at each tier, the owner of a pass-thru 
entity (or the entity on behalf of the owner) calculates the amounts 
described in sections 199(d)(1)(A)(iii)(I) (owner's allocable share) 
and 199(d)(1)(A)(iii)(II) (twice the applicable percentage of the 
owner's QPAI from that entity) separately with regard to its interest 
in that pass-thru entity.
    (2) Share of W-2 wages. For purposes of section 199(d)(1)(A)(iii) 
and section 199(b), the W-2 wages of the owner of an interest in a 
pass-thru entity (upper-tier entity) that owns an interest in one or 
more pass-thru entities (lower-tier entities) are equal to the sum of 
the owner's allocable share of W-2 wages of the upper-tier entity, as 
limited in accordance with section 199(d)(1)(A)(iii), and the owner's 
own W-2 wages. The upper-tier entity's W-2 wages are equal to the sum 
of the upper-tier entity's allocable share of W-2 wages of the next 
lower-tier entity, as limited in accordance with section 
199(d)(1)(A)(iii), and the upper-tier entity's own W-2 wages. The W-2 
wages of each lower-tier entity in a tiered structure, in turn, is 
computed as described in the preceding sentence. Except as provided by 
publication in the Internal Revenue Bulletin (see Sec.  
601.601(d)(2)(ii)(b) of this chapter)--
    (i) An upper-tier entity may compute its share of QPAI attributable 
to items from a lower-tier entity solely for purposes of section 
199(d)(1)(A)(iii)(II) by applying either the section 861 method 
described in Sec.  1.199-4(d) or the simplified deduction method 
described in Sec.  1.199-4(e), provided the upper tier entity would 
otherwise qualify to use such method.
    (ii) Alternatively, the upper-tier entity (other than a trust or 
estate described in paragraph (e) of this section) may compute its 
share of QPAI attributable to items from a lower-tier entity solely for 
purposes of section 199(d)(1)(A)(iii)(II) by applying the small 
business simplified overall method described in Sec.  1.199-4(f), 
regardless of whether such upper-tier entity would otherwise qualify to 
use the small business simplified overall method.
    (3) Example. The following example illustrates the application of 
this paragraph (g). Assume that each partnership and each partner 
(whether or not an individual) is a calendar year taxpayer.

    Example. (i) In 2006, A, an individual, owns a 50% interest in a 
partnership, UTP, which in turn owns a 50% interest in another 
partnership, LTP. All partnership items are allocated in proportion 
to these ownership percentages. LTP has $900 DPGR, $450 CGS (which 
includes W-2 wages of $100), and $50 other deductions. Before taking 
into account its share of items from LTP, UTP has $500 DPGR, $500 
CGS (which includes W-2 wages of $200), and $500 other deductions. 
UTP chooses to compute its share of QPAI attributable to items from 
LTP for purposes of section 199(d)(1)(A)(iii)(II) by applying the 
small business simplified overall method described in Sec.  1.199-
4(f). For purposes of the wage limitation of section 
199(d)(1)(A)(iii), UTP's distributive share of LTP's QPAI is $200 
($450 DPGR - $250 CGS and other deductions).
    (ii) UTP's share of LTP's W-2 wages for purposes of the section 
199(d)(1)(A)(iii) limitation is $12, the lesser of $50 (UTP's 50% 
allocable share of LTP's $100 of W-2 wages) or $12 (2 x ($200 QPAI x 
.03)). After taking into account its share of items from LTP, UTP 
has $950 DPGR, $725 CGS, and $525 other deductions. A is eligible 
for and uses the simplified deduction method described in Sec.  
1.199-4(e). For purposes of the wage limitation of section 
199(d)(1)(A)(iii), A's distributive share of UTP's QPAI is ($151) 
($475 DPGR - $363 CGS - $263 other deductions). A's wage limitation 
under section 199(d)(1)(A)(iii) with respect to A's interest in UTP 
is $0, the lesser of $106 (A's 50% allocable share of UTP's $212 of 
W-2 wages) or $0 (because A's share of UTP's QPAI ($151), is less 
than zero).

    (h) No attribution of qualified activities. Except as provided in 
paragraph (i) of this section regarding qualifying in-kind partnerships 
and paragraph (j) of this section regarding EAG partnerships, an owner 
of a pass-thru entity is not treated as conducting the qualified 
production activities of the pass-thru entity, and vice versa. For 
example, if a partnership MPGE QPP within the United States, or 
produces a qualified film or produces utilities in the United States, 
and distributes or leases, rents, licenses, sells, exchanges, or 
otherwise disposes of such property to a partner who then, without 
performing its own qualifying MPGE or other production, leases, rents, 
licenses, sells, exchanges, or otherwise disposes of such property, 
then the partner's gross receipts from this latter lease, rental, 
license, sale, exchange, or other disposition are treated as non-DPGR. 
In addition, if a partner MPGE QPP within the United States, or 
produces a qualified film or produces utilities in the United States, 
and contributes or leases, rents, licenses, sells, exchanges, or 
otherwise disposes of such property to a partnership which then, 
without performing its own qualifying MPGE or other production, leases, 
rents, licenses, sells, exchanges, or otherwise disposes of such 
property, then the partnership's gross receipts from this latter 
disposition are treated as non-DPGR.
    (i) Qualifying in-kind partnership--(1) In general. If a 
partnership is a qualifying in-kind partnership described in paragraph 
(i)(2) of this section, then each partner is treated as MPGE or 
producing the property MPGE or produced by the partnership that is 
distributed to that partner. If a partner of a qualifying in-kind 
partnership derives gross receipts from the lease, rental, license, 
sale, exchange, or other disposition of the property that was MPGE or 
produced by the qualifying in-kind partnership, then, provided such 
partner is a partner of the qualifying in-kind partnership at the time 
the partner disposes of the property, the partner is treated as 
conducting the MPGE or production activities previously conducted by 
the qualifying in-kind partnership with respect to that property. With 
respect to a lease, rental, or license, the partner is treated as 
having disposed of the property on the date or dates on which it takes 
into account its gross receipts derived from the lease, rental, or 
license under its methods of accounting. With respect to a sale, 
exchange, or other disposition, the partner is treated as having 
disposed of the property on the date on which it ceases to own the 
property for Federal income tax purposes, even if no gain or loss is 
taken into account.
    (2) Definition of qualifying in-kind partnership. For purposes of 
this paragraph (i), a qualifying in-kind partnership is a partnership 
engaged solely in--
    (i) The extraction, refining, or processing of oil, natural gas (as 
described in Sec.  1.199-3(l)(2)), petrochemicals, or products derived 
from oil, natural gas, or petrochemicals

[[Page 31331]]

in whole or in significant part within the United States;
    (ii) The production or generation of electricity in the United 
States; or
    (iii) An activity or industry designated by the Secretary by 
publication in the Internal Revenue Bulletin (see Sec.  
601.601(d)(2)(ii)(b) of this chapter).
    (3) Special rules for distributions. If a qualifying in-kind 
partnership distributes property to a partner, then, solely for 
purposes of section 199(d)(1)(A)(iii)(II), the partnership is treated 
as having gross receipts in the taxable year of the distribution equal 
to the fair market value of the distributed property at the time of 
distribution to the partner and the deemed gross receipts are allocated 
to that partner, provided that the partner derives gross receipts from 
the distributed property (and takes into account such receipts under 
its method of accounting) during the taxable year of the partner with 
or within which the partnership's taxable year (in which the 
distribution occurs) ends. For rules for taking costs into account 
(such as costs included in the adjusted basis of the distributed 
property), see Sec.  1.199-4.
    (4) Other rules. Except as provided in this paragraph (i), a 
qualifying in-kind partnership is treated the same as other 
partnerships for purposes of section 199. Accordingly, a qualifying in-
kind partnership is subject to the rules of this section regarding the 
application of section 199 to pass-thru entities, including application 
of the section 199(d)(1)(A)(iii) wage limitation under paragraph (b)(3) 
of this section. In determining whether a qualifying in-kind 
partnership or its partners MPGE QPP in whole or in significant part 
within the United States, see Sec.  1.199-3(g)(2) and (3).
    (5) Example. The following example illustrates the application of 
this paragraph (i). Assume that PRS and X are calendar year taxpayers.

    Example. X, Y and Z are partners in PRS, a qualifying in-kind 
partnership described in paragraph (i)(2) of this section. X, Y, and 
Z are corporations. In 2006, PRS distributes oil to X that PRS 
derived from its oil extraction. PRS incurred $600 of CGS, including 
$500 of W-2 wages (as defined in Sec.  1.199-2(e)), extracting the 
oil distributed to X, and X's adjusted basis in the distributed oil 
is $600. The fair market value of the oil at the time of the 
distribution to X is $1,000. X incurs $200 of CGS, including $100 of 
W-2 wages, in refining the oil within the United States. In 2006, X, 
while it is a partner in PRS, sells the oil to a customer for 
$1,500, taking the gross receipts into account under its method of 
accounting in the same taxable year. Under paragraph (i)(1) of this 
section, X is treated as having extracted the oil. The extraction 
and refining of the oil qualify as an MPGE activity under Sec.  
1.199-3(e)(1). Therefore, X's $1,500 of gross receipts qualify as 
DPGR. X subtracts from the $1,500 of DPGR the $600 of CGS incurred 
by PRS and the $200 of refining costs incurred by X. Thus, X's QPAI 
is $700 for 2006. In addition, PRS is treated as having $1,000 of 
DPGR solely for purposes of applying the wage limitation in section 
199(d)(1)(A)(iii) based on the applicable percentage of QPAI. 
Accordingly, X's share of PRS's W-2 wages determined under section 
199(d)(1)(A)(iii) is $24, the lesser of $500 (X's allocable share of 
PRS's W-2 wages included in CGS) and $24 (2 x ($400 ($1,000 deemed 
DPGR less $600 of CGS) x .03)). X adds the $24 of PRS W-2 wages to 
its $100 of W-2 wages incurred in refining the oil for purposes of 
section 199(b).

    (j) Partnerships owned by members of a single expanded affiliated 
group--(1) In general. For purposes of this section, if all of the 
interests in the capital and profits of a partnership are owned by 
members of a single EAG at all times during the taxable year of the 
partnership (EAG partnership), then the EAG partnership and all members 
of that EAG are treated as a single taxpayer for purposes of section 
199(c)(4) during that taxable year.
    (2) Attribution of activities--(i) In general. If a member of an 
EAG (disposing member) derives gross receipts from the lease, rental, 
license, sale, exchange, or other disposition of property that was MPGE 
or produced by an EAG partnership, all the partners of which are 
members of the same EAG to which the disposing member belongs at the 
time that the disposing member disposes of such property, then the 
disposing member is treated as conducting the MPGE or production 
activities previously conducted by the EAG partnership with respect to 
that property. The previous sentence applies only for those taxable 
years in which the disposing member is a member of the EAG of which all 
the partners of the EAG partnership are members for the entire taxable 
year of the EAG partnership. With respect to a lease, rental, or 
license, the disposing member is treated as having disposed of the 
property on the date or dates on which it takes into account its gross 
receipts from the lease, rental, or license under its methods of 
accounting. With respect to a sale, exchange, or other disposition, the 
disposing member is treated as having disposed of the property on the 
date on which it ceases to own the property for Federal income tax 
purposes, even if no gain or loss is taken into account. Likewise, if 
an EAG partnership derives gross receipts from the lease, rental, 
license, sale, exchange, or other disposition of property that was MPGE 
or produced by a member (or members) of the same EAG (the producing 
member) to which all the partners of the EAG partnership belong at the 
time that the EAG partnership disposes of such property, then the EAG 
partnership is treated as conducting the MPGE or production activities 
previously conducted by the producing member with respect to that 
property. The previous sentence applies only for those taxable years in 
which the producing member is a member of the EAG of which all the 
partners of the EAG partnership are members for the entire taxable year 
of the EAG partnership. With respect to a lease, rental, or license, 
the EAG partnership is treated as having disposed of the property on 
the date or dates on which it takes into account its gross receipts 
derived from the lease, rental, or license under its methods of 
accounting. With respect to a sale, exchange, or other disposition, the 
EAG partnership is treated as having disposed of the property on the 
date on which it ceases to own the property for Federal income tax 
purposes, even if no gain or loss is taken into account. See paragraph 
(j)(5) Example 3 of this section.
    (ii) Attribution between EAG partnerships. If an EAG partnership 
(disposing partnership) derives gross receipts from the lease, rental, 
license, sale, exchange, or other disposition of property that was MPGE 
or produced by another EAG partnership (producing partnership), then 
the disposing partnership is treated as conducting the MPGE or 
production activities previously conducted by the producing partnership 
with respect to that property, provided that the producing partnership 
and the disposing partnership are owned by members of the same EAG for 
the entire taxable year of the respective partnership in which the 
disposing partnership disposes of such property. With respect to a 
lease, rental, or license, the disposing partnership is treated as 
having disposed of the property on the date or dates on which it takes 
into account its gross receipts from the lease, rental, or license 
under its methods of accounting. With respect to a sale, exchange, or 
other disposition, the disposing partnership is treated as having 
disposed of the property on the date on which it ceases to own the 
property for Federal income tax purposes, even if no gain or loss is 
taken into account.
    (iii) Exceptions to attribution. Attribution of activities does not 
apply for purposes of the construction of real property under Sec.  
1.199-3(m)(1) and the performance of engineering and architectural 
services under Sec.  1.199-3(n)(2) and (3), respectively.

[[Page 31332]]

    (3) Special rules for distributions. If an EAG partnership 
distributes property to a partner, then, solely for purposes of section 
199(d)(1)(A)(iii)(II), the EAG partnership is treated as having gross 
receipts in the taxable year of the distribution equal to the fair 
market value of the property at the time of distribution to the partner 
and the deemed gross receipts are allocated to that partner, provided 
that the partner derives gross receipts from the distributed property 
(and takes such receipts into account under its methods of accounting) 
during the taxable year of the partner with or within which the 
partnership's taxable year (in which the distribution occurs) ends. For 
rules for taking costs into account (such as costs included in the 
adjusted basis of the distributed property), see Sec.  1.199-4.
    (4) Other rules. Except as provided in this paragraph (j), an EAG 
partnership is treated the same as other partnerships for purposes of 
section 199. Accordingly, an EAG partnership is subject to the rules of 
this section regarding the application of section 199 to pass-thru 
entities, including application of the section 199(d)(1)(A)(iii) wage 
limitation under paragraph (b)(3) of this section. In determining 
whether a member of an EAG or an EAG partnership MPGE QPP in whole or 
in significant part within the United States or produced a qualified 
film or produced utilities within the United States, see Sec.  1.199-
3(g)(2) and (3) and Example 5 of paragraph (j)(5) of this section.
    (5) Examples. The following examples illustrate the rules of this 
paragraph (j). Assume that PRS, X, Y, and Z all are calendar year 
taxpayers.

    Example 1. Contribution. X and Y are the only partners in PRS, a 
partnership, for PRS's entire 2006 taxable year. X and Y are both 
members of a single EAG for the entire 2006 year. In 2006, X MPGE 
QPP within the United States and contributes the property to PRS. In 
2006, PRS sells the QPP for $1,000. Under this paragraph (j), PRS is 
treated as having MPGE the QPP within the United States, and PRS's 
$1,000 gross receipts constitute DPGR. PRS, X, and Y must apply the 
rules of this section regarding the application of section 199 to 
pass-thru entities with respect to the activity of PRS, including 
application of the section 199(d)(1)(A)(iii) wage limitation under 
paragraph (b)(3) of this section.
    Example 2. Sale. X, Y, and Z are the only members of a single 
EAG for the entire 2006 year. X and Y each own 50% of the capital 
and profits interests in PRS, a partnership, for PRS's entire 2006 
taxable year. In 2006, PRS MPGE QPP within the United States and 
then sells the property to X for $6,000, its fair market value at 
the time of the sale. PRS's gross receipts of $6,000 qualify as 
DPGR. In 2006, X sells the QPP to customers for $10,000, incurring 
selling expenses of $2,000. Under this paragraph (j), X is treated 
as having MPGE the QPP within the United States, and X's $10,000 of 
gross receipts qualify as DPGR. PRS, X and Y must apply the rules of 
this section regarding the application of section 199 to pass-thru 
entities with respect to the activity of PRS, including application 
of the section 199(d)(1)(A)(iii) wage limitation under paragraph 
(b)(3) of this section. The results would be the same if PRS sold 
the property to Z rather than to X.
    Example 3. Lease. X, Y, and Z are the only members of a single 
EAG for the entire 2005 year. X and Y each own 50% of the capital 
and profits interests in PRS, a partnership, for PRS's entire 2005 
taxable year. In 2005, PRS MPGE QPP within the United States and 
then sells the property to X for $6,000, its fair market value at 
the time of the sale. PRS's gross receipts of $6,000 qualify as 
DPGR. In 2005, X rents the QPP it acquired from PRS to customers 
unrelated to X. X takes the gross receipts attributable to the 
rental of the QPP into account under its methods of accounting in 
2005 and 2006. On July 1, 2006, X ceases to be a member of the same 
EAG to which Y, the other partner in PRS, belongs. For 2005, X is 
treated as having MPGE the QPP in the United States, and its gross 
receipts derived from the rental of the QPP qualify as DPGR. For 
2006, however, because X and Y, partners in PRS, are no longer 
members of the same EAG for the entire year, the gross rental 
receipts X takes into account in 2006 do not qualify as DPGR.
    Example 4. Distribution. X and Y are the only partners in PRS, a 
partnership, for PRS's entire 2006 taxable year. X and Y are both 
members of a single EAG for the entire 2006 year. In 2006, PRS MPGE 
QPP within the United States, incurring $600 of CGS, including $500 
of W-2 wages (as defined in Sec.  1.199-2(e)), and then distributes 
the QPP to X. X's adjusted basis in the QPP is $600. At the time of 
the distribution, the fair market value of the QPP is $1,000. X 
incurs $200 of directly allocable costs, including $100 of W-2 
wages, to further MPGE the QPP within the United States. In 2006, X 
sells the QPP for $1,500 to an unrelated customer and takes the 
gross receipts into account under its method of accounting in the 
same taxable year. Under paragraph (j)(1) of this section, X is 
treated as having MPGE the QPP within the United States, and X's 
$1,500 of gross receipts qualify as DPGR. In addition, PRS is 
treated as having DPGR of $1,000 solely for purposes of applying the 
wage limitation in section 199(d)(1)(A)(iii) based on the applicable 
percentage of QPAI.
    Example 5. Multiple sales. (i) Facts. X and Y are the only 
partners in PRS, a partnership, for PRS's entire 2006 taxable year. 
X and Y are both non-consolidated members of a single EAG for the 
entire 2006 year. PRS produces in bulk form in the United States the 
active ingredient for a pharmaceutical product. Assume that PRS's 
own MPGE activity with respect to the active ingredient is not 
substantial in nature, taking into account all of the facts and 
circumstances, and PRS's direct labor and overhead to MPGE the 
active ingredient within the United States are $15 and account for 
15% of PRS's $100 CGS of the active ingredient. In 2006, PRS sells 
the active ingredient in bulk form to X. X uses the active 
ingredient to produce the finished dosage form drug. Assume that X's 
own MPGE activity with respect to the drug is not substantial in 
nature, taking into account all of the facts and circumstances, and 
X's direct labor and overhead to MPGE the drug within the United 
States are $12 and account for 10% of X's $120 CGS of the drug. In 
2006, X sells the drug in finished dosage to Y and Y sells the drug 
to customers. Assume that Y's own MPGE activity with respect to the 
drug is not substantial in nature, taking into account all of the 
facts and circumstances, and Y incurs $2 of direct labor and 
overhead and Y's CGS in selling the drug to customers is $130.
    (ii) Analysis. PRS's gross receipts from the sale of the active 
ingredient to X are non-DPGR because PRS's MPGE activity is not 
substantial in nature and PRS does not satisfy the safe harbor 
described in Sec.  1.199-3(g)(3) because PRS's direct labor and 
overhead account for less than 20% of PRS's CGS of the active 
ingredient. X's gross receipts from the sale of the drug to Y are 
DPGR because X is considered to have MPGE the drug in significant 
part in the United States pursuant to the safe harbor described in 
Sec.  1.199-3(g)(3) because the $27 ($15 + $12) of direct labor and 
overhead incurred by PRS and X equals or exceeds 20% of X's total 
CGS ($120) of the drug at the time X disposes of the drug to Y. 
Similarly, Y's gross receipts from the sale of the drug to customers 
are DPGR because Y is considered to have MPGE the drug in 
significant part in the United States pursuant to the safe harbor 
described in Sec.  1.199-3(g)(3) because the $29 ($15 + $12 + $2) of 
direct labor and overhead incurred by PRS, X, and Y equals or 
exceeds 20% of Y's total CGS ($130) of the drug at the time Y 
disposes of the drug to Y's customers.

    (k) Effective dates. Section 199 applies to taxable years beginning 
after December 31, 2004. 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 1.199-9 does 
not apply to taxable years beginning after May 17, 2006, the enactment 
date of the Tax Increase Prevention and Reconciliation Act of 2005 
(Public Law 109-222, 120 Stat. 345). For taxable years beginning on or 
before May 17, 2006, a taxpayer must apply Sec.  1.199-9 if the 
taxpayer applies Sec. Sec.  1.199-1 through 1.199-8 to that taxable 
year. Notwithstanding the preceding sentence, a partnership or S 
corporation that is a qualifying small taxpayer under Sec.  1.199-4(f) 
of REG-105847-05 (2005-47 I.R.B. 987) (see Sec.  601.601(d)(2) of this 
chapter) may use the small business simplified overall method to 
apportion CGS and deductions between DPGR and non-DPGR at the entity 
level under Sec.  1.199-4(f) of REG-105847-05 for taxable years

[[Page 31333]]

beginning on or before May 17, 2006. If a taxpayer chooses not to rely 
on Sec. Sec.  1.199-1 through 1.199-9 (as provided in Sec.  1.199-8(i)) 
for a taxable year beginning before June 1, 2006, the guidance under 
section 199 that applies to taxable years beginning before June 1, 
2006, is contained in Notice 2005-14 (2005-1 C.B. 498) (see Sec.  
601.601(d)(2) of this chapter). In addition, a taxpayer also may rely 
on the provisions of REG-105847-05 for taxable years beginning before 
June 1, 2006. If Notice 2005-14 and REG-105847-05 include different 
rules for the same particular issue, then a taxpayer may rely on either 
the rule set forth in Notice 2005-14 or the rule set forth in REG-
105847-05. However, if REG-105847-05 includes a rule that was not 
included in Notice 2005-14, then a taxpayer is not permitted to rely on 
the absence of a rule in Notice 2005-14 to apply a rule contrary to 
REG-105847-05. For taxable years beginning after May 17, 2006, and 
before June 1, 2006, a taxpayer may not apply Notice 2005-14, REG-
105847-05, or any other guidance under section 199 in a manner 
inconsistent with amendments made to section 199 by section 514 of the 
Tax Increase Prevention and Reconciliation Act of 2005.

PART 602--OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT

0
Par. 3. The authority citation for part 602 continues to read as 
follows:

    Authority: 26 U.S.C. 7805.

0
Par. 4. In Sec.  602.101, paragraph (b) is amended by adding an entry 
to the table in numerical order to read, in part, as follows:


Sec.  602.101  OMB Control numbers.

* * * * *
    (b) * * *

------------------------------------------------------------------------
                                                            Current OMB
   CFR part or section where identified and described       control No.
------------------------------------------------------------------------
 
                                * * * * *
1.199-6.................................................       1545-1966
 
                                * * * * *
------------------------------------------------------------------------


Mark E. Matthews,
Deputy Commissioner for Services and Enforcement.
    Approved: May 2, 2006.
Eric Solomon,
Acting Deputy Assistant Secretary of the Treasury.
[FR Doc. 06-4829 Filed 5-24-06; 11:47 am]
BILLING CODE 4830-01-P