[Federal Register Volume 80, Number 166 (Thursday, August 27, 2015)]
[Proposed Rules]
[Pages 51978-51990]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2015-20772]



[[Page 51978]]

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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-136459-09]
RIN 1545-BI90


Amendments to Domestic Production Activities Deduction 
Regulations; Allocation of W-2 Wages in a Short Taxable Year and in an 
Acquisition or Disposition

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking, notice of proposed rulemaking by 
cross reference to temporary regulations and notice of public hearing.

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SUMMARY: This document contains proposed regulations involving the 
domestic production activities deduction under section 199 of the 
Internal Revenue Code (Code). The proposed regulations provide guidance 
to taxpayers on the amendments made to section 199 by the Energy 
Improvement and Extension Act of 2008 and the Tax Extenders and 
Alternative Minimum Tax Relief Act of 2008, involving oil related 
qualified production activities income and qualified films, and the 
American Taxpayer Relief Act of 2012, involving activities in Puerto 
Rico. The proposed regulations also provide guidance on: Determining 
domestic production gross receipts; the terms manufactured, produced, 
grown, or extracted; contract manufacturing; hedging transactions; 
construction activities; allocating cost of goods sold; and 
agricultural and horticultural cooperatives. In the Rules and 
Regulations of this issue of the Federal Register, the Treasury 
Department and the IRS also are issuing temporary regulations (TD 9731) 
clarifying how taxpayers calculate W-2 wages for purposes of the W-2 
wage limitation in the case of a short taxable year or an acquisition 
or disposition of a trade or business (including the major portion of a 
trade or business, or the major portion of a separate unit of a trade 
or business) during the taxable year. This document also contains a 
notice of a public hearing on the proposed regulations.

DATES: Written or electronic comments must be received by November 25, 
2015. Outlines of topics to be discussed at the public hearing 
scheduled for December 16, 2015, at 10:00 a.m., must be received by 
November 25, 2015.

ADDRESSES: Send submissions to: CC:PA:LPD:PR (REG-136459-09), Room 
5203, Internal Revenue Service, P.O. Box 7604, Ben Franklin Station, 
Washington, DC 20044. Submissions may be hand-delivered Monday through 
Friday between the hours of 8 a.m. and 4 p.m. to CC:PA:LPD:PR (REG-
136459-09), Courier's Desk, Internal Revenue Service, 1111 Constitution 
Avenue NW., Washington, DC, or sent electronically, via the Federal 
eRulemaking Portal at http://www.regulations.gov (IRS REG-136459-09). 
The public hearing will be held in the Auditorium of the Internal 
Revenue Building, 1111 Constitution Avenue NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning Sec. Sec.  1.199-1(f), 
1.199-2(c), 1.199-2(e), 1.199-2(f), 1.199-3(b), 1.199-3(e), 1.199-3(h), 
1.199-3(k), 1.199-3(m), 1.199-6(m), and 1.199-8(i) of the proposed 
regulations, James Holmes, (202) 317-4137; concerning Sec.  1.199-4(b) 
of the proposed regulations, Natasha Mulleneaux (202) 317-7007; 
concerning submissions of comments, the hearing, or to be placed on the 
building access list to attend the hearing, Regina Johnson, at (202) 
317-6901 (not toll-free numbers).

SUPPLEMENTARY INFORMATION: 

Background

    This document contains proposed amendments to Sec. Sec.  1.199-0, 
1.199-1, 1.199-2, 1.199-3, 1.199-4(b), 1.199-6, and 1.199-8(i) of the 
Income Tax Regulations (26 CFR part 1). Section 1.199-1 relates to 
income that is attributable to domestic production activities. Section 
1.199-2 relates to W-2 wages as defined in section 199(b). Section 
1.199-3 relates to determining domestic production gross receipts 
(DPGR). Section 1.199-4(b) describes the costs of goods sold allocable 
to DPGR. Section 1.199-6 applies to agricultural and horticultural 
cooperatives. Section 1.199-8(i) provides the effective/applicability 
dates.
    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 (2004)), and 
amended by section 403(a) of the Gulf Opportunity Zone Act of 2005 
(Pub. L. 109-135, 119 Stat. 25 (2005)), section 514 of the Tax Increase 
Prevention and Reconciliation Act of 2005 (Pub. L. 109-222, 120 Stat. 
345 (2005)), section 401 of the Tax Relief and Health Care Act of 2006 
(Pub. L. 109-432, 120 Stat. 2922 (2006)), section 401(a), Division B of 
the Energy Improvement and Extension Act of 2008 (Pub. L. 110-343, 122 
Stat. 3765 (2008)) (Energy Extension Act of 2008), sections 312(a) and 
502(c), Division C of the Tax Extenders and Alternative Minimum Tax 
Relief Act of 2008 (Pub. L. 110-343, 122 Stat. 3765 (2008)) (Tax 
Extenders Act of 2008), section 746(a) of the Tax Relief, Unemployment 
Insurance Reauthorization, and Job Creation Act of 2010 (Pub. L. 111-
312, 124 Stat. 3296 (2010)), section 318 of the American Taxpayer 
Relief Act of 2012 (Pub. L. 112-240, 126 Stat. 2313 (2013)), and 
sections 130 and 219(b) of the Tax Increase Prevention Act of 2014 
(Pub. L. 113-295, 128 Stat. 4010 (2014)).

General Overview

    Section 199(a)(1) allows a deduction equal to nine percent (three 
percent in the case of taxable years beginning in 2005 or 2006, and six 
percent in the case of taxable years beginning in 2007, 2008, or 2009) 
of the lesser of: (A) The qualified production activities income (QPAI) 
of the taxpayer for the taxable year, or (B) taxable income (determined 
without regard to section 199) for the taxable year (or, in the case of 
an individual, adjusted gross income).
    Section 199(b)(1) provides that the amount of the deduction 
allowable under section 199(a) for any taxable year shall not exceed 50 
percent of the W-2 wages of the taxpayer for the taxable year. Section 
199(b)(2)(A) generally defines W-2 wages, with respect to any person 
for any taxable year of such person, as the sum of 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. Section 199(b)(3), after its amendment by 
section 219(b) of the Tax Increase Prevention Act of 2014, provides 
that the Secretary shall provide for the application of section 199(b) 
in cases of a short taxable year or where the taxpayer acquires, or 
disposes of, the major portion of a trade or business, or the major 
portion of a separate unit of a trade or business during the taxable 
year. Section 199(b)(2)(B) limits the W-2 wages to those properly 
allocable to DPGR for taxable years beginning after May 17, 2006.
    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)(4)(A)(i) provides that the term DPGR means the 
taxpayer's gross receipts that are derived from any lease, rental, 
license, sale, exchange, or other disposition of: (I) Qualifying

[[Page 51979]]

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 (utilities) produced 
by the taxpayer in the United States.
    Section 199(d)(10), as renumbered by section 401(a), Division B of 
the Energy Extension Act of 2008, authorizes the Secretary to prescribe 
such regulations as are necessary to carry out the purposes of section 
199, including regulations that prevent more than one taxpayer from 
being allowed a deduction under section 199 with respect to any 
activity described in section 199(c)(4)(A)(i).

Explanation of Provisions

1. Allocation of W-2 Wages in a Short Taxable Year and in an 
Acquisition or Disposition of a Trade or Business (or Major Portion)

    Temporary regulations in the Rules and Regulations section of this 
issue of the Federal Register contain amendments to the Income Tax 
Regulations that provide rules clarifying how taxpayers calculate W-2 
wages for purposes of the W-2 wage limitation under section 199(b)(1) 
in the case of a short taxable year or where a taxpayer acquires, or 
disposes of, the major portion of a trade or business, or the major 
portion of a separate unit of a trade or business during the taxable 
year under section 199(b)(3). The text of those regulations serves as 
the text of these proposed regulations. The preamble to the temporary 
regulations explains the temporary regulations.

2. Oil Related Qualified Production Activities Income

    Section 401(a), Division B of the Energy Extension Act of 2008 
added new section 199(d)(9), which applies to taxable years beginning 
after December 31, 2008. Section 199(d)(9) reduces the otherwise 
allowable section 199 deduction when a taxpayer has oil related 
qualified production activities income (oil related QPAI), and defines 
oil related QPAI. Section 199(d)(9)(A) provides that if a taxpayer has 
oil related QPAI for any taxable year beginning after 2009, the amount 
otherwise allowable as a deduction under section 199(a) must be reduced 
by three percent of the least of: (i) The oil related QPAI of the 
taxpayer for the taxable year, (ii) the QPAI of the taxpayer for the 
taxable year, or (iii) taxable income (determined without regard to 
section 199).
    Section 1.199-1(f) of the proposed regulations provides guidance on 
oil related QPAI. In defining oil related QPAI, the Treasury Department 
and the IRS considered the relationship between QPAI and oil related 
QPAI. Section 199(c)(1) defines QPAI as the amount equal to the excess 
(if any) of the taxpayer's DPGR for the taxable year over the sum of 
CGS allocable to such receipts and other costs, expenses, losses, and 
deductions allocable to such receipts. So, for example, if gross 
receipts are not included within DPGR, those gross receipts are not 
included when calculating QPAI. Section 199(d)(9)(B) defines oil 
related QPAI as QPAI attributable to the production, refining, 
processing, transportation, or distribution of oil, gas, or any primary 
product thereof. In general, gross receipts from the transportation and 
distribution of QPP are not includable in DPGR because those activities 
are not considered part of the MPGE of QPP. See Sec.  1.199-3(e)(1), 
which defines MPGE. Section 199(c)(4)(B)(ii) specifically excludes 
gross receipts attributable to the transmission or distribution of 
natural gas from the definition of DPGR.
    Based on these considerations, the proposed regulations define oil 
related QPAI as an amount equal to the excess (if any) of the 
taxpayer's DPGR from the production, refining, or processing of oil, 
gas, or any primary product thereof (oil related DPGR) over the sum of 
the CGS that is allocable to such receipts and other expenses, losses, 
or deductions that are properly allocable to such receipts. The 
proposed regulations specifically provide that oil related DPGR does 
not include gross receipts derived from the transportation or 
distribution of oil, gas, or any primary product thereof, except if the 
de minimis rule under Sec.  1.199-1(d)(3)(i) or an exception for 
embedded services applies under Sec.  1.199-3(i)(4)(i)(B). The proposed 
regulations further provide that, to the extent a taxpayer treats gross 
receipts derived from the transportation or distribution of oil, gas, 
or any primary product thereof as DPGR under Sec.  1.199-1(d)(3)(i) or 
Sec.  1.199-3(i)(4)(i)(B), the taxpayer must include those gross 
receipts in oil related DPGR.
    The proposed regulations define oil as including oil recovered from 
both conventional and non-conventional recovery methods, including 
crude oil, shale oil, and oil recovered from tar/oil sands. Section 
199(d)(9)(C) defines primary product as having the same meaning as when 
used in section 927(a)(2)(C) (relating to property excluded from the 
term export property under the former foreign sales corporations 
rules), as in effect before its repeal. The proposed regulations 
incorporate the rules in Sec.  1.927(a)-1T(g)(2)(i) regarding the 
definition of a primary product with modifications that are consistent 
with the definition of oil for purposes of section 199(d)(9).
    Section 1.199-1(f)(2) of the proposed regulations provides guidance 
on how a taxpayer should allocate and apportion costs under the section 
861 method, the simplified deduction method, and the small business 
simplified overall method when determining oil related QPAI. The 
proposed regulations require taxpayers to use the same cost allocation 
method to allocate and apportion costs to oil related DPGR as the 
taxpayer uses to allocate and apportion costs to DPGR.

3. Qualified Films

a. Statutory Amendments
    Section 502(c), Division C of the Tax Extenders Act of 2008 amended 
the rules relating to qualified films. Section 502(c)(1) added section 
199(b)(2)(D) to broaden the definition of the term W-2 wages as applied 
to a qualified film to include compensation for services performed in 
the United States by actors, production personnel, directors, and 
producers.
    Section 502(c)(2), Division C of the Tax Extenders Act of 2008 
amended the definition of qualified film in section 199(c)(6) 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 502(c)(2), Division C of the Tax Extenders Act of 
2008 also amended the definition of a qualified film under section 
199(c)(6) to include any copyrights, trademarks, or other intangibles 
with respect to such film. The method and means of distributing a 
qualified film does not affect the availability of the deduction.
    Section 502(c)(3), Division C of the Tax Extenders Act of 2008 
added an attribution rule for a qualified film for taxpayers who are 
partnerships or S

[[Page 51980]]

corporations, or partners or shareholders of such entities under 
section 199(d)(1)(A)(iv). Section 199(d)(1)(A)(iv) provides that in the 
case of each partner of a partnership, or shareholder of an S 
corporation, who owns (directly or indirectly) at least 20 percent of 
the capital interests in such partnership or the stock of such S 
corporation, such partner or shareholder is treated as having engaged 
directly in any film produced by such partnership or S corporation, and 
that such partnership or S Corporation is treated as having engaged 
directly in any film produced by such partner or shareholder.
    The amendments made by section 502(c), Division C of the Tax 
Extenders Act of 2008 apply to taxable years beginning after December 
31, 2007.
b. W-2 Wages
    Section 1.199-2(e)(1) of the proposed regulations modifies the 
definition of W-2 wages to include compensation for services (as 
defined in Sec.  1.199-3(k)(4)) performed in the United States by 
actors, production personnel, directors, and producers (as defined in 
Sec.  1.199-3(k)(1)).
c. Definition of Qualified Films
    To address the amendments to the definition of qualified film in 
section 199(c)(6) for taxable years beginning after 2007, the proposed 
regulations amend the definition of qualified film in Sec.  1.199-
3(k)(1) to include copyrights, trademarks, or other intangibles with 
respect to such film. The proposed regulations define other intangibles 
with a non-exclusive list of intangibles that fall within the 
definition.
    Section 1.199-3(k)(10) provides a special rule for disposition of 
promotional films to address concerns of the Treasury Department and 
the IRS that the inclusion of intangibles in the definition of 
qualified film could be interpreted too broadly. This rule clarifies 
that, when a taxpayer produces a qualified film that is promoting a 
product or service, the gross receipts a taxpayer later derives from 
the disposition of the product or service promoted in the qualified 
film are derived from the disposition of the product or service and not 
from a disposition of the qualified film (including any intangible with 
respect to such qualified film). The rule is intended to prevent 
taxpayers from claiming that gross receipts are derived from the 
disposition of a qualified film (rather than the product or service 
itself) when a taxpayer sells a product or service with a logo, 
trademark, or other intangible that appears in a promotional film 
produced by the taxpayer. The Treasury Department and the IRS recognize 
that a taxpayer can, in certain cases, derive gross receipts from a 
disposition of a promotional film or the intangibles in a promotional 
film. The proposed regulations add Example 9 in Sec.  1.199-3(k)(11) 
relating to a license to reproduce a character used in a promotional 
film to illustrate a situation where gross receipts can qualify as DPGR 
because the gross receipts are distinct (separate and apart) from the 
disposition of the product or service. The Treasury Department and the 
IRS request comments on how to determine when gross receipts are 
distinct.
    The proposed regulations add four examples in redesignated Sec.  
1.199-3(k)(11), formerly Sec.  1.199-3(k)(10), to illustrate 
application of the amended definition of qualified film that includes 
copyrights, trademarks, or other intangibles.
    The proposed regulations remove the last sentence of Sec.  1.199-
3(k)(3)(ii) (which states that gross receipts derived from a license of 
the right to use or exploit film characters are not gross receipts 
derived from a qualified film) because gross receipts derived from a 
license of the right to use or exploit film characters are now 
considered gross receipts derived from a qualified film.
    Section 1.199-3(k)(2)(ii), which allows a taxpayer to treat certain 
tangible personal property as a qualified film (for example, a DVD), is 
amended to exclude film intangibles because tangible personal property 
affixed with a film intangible (such as a trademark) should not be 
treated as a qualified film. For example, the total revenue from the 
sale of an imported t-shirt affixed with a film intangible should not 
be treated as gross receipts derived from the sale of a qualified film. 
The portion of the gross receipts attributable to the qualified film 
intangible separate from receipts attributable to the t-shirt may 
qualify as DPGR, however. The proposed regulations also add Example 10 
and Example 11 in redesignated Sec.  1.199-3(k)(11) to address 
situations in which tangible personal property is offered for sale in 
combination with a qualified film affixed to a DVD.
    Section 1.199-3(k)(3)(i) and (k)(3)(ii) of the proposed regulations 
address the amendment to section 199(c)(6) (effective for taxable years 
beginning after 2007) that provides the methods and means of 
distributing a qualified film will not affect the availability of the 
deduction under section 199. The exception that describes the receipts 
from showing a qualified film in a movie theater or by broadcast on a 
television station as not derived from a qualified film is removed from 
Sec.  1.199-3(k)(3)(ii) because, if a taxpayer produces a qualified 
film, then the receipts the taxpayer derives from these showings 
qualify as DPGR in taxable years beginning after 2007. In addition, 
Example 4 in Sec.  1.199-3(i)(5)(iii) and Example 3 in Sec.  1.199-
3(k)(11) (formerly Sec.  1.199-3(k)(10)) have been revised to 
illustrate that, for taxable years beginning after 2007, product 
placement and advertising income derived from the distribution of a 
qualified film qualifies as DPGR if the qualified film containing the 
product placements and advertising is broadcast over the air or watched 
over the Internet.
    The proposed regulations also add a sentence to Sec.  1.199-3(k)(6) 
to clarify that production activities do not include activities related 
to the transmission or distribution of films. The Treasury Department 
and the IRS are aware that some taxpayers have taken the inappropriate 
position that these activities are part of the production of a film. 
The Treasury Department and the IRS consider film production as 
distinct from the transmission and distribution of films. This 
clarification is also consistent with the amendment to the definition 
of qualified film, which provides that the methods and means of 
distribution do not affect the availability of the deduction under 
section 199.
d. Partnerships and S Corporations
    Section 1.199-3(i)(9) of the proposed regulations describes the 
application of section 199(d)(1)(A)(iv) to partners and partnerships 
and shareholders and S corporations for taxable years beginning after 
2007. The Treasury Department and the IRS have determined that for a 
partnership to apply the provisions of section 199(d)(1)(A)(iv) to 
treat itself as having engaged directly in a film produced by a 
partner, the partnership must treat itself as a partnership for all 
purposes of the Code. Further, a partner of a partnership can apply the 
provisions of section 199(d)(1)(A)(iv) to treat itself as having 
engaged directly in a film produced by the partnership only if the 
partnership treats itself as a partnership for all purposes of the 
Code. Section 1.199-3(i)(9)(i) describes generally that a partner of a 
partnership or shareholder of an S corporation who owns (directly or 
indirectly) at least 20 percent of the capital interests in such 
partnership or the stock of such S corporation is treated as having 
engaged directly in any film produced by such partnership or S 
corporation. Further, such partnership or S corporation is treated as 
having engaged directly in any film produced by such partner or 
shareholder.

[[Page 51981]]

    Section 1.199-3(i)(9)(ii) of the proposed regulations generally 
prohibits attribution between partners of a partnership or shareholders 
of an S corporation, partnerships with a partner in common, or S 
corporations with a shareholder in common. Thus, when a partnership or 
S corporation is treated as having engaged directly in any film 
produced by a partner or shareholder, any other partners or 
shareholders who did not participate directly in the production of the 
film are treated as not having engaged directly in the production of 
the film at the partner or shareholder level. Similarly, when a partner 
or shareholder is treated as having engaged directly in any film 
produced by a partnership or S corporation, any other partnerships or S 
corporations in which that partner or shareholder owns an interest 
(excluding the partnership or S corporation that produced the film) are 
treated as not having engaged directly in the production of the film at 
the partnership or S corporation level.
    Section 1.199-3(i)(9)(iii) of the proposed regulations describes 
the attribution period for a partner or partnership or shareholder or S 
corporation under section 199(d)(1)(A)(iv). A partner or shareholder is 
treated as having engaged directly in any qualified film produced by 
the partnership or S corporation, and a partnership or S corporation is 
treated as having engaged directly in any qualified film produced by 
the partner or shareholder, regardless of when the qualified film was 
produced, during the period in which the partner or shareholder owns 
(directly or indirectly) at least 20 percent of the capital interests 
in the partnership or the stock of the S corporation. During any period 
that a partner or shareholder owns less than 20 percent of the capital 
interests in such partnership or the stock of such S corporation that 
partner or shareholder is not treated as having engaged directly in the 
qualified film produced by the partnership or S corporation for 
purposes of Sec.  1.199-3(i)(9)(iii), and that partnership or S 
corporation is not treated as having engaged directly in any qualified 
film produced by the partner or shareholder.
    Section 1.199-3(i)(9)(iv) of the proposed regulations provides 
examples that illustrate section 199(d)(1)(A)(iv).
e. Qualified Film Safe Harbor
    Existing Sec.  1.199-3(k)(7)(i) provides a safe harbor that treats 
a film as a qualified film produced by the taxpayer if not less than 50 
percent of the total compensation for services paid by the taxpayer is 
compensation for services performed in the United States and the 
taxpayer satisfies the safe harbor in Sec.  1.199-3(g)(3) for treating 
a taxpayer as MPGE QPP in whole or significant part in the United 
States. The Treasury Department and the IRS are aware that it may be 
unclear how the safe harbor in Sec.  1.199-3(k)(7)(i) applies to costs 
of live or delayed television programs that may be expensed 
(specifically, whether such expensed costs are part of the CGS or 
unadjusted depreciable basis of the qualified film for purposes of 
Sec.  1.199-3(g)(3)). Further, it may be unclear whether license fees 
paid for third-party produced programs are included in direct labor and 
overhead when applying the safe harbor in Sec.  1.199-3(g)(3). The 
proposed regulations clarify how a taxpayer producing live or delayed 
television programs should apply the safe harbor in Sec.  1.199-
3(k)(7)(i); in particular, how a taxpayer should calculate its 
unadjusted depreciable basis under Sec.  1.199-3(g)(3)(ii). 
Specifically, proposed Sec.  1.199-3(k)(7)(i) requires a taxpayer to 
include all costs paid or incurred in the production of a live or 
delayed television program in the taxpayer's unadjusted depreciable 
basis of such program under Sec.  1.199-3(g)(3)(ii), including the 
licensing fees paid to a third party under Sec.  1.199-3(g)(3)(ii). The 
proposed regulations further clarify that license fees for third-party 
produced programs are not included in the direct labor and overhead to 
produce the film for purposes of applying Sec.  1.199-3(g)(3).

4. Treatment of Activities in Puerto Rico

    Section 199(d)(8)(A) provides that in the case of any taxpayer with 
gross receipts for any taxable year from sources within the 
Commonwealth of Puerto Rico, if all of such receipts are taxable under 
section 1 or 11 for such taxable year, then for purposes of determining 
the DPGR of such taxpayer for such taxable year under section 
199(c)(4), the term United States includes the Commonwealth of Puerto 
Rico. Section 199(d)(8)(B) provides that in the case of a taxpayer 
described in section 199(d)(8)(A), for purposes of applying the wage 
limitation under section 199(b) for any taxable year, the determination 
of W-2 wages of such taxpayer is made without regard to any exclusion 
under section 3401(a)(8) for remuneration paid for services performed 
in Puerto Rico. Section 130 of the Tax Increase Prevention Act of 2014 
amended section 199(d)(8)(C) for taxable years beginning after December 
31, 2013. As amended, section 199(d)(8)(C) provides that section 
199(d)(8) applies only with respect to the first nine taxable years of 
the taxpayer beginning after December 31, 2005, and before January 1, 
2015.
    Section 1.199-2(f) of the proposed regulations modifies the W-2 
wage limitation under section 199(b) to the extent provided by section 
199(d)(8). Section 1.199-3(h)(2) of the proposed regulations modifies 
the term United States to include the Commonwealth of Puerto Rico to 
the extent provided by section 199(d)(8).

5. Determining DPGR on Item-by-Item Basis

    Section 1.199-3(d)(1) provides that 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. Section 1.199-3(d)(1)(i) provides that 
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 Sec.  1.199-3(d), collectively 
referred to as disposition) to customers, if the gross receipts from 
the disposition of such property qualify as DPGR. Section 1.199-
3(d)(2)(iii) provides that, 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.
    The Treasury Department and the IRS are aware that the item rule in 
Sec.  1.199-3(d)(2)(iii) has been interpreted to mean that the gross 
receipts derived from the sale of a multiple-building project may be 
treated as DPGR when only one building in the project is substantially 
renovated. The Treasury Department and the IRS have concluded that 
treating gross receipts from the sale of a multiple-building project as 
DPGR, and the multiple-building project as one item, is not a 
reasonable method satisfactory to the Secretary for purposes of Sec.  
1.199-3(d)(2)(iii) if a taxpayer did not substantially renovate each 
building in the multiple-building project. Section 1.199-3(d)(4) of the 
proposed regulations includes an example (Example 14) illustrating the 
appropriate application of Sec.  1.199-3(d)(2)(iii) to a multiple 
building project.
    In addition, the Treasury Department and the IRS are aware that 
taxpayers may be unsure how to apply the item rule in Sec.  1.199-
3(d)(2)(i) when the property offered for disposition to customers 
includes embedded services

[[Page 51982]]

as described in Sec.  1.199-3(i)(4)(i). The proposed regulations add 
Example 6 to Sec.  1.199-3(d)(4) to clarify that the item rule applies 
after excluding the gross receipts attributable to services.

6. MPGE

    Section 1.199-3(e)(1) provides that 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 Treasury Department and 
the IRS are aware that Example 5 in Sec.  1.199-3(e)(5) has been 
interpreted to mean that testing activities qualify as an MPGE activity 
even if the taxpayer engages in no other MPGE activity. The Treasury 
Department and the IRS disagree that testing activities, alone, qualify 
as an MPGE activity. The proposed regulations add a sentence to Example 
5 in Sec.  1.199-3(e)(5) to further illustrate that certain activities 
will not be treated as MPGE activities if they are not performed as 
part of the MPGE of QPP. Taxpayers are not required to allocate gross 
receipts to certain activities that are not MPGE activities when those 
activities are performed in connection with the MPGE of QPP. However, 
if the taxpayer in Example 5 in Sec.  1.199-3(e)(5) did not MPGE QPP, 
then the activities described in the example, including testing, are 
not MPGE activities.
    Section 1.199-3(e)(2) provides that if a taxpayer packages, 
repackages, labels, or performs minor assembly of QPP and the taxpayer 
engages in no other MPGE activities with respect to that QPP, the 
taxpayer's packaging, repackaging, labeling, or minor assembly does not 
qualify as MPGE with respect to that QPP. This rule has been the 
subject of recent litigation. See United States v. Dean, 945 F. Supp. 
2d 1110 (C.D. Cal. 2013) (concluding that the taxpayer's activity of 
preparing gift baskets was a manufacturing activity and not solely 
packaging or repackaging for purposes of section 199). The Treasury 
Department and the IRS disagree with the interpretation of Sec.  1.199-
3(e)(2) adopted by the court in United States v. Dean, and the proposed 
regulations add an example (Example 9) that illustrates the appropriate 
application of this rule in a situation in which the taxpayer is 
engaged in no other MPGE activities with respect to the QPP other than 
those described in Sec.  1.199-3(e)(2).

7. Definition of ``by the taxpayer''

    Section 1.199-3(f)(1) provides that if one taxpayer performs a 
qualifying activity under Sec.  1.199-3(e)(1), Sec.  1.199-3(k)(1), or 
Sec.  1.199-3(l)(1) 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.
    Taxpayers and the IRS have had difficulty determining which party 
to a contract manufacturing arrangement has the benefits and burdens of 
ownership of the property while the qualifying activity occurs. Cases 
analyzing the benefits and burdens of ownership have considered the 
following factors relevant: (1) Whether legal title passes; (2) how the 
parties treat the transaction; (3) whether an equity interest was 
acquired; (4) whether the contract creates a present obligation on the 
seller to execute and deliver a deed and a present obligation on the 
purchaser to make payments; (5) whether the right of possession is 
vested in the purchaser and which party has control of the property or 
process; (6) which party pays the property taxes; (7) which party bears 
the risk of loss or damage to the property; (8) which party receives 
the profits from the operation and sale of the property; and (9) 
whether a taxpayer actively and extensively participated in the 
management and operations of the activity. See ADVO, Inc. & 
Subsidiaries v. Commissioner, 141 T.C. 298, 324-25 (2013); see also 
Grodt & McKay Realty, Inc. v. Commissioner, 77 T.C. 1221 (1981). The 
ADVO court noted that the factors it used in its analysis are not 
exclusive or controlling, but that they were in the particular case 
sufficient to determine which party had the benefits and burdens of 
ownership. ADVO, Inc., 141 T.C. at 325 n. 21. Determining which party 
has the benefits and burdens of ownership under Federal income tax 
principles for purposes of section 199 requires an analysis and 
weighing of many factors, which in some contexts could result in more 
than one taxpayer claiming the benefits of section 199 with respect to 
a particular activity. Resolving the benefits and burdens of ownership 
issue often requires significant IRS and taxpayer resources.
    Section 199(d)(10) directs the Treasury Department to provide 
regulations that prevent more than one taxpayer from being allowed a 
deduction under section 199 with respect to any qualifying activity (as 
described in section 199(c)(4)(A)(i)). The Treasury Department and the 
IRS have interpreted the statute to mean that only one taxpayer may 
claim the section 199 deduction with respect to the same activity 
performed with respect to the same property. See Sec.  1.199-3(f)(1). 
Example 1 and Example 2 in Sec.  1.199-3(f)(4) currently illustrate 
this one-taxpayer rule using factors that are relevant to the 
determination of who has the benefits and burdens of ownership.
    The Large Business and International (LB&I) Division issued an 
Industry Director Directive on February 1, 2012 (LB&I Control No. LB&I-
4-0112-01) (Directive) addressing the benefits and burdens factors. The 
Directive provides a three-step analysis of facts and circumstances 
relating to contract terms, production activities, and economic risks 
to determine whether a taxpayer has the benefits and burdens of 
ownership for purposes of Sec.  1.199-3(f)(1). LB&I issued a 
superseding second directive on July 24, 2013 (LB&I Control No. LB&I-
04-0713-006), and a third directive updating the second directive on 
October 29, 2013 (LB&I Control No. LB&I-04-1013-008). The third 
directive allows a taxpayer to provide a statement explaining the 
taxpayer's determination that it had the benefits and burdens of 
ownership, along with certification statements signed under penalties 
of perjury by the taxpayer and the counterparty verifying that only the 
taxpayer is claiming the section 199 deduction.
    To provide administrable rules that are consistent with section 
199, reduce the burden on taxpayers and the IRS in evaluating factors 
related to the benefits and burdens of ownership, and prevent more than 
one taxpayer from being allowed a deduction under section 199 with 
respect to any qualifying activity, the proposed regulations remove the 
rule in Sec.  1.199-3(f)(1) that treats a taxpayer in a contract 
manufacturing arrangement as engaging in the qualifying activity only 
if the taxpayer has the benefits and burdens of ownership during the 
period in which the qualifying activity occurs. In place of the 
benefits and burdens of ownership rule, these proposed regulations 
provide that if a qualifying activity is performed under a contract, 
then the party that performs the activity is the taxpayer for purposes 
of section 199(c)(4)(A)(i). This rule, which applies solely for 
purposes of section 199, reflects the conclusion that the party 
actually producing the property should be treated as engaging in the 
qualifying activity for purposes of section 199, and is therefore 
consistent with the statute's goal of incentivizing domestic

[[Page 51983]]

manufacturers and producers. The proposed rule would also provide a 
readily administrable approach that would prevent more than one 
taxpayer from being allowed a deduction under section 199 with respect 
to any qualifying activity.
    Example 1 has been revised, and current Example 2 has been removed, 
to reflect the new rule. In addition, the benefits and burdens language 
has been removed from: (1) The definition of MPGE in Sec.  1.199-
3(e)(1) and (3), including Example 1, Example 4, and Example 5 in Sec.  
1.199-3(e)(5); (2) the definition of in whole or in significant part in 
Sec.  1.199-3(g)(1); (3) Example 5 in the qualified film rules in 
existing Sec.  1.199-3(k)(7); and (4) the production pursuant to a 
contract in the qualified film rules in Sec.  1.199-3(k)(8).
    The Treasury Department and the IRS request comments on whether 
there are narrow circumstances that could justify an exception to the 
proposed rule. In particular, the Treasury Department and the IRS 
request comments on whether there should be a limited exception to the 
proposed rule for certain fully cost-plus or cost-reimbursable 
contracts. Under such an exception, the party that is not performing 
the qualifying activity would be treated as the taxpayer engaged in the 
qualifying activity if the party performing the qualifying activity is 
(i) reimbursed for, or provided with, all materials, labor, and 
overhead costs related to fulfilling the contract, and (ii) provided 
with an additional payment to allow for a profit. The Treasury 
Department and the IRS are uncertain regarding the extent to which such 
fully cost-plus or cost-reimbursable contracts are in fact used in 
practice. Comments suggesting circumstances that could justify an 
exception to the proposed rule should address the rationale for the 
proposed exception, the ability of the IRS to administer the exception, 
and how the suggested exception will prevent two taxpayers from 
claiming the deduction for the qualifying activity.

8. Hedging Transactions

    The proposed regulations make several revisions to the hedging 
rules in Sec.  1.199-3(i)(3). Section 1.199-3(i) of the proposed 
regulations defines a hedging transaction to include transactions in 
which the risk being hedged relates to property described in section 
1221(a)(1) giving rise to DPGR, whereas the existing regulations 
require the risk being hedged relate to QPP described in section 
1221(a)(1). A taxpayer commented in a letter to the Treasury Department 
and the IRS that there is no reason to limit the hedging rules to QPP 
giving rise to DPGR, and the proposed regulations accept the comment.
    The other changes to the hedging rules are administrative. Section 
1.199-3(i)(3)(ii) of the existing regulations on currency fluctuations 
was eliminated because the regulations under sections 988(d) and 1221 
adequately cover the treatment of currency hedges. Similarly, the rules 
in Sec.  1.199-3(i)(3)(iii) that address the effect of identification 
and non-identification were duplicative of the rules in the section 
1221 regulations. Accordingly, Sec.  1.199-3(i)(3)(ii) has been revised 
to cross-reference the appropriate rules in Sec.  1.1221-2(g), and to 
clarify that the consequence of an abusive identification or non-
identification is that deduction or loss, but not income or gain, is 
taken into account in calculating DPGR.

9. Construction Activities

    Section 199(c)(4)(A)(ii) includes in DPGR, in the case of a 
taxpayer engaged in the active conduct of a construction trade or 
business, gross receipts derived from construction of real property 
performed in the United States by the taxpayer in the ordinary course 
of such trade or business. Under Sec.  1.199-3(m)(2)(i), activities 
constituting construction include activities performed by a general 
contractor or 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 progress 
of the construction project, and required job modifications. The 
Treasury Department and the IRS are aware that some taxpayers have 
interpreted this language to mean that a taxpayer who only approves or 
authorizes payments is engaged in activities typically performed by a 
general contractor under Sec.  1.199-3(m)(2)(i). The Treasury 
Department and the IRS disagree that a taxpayer who only approves or 
authorizes payments is engaged in construction for purposes of Sec.  
1.199-3(m)(2)(i). Accordingly, Sec.  1.199-3(m)(2)(i) of the proposed 
regulations clarifies that a taxpayer must engage in construction 
activities that include more than the approval or authorization of 
payments or invoices for that taxpayer's activities to be considered as 
activities typically performed by a general contractor.
    Section 1.199-3(m)(2)(i) provides that activities constituting 
construction are activities performed in connection with a project to 
erect or substantially renovate real property. Section 1.199-3(m)(5) 
currently defines substantial renovation to mean 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. This standard reflects regulations under Sec.  1.263(a)-
3 related to amounts paid to improve tangible property that existed at 
the time of publication of the final Sec.  1.199-3(m)(5) regulations 
(TD 9263 [71 FR 31268] June 19, 2006) but which have since been 
revised. See (TD 9636 [78 FR 57686] September 19, 2013).
    The proposed regulations under Sec.  1.199-3(m)(5) revise the 
definition of substantial renovation to conform to the final 
regulations under Sec.  1.263(a)-3, which provide rules requiring 
capitalization of amounts paid for improvements to a unit of property 
owned by a taxpayer. Improvements under Sec.  1.263(a)-3 are amounts 
paid for a betterment to a unit of property, amounts paid to restore a 
unit of property, and amounts paid to adapt a unit of property to a new 
or different use. See Sec.  1.263(a)-3(j), (k), and (l). Under the 
proposed regulations, a substantial renovation of real property is a 
renovation the costs of which are required to be capitalized as an 
improvement under Sec.  1.263(a)-3, other than an amount described in 
Sec.  1.263(a)-3(k)(1)(i) through (iii) (relating to amounts for which 
a loss deduction or basis adjustment requires capitalization as an 
improvement). The improvement rules under Sec.  1.263(a)-3 provide 
specific rules of application for buildings (see Sec.  1.263(a)-
3(j)(2)(ii), (k)(2), and (l)(2)), which apply for purposes of Sec.  
1.199-3(m)(5).

10. Allocating Cost of Goods Sold

    Section 1.199-4(b)(1) describes how a taxpayer determines its CGS 
allocable to DPGR. The Treasury Department and the IRS are aware that 
in the case of transactions accounted for under a long-term contract 
method of accounting (either the percentage-of-completion method (PCM) 
or the completed-contract method (CCM)), a taxpayer incurs allocable 
contract costs. The Treasury Department and the IRS recognize that 
allocable contract costs under PCM or CCM are analogous to CGS and 
should be treated in the same manner. Section 1.199-4(b)(1) of the 
proposed regulations provides that in the case of a long-term contract 
accounted for under PCM or CCM, CGS for purposes of Sec.  1.199-4(b)(1) 
includes allocable contract costs described in Sec.  1.460-5(b) or 
Sec.  1.460-5(d), as applicable.
    Existing Sec.  1.199-4(b)(2)(i) provides that a taxpayer must use a 
reasonable method that is satisfactory to the

[[Page 51984]]

Secretary based on all of the facts and circumstances to allocate CGS 
between DPGR and non-DPGR. This allocation must be determined based on 
the rules provided in Sec.  1.199-4(b)(2)(i) and (ii). Taxpayers have 
asserted that under Sec.  1.199-4(b)(2)(ii) the portion of current year 
CGS associated with activities in earlier tax years (including pre-
section 199 tax years) may be allocated to non-DPGR even if the related 
gross receipts are treated by the taxpayer as DPGR. Section 1.199-
4(b)(2)(iii)(A) of the proposed regulations clarifies that the CGS must 
be allocated between DPGR and non-DPGR, regardless of whether any 
component of the costs included in CGS can be associated with 
activities undertaken in an earlier taxable year. Section 1.199-
4(b)(2)(iii)(B) of the proposed regulations provides an example 
illustrating this rule.

11. Agricultural and Horticultural Cooperatives

    Section 199(d)(3)(A) provides that any person who receives a 
qualified payment from a specified agricultural or horticultural 
cooperative must 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 that 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).
    Under Sec.  1.199-6(c), the cooperative's QPAI is computed without 
taking into account any deduction allowable under section 1382(b) or 
section 1382(c) (relating to patronage dividends, per-unit retain 
allocations, and nonpatronage distributions).
    Section 1.199-6(e) provides that the term qualified payment means 
any amount of a patronage dividend or per-unit retain allocation, as 
described in section 1385(a)(1) or section 1385(a)(3), received by a 
patron from a cooperative that is attributable to the portion of the 
cooperative's QPAI 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.
    Section 1388(f) defines the term per-unit retain allocation to mean 
any allocation by an organization to which part I of subchapter T 
applies to a patron with respect to products marketed for him, the 
amount of which is fixed without reference to net earnings of the 
organization pursuant to an agreement between the organization and the 
patron. Per-unit retain allocations may be made in money, property, or 
certificates.
    The Treasury Department and the IRS are aware that Example 1 in 
Sec.  1.199-6(m) has been interpreted as describing that the 
cooperative's payment for its members' corn is a per-unit retain 
allocation paid in money as defined in sections 1382(b)(3) and 1388(f). 
Example 1 in Sec.  1.199-6(m) does not identify the cooperative's 
payment for its members' corn as a per-unit retain allocation and is 
not intended to illustrate how QPAI is computed when a cooperative's 
payments to its patrons are per-unit retain allocations. The proposed 
regulations provide an example (Example 4) in Sec.  1.199-6(m) 
illustrating how QPAI is computed when the cooperative's payments to 
members for corn qualify as per-unit retain allocations paid in money 
under section 1388(f). The new example has the same facts as Example 1 
in Sec.  1.199-6(m), except that the cooperative's payments for its 
members' corn qualify as per-unit retain allocations paid in money 
under section 1388(f) and the cooperative reports per-unit retain 
allocations paid in money on Form 1099-PATR, ``Taxable Distributions 
Received From Cooperatives.''

Request for Comments

    Existing Sec.  1.199-3(e)(2) provides that 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.
    The term minor assembly for purposes of section 199 was first 
introduced in Notice 2005-14 (2005-1 CB 498 (February 14, 2005)) (see 
Sec.  601.601(d)(2)(ii)(b)) (Notice 2005-14), and was used (by 
exclusion) in determining whether a taxpayer met the in-whole-or-in-
significant-part requirement. Specifically, section 3.04(5)(d) of 
Notice 2005-14 states that in connection with the MPGE of QPP, 
packaging, repackaging, and minor assembly operations should not be 
considered in applying the general ``substantial in nature'' test, and 
the costs should not be considered in applying the safe harbor. The 
section further states that this rule is similar to the rule in Sec.  
1.954-3(a)(4)(iii). The rule in Sec.  1.954-3(a)(4)(iii) applies when 
deciding whether a taxpayer selling property will be treated as selling 
a manufactured product rather than components of that sold property.
    Section 1.199-3(g) of the current regulations, which superseded 
Notice 2005-14, does not provide a specific definition of minor 
assembly, but it does allow taxpayers to consider minor assembly 
activities to determine whether the taxpayer has met the in-whole-or-
in-significant-part requirement (either by showing their activities 
were substantial in nature under Sec.  1.199-3(g)(2) or by meeting the 
safe harbor in Sec.  1.199-3(g)(3)). However, the current regulations 
also contain Sec.  1.199-3(e)(2), which excludes certain activities 
from the definition of MPGE. Section 1.199-3(e)(2) provides that 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. Therefore, 
a taxpayer with only minor assembly activities would not meet the 
definition of MPGE and a determination of whether a taxpayer met the 
in-whole-or-in-significant-part requirement is not made.
    In considering whether to provide a specific definition of minor 
assembly, the Treasury Department and the IRS have found it difficult 
to identify an objective test that would be widely applicable.
    The definition of minor assembly could focus on whether a 
taxpayer's activity is only a single process that does not transform an 
article into a materially different QPP. Such process may include, but 
would not be limited to, blending or mixing two materials together, 
painting an article, cutting, chopping, crushing (non-agricultural 
products), or other similar activities. An example of blending or 
mixing two materials is using a paint mixing machine to combine paint 
with a pigment to match a customer's color selection when a taxpayer 
did not MPGE the paint or the pigment. An example of cutting is a 
taxpayer using an industrial key cutting machine to custom cut keys for 
customers using blank keys that taxpayer purchased from unrelated third 
parties. Examples of other similar activities include adding an 
additive to extend the shelf life of a product and time ripening 
produce that was purchased from unrelated third parties.
    Another possible definition could be based on whether an end user 
could reasonably engage in the same assembly activity of the taxpayer. 
For example, assume QPP made up of component parts purchased by 
taxpayer is sold by a taxpayer to end users in either assembled or 
disassembled form. To the

[[Page 51985]]

extent an end user can reasonably assemble the QPP sold in disassembled 
form, the taxpayer's assembly activity would be considered minor 
assembly.
    The Treasury Department and the IRS request comments on how the 
term minor assembly in Sec.  1.199-3(e)(2) should be defined and 
encourage the submission of examples illustrating the term.

Special Analyses

    Certain IRS regulations, including this one, are exempt from the 
requirements of Executive Order 12866 of, as supplemented and 
reaffirmed by Executive Order 13563. Therefore, a regulatory assessment 
is not required. It also has been determined that section 553(b) of the 
Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to 
these regulations, and because the regulations do not impose a 
collection of information on small entities, the Regulatory Flexibility 
Act (5 U.S.C. chapter 6) does not apply. Pursuant to section 7805(f) of 
the Code, this notice of proposed rulemaking has been submitted to the 
Chief Counsel for Advocacy of the Small Business Administration for 
comment on their impact on small business.

Comments and Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any written comments (a signed original 
and eight (8) copies) or electronic comments that are submitted timely 
to the IRS. Comments are requested on all aspects of the proposed 
regulations. All comments will be available for public inspection and 
copying at http://www.regulations.gov or upon request.
    A public hearing has been scheduled for December 16, 2015, 
beginning at 10 a.m. in the Auditorium of the Internal Revenue 
Building, 1111 Constitution Avenue NW., Washington, DC. Due to building 
security procedures, visitors must enter at the Constitution Avenue 
entrance. Because of access restrictions, visitors will not be admitted 
beyond the immediate entrance area more than 30 minutes before the 
hearing starts. In addition, all visitors must present photo 
identification to enter the building. For information about having your 
name placed on the building access list to attend the hearing, see the 
FOR FURTHER INFORMATION CONTACT section of this preamble.
    The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons who 
wish to present oral comments at the hearing must submit electronic or 
written comments by November 25, 2015, and an outline of the topics to 
be discussed and the time to be devoted to each topic by November 25, 
2015. A period of 10 minutes will be allotted to each person for making 
comments. An agenda showing the scheduling of the speakers will be 
prepared after the deadline for receiving outlines has passed. Copies 
of the agenda will be available free of charge at the hearing.

Drafting Information

    The principal author of these regulations is James Holmes, Office 
of the Associate Chief Counsel (Passthroughs and Special Industries). 
However, other personnel from the Treasury Department and the IRS 
participated in their development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

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

PART 1--INCOME TAXES

0
Paragraph 1. The authority citation for part 1 continues to read in 
part as follows:

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

0
Par. 2. Section 1.199-0 is amended by:
0
1. Adding entries in the table of contents for Sec.  1.199-1(f).
0
2. Revising the entry in the table of contents for Sec.  1.199-2(c) and 
adding entries for Sec.  1.199-2(c)(1), (2), and (3).
0
3. Adding an entry in the table of contents for Sec.  1.199-2(f).
0
4. Redesignating the entry in the table of contents for Sec.  1.199-
3(h) as the entry for Sec.  1.199-3(h)(1), adding introductory text for 
Sec.  1.199-3(h), and adding an entry for Sec.  1.199-3(h)(2).
0
5. Redesignating the entry in the table of contents for Sec.  1.199-
3(i)(9) as the entry for Sec.  1.199-3(i)(10) and adding introductory 
text and entries in the table of contents for Sec.  1.199-3(i)(9).
0
6. Redesignating the entry in the table of contents for Sec.  1.199-
3(k)(10) as the entry for Sec.  1.199-3(k)(11) and adding an entry for 
Sec.  1.199-3(k)(10).
0
7. Adding entries in the table of contents for Sec.  1.199-
4(b)(2)(iii).
0
8. Revising the introductory text in the table of contents for Sec.  
1.199-8(i) and adding the entries for Sec.  1.199-8(i)(10) and (i)(11).
    The additions and revision read as follows:


Sec.  1.199-0  Table of contents.

* * * * *


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

* * * * *
    (f) Oil related qualified production activities income.
    (1) In general.
    (i) Oil related QPAI.
    (ii) Special rule for oil related DPGR.
    (iii) Definition of oil.
    (iv) Primary product from oil or gas.
    (A) Primary product from oil.
    (B) Primary product from gas.
    (C) Primary products from changing technology.
    (D) Non-primary products.
    (2) Cost allocation methods for determining oil related QPAI.
    (i) Section 861 method.
    (ii) Simplified deduction method.
    (iii) Small business simplified overall method.


Sec.  1.199-2  Wage limitation.

* * * * *
    (c) Acquisitions, dispositions, and short taxable years.
    (1) Allocation of wages between more than one taxpayer.
    (2) Short taxable years.
    (3) Operating rules.
    (i) Acquisition or disposition.
    (ii) Trade or business.
* * * * *
    (f) Commonwealth of Puerto Rico.


Sec.  1.199-3  Domestic production gross receipts.

* * * * *
    (h) United States.
* * * * *
    (2) Commonwealth of Puerto Rico.
    (i) * * *
    (9) Engaging in production of qualified films.
    (i) In general.
    (ii) No double attribution.
    (iii) Timing of attribution.
    (iv) Examples.
* * * * *
    (k) * * *
    (10) Special rule for disposition of promotional films and products 
or services promoted in promotional films.
* * * * *


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

* * * * *
    (b) * * *
    (2) * * *
    (iii) Cost of goods sold associated with activities undertaken in 
an earlier taxable year.
    (A) In general.
    (B) Example.
* * * * *


Sec.  1.199-8  Other rules.

* * * * *

[[Page 51986]]

    (i) Effective/applicability dates.
* * * * *
    (10) Acquisition or disposition of a trade or business (or major 
portion).
    (11) Energy Improvement and Extension Act of the 2008, Tax 
Extenders and Alternative Minimum Tax Relief Act of 2008, American 
Taxpayer Relief Act of 2012, and other provisions.
* * * * *
0
Par. 3. Section 1.199-1 is amended by adding paragraph (f) to read as 
follows:


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

* * * * *
    (f) Oil related qualified production activity income (Oil related 
QPAI)--(1) In general--(i) Oil related QPAI. Oil related QPAI for any 
taxable year is an amount equal to the excess (if any) of the 
taxpayer's DPGR (as defined in Sec.  1.199-3) derived from the 
production, refining or processing of oil, gas, or any primary product 
thereof (oil related DPGR) over the sum of:
    (A) The CGS that is allocable to such receipts; and
    (B) 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.
    (ii) Special rule for oil related DPGR. Oil related DPGR does not 
include gross receipts derived from the transportation or distribution 
of oil, gas, or any primary product thereof. However, to the extent 
that a taxpayer treats gross receipts derived from transportation or 
distribution of oil, gas, or any primary product thereof as DPGR under 
paragraph (d)(3)(i) of this section or under Sec.  1.199-3(i)(4)(i)(B), 
then the taxpayer must treat those gross receipts as oil related DGPR.
    (iii) Definition of oil. The term oil includes oil recovered from 
both conventional and non-conventional recovery methods, including 
crude oil, shale oil, and oil recovered from tar/oil sands.
    (iv) Primary product from oil or gas. A primary product from oil or 
gas is, for purposes of this paragraph:
    (A) Primary product from oil. The term primary product from oil 
means all products derived from the destructive distillation of oil, 
including:
    (1) Volatile products;
    (2) Light oils such as motor fuel and kerosene;
    (3) Distillates such as naphtha;
    (4) Lubricating oils;
    (5) Greases and waxes; and
    (6) Residues such as fuel oil.
    (B) Primary product from gas. The term primary product from gas 
means all gas and associated hydrocarbon components from gas wells or 
oil wells, whether recovered at the lease or upon further processing, 
including:
    (1) Natural gas;
    (2) Condensates;
    (3) Liquefied petroleum gases such as ethane, propane, and butane; 
and
    (4) Liquid products such as natural gasoline.
    (C) Primary products and changing technology. The primary products 
from oil or gas described in paragraphs (f)(1)(iv)(A) and (B) of this 
section are not intended to represent either the only primary products 
from oil or gas, or the only processes from which primary products may 
be derived under existing and future technologies.
    (D) Non-primary products. Examples of non-primary products include, 
but are not limited to, petrochemicals, medicinal products, 
insecticides, and alcohols.
    (2) Cost allocation methods for determining oil related QPAI--(i) 
Section 861 method. A taxpayer that uses the section 861 method to 
determine deductions that are allocated and apportioned to gross income 
attributable to DPGR must use the section 861 method to determine 
deductions that are allocated and apportioned to gross income 
attributable to oil related DPGR. See Sec.  1.199-4(d).
    (ii) Simplified deduction method. A taxpayer that uses the 
simplified deduction method to apportion deductions between DPGR and 
non-DPGR must determine the portion of deductions allocable to oil 
related DPGR by multiplying the deductions allocable to DPGR by the 
ratio of oil related DPGR divided by DPGR from all activities. See 
Sec.  1.199-4(e).
    (iii) Small business simplified overall method. A taxpayer that 
uses the small business simplified overall method to apportion total 
costs (CGS and deductions) between DPGR and non-DPGR must determine the 
portion of total costs allocable to DPGR that are allocable to oil 
related DPGR by multiplying the total costs allocable to DPGR by the 
ratio of oil related DPGR divided by DPGR from all activities. See 
Sec.  1.199-4(f).
0
Par. 4. Section 1.199-2 is amended by revising paragraph (c), adding a 
sentence at the end of paragraph (e)(1), and adding paragraph (f) to 
read as follows:


Sec.  1.199-2  Wage limitation.

* * * * *
    (c) [The text of the proposed amendments to Sec.  1.199-2(c) is the 
same as the text of Sec.  1.199-2T(c) published elsewhere in this issue 
of the Federal Register].
* * * * *
    (e) * * *
    (1) * * * In the case of a qualified film (as defined in Sec.  
1.199-3(k)) for taxable years beginning after 2007, the term W-2 wages 
includes compensation for services (as defined in Sec.  1.199-3(k)(4)) 
performed in the United States by actors, production personnel, 
directors, and producers (as defined in Sec.  1.199-3(k)(1)).
* * * * *
    (f) Commonwealth of Puerto Rico. In the case of a taxpayer 
described in Sec.  1.199-3(h)(2), the determination of W-2 wages of 
such taxpayer shall be made without regard to any exclusion under 
section 3401(a)(8) for remuneration paid for services performed in the 
Commonwealth of Puerto Rico. This paragraph (f) only applies as 
provided in section 199(d)(8).
0
Par. 5. Section 1.199-3 is amended by:
0
1. In paragraph (d)(4):
0
a. Redesignating Example 6, Example 7, Example 8, Example 9, Example 
10, Example 11, and Example 12 as Example 7, Example 8, Example 9, 
Example 10, Example 11, Example 12, and Example 13, respectively;
0
b. In newly-designated Example 10, removing the language ``Example 8'' 
and adding ``Example 9'' in its place; and
0
c. Adding Example 6 and Example 14.
0
2. Revising the last sentence in paragraphs (e)(1) and (3).
0
3. In paragraph (e)(5):
0
a. Revising the third sentence in Example 1, the second sentence in 
Example 4, and Example 5.
0
b. Adding Example 9.
0
4. Revising the last sentence in paragraph (f)(1).
0
5. Revising Example 1, removing Example 2, and redesignating Example 3 
as Example 2 in paragraph (f)(4).
0
6. Removing the second and third sentences in paragraph (g)(1).
0
7. Revising paragraph (g)(4)(i).
0
8. Redesignating paragraph (h) as paragraph (h)(1), adding paragraph 
(h) heading and adding paragraph (h)(2).
0
9. Revising paragraph (i)(3).
0
10. Removing Example 3; redesignating Example 5 as Example 3; and 
revising Example 4 in paragraph (i)(5)(iii).
0
11. In paragraph (i)(6)(iv)(D)(2), removing the language ``Sec.  1.199-
3T(i)(8)'' and adding ``Sec.  1.199-3(i)(8)'' in its place.
0
12. Redesignating paragraph (i)(9) as paragraph (i)(10) and adding 
paragraph (i)(9).
0
13. Adding three sentences after the first sentence in paragraph 
(k)(1),

[[Page 51987]]

revising paragraph (k)(2)(ii) introductory text, and adding a sentence 
at the end of paragraph (k)(3)(i).
0
14. Removing the first, second, and fifth sentences in paragraph 
(k)(3)(ii).
0
15. Adding one sentence at the end of paragraph (k)(6).
0
16. Adding two sentences before the last sentence in paragraph 
(k)(7)(i).
0
17. Revising the last sentence in paragraph (k)(8).
0
18. Redesignating paragraph (k)(10) as paragraph (k)(11) and adding 
paragraph (k)(10).
0
19. In newly redesignated paragraph (k)(11):
0
a. Revising Example 3;
0
b. Removing Example 4; redesignating Example 5 and Example 6 as Example 
4 and Example 5, respectively; and adding Example 6, Example 7, Example 
8, Example 9, Example 10, and Example 11; and
0
c. Revising the third sentence in newly redesignated Example 4.
0
20. Adding one sentence at the end of paragraph (m)(2)(i).
0
21. Revising paragraph (m)(5).
    The revisions and additions read as follows:


Sec.  1.199-3  Domestic production gross receipts.

* * * * *
    (d) * * *
    (4) * * *
    Example 6.  The facts are the same as Example 3 except that R 
offers three-car sets together with a coupon for a car wash for sale 
to customers in the normal course of R's business. The gross 
receipts attributable to the car wash do not qualify as DPGR because 
a car wash is a service, assuming the de minimis exception under 
paragraph (i)(4)(i)(B)(6) of this section does not apply. In 
determining R's DPGR, under paragraph (d)(2)(i) of this section, the 
three-car set is an item if the gross receipts derived from the sale 
of the three-car sets without the car wash qualify as DPGR under 
this section.
* * * * *
    Example 14.  Z is engaged in the trade or business of 
construction under NAICS code 23 on a regular and ongoing basis. Z 
purchases a piece of property that has two buildings located on it. 
Z performs construction activities in connection with a project to 
substantially renovate building 1. Building 2 is not substantially 
renovated and together building 1 and building 2 are not 
substantially renovated, as defined under paragraph (m)(5) of this 
section. Z later sells building 1 and building 2 together in the 
normal course of Z's business. Z can use any reasonable method to 
determine what construction activities constitute an item under 
paragraph (d)(2)(iii) of this section. Z's method is not reasonable 
if Z treats the gross receipts derived from the sale of building 1 
and building 2 as DPGR. This is because Z's construction activities 
would not have substantially renovated buildings 1 and 2 if they 
were considered together as one item. Z's method is reasonable if it 
treats the construction activities with respect to building 1 as the 
item under paragraph (d)(2)(iii) of this section because the 
proceeds from the sale of building 1 constitute DPGR.
    (e) * * *
    (1) * * * Pursuant to paragraph (f)(1) of this section, the 
taxpayer must be the party engaged in the MPGE of the QPP during the 
period the MPGE activity occurs in order for gross receipts derived 
from the MPGE of QPP to qualify as DPGR.
* * * * *
    (3) * * * Notwithstanding paragraph (i)(4)(i)(B)(4) of this 
section, if the taxpayer installs QPP MPGE by the taxpayer, then the 
portion of the installing activity that relates to the QPP is an MPGE 
activity.
* * * * *
    (5) * * *
    Example 1.  * * * A stores the agricultural products. * * *
* * * * *
    Example 4.  * * * Y engages in the reconstruction and 
refurbishment activity and installation of the parts. * * *
    Example 5.  The following activities are performed by Z as part 
of the MPGE of the QPP: 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. If Z did not MPGE the QPP, then 
these activities, such as testing of component parts, performed by Z 
are not the MPGE of QPP.
* * * * *
    Example 9.  X is in the business of selling gift baskets 
containing various products that are packaged together. X purchases 
the baskets and the products included within the baskets from 
unrelated third parties. X plans where and how the products should 
be arranged into the baskets. On an assembly line in a gift basket 
production facility, X arranges the products into the baskets 
according to that plan, sometimes relabeling the products before 
placing them into the baskets. X engages in no other activity 
besides packaging, repackaging, labeling, or minor assembly with 
respect to the gift baskets. Therefore, X is not considered to have 
engaged in the MPGE of QPP under paragraph (e)(2) of this section.
* * * * *
    (f) * * *
    (1) * * * If a qualifying activity under paragraph (e)(1), (k)(1), 
or (l)(1) of this section is performed under a contract, then the party 
to the contract that is the taxpayer for purposes of this paragraph (f) 
during the period in which the qualifying activity occurs is the party 
performing the qualifying activity.
* * * * *
    (4) * * *
    Example 1.  X designs 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 fixed-price contract. To 
manufacture the machines, Y purchases components and raw materials. 
Y tests the purchased components. Y manufactures the raw materials 
into additional components and Y physically performs the assembly of 
the components into machines. Y oversees and directs the activities 
under which the machines are manufactured by its employees. X also 
has employees onsite during the manufacturing for quality control. Y 
packages the finished machines and ships them to X's customers. 
Pursuant to paragraph (f)(1) of this section, Y is the taxpayer 
during the period the manufacturing of the machines occurs and, as a 
result, Y is treated as the manufacturer of the machines.
* * * * *
    (g) * * *
    (4) * * *
    (i) Contract with an unrelated person. If a taxpayer enters into a 
contract with an unrelated person pursuant to which the unrelated 
person is required to MPGE QPP within the United States for the 
taxpayer, the taxpayer is not considered to have engaged in the MPGE of 
that QPP pursuant to paragraph (f)(1) of this section, and therefore, 
for purposes of making any determination under this paragraph (g), the 
MPGE or production activities or direct labor and overhead of the 
unrelated person under the contract are only attributed to the 
unrelated person.
* * * * *
    (h) United States * * *
    (2) Commonwealth of Puerto Rico. The term United States includes 
the Commonwealth of Puerto Rico in the case of any taxpayer with gross 
receipts for any taxable year from sources within the Commonwealth of 
Puerto Rico, if all of such receipts are taxable under section 1 or 11 
for such taxable year. This paragraph (h)(2) only applies as provided 
in section 199(d)(8).
    (i) * * *
    (3) Hedging transactions--(i) In general. For purposes of this 
section, provided that the risk being hedged relates to property 
described in section 1221(a)(1) giving rise to DPGR 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--

[[Page 51988]]

    (A) In the case of a hedge of purchases of property described in 
section 1221(a)(1), income, deduction, 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), income, deduction, 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), income, deduction, gain, or loss on the hedging 
transaction must be taken into account in determining DPGR.
    (ii) Effect of identification and nonidentification. The principles 
of Sec.  1.1221-2(g) apply to a taxpayer that identifies or fails to 
identify a transaction as a hedging transaction, except that the 
consequence of identifying as a hedging transaction a transaction that 
is not in fact a hedging transaction described in paragraph (i)(3)(i) 
of this section, or of failing to identify a transaction that the 
taxpayer has no reasonable grounds for treating as other than a hedging 
transaction described in paragraph (i)(3)(i) of this section, is that 
deduction or loss (but not income or gain) from the transaction is 
taken into account under paragraph (i)(3) of this section.
    (iii) 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.
* * * * *
    (5) * * *
    (iii) * * *
    Example 4.  X produces a live television program that is a 
qualified film. In 2010, X broadcasts the television program on its 
station and distributes the program through the Internet. The 
television program contains product placements and advertising for 
which X received compensation in 2010. Because the methods and means 
of distributing a qualified film under paragraph (k)(1) of this 
section do not affect the availability of the deduction under 
section 199 for taxable years beginning after 2007, pursuant to 
paragraph (i)(5)(ii) of this section, all of X's product placement 
and advertising gross receipts for the program are treated as 
derived from the distribution of the qualified film.
* * * * *
    (9) Partnerships and S corporations engaging in production of 
qualified films--(i) In general. For taxable years beginning after 
2007, in the case of each partner of a partnership or shareholder of an 
S corporation who owns (directly or indirectly) at least 20 percent of 
the capital interests in such partnership or the stock of such S 
corporation, such partner or shareholder shall be treated as having 
engaged directly in any qualified film produced by such partnership or 
S corporation, and such partnership or S corporation shall be treated 
as having engaged directly in any qualified film produced by such 
partner or shareholder.
    (ii) No double attribution. When a partnership or S corporation is 
treated as having engaged directly in any qualified film produced by a 
partner or shareholder, any other partners of the partnership or 
shareholders of the S corporation who did not participate directly in 
the production of the qualified film are treated as not having engaged 
directly in the production of the qualified film at the partner or 
shareholder level. When a partner or shareholder is treated as having 
engaged directly in any qualified film produced by a partnership or S 
corporation, any other partnerships or S corporations in which that 
partner or shareholder owns an interest (excluding the partnership or S 
corporation that produced the film), are treated as not having engaged 
directly in the production of the qualified film at the partnership or 
S corporation level.
    (iii) Timing of attribution. A partner or shareholder is treated as 
having engaged directly in any qualified film produced by the 
partnership or S corporation, regardless of when the qualified film was 
produced by the partnership or S corporation, during any period that 
the partner or shareholder owns (directly or indirectly) at least 20 
percent of the capital interests in the partnership or stock of the S 
corporation (attribution period). During any period that a partner or 
shareholder owns less than a 20 percent of the capital interests in 
such partnership or the stock of such S corporation, that partner or 
shareholder is not treated as having engaged directly in the qualified 
film produced by the partnership or S corporation for purposes of this 
paragraph (i)(9). A partnership or S corporation is treated as having 
engaged directly in a qualified film produced by a partner or 
shareholder during any period the partner or shareholder owns (directly 
or indirectly) at least 20 percent of the capital interests in such 
partnership or the stock of S corporation (attribution period). During 
any period that the partner or shareholder owns less than 20 percent of 
the capital interests in such partnership or stock of such S 
corporation, the partnership or S corporation is not treated as having 
engaged directly in the qualified film produced by the partner or 
shareholder for purposes of this paragraph (i)(9). The attribution 
period under this paragraph (i)(9) may be shorter or longer than a 
taxpayer's taxable year, depending on the length of the attribution 
period.
    (iv) Examples. The following examples illustrate an application of 
this paragraph (i)(9). Assume that all taxpayers are calendar year 
taxpayers.

    Example 1.  In 2010, Studio A and Studio B form an S corporation 
in which each is a 50-percent shareholder to produce a qualified 
film. Studio A owns the rights to distribute the film domestically 
and Studio B owns the rights to distribute the film outside of the 
United States. The production activities of the S corporation are 
attributed to each shareholder, and thus each shareholder's revenue 
from the distribution of the qualified film is treated as DPGR 
during the attribution period because Studio A and Studio B are 
treated as having directly engaged in any film that was produced by 
the S corporation.
    Example 2.  The facts are the same as Example 1 except that, in 
2011, after the S corporation's production of the qualified film, 
Studio C becomes a shareholder that owns at least 20 percent of the 
stock of the S corporation. Studio C is treated as having directly 
engaged in any film that was produced by the S corporation during 
the attribution period, as defined in paragraph (i)(9)(iii) of this 
section.
    Example 3.  In 2010, Studio A and Studio B form a partnership in 
which each is a 50-percent partner to distribute a qualified film. 
Studio A produced the film and contributes it to the partnership and 
Studio B contributes cash to the partnership. The production 
activities of Studio A are attributed to the partnership, and thus 
the partnership's revenue from the distribution of the qualified 
film is treated as DPGR during the attribution period, as defined in 
paragraph (i)(9)(iii) of this section, because the partnership is 
treated as having directly engaged in any film that was produced by 
Studio A.
    Example 4.  The facts are the same as Example 3 except that 
Studio B receives a distribution of the rights to license an 
intangible associated with the qualified film produced by Studio A. 
Any receipts derived from the licensing of the intangible by Studio 
B are non-DPGR because Studio A's production activities are 
attributed to the partnership, and are not further attributed to 
Studio B.
    Example 5.  The facts are the same as Example 3 except that, at 
some point in 2011, Studio A owns less than a 20-percent capital 
interest in the partnership. During the period that Studio A owns 
less than a 20-percent capital interest in the partnership between 
Studio A and Studio B, the partnership is not treated as directly 
engaging in the production of a qualified film. Therefore, any 
future receipts the partnership derives from the film after the end 
of the attribution period, as defined in paragraph (i)(9)(iii) of 
this section, are non-DPGR. Studio A, however, is still treated as 
having engaged directly in the production of the qualified film.
* * * * *
    (k) * * *
    (1) * * * For taxable years beginning after 2007, the term 
qualified film

[[Page 51989]]

includes any copyrights, trademarks, or other intangibles with respect 
to such film (intangibles). For purposes of this paragraph (k), other 
intangibles include rights associated with the exploitation of a 
qualified film, such as endorsement rights, video game rights, 
merchandising rights, and other similar rights. See paragraph (k)(10) 
of this section for a special rule for disposition of promotional 
films. * * *
    (2) * * *
    (ii) Film produced by a taxpayer. Except for intangibles under 
paragraph (k)(1) of this section, 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--
* * * * *
    (3) * * *
    (i) * * * For taxable years beginning after 2007, the methods and 
means of distributing a qualified film shall not affect the 
availability of the deduction under section 199.
* * * * *
    (6) * * * Production activities do not include transmission or 
distribution activities with respect to a film, including the 
transmission of a film by electronic signal and the activities 
facilitating such transmission (such as formatting that enables the 
film to be transmitted).
    (7) * * *
    (i) * * * Paragraph (g)(3)(ii) of this section includes all costs 
paid or incurred by a taxpayer, whether or not capitalized or required 
to be capitalized under section 263A, to produce a live or delayed 
television program, and also includes any lease, rental, or license 
fees paid by a taxpayer for all or any portion of a film, or films 
produced by a third party that taxpayer uses in its film. License fees 
for films produced by third parties are not included in the direct 
labor and overhead to produce the film for purposes of applying 
paragraph (g)(3) of this section. * * *
* * * * *
    (8) * * * If one party performs a production activity pursuant to a 
contract with another party, then only the party that is considered the 
taxpayer pursuant to paragraph (f)(1) of this section during the period 
in which the production activity occurs is treated as engaging in the 
production activity.
* * * * *
    (10) Special rule for disposition of promotional films and products 
or services promoted in promotional films. A promotional film is a film 
produced to promote a taxpayer's particular product or service and the 
term includes, but is not limited to, commercials, infomercials, 
advertising films, and sponsored films. A product or service is 
promoted in a promotional film if the product or service appears in, is 
described during, or is in a similar way alluded to by such film. If a 
promotional film meets the requirements to be treated as a qualified 
film produced by the taxpayer, then a taxpayer derives gross receipts 
from the lease, rental, license, sale, exchange, or other disposition 
of a qualified film, including any copyrights, trademarks, or other 
intangibles when the promotional film's disposition is distinct 
(separate and apart) from the disposition of the promoted product or 
service. Gross receipts are not derived from the disposition of a 
qualified film, including any copyrights, trademarks, or other 
intangibles when gross receipts are derived from a disposition of the 
promoted product or service.
    (11) * * *

    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 the methods and means of distributing a qualified 
film under paragraph (k)(1) of this section do not affect the 
availability of the deduction under section 199 for taxable years 
beginning after 2007, the advertising income X receives from 
advertisers is derived from the lease, rental, license, sale, 
exchange, or other disposition of the qualified films and is DPGR.
    Example 4.  * * * Y is considered the taxpayer performing the 
qualifying activities pursuant to paragraph (f)(1) of this section 
with respect to the DVDs during the MPGE and duplication process. * 
* *
* * * * *
    Example 6.  X produced a qualified film and licenses the 
trademark of Character A, a character in the qualified film, to Y 
for reproduction of the Character A image onto t-shirts. Y sells the 
t-shirts with Character A's likeness to customers, and pays X a 
royalty based on sales of the t-shirts. X's qualified film only 
includes intangibles with respect to the qualified film in taxable 
years beginning after 2007, including the trademark of Character A. 
Accordingly, any gross receipts derived from the license of the 
trademark of Character A to Y occurring in a taxable year beginning 
before 2008 are non-DPGR, and any gross receipts derived from the 
license of the trademark of Character A occurring in a taxable year 
beginning after 2007 are DPGR (assuming all other requirements of 
this section are met). The royalties X derives from Y occurring in a 
taxable year beginning before 2008 are non-DPGR because the 
royalties are derived from an intangible (which is not within the 
definition of a qualified film under paragraph (k)(1) of this 
section for taxable years beginning before 2008).
    Example 7.  Y, a media company, acquires all of the intangible 
rights to Book A, which was written and published in 2008, and all 
of the intangible rights associated with a qualified film that is 
based on Book A. The qualified film based on Book A is produced in 
2009 by Y. Y owns the copyright and trademark to Character B, the 
lead character in Book A and the qualified film based on Book A. Y 
licenses Character B's copyright and trademark to Z for $50,000,000. 
For 2009, without taking into account the payment from Z, Y derives 
40 percent of its gross receipts from the qualified film based on 
Book A, and 60 percent from Book A. Z's payment is attributable to 
both Book A and the qualified film based on Book A. Therefore, Y 
must allocate Z's payment, and only the gross receipts derived from 
licensing the intangible rights associated with the qualified film 
based on Book A, or 40 percent, are DPGR.
    Example 8.  Z produces a commercial in the United States that 
features Z's shirts, shoes, and other athletic equipment that all 
have Z's trademarked logo affixed (promoted products). Z's 
commercial is a qualified film produced by Z. Z sells the shirts, 
shoes, and athletic equipment to customers at retail establishments. 
Z's gross receipts are derived from the disposition of the promoted 
products and are not derived from the disposition of Z's qualified 
film, including any copyrights, trademarks, or other intangibles 
with respect to Z's qualified film.
    Example 9.  X produces a commercial in the United States that 
features X's services (promoted services). X's commercial is a 
qualified film produced by X. The commercial includes Character A 
developed to promote X's services. Gross receipts that X derives 
from providing the promoted services are not derived from the 
disposition of X's qualified film, including any copyrights, 
trademarks, or other intangibles with respect to X's qualified film. 
X also licenses the right to reproduce Character A developed to 
promote X's services to Y so that Y can produce t-shirts featuring 
Character A. This license is distinct (separate and apart) from a 
disposition of the promoted services and the gross receipts are 
derived from the license of an intangible with respect to X's 
qualified film produced by X. X's gross receipts derived from the 
license to reproduce Character A are DPGR.
    Example 10.  Y produces a qualified film in the United States. Y 
purchases DVDs and affixes the qualified film to the DVDs. Y 
purchases gift baskets and sells individual gift baskets that 
contain a DVD with the affixed qualified film in its retail stores 
in the normal course of Y's business. Under Sec.  1.199-
3(k)(2)(ii)(A), Y may treat the DVD as part of the qualified film 
produced by taxpayer, but Y cannot treat the gift baskets as part of 
the qualified film produced by taxpayer. The gross receipts that Y 
derives from the sale of the DVD are DPGR derived from a qualified 
film, but the gross receipts that Y derives from the sale of the 
gift baskets are non-DPGR.
    Example 11.  The facts are the same as in Example 10 except that 
the individual gift baskets that Y sells also contain boxes of 
popcorn and candy manufactured by Y within the United States. Under 
Sec.  1.199-3(k)(2)(ii)(A), Y cannot treat the gift baskets 
including the boxes of popcorn and candy manufactured by Y as part 
of the qualified

[[Page 51990]]

film produced by taxpayer. Gross receipts from the sale of the DVD 
are still treated as DPGR derived from a qualified film. Y must 
separately determine whether the gross receipts from the tangible 
personal property it sells qualify as DPGR. Thus, Y must determine 
whether the gift basket, including the boxes of popcorn and candy 
but excluding the qualified film, is an item for purposes of Sec.  
1.199-3(d)(1)(i).
* * * * *
    (m) * * *
    (2) * * *
    (i) * * * A taxpayer whose engagement in the activity is primarily 
limited to approving or authorizing invoices or payments is not 
considered engaged in a construction activity as a general contractor 
or in any other capacity.
* * * * *
    (5) Definition of substantial renovation. The term substantial 
renovation means activities the costs of which would be required to be 
capitalized by the taxpayer as an improvement under Sec.  1.263(a)-3, 
other than an amount described in Sec.  1.263(a)-3(k)(1)(i) through 
(iii). If not otherwise defined under Sec.  1.263(a)-3, the unit of 
property for purposes of Sec.  1.263(a)-3 is the real property, as 
defined in paragraph (m)(3) of this section, to which the activities 
relate.
* * * * *
    Par. 6. Section 1.199-4 is amended by adding a sentence after the 
seventh sentence in paragraph (b)(1) and adding paragraph (b)(2)(iii) 
to read as follows:


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

* * * * *
    (b) * * *
    (1) * * * In the case of a long-term contract accounted for under 
the percentage-of-completion method described in Sec.  1.460-4(b) 
(PCM), or the completed-contract method described in Sec.  1.460-4(d) 
(CCM), CGS for purposes of this section includes the allocable contract 
costs described in Sec.  1.460-5(b) (in the case of a contract 
accounted for under PCM) or Sec.  1.460-5(d) (in the case of a contract 
accounted for under CCM). * * *
    (2) * * *
    (iii) Cost of goods sold associated with activities undertaken in 
an earlier taxable year--(A) In general. A taxpayer must allocate CGS 
between DPGR and non-DPGR under the rules provided in paragraphs 
(b)(2)(i) and (ii) of this section, regardless of whether certain costs 
included in CGS can be associated with activities undertaken in an 
earlier taxable year (including a year prior to the effective date of 
section 199). A taxpayer may not segregate CGS into component costs and 
allocate those component costs between DPGR and non-DPGR.
    (B) Example. The following example illustrates an application of 
paragraph (b)(2)(iii)(A) of this section:
    Example. During the 2009 taxable year, X manufactured and sold 
Product A. All of the gross receipts from sales recognized by X in 
2009 were from the sale of Product A and qualified as DPGR. Employee 
1 was involved in X's production process until he retired in 2003. 
In 2009, X paid $30 directly from its general assets for Employee 
1's medical expenses pursuant to an unfunded, self-insured plan for 
retired X employees. For purposes of computing X's 2009 taxable 
income, X capitalized those medical costs to inventory under section 
263A. In 2009, the CGS for a unit of Product A was $100 (including 
the applicable portion of the $30 paid for Employee 1's medical 
costs that was allocated to cost of goods sold under X's allocation 
method for additional section 263A costs). X has information readily 
available to specifically identify CGS allocable to DPGR and can 
identify that amount without undue burden and expense because all of 
X's gross receipts from sales in 2009 are attributable to the sale 
of Product A and qualify as DPGR. The inventory cost of each unit of 
Product A sold in 2009, including the applicable portion of retiree 
medical costs, is related to X's gross receipts from the sale of 
Product A in 2009. X may not segregate the 2009 CGS by separately 
allocating the retiree medical costs, which are components of CGS, 
to DPGR and non-DPGR. Thus, even though the retiree medical costs 
can be associated with activities undertaken in prior years, $100 of 
inventory cost of each unit of Product A sold in 2009, including the 
applicable portion of the retiree medical expense cost component, is 
allocable to DPGR in 2009.
* * * * *
0
Par. 7. Section 1.199-6 is amended by adding Example 4 to paragraph (m) 
to read as follows:


Sec.  1.199-6  Agricultural and horticultural cooperatives.

* * * * *
    (m) * * *
    Example 4. (i) The facts are the same as Example 1 except that 
Cooperative X's payments of $370,000 for its members' corn qualify 
as per-unit retain allocations paid in money within the meaning of 
section 1388(f) and Cooperative X reports the per-unit retain 
allocations paid in money on Form 1099-PATR.
    (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 in Sec.  1.199-3(a)). Cooperative X's QPAI is 
$1,370,000. Cooperative X's section 199 deduction for its taxable 
year 2007 is $82,200 (.06 x $1,370,000). Because this amount is more 
than 50% of Cooperative X's W-2 wages (.5 x $130,000 = $65,000), the 
entire amount is not allowed as a section 199 deduction, but is 
instead subject to the wage limitation section 199(b), and also 
remains subject to the rules of section 199(d)(3) and this section.
0
Par. 8. Section 1.199-8 is amended by revising the heading of paragraph 
(i) and adding paragraphs (i)(10) and (11) to read as follows:


Sec.  1.199-8  Other rules.

* * * * *
    (i) Effective/applicability dates * * *
* * * * *
    (10) [The text of the proposed amendments to Sec.  1.199-8(i)(10) 
is the same as the text of Sec.  1.199-8T(i)(10) published elsewhere in 
this issue of the Federal Register].
    (11) Energy Improvement and Extension Act of the 2008, Tax 
Extenders and Alternative Minimum Tax Relief Act of 2008, Tax Relief, 
Unemployment Insurance Reauthorization, and Job Creation Act of 2010, 
and other provisions. Section 1.199-1(f); the last sentence in Sec.  
1.199-2(e)(1) and paragraph (f); Sec.  1.199-3(d)(4) Example 6 and 
Example 14, the last sentence in paragraph (e)(1), the last sentence in 
paragraph (e)(3), the third sentence in paragraph (e)(5) Example 1, the 
second sentence in paragraph (e)(5) Example 4, paragraph (e)(5) Example 
5 and Example 9, the last sentence in paragraph (f)(1), paragraph 
(f)(4) Example 1, paragraph (g)(4)(i), paragraphs (h)(2), (i)(3), 
(i)(5) Example 4, and (i)(9), the second, third, and fourth sentences 
in paragraph (k)(1), paragraph (k)(2)(ii), the second sentence in 
paragraph (k)(3)(i), the last sentence in paragraph (k)(6), the second 
sentence from the last sentence in paragraph (k)(7)(i), the last 
sentence in paragraph (k)(8), paragraph (k)(10), the third sentence in 
paragraph (k)(11) Example 4, paragraph (k)(11) Example 3, Example 6, 
Example 7, Example 8, Example 9, Example 10, and Example 11, the last 
sentence in paragraph (m)(2)(i), paragraph (m)(5); the eighth sentence 
in Sec.  1.199-4(b)(1) and paragraph (b)(2)(iii); and Sec.  1.199-6(m) 
Example 4 apply to taxable years beginning on or after the date the 
final regulations are published in the Federal Register.

John M. Dalrymple,
Deputy Commissioner for Services and Enforcement.
[FR Doc. 2015-20772 Filed 8-26-15; 8:45 am]
 BILLING CODE 4830-01-P