As part of the recently enacted American Jobs Creation Act of 2004, signed by President Bush on October 22, 2004, Congress has provided a tax benefit for certain manufacturing, production, agricultural, mining, computer software and construction activities. The benefit is in the form of a deduction that, when fully phased in, will be equal to 9 percent of net income from such activities (the equivalent of a 3.15 percentage point reduction in the maximum federal income tax rate for corporations). Although this deduction has received attention primarily with respect to manufacturing activities, in fact it will be available to a much broader range of taxpayers. Accordingly, most businesses should seriously consider whether their activities qualify, or can be restructured to qualify, for this deduction.
Who Can Claim the Deduction?
The deduction is technically available to any producer of "qualifying production property," "qualifying films," or electricity, natural gas or potable water. Therefore, any business that manufactures, produces, grows or extracts tangible personal property, computer software or sound recordings, or produces electricity, natural gas or potable water is potentially eligible for the deduction. Additionally, any business performing construction activities in the United States, or architectural or engineering services in the United States in connection with a U.S. construction project, is considered a producer under the new tax law. Finally, the production of films can be considered to give rise to a deduction as a production activity if certain production expense thresholds are satisfied.
The deduction is available not only to the production activities of corporations, including S corporations, but also to partnerships, limited liability companies, trusts, and estates as well as businesses conducted as sole proprietorships. When these taxpayers take advantage of the deduction, the amount of the tax benefit would depend upon the marginal tax rate of the partners, members, and trust, estate or beneficiaries to whom the relevant income is taxed.
Although most of the focus of the deduction is on U.S.-based activity, in some cases foreign activity may provide the basis, in part, for the deduction. For example, income from a manufacturing, production, growing, extraction or film production activity is eligible for the deduction even if part of the activity takes place outside the United States.
How Large is the Deduction?
The deduction will be calculated as a percentage (3 percent for taxable years beginning in 2005 and 2006, 6 percent for taxable years beginning in 2007-2009, and 9 percent thereafter) of "qualified production activities income," subject to two limitations. First, the deduction for any given year cannot exceed the appropriate percentage of the taxpayer's taxable income for the year, computed after taking into account net operating losses carried over to the year. Second, the deduction cannot exceed 50 percent of the W-2 wages paid during the year by the taxpayer and its "expanded affiliated group," which encompasses corporations affiliated through 50 percent or greater common ownership. It should be noted that the wages that are taken into account are not limited to wages associated with the production activity that is eligible for the deduction. Therefore, even taxpayers that have relatively few employees (for example, because they are staffed primarily by independent contractors) may not be excluded from benefiting significantly from the deduction if their affiliates have a significant employee workforce.
What Are the Specifics/What Must Be Produced?
The new law allows a deduction for corporations from taxable income and, for individuals, from adjusted gross income. The deduction for a qualifying producer is calculated by first determining the "qualified production activities income" (QPAI) of a taxpayer for the taxable year. QPAI is defined as the taxpayer's "domestic production gross receipts" reduced by cost of goods sold and the direct and indirect costs allocable to such receipts.
"Domestic production gross receipts" is defined as gross receipts from:
A. the sale, exchange, lease, rental or license of:
- tangible personal property, computer software, and sound recordings manufactured, produced, grown or extracted by the taxpayer in whole or "significant part" in the United States,
- any motion picture film or videotape produced by the taxpayer so long as at least 50 percent of the compensation (including film rights and residuals) attributable to acting, directing, and production compensation is attributable to services performed in the United States, and
- electricity, natural gas or potable water produced in the United States (but not to the extent attributable to the transmission or distribution thereof);
B. construction performed in the United States; and
C. engineering or architectural services performed in the United States for U.S. construction projects.
Gross receipts from some activities that might otherwise be "domestic production gross receipts" are specifically excluded. For instance, gross receipts from the lease, license or rental of property for use by any person related to the taxpayer are not considered "domestic production gross receipts." However, gross receipts from the sale of property to a related party appear to be eligible for "domestic production gross receipts" treatment. In addition, gross receipts from the sale of food and beverages prepared by the taxpayer at a restaurant or for carry out purposes are not considered "domestic production gross receipts."
The production activity deduction brings with it a wide array of interpretive issues and planning considerations. The scope and extent of what constitutes manufacturing or production activities is not entirely clear. Similarly, there are ambiguities as to whether a given production-related function is an eligible activity or falls within one of the functions specifically excluded from qualified production activity status. Maximizing the benefits from the deduction will take significant planning and, in some cases, may necessitate a restructuring of operations. Thus, in some cases, what are by themselves not qualifying activities may, when combined with other functions, legitimately generate domestic production gross receipts. Where certain transactions with related parties do not generate qualifying gross receipts, a restructuring to expand the functions of the producing entity may permit a taxpayer to deal directly with unrelated customers and therefore earn domestic production gross receipts. Where comprehensive restructuring is not commercially reasonable, the producing entity may nonetheless be able to generate some domestic production gross receipts, subject to ensuring that its affiliates report arm's length profits for the functions they carry out.
Buchanan Ingersoll & Rooney has assisted clients on the federal and state income tax levels in dealing with issues that will be of importance in applying the new production activity deduction, such as the categorization of income and maximization of tax benefits that are targeted to manufacturers or producers. The firm has more than 40 years of experience in tax accounting issues, and can assist eligible taxpayers in analyzing how to allocate expenses to qualifying receipts. In addition, the firm has handled many matters in the transfer pricing area, not just in helping to establish defensible transfer prices between affiliates, but also in restructuring functions to minimize overall taxes based on detailed functional analyses. This experience can help our clients determine whether and how they can maximize the benefits from the new production activity deduction.
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