As expected, the Treasury Department on January 19 released much-anticipated guidance (Notice 2005-14) on the phased-in deduction for qualified domestic production income that was enacted last October as part of the American Jobs Creation Act of 2004. The deduction is effective for taxable years beginning after December 31, 2004. Taxpayers may rely on the interim guidance provided in the detailed 102-page notice until final regulations are issued.
In addition to the notice, Treasury also issued a fact sheet outlining the guidance. A draft version of the fact sheet was inadvertently released electronically to the public on January 13. (For coverage, see Tax News & Views, Vol. 6, No. 3, Jan. 14, 2005.) The description of the guidance in the final version of the fact sheet is generally similar to the draft version. The significant differences between the two are discussed below.
Qualified Production Activities
The final fact sheet contains the same list of qualifying activities that was provided in the draft, but it clarifies that (1) the construction and substantial renovation of real property must take place in the United States; and (2) the engineering and architectural services must be performed in the United States and must relate to the construction of real property. Thus, the final fact sheet states that qualified production activities include:
The manufacture, production, growth, or extraction in whole or significant part in the United States of tangible personal property (e.g., clothing, goods, and food), software development, or music recordings;
Film production (with exclusions specified in the statute), provided at least 50 percent of the total compensation relating to the production of the film is compensation for specified production services performed in the United States;
Production of electricity, natural gas, or water in the United States;
Construction or substantial renovation of real property in the United States, including residential and commercial buildings and infrastructure such as roads, power lines, water systems, and communications facilities; or
Engineering and architectural services performed in the United States and relating to construction of real property.
The final fact sheet contains the same description of qualifying construction activities that is in the draft. These include construction and substantial renovation of real property, including residential and commercial buildings and infrastructure such as roads, power lines, water systems, and communications facilities. Both versions of the fact sheet also explain that rental income for real property is not eligible for the qualified production activities deduction. However, in the final fact sheet, Treasury notes that the later sale of the property may qualify for the deduction if all other requirements are satisfied.
Eligible Income Derived From Computer Software
The final fact sheet states that income from “on-line services” does not qualify for the deduction. The draft version of the fact sheet contained a narrower limitation; it stated that income from “on-line subscription services” does not qualify for the deduction. The list of income sources that do not qualify for the qualified production activities deduction includes:
Fees for on-line use of software;
Fees for customer support with respect to computer software;
Fees for telephone services provided in part through use of software;
Fees for playing computer games on-line; and
Provider-controlled online access services.
Partnerships and S Corporations
According to the draft fact sheet, the deduction attributable to the qualifying production activities of a partnership or S corporation (passthrough entity) is determined at the partner or shareholder (partner) level. As a result, each partner must compute its deduction separately. The final fact sheet adds that the guidance contains simplifying rules for certain small partnerships to determine the deduction.
Allocating Cost of Goods Sold and Other Deductions
Like the draft, the final fact sheet states that two methods have been provided for allocating deductions (other than cost of goods sold) to qualified production activities and that the first method is available to all taxpayers. However, the final fact sheet clarifies that the second method is available to taxpayers with average annual gross receipts (over the three prior years) of $25 million or less — not less than $25 million as stated in the draft. Further, the second method provides a simplified formula that allocates deductions based on the ratio of the taxpayer’s receipts derived from qualifying production activities as compared to the taxpayer’s receipts from all sources. The draft had indicated that the formula was based on the taxpayer’s income rather than the taxpayer’s receipts. Finally, a third allocation method is available for taxpayers with average annual gross receipts of $5 million or less and certain other small taxpayers permitted to use the cash method of accounting. The draft fact sheet had stated that the third method was available for small taxpayers with annual gross receipts of less than $5 million and certain other small taxpayers permitted to use the cash method of accounting.
The Treasury Department and the IRS anticipate that forthcoming proposed regulations will incorporate the rules set forth in Notice 2005-14. Comments on the rules contained in the notice — and on any additional guidance that should be provided in the regulations — should be submitted by March 31, 2005.
— Donna Edwards
Tax Policy Services Group
Deloitte Tax LLP