SECTION 4. INTERIM GUIDANCE

.01 In General . Under § 199(a)(1), a taxpayer may deduct an amount equal to 9 percent (3 percent in the case of taxable years beginning in 2005 and 2006, and 6 percent in the case of taxable years beginning in 2007, 2008, or 2009) of the lesser of the taxpayer’s QPAI (as defined in section 4.03 of this notice) for the taxable year, or the taxpayer’s taxable income (determined without regard to § 199) for the taxable year. For purposes of the preceding sentence, the definition of taxable income under § 63 shall apply.

.02 Wage Limitation . (1) Rules of ap- plication . (a) In general . Pursuant to § 199(b)(1), the amount of the deduction allowable to the taxpayer under § 199(a) for any taxable year shall not exceed 50 percent of the W–2 wages of the taxpayer. For this purpose, except as provided in section 4.02(1)(c) of this notice, the Forms W–2 used in determining the amount of W–2 wages are those issued for the cal

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§ 3402(o)(2)(A)) that were included in the total in Step A; and

(C) Add to the amount obtained after Step (B) amounts that are reported in Box 12 of Forms W–2 with respect to employees of the taxpayer for employment by the taxpayer and that are properly coded D, E, F, G or S.

.03 Determining Qualified Produc- tion Activities Income . (1) In general . 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 (as defined in section 4.04 of this notice), over (B) the sum of (i) the CGS that are allocable to such receipts ( see section 4.05), (ii) other deductions, expenses, or losses directly allocable to such receipts ( see section 4.05), and (iii) a ratable portion of other deductions, expenses, and losses that are not directly allocable to such receipts or another class of income ( see section 4.05). For purposes of § 199, QPAI is determined on an item-by-item basis (and not, for example, on a division-by-division, product line-by-product line, or transaction-by-transaction basis) and is the sum of QPAI derived by the taxpayer from each item. For purposes of this determination, QPAI from each item may be positive or negative. For example, if a taxpayer manufactures a shirt and a hat in the United States, and the QPAI derived from the manufacture of the shirt is $3 and the QPAI derived from the manufacture of the hat is ($1), the taxpayer’s QPAI is $2.

(2) Allocation of gross receipts . A taxpayer must determine the portion of its gross receipts that are DPGR and the portion of its gross receipts that are not DPGR. For example, if a taxpayer leases, rents, licenses, sells, exchanges, or otherwise disposes of QPP, the gross receipts of which constitute DPGR, and engages in transactions with respect to similar property, the gross receipts of which do not constitute DPGR, the taxpayer must allocate its gross receipts from all the transactions based on a reasonable method that is satisfactory to the Secretary and that accurately identifies the gross receipts that constitute DPGR. Factors taken into consideration in determining whether the method is reasonable include whether the taxpayer uses the most accurate information available; the relationship between the gross receipts and the apportionment base chosen; the accuracy of the method chosen

employment compensation benefits paid during the short taxable year are required to be deducted and that in step (C) of such method only the portions of the amounts reported in Box 12, Codes D, E, F, G, and S actually deferred or contributed during the short taxable year may be included in the W–2 wages.

(d) Acquisition or disposition of a trade or business (or major portion) . If a taxpayer (a successor) acquires the major portion of a trade or business or the major portion of a separate unit of a trade or business from another taxpayer (a predecessor), the W–2 wages of each of the successor and predecessor for purposes of computing the § 199 deduction shall be computed pursuant to the rules of this notice, including sections 4.02(1) and 4.02(2) of this notice, regardless of whether the W–2 wages are reported on Forms W–2 furnished by the successor or Forms W–2 furnished by the predecessor.

(e) Non-duplication rule . Amounts that are treated as W–2 wages for a taxable year under any method may not be treated as W–2 wages of any other taxable year.

(2) Definition of “W–2 wages.” (a) In general . Section 199(b)(2) defines W–2 wages for purposes of § 199(b)(1) as the sum of the amounts required to be included on statements under § 6051(a)(3) and (8) with respect to employment of employees of the taxpayer for the calendar year. Thus, the term W–2 wages includes: (i) the total amount of wages as defined in § 3401(a); (ii) the total amount of elective deferrals (within the meaning of § 402(g)(3)); (iii) the compensation deferred under § 457; and (iv) for tax years beginning after December 31, 2005, the amount of designated Roth contributions (as defined in § 402A). Under the 2004 and 2005 Form W–2, the elective deferrals under § 402(g)(3) and the amounts deferred under § 457 directly correlate to coded items reported in Box 12 on Form W–2. Box 12, Code D is for elective deferrals to a § 401(k) cash or deferred arrangement; Box 12, Code E is for elective deferrals under a § 403(b) salary reduction agreement; Box 12, Code F is for elective deferrals under a § 408(k)(6) salary reduction Simplified Employee Pension (SEP); Box 12, Code G is for elective deferrals under a § 457(b) plan; and Box 12, Code S is for employee salary reduction contributions under a § 408(p) SIMPLE (simple retirement account).

(b) Methods for calculating W–2 wages . Taxpayers may use one of three methods in calculating W–2 wages. These three methods are subject to the non-duplication rule provided in section 4.02(1)(e) of this notice, and the tracking wages method is subject to the rule provided in section 4.02(1)(c), if applicable. (i) Unmodified box method . Under this method, W–2 wages are calculated by taking, without modification, the lesser of:

(A) The total entries in Box 1 of all Forms W–2 filed with the SSA by the taxpayer with respect to employees of the taxpayer for employment by the taxpayer; or

(B) The total entries in Box 5 of all Forms W–2 filed with the SSA by the taxpayer with respect to employees of the taxpayer for employment by the taxpayer.

(ii) Modified Box 1 method . Under this method, the taxpayer makes modifications to the total entries in Box 1 of Forms W–2 filed with respect to employees of the taxpayer. W–2 wages under this method are calculated as follows:

(A) Total the amounts in Box 1 of Forms W–2 with respect to employees of the taxpayer for employment by the taxpayer;

(B) Subtract from the total in Step (A) amounts included in Box 1 of Forms W–2 that are not wages for federal income tax withholding purposes and amounts included in Box 1 of Forms W–2 that are treated as wages under § 3402(o) (for example, supplemental unemployment compensation benefits); and

(C) Add to the amount obtained after Step (B) amounts that are reported in Box 12 of Forms W–2 with respect to employees of the taxpayer for employment by the taxpayer and that are properly coded D, E, F, G, or S.

(iii) Tracking wages method . Under this method, the taxpayer actually tracks total wages subject to federal income tax withholding and makes appropriate modifications. W–2 wages under this method are calculated as follows:

(A) Total the amounts of wages subject to federal income tax withholding that are paid to employees of the taxpayer for employment by the taxpayer and that are reported on Forms W–2 for the calendar year;

(B) Subtract from the total in Step (A) the supplemental unemployment compensation benefits (as defined in

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receipts do not include the repayment of a loan or similar instrument (for example, a repayment of the principal amount of a loan held by a commercial lender) and, except to the extent of gain recognized, do not include gross receipts derived from a non-recognition transaction such as a § 1031 exchange. Finally, gross receipts do not include amounts received by the taxpayer with respect to sales tax or other similar state and local taxes if, under the applicable state or local law, the tax is legally imposed on the purchaser of the good or service, and the taxpayer merely collects and remits the tax to the taxing authority. If, in contrast, the tax is imposed on the taxpayer under the applicable law, then gross receipts include the amounts received that are allocable to the payment of such tax.

(3) Definition of “manufactured, pro- duced, grown, or extracted.” (a) In gen- eral . The terms MPGE in § 199(c) (4)(A)(i)(I) include activities relating to 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 terms also include storage, handling or other processing activities (other than transportation activities) within the United States related to the sale, exchange or other disposition of agricultural products, provided the products are consumed in connection with, or incorporated into, the MPGE of QPP whether or not by the taxpayer. For example, assume A, B, and C are unrelated taxpayers. A owns grain storage bins in the United States in which it stores for a fee B’s corn that was grown in the United States. B sells its corn to C. C processes B’s corn into corn syrup in the United States. The gross receipts from A’s, B’s, and C’s activities are DPGR from the MPGE of QPP.

(b) Consistency with § 263A . A taxpayer that has MPGE QPP for the taxable year should treat itself as a producer under § 263A with respect to the QPP for the taxable year unless the taxpayer is not subject to § 263A under the Code, regulations, or other published guidance. A taxpayer that currently is not properly ac

as compared with other possible methods; whether the method is used by the taxpayer for internal management or other business purposes; whether the method is used for other federal, state, or foreign income tax purposes; the time, burden, and cost of using various methods; and whether the taxpayer applies the method consistently from year to year. All of a taxpayer’s gross receipts are treated as DPGR if less than 5 percent of the taxpayer’s total gross receipts are non-DPGR (after application of other de minimis safe harbors provided in section 4 of this notice that result in gross receipts being treated as DPGR). If the amount of the taxpayer’s gross receipts that do not qualify as DPGR equals or exceeds 5 percent of the total gross receipts, the taxpayer is required to allocate all gross receipts between DPGR and non-DPGR. For example, if a taxpayer only derives gross receipts from the sale of gasoline refined by the taxpayer in the United States and the sale of gasoline the taxpayer acquired (either by purchase or in exchange for gasoline refined by the taxpayer in the United States) from an unrelated party, the taxpayer must allocate its gross receipts between the gross receipts attributable to the gasoline refined by the taxpayer in the United States (that qualify as DPGR assuming all other requirements of § 199 are met) and the taxpayer’s gross receipts derived from the resale of the acquired gasoline (that do not qualify as DPGR) if 5 percent or more of the taxpayer’s total gross receipts are not from the sale of gasoline refined by the taxpayer in the United States. Similarly, a taxpayer that manufactures the same type of QPP at facilities within the United States and outside the United States must allocate its gross receipts between the receipts from the QPP manufactured in the United States and receipts from the QPP not manufactured in the United States if 5 percent or more of its total gross receipts are non-DPGR.

(3) Treatment of advance payments . If a taxpayer recognizes an advance payment for goods, services, use of property, etc., in gross receipts in a taxable year earlier than the taxable year the goods, services, use of property, etc., to which the advance payment relates are delivered, performed, provided, etc., the taxpayer must accurately identify based on a reasonable method that is satisfactory to the Secretary whether the receipts (and correspond

ing CGS and expenses) qualify as DPGR. See section 4.03(2) of this notice for the factors taken into consideration in determining whether the taxpayer’s method is reasonable.

.04 Determining Domestic Produc- tion Gross Receipts . (1) In general . Section 199(c)(4)(A) defines DPGR as the gross receipts (as defined in section 4.04(2) of this notice) of the taxpayer that are derived from (as defined in section 4.04(7)): (a) Any lease, rental, license, sale, exchange, or other disposition of:

(i) QPP (as defined in section 4.04(8)) that is MPGE (as defined in section 4.04(3)) by the taxpayer (as defined in section 4.04(4)) in whole or in significant part (as defined in section 4.04(5)) within the United States (as defined in section of 4.04(6)), (ii) Any qualified film (as defined in section 4.04(9)) produced by the taxpayer (in accordance with section 4.04(9)), or

(iii) Electricity, natural gas, or potable water (as defined in section 4.04(10)) produced by the taxpayer in the United States (in accordance with section 4.04(10)),

(b) Construction (as defined in section 4.04(11)) performed in the United States (in accordance with section 4.04(11)), or

(c) Engineering or architectural services (as defined in section 4.04(12)) performed in the United States for construction projects in the United States (in accordance with 4.04(12)).

(2) Definition of “gross receipts.” The term “gross receipts” means the taxpayer’s receipts for the taxable year that are recognized under the taxpayer’s method of accounting used in that taxable year for federal income tax purposes. For this purpose, gross receipts include total sales (net of returns and allowances) and all amounts received for services. In addition, gross receipts include any income from investments, and from incidental or outside sources. For example, gross receipts include interest (including original issue discount and tax-exempt interest within the meaning of § 103), dividends, rents, royalties, and annuities, regardless of whether the amounts are derived in the ordinary course of the taxpayer’s trade of business. Gross receipts are not reduced by CGS or by the cost of property sold if such property is described in § 1221(a)(1), (2), (3), (4) or (5). Gross

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nor assembly operations do not qualify as conversion costs.

(6) Definition of “United States.” For purposes of § 199, the term “United States” includes the 50 states, the District of Columbia, the territorial waters of the United States, and the seabed and subsoil of those submarine areas that are adjacent to the territorial waters of the United States and over which the United States has exclusive rights, in accordance with international law, with respect to the exploration and exploitation of natural resources. The term “United States” does not include possessions and territories of the United States or the airspace over the United States and these areas.

(7) Definition of “derived from the lease, rental, license, sale, exchange, or other disposition of qualifying production property.” (a) In general . The term “derived from the lease, rental, license, sale, exchange, or other disposition of qualifying production property” is defined as, and limited to, the gross receipts directly from the lease, rental, license, sale, exchange, or other disposition of QPP. For example, “derived from the sale of QPP” includes gross receipts from the sale of QPP manufactured in whole or in significant part in the United States by a taxpayer for sale, as well as gross receipts from the sale of self-constructed QPP manufactured in whole or in significant part in the United States by a taxpayer and used in the taxpayer’s trade or business before being sold. In addition, the proceeds from business interruption insurance and payments not to produce are treated as gross receipts “derived from the lease, rental, license, sale, exchange, or other disposition of QPP” to the extent that they are substitutes for gross receipts that would qualify as DPGR. The value of property received in an exchange of QPP that was MPGE by the taxpayer for QPP that was MPGE by an unrelated taxpayer is DPGR for the taxpayer. The value of property acquired by a taxpayer in exchange for QPP is gross receipts derived from an exchange of the QPP, and is DPGR if the QPP was MPGE by the taxpayer in whole or in significant part within the United States. However, any gross receipts from the subsequent sale by the taxpayer of the property that the taxpayer acquired in the exchange are not DPGR, because the taxpayer did not MPGE the property acquired in the ex

counting for its production activities under § 263A, and wishes to change its method of accounting to comply with the producer requirements of § 263A, must follow the procedures of Rev. Proc. 97–27 or Rev. Proc. 2002–9, whichever applies.

(4) Definition of “by the taxpayer.” With the exception of the rules provided in section 4.09(2)(b) of this notice applicable to an EAG, if one taxpayer performs a qualifying activity under § 199(c)(4)(A)(i) pursuant to a contract with another party, then only the taxpayer that has the benefits and burdens of ownership of the property under federal income tax principles during the period the qualifying activity occurs is treated as engaging in the qualifying activity.

(5) Definition of “in whole or in signif- icant part.” (a) In general . QPP described in § 199(c)(4)(A)(i)(I) must be MPGE in whole or in significant part by the taxpayer within the United States. Except in the case of a related person transaction under § 199(c)(7), DPGR includes all of the taxpayer’s gross receipts derived from the lease, rental, license, sale, exchange, or other disposition of QPP for which the taxpayer MPGE the QPP in whole or in significant part in the United States. For example, if a taxpayer imports QPP that is partially manufactured, the taxpayer completes the manufacture of the QPP in the United States, and the taxpayer’s completion of the manufacturing of the QPP in the United States satisfies the “in significant part” requirement, then the taxpayer’s gross receipts from the sale of the QPP qualify as DPGR (assuming all other requirements of § 199(c) are met). In addition, if a taxpayer manufactures QPP in significant part in the United States and exports the QPP for further manufacture outside the United States, the taxpayer’s gross receipts derived from the lease, rental, license, sale, exchange, or other disposition of that QPP will be considered DPGR, regardless of whether the QPP is imported back into the United States prior to the lease, rental, license, sale, exchange, or other disposition of the QPP (assuming all other requirements of § 199(c) are met). If a taxpayer enters into a contract with another party and the taxpayer has the benefits and burdens of ownership of the QPP under federal income tax principles during the period the MPGE activity occurs and the taxpayer is considered to MPGE the

QPP under § 199, then the taxpayer must determine whether the MPGE performed by the other party on behalf of the taxpayer is performed in whole or in significant part within the United States.

(b) Substantial in nature . QPP will be treated as MPGE in significant part by the taxpayer within the United States if the MPGE of the QPP performed by the taxpayer within the United States is substantial in nature taking into account all the facts and circumstances, including the relative value added by, and relative cost of, the taxpayer’s MPGE activity in the United States, the nature of the property, and the nature of the MPGE activity that the taxpayer performs in the United States. For example, if property is MPGE by the taxpayer outside the United States or by an unrelated party within the United States and the property is used as a component part of the QPP produced by the taxpayer within the United States, the QPP (including the component part) will be treated as MPGE in significant part by the taxpayer within the United States if the production of the QPP performed by the taxpayer within the United States is substantial in nature. In addition, if a taxpayer purchases unrefined oil extracted outside the United States by an unrelated party and the taxpayer refines the oil in the United States, the refining of the oil by the taxpayer in the United States will be treated as MPGE that is substantial in nature within the United States. However, packaging, repackaging, labeling, and minor assembly operations do not qualify as substantial in nature. In addition, development activities and the creation or licensing of intangibles do not qualify as substantial in nature for any QPP other than computer software and sound recordings.

(c) Safe harbor . A taxpayer will be treated as having MPGE property in whole or in significant part within the United States if, in connection with the property, conversion costs (direct labor and related factory burden) to MPGE the property are incurred by the taxpayer within the United States and the costs account for 20 percent or more of the total CGS of the property. For purposes of this safe harbor, development costs and the cost of any intangibles do not qualify as conversion costs for any QPP other than computer software and sound recordings. In addition, the costs of packaging, repackaging, labeling, and mi

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purposes of § 199(c)(5)(A) even though under local law the property is considered a fixture and therefore real property. Thus, property such as production machinery, printing presses, transportation and office equipment, refrigerators, grocery counters, testing equipment, display racks and shelves, and neon and other signs that is contained in or attached to a building constitutes tangible personal property for purposes of § 199(c)(5)(A). Further, property that is in the nature of machinery (other than structural components of a building) is tangible personal property even though located outside a building. Thus, for example, a gasoline pump, hydraulic car lift, or automatic vending machine, although annexed to the ground, is considered tangible personal property. A structure that is property in the nature of machinery or is essentially an item of machinery or equipment is not an inherently permanent structure and is tangible personal property. In the case, however, of a building or inherently permanent structure that includes property in the nature of machinery as a structural component, the property in the nature of machinery is real property. The term “tangible personal property” does not include the creation of copyrighted material such as a manuscript in a form other than in a tangible medium.

(c) Computer software . The term “computer software” means any program or routine or any sequence of machine-readable code that is designed to cause a computer to perform a desired function or set of functions, and the documentation required to describe and maintain that program or routine. Computer software also includes the machine-readable coding for video games and similar programs, regardless of whether the program is designed to operate on a “computer” (as defined in § 168(i)(2)(B)). If the medium in which the software is contained, whether written, magnetic, or otherwise, is tangible, then such medium is considered tangible personal property for purposes of § 199. Therefore, if a taxpayer develops a software program that it reproduces and sells on diskettes, the program fixed on the diskette is treated as computer software, and the diskette is treated as tangible personal property. Computer programs of all classes, for example, operating systems, executive systems, monitors, compilers and translators, assembly routines, and

change, even if that property is QPP that had been MPGE within the United States by the other party to the exchange.

(b) Allocation of gross receipts - em- bedded services . Except with respect to construction or engineering or architectural services described in § 199(c)(4)(ii) and (iii), gross receipts “derived from” the performance of services do not qualify as DPGR. In the case of an embedded service, that is, a service the price of which is included in the amount charged for the lease, rental, license, sale, exchange, or other disposition of property, DPGR includes only the receipts from the lease, rental, license, sale, exchange, or other disposition of the property and not any receipts attributable to the embedded service (assuming all other requirements of § 199(c) are met). There are two exceptions to this general rule regarding embedded services. First, a taxpayer may include in DPGR (assuming all other requirements of § 199(c) are met) gross receipts from a qualified warranty (that is, a warranty that is provided in connection with the sale of QPP if (1) in the normal course of its business, the charge for the warranty is included in the price charged for the lease, rental, license, sale, exchange, or other disposition of the QPP and (2) the warranty is neither separately offered by the taxpayer nor separately bargained for with the customer (that is, the customer cannot purchase the QPP without the warranty)). Second, a de minimis amount of gross receipts from embedded services for each item of property may qualify as DPGR. A de minimis amount of gross receipts from embedded services is less than 5 percent of the gross receipts derived from the lease, rental, license, sale, exchange, or other disposition of the property. For purposes of applying this de minimis test, gross receipts from qualified warranties are not treated as gross receipts for services.

(c) Advertising income . Gross receipts that are “derived from” the sale or other disposition of newspapers and magazines include advertising income. For example, a newspaper manufacturer’s gross receipts from an advertiser to publish display advertising or classified advertisements in its newspaper are treated as gross receipts derived from the sale of the newspapers (assuming all other requirements of § 199 are met).

(d) Computer software . Gross receipts derived from computer software (as defined in section 4.04(8)(c)) do not include gross receipts derived from Internet access services, online services, customer support, telephone services, games played through a website, provider-controlled software online access services, and other services that do not constitute the lease, rental, license, sale, exchange, or other disposition of computer software that was developed by the taxpayer.

(e) Exception for certain oil and gas partnerships . If a partnership is engaged solely in the extraction, refining, processing, etc., of oil or gas and distributes the oil or gas or products derived from the oil or gas (products) to its partners who then sell the oil or gas or products, then, for purposes of § 199, the gross receipts derived by the partners from the sale of the oil or gas or products are treated as gross receipts derived by the partnership from the MPGE of QPP. The partnership must follow the rules provided in section 4.06 of this notice regarding the application of § 199 to pass-thru entities to ensure that the costs attributable to oil or gas or products are properly taken into account.

(8) Definition of “qualifying produc- tion property.” (a) In general. Qualifying production property includes: (1) tangible personal property, as defined in section 4.04(8)(b); (2) computer software, as defined in section 4.04(8)(c); and (3) sound recordings, as defined in section 4.04(8)(d). (b) Tangible personal property . The term “tangible personal property” is any tangible property other than land, buildings, (including items that are structural components of such buildings) and any property described under § 199(c)(4)(A)(i)(II) and (III), or § 199(c)(5)(B) and (C). Thus, qualified films, computer software, and sound recordings are not tangible personal property regardless of whether they are fixed on a tangible medium. However, the tangible medium on which the property is fixed (for example, a videocassette, a computer diskette, or other similar tangible item) is tangible personal property. In determining whether property is “tangible personal property,” the fact that property is personal property or tangible property under local law is not controlling. Conversely, property may be tangible personal property for

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Title 18 requires maintenance of certain records with respect to any book, magazine, periodical, film, videotape, or other matter that (1) contains one or more visual depictions made after November 1, 1990, of actual sexually explicit conduct and (2) is produced in whole or in part with materials that have been mailed or shipped in interstate or foreign commerce, or is shipped or transported or is intended for shipment or transportation in interstate or foreign commerce.

(10) Electricity, natural gas, and potable water . (a) In general . DPGR includes gross receipts derived from any lease, rental, license, sale, exchange, or other disposition of electricity, natural gas, or potable water produced by the taxpayer in the United States (assuming all other requirements of § 199(c) are met). DPGR does not include gross receipts of the taxpayer derived from the transmission or distribution of these items.

(b) Natural gas . The term “natural gas” includes only natural gas extracted from a natural deposit and does not include, for example, methane gas extracted from a landfill. In the case of natural gas, production activities include all activities involved in extracting natural gas from the ground and processing the gas into pipeline quality gas.

(c) Potable water . The term “potable water” means unbottled drinking water. In the case of potable water, production activities include the acquisition, collection, and storage of raw water (untreated water), transportation of raw water to a water treatment facility, and treatment of raw water at such a facility. Gross receipts attributable to any of these activities are included in DPGR (assuming all other requirements of § 199(c) are met). DPGR does not include, however, gross receipts derived from the storage of potable water after completion of treatment of the potable water, or delivery of potable water to customers.

(d) Exceptions . In the case of an integrated producer that both produces and delivers electricity, natural gas, or potable water, the taxpayer must allocate its gross receipts between production (DPGR) and distribution and transmission (non-DPGR). However, if less than 5 percent of a taxpayer’s gross receipts derived from a sale of electricity, natural gas, or potable water are attributable to the transmission or distribution of the elec

utility programs as well as application programs, are included. Computer software also includes any incidental and ancillary rights that are necessary to effect the acquisition of the title to, the ownership of, or the right to use the computer software, and that are used only in connection with that specific computer software. Such incidental and ancillary rights are not included in the definition of trademark or trade name under § 1.197–2(b)(10)(i). For example, a trademark or trade name that is ancillary to the ownership or use of a specific computer software program in the taxpayer’s trade or business and is not acquired for the purpose of marketing the computer software is included in the definition of computer software and is not included in the definition of trademark or trade name. Computer software does not include any data or information base unless the data base or item is in the public domain and is incidental to a computer program. For this purpose, a copyrighted or proprietary data or information base is treated as in the public domain if its availability through the computer program does not contribute significantly to the cost of the program. For example, if a word-processing program includes a dictionary feature that may be used to spell-check a document or any portion thereof, the entire program (including the dictionary feature) is computer software regardless of the form in which the dictionary feature is maintained or stored.

(d) Sound recordings . The term “sound recordings” means any works that result from the fixation of a series of musical, spoken, or other sounds. If the medium (such as compact discs, tapes, or other phonorecordings) in which the sounds are embodied is tangible, the medium is considered tangible personal property for purposes of § 199. Therefore, the sale of an audio cassette involves both a sound recording (the sounds fixed on the tape) and tangible personal property (the cassette itself). See section 4.04(8)(c) of this notice. The term “sound recordings” does not include the creation of copyrighted material in a form other than a sound recording, such as lyrics or music written on paper or other similar material.

(9) Definition of “qualified film.” (a) In general . The term “qualified film” means any motion picture film, video tape, or live or delayed television programming if

not less than 50 percent of the total compensation relating to the production of the property is compensation for services performed in the United States by actors, production personnel, directors, and producers. The term “production personnel” includes writers, choreographers and composers providing services during the production of a film, casting agents, camera operators, set designers, lighting technicians, make-up artists, and others whose activities are directly related to the production of the film. “Production personnel” do not include, however, individuals whose activities are ancillary to the production, such as advertisers and promoters, distributors, studio administrators and managers, studio security personnel, and personal assistants to actors. If the medium on which a qualified film is fixed is tangible (such as a DVD), such medium is treated as tangible personal property. Therefore, a DVD copy of a motion picture consists of both a qualified film (the motion picture content embodied in the disc) and tangible personal property (the disc itself).

(b) Compensation for services . The term “compensation for services” means all payments for services performed by actors, production personnel, directors, and producers, including participations and residuals. In the case of a taxpayer that uses the income forecast method of § 167(g) and capitalizes participations and residuals into the adjusted basis of the qualified film, the taxpayer must use the same estimate of participations and residuals for purposes of § 199 that it uses for purposes of § 167(g). In the case of a taxpayer that excludes participations and residuals from adjusted basis of the qualified film under § 167(g)(7)(D)(i), the taxpayer must determine the compensation expected to be paid as participations and residuals based on the total forecasted income used in determining income forecast depreciation.

(c) Determination of 50 percent . A taxpayer may use any reasonable method of making the allocation. Among the factors to be considered in determining whether a taxpayer’s method of allocating compensation is reasonable is whether the taxpayer uses that method consistently.

(d) Exception . A “qualified film” does not include property with respect to which records are required to be maintained under 18 U.S.C. § 2257. Section 2257 of

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from the sale, exchange, or other disposition of real property constructed by the taxpayer in the United States (whether or not the property is sold immediately after construction is completed). DPGR derived from the construction of real property also includes compensation for the performance of construction services by the taxpayer in the United States. However, DPGR derived from the construction of real property does not include gross receipts from the lease or rental of real property constructed by the taxpayer or gross receipts attributable to the sale or other disposition of land.

(12) Definition of “Engineering and architectural services.” (a) In general . DPGR includes gross receipts derived from engineering or architectural services performed in the United States for construction projects in the United States (assuming all other requirements of § 199(c) are met). The engineering or architectural services must relate to real property, must be performed in the United States, and the taxpayer providing these services must be able to substantiate that the services relate to a construction project within the United States. DPGR includes gross receipts derived from engineering or architectural services even if the planned construction project is not undertaken or is not completed (subject to the taxpayer substantiating that the services relate to a construction project that would have been within the United States if it had been undertaken and assuming all other requirements of § 199(c) are met).

(b) Engineering services . Engineering services in connection with any construction project include any professional services requiring engineering education, training, and experience and the application of special knowledge of the mathematical, physical, or engineering sciences to those professional services such as consultation, investigation, evaluation, planning, design, or responsible supervision of construction for the purpose of assuring compliance with plans, specifications, and design.

(c) Architectural services . Architectural services in connection with any construction project include the offering or furnishing of any professional services such as consultation, planning, aesthetic and structural design, drawings and specifications, or responsible supervision of

tricity, natural gas, or potable water, then the gross receipts derived from that sale that are attributable to the transmission and distribution of the electricity, natural gas, or potable water will be treated for purposes of § 199 as being DPGR (assuming all other requirements of § 199(c) are met).

(i) Electricity . Gross receipts attributable to the transmission of electricity from the generating facility to a point of local distribution and gross receipts attributable to the distribution of electricity to final customers are not DPGR.

(ii) Natural gas . Gross receipts attributable to the transmission of pipeline quality gas from a natural gas field (or from a natural gas processing plant) to a local distribution company’s citygate (or to another customer) are not DPGR. Likewise, gross receipts of a local gas distribution company attributable to distribution from the citygate to the local customers are not DPGR.

(iii) Potable water . Gross receipts attributable to the storage of potable water after completion of treatment of the potable water, as well as gross receipts attributable to the transmission and distribution of potable water, are not DPGR.

(11) Definition of “construction per- formed in the United States.” (a) Construction of real property. The term “construction” means the construction or erection of real property (that is, residential and commercial buildings (including items that are structural components of such buildings), inherently permanent structures other than tangible personal property in the nature of machinery ( see section 4.04(8)(b) of this notice), inherently permanent land improvements, and infrastructure) by a taxpayer that is in a trade or business that is considered construction for purposes of the North American Industry Classification System (NAICS codes). Tangible personal property (as defined under section 4.04(8)(b)) (for example, appliances, furniture and fixtures) that is sold as part of a construction project is not considered real property for this purpose. However, if more than 95 percent of the total gross receipts derived by a taxpayer from a construction project are derived from real property (as defined in § 1.263A–8(c)), then the total gross receipts derived by the taxpayer from the project are DPGR from construction (assuming all other requirements of § 199(c) are met). In determin

ing whether property is “real property,” the fact that property is real property under local law is not controlling. Conversely, property may be real property for purposes of § 199(c)(4)(A)(ii) even though under local law the property is considered tangible personal property.

(b) Activities constituting construction . Activities constituting construction include activities performed in connection with a project to erect or substantially renovate real property, but do not include tangential services such as hauling trash and debris, and delivering materials, even if the tangential services are essential for construction. However, if the taxpayer performing construction also, in connection with the construction project, provides tangential services such as delivering materials to the construction site and removing its construction debris, the gross receipts derived from the tangential services are DPGR. Improving land (for example, grading and landscaping) and painting are activities constituting construction only if these activities are performed in connection with other activities (whether or not by the same taxpayer) that constitute the erection or substantial renovation of real property. The taxpayer engaged in these activities must make a reasonable inquiry to determine whether the activity relates to the erection or substantial renovation of real property. The term “construction” does not include any activity that is within the definition of “engineering and architectural services” ( see section 4.04(12) of this notice).

(c) Definition of “infrastructure.” The term “infrastructure” includes roads, power lines, water systems, railroad spurs, communications facilities, sewers, sidewalks, cable, and wiring. The term also includes inherently permanent oil and gas platforms.

(d) Definition of “substantial renova- tion.” The term “substantial renovation” means the renovation of a major component or substantial structural part of real property that materially increases the value of the property, substantially prolongs the useful life of the property, or adapts the property to a new or different use.

(e) “Derived from construction.” Assuming all other requirements of § 199(c) are met, DPGR derived from the construction of real property performed in the United States includes the proceeds

2005–7 I.R.B. 520 February 14, 2005

justed basis of noninventory property, the gross receipts from the sale or other disposition of which are included in DPGR.

(b) Allocating cost of goods sold . If a taxpayer can identify from its books and records CGS allocable to DPGR, CGS allocable to DPGR is that amount. However, if a taxpayer’s books and records do not allow the taxpayer to identify CGS allocable to DPGR, the taxpayer must use a reasonable method to allocate CGS between DPGR and other gross receipts. If a taxpayer uses a method to allocate gross receipts between DPGR and non-DPGR, the taxpayer may not use a different method for purposes of allocating CGS. In other cases, whether an allocation method is reasonable is based on all of the facts and circumstances including the relationship between CGS and the base chosen; the accuracy of the method chosen as compared with other possible methods; whether the method is used by the taxpayer for internal management and other business purposes; whether the method is used for other federal or state income tax purposes; the availability of costing information; and the time, burden, and cost of using various methods. Depending on the facts and circumstances, reasonable methods may include methods based on gross receipts, number of units sold, number of units produced, or total production costs.

(c) Special rules for imported items or services . Under § 199(c)(3), the cost of any item or service brought into the United States is treated as not less than its value immediately after it entered the United States for purposes of determining the CGS to be used in the computation of QPAI. When an item or service is brought into the United States that had been exported by the taxpayer for further manufacture, the increase in cost may not exceed the difference between the value of the property when exported and the value of the property when brought back into the United States after further manufacture. For this purpose, the value of property is its customs value as defined in § 1059A(b)(1).

(3) Other deductions allocable or apportionable to domestic production gross receipts . (a) In general . Section 199(c)(1)(B)(ii) and (iii) requires a taxpayer to reduce DPGR by deductions that are directly allocable to DPGR, and a ratable portion of deductions that are not

construction (for the purpose of assuring compliance with plans, specifications, and design) or erection, in connection with any construction project.

(d) De minimis exception for perfor- mance of services in the United States . If gross receipts derived from engineering or architectural services (1) performed outside the United States or (2) related to property other than real property for a construction project inside the United States total less than 5 percent of the total gross receipts of the taxpayer derived from engineering or architectural services performed by the taxpayer with regard to the same construction project, such receipts will be treated as DPGR.

(13) Exception for sales of certain food and beverages . DPGR does not include gross receipts of the taxpayer that are derived from the sale of food or beverages prepared by the taxpayer at a retail establishment. A “retail establishment” is defined as real property leased, occupied, or otherwise used by the taxpayer in its trade or business of selling food or beverages to the public at which retail sales are made. A facility at which food or beverages are prepared will not be treated as a retail establishment if less than 5 percent of the food or beverages that are sold at that facility during the taxable year are retail sales. If a taxpayer’s facility is a retail establishment, then, as a matter of administrative grace, the taxpayer may allocate its gross receipts between gross receipts derived from the retail sale of the food and beverages prepared and sold at the retail establishment (which are non-DPGR) and gross receipts derived from the wholesale sale of the food and beverages prepared at the retail establishment (which are DPGR). The exception for sales of certain food and beverages also applies to food and beverages for non-human consumption.

(14) Related persons . Section 199(c)(7) provides that DPGR does not include any gross receipts of the taxpayer derived from property leased, licensed, or rented by the taxpayer for use by any related person. A person is treated as related to another person if both persons are treated as a single employer under either § 52(a) or (b) (without regard to § 1563(b)), or § 414 (m) or (o).

.05 Determining Costs . (1) In gen- eral . To determine its QPAI for the taxable year, a taxpayer must reduce its DPGR

by the amount of CGS directly allocable to DPGR, the amount of deductions directly allocable to DPGR and a ratable portion of other deductions not directly allocable to DPGR, or another class of income. Section 4.05(2) of this notice provides rules for determining CGS directly allocable to DPGR. Section 4.05(3) provides rules for determining the deductions allocated and apportioned to DPGR and a ratable portion of deductions not directly allocable to DPGR or another class of income. Section 4.05(3) generally provides that a taxpayer must determine deductions allocated and apportioned to DPGR using the rules of the regulations under § 861 of the Code. Section 4.05(3) provides, however, that a taxpayer with average annual gross receipts of $25,000,000 or less may determine deductions apportionable to DPGR using the simplified deduction method. Section 4.05(4) provides a simplified overall method that a qualifying small taxpayer may use to allocate and apportion CGS and deductions to DPGR. Consistent with the rule in section 4.09(1) that treats all members of an EAG as a single corporation for purposes of § 199, whether the members of an EAG may use the simplified deduction method or the small business simplified overall method is determined at the EAG level. In addition, a member of an EAG that may use the simplified deduction method or the small business simplified overall method may do so only if all members of the EAG agree to and use the same method.

(2) Cost of goods sold allocable to do- mestic production gross receipts . (a) In general . Section 199(c)(1)(B)(i) requires a taxpayer to reduce DPGR by the CGS directly allocable to DPGR. A taxpayer must allocate CGS in accordance with this section 4.05(2) of this notice or, if applicable, section 4.05(4). CGS is equal to beginning inventory plus purchases and production costs incurred during the taxable year less ending inventory. For purposes of § 199, CGS allocable to DPGR includes the costs that would have been included in ending inventory under the principles of §§ 263A, 471, and 472 if the goods sold during the taxable year were on hand at the end of the taxable year. CGS allocable to DPGR includes inventory valuation adjustments such as writedowns under the lower of cost or market method. For purposes of § 199, CGS also includes the ad

February 14, 2005 521 2005–7 I.R.B.

and 882(c)(1)(B)) must be ratably apportioned between gross income attributable to DPGR and other gross income based on the relative amounts of gross income. For individuals, this provision applies solely to deductions for charitable contributions that are attributable to the actual conduct of a trade or business.

(iii) Research and experimental expen- ditures . Research and experimental expenditures must be allocated and apportioned in accordance with § 1.861–17. Because an apportionment based on geographic sources is not required for purposes of § 199, the exclusive apportionment rule of § 1.861–17(b) does not apply for purposes of the § 861 method.

(d) Simplified deduction method . A taxpayer with average annual gross receipts (as defined in section 4.05(5) of this notice) of $25,000,000 or less may use the simplified deduction method. Under the simplified deduction method, except as provided in section 4.05(3)(b) of this notice, a taxpayer’s deductions are ratably apportioned between DPGR and non-DPGR based on relative gross receipts. Accordingly, the amount of deductions apportioned to DPGR is equal to the same proportion of the deductions that the amount of DPGR bears to total gross receipts. In the case of an owner of a pass-thru entity, the simplified deduction method (including whether the method may be used) is applied at the level of the owner of the pass-thru entity taking into account the owner’s DPGR, receipts, and other items from all sources including its distributive or allocable share of those items of the pass-thru entity.

(4) Small business simplified overall method . (a) In general . A qualifying small taxpayer may use the small business simplified overall method to allocate and apportion CGS and deductions between DPGR and non-DPGR. Under the small business simplified overall method, a taxpayer’s total CGS and deductions (except as provided in section 4.05(3)(b) of this notice) are ratably apportioned between DPGR and other receipts based on relative gross receipts. Accordingly, the amount of CGS and deductions apportioned to DPGR is equal to the same proportion of CGS and deductions that the amount of DPGR bears to total gross receipts.

(b) Qualifying small taxpayer . For purposes of section 4.05(4)(a) of this notice,

directly allocable to DPGR or another class of income. Any cost that may not be taken into account in computing taxable income for the taxable year is not treated as a deduction for purposes of this section. A taxpayer generally must allocate and apportion these deductions using the rules provided in the § 861 regulations, subject to the rules provided in this section 4.05(3) (the § 861 method). In lieu of the § 861 method, a taxpayer with average annual gross receipts of $25,000,000 or less may apportion these deductions using the simplified deduction method. A taxpayer electing the simplified deduction method must use that method for all deductions. See also section 4.05(4) for the small business simplified overall method available to a qualified small taxpayer.

(b) Rules that apply to all alloca- tion and apportionment methods . (i) In general . The rules provided in section 4.05(3)(b)(ii) through (v) apply to losses, net operating losses, and certain other deductions when allocating and apportioning deductions to DPGR or gross income attributable to DPGR under the § 861 method (section 4.05(3)(c)), the simplified deduction method (section 4.05(3)(d)), or the small business simplified overall method (section 4.05(4)).

(ii) Losses . A deduction under § 165 for a loss related to property (including theft, casualty, or abandonment losses) is allocated or apportioned to DPGR or gross income attributable to DPGR only if the proceeds from the sale of the property are, or would have been, included in DPGR.

(iii) Net operating losses . A deduction allowed under § 172 for a net operating loss is not allocated or apportioned to DPGR or gross income attributable to DPGR.

(iv) Deductions not attributable to the actual conduct of a trade or business . Deductions not attributable to the actual conduct of a trade or business are not allocated or apportioned to DPGR or gross income attributable to DPGR. See § 199(d)(5). For example, the standard deduction provided by § 63(c) and the deduction for personal exemptions provided by § 151 are not allocated or apportioned to DPGR or gross income attributable to DPGR.

(v) Deductions related to de minimis gross receipts and embedded services included in domestic production gross re- ceipts . If a taxpayer is permitted to treat

non-DPGR as DPGR pursuant to a safe harbor or de minimis rule provided in this notice ( e.g., section 4.03(2) or section 4.04(10)(d) of this notice), deductions related to such non-DPGR treated as DPGR must be allocated or apportioned to DPGR or gross income attributable to DPGR. If the gross receipts related to embedded services are included in DPGR under section 4.04(7), the deductions related to providing such services must be allocated or apportioned to DPGR or gross income attributable to DPGR.

(c) Section 861 method. (i) In gen- eral . A taxpayer must allocate and apportion its deductions using the allocation and apportionment rules provided by the § 861 regulations, subject to the modifications provided in section 4.05(3)(b)(ii) through (v) and section 4.05(3)(c)(ii) and (iii) of this notice. Under this method, § 199 is treated as an “operative section” described in § 1.861–8(f). Accordingly, the taxpayer applies the rules of the § 861 regulations to allocate and apportion deductions (including its distributive shares of deductions) to gross income attributable to DPGR. Generally, the taxpayer allocates deductions to the relevant class of gross income and apportions (if necessary) such deductions within the class of gross income between gross income attributable to DPGR (the statutory grouping) and other income (the residual grouping). The § 861 regulations generally are applied on a single entity basis, although the rules are applied on the basis of the affiliated group (as determined under the § 861 regulations) for certain expenses such as interest expense and research and experimental expenses. Consistent with these rules, allocation and apportionment of deductions generally are determined on an aggregate basis by the owner of the pass-thru entity. See for example, §§ 1.861–9T(e) and –17(f). If the taxpayer uses the allocation and apportionment rules of the § 861 regulations for another operative section of the Code, it must use the same method of allocation and the same principles for apportionment for purposes of all operative sections (subject to, in the case of the § 861 method, the rules provided in section 4.05(3)(b)(ii) through (v) and section 4.05(3)(c)(ii) and (iii) of this notice). See § 1.861–8(f)(2)(i).

(ii) Deductions for charitable contribu- tions . Deductions for charitable contributions (as allowed under §§ 170, 873(b)(2),

2005–7 I.R.B. 522 February 14, 2005

computing its QPAI for that later taxable year.

(iii) W–2 wages . Under § 199(d)(1)(B), a partner’s share of W–2 wages of the partnership for purposes of determining the partner’s § 199(b) limitation is the lesser of the partner’s allocable share of the wages (without regard to § 199(d)(1)(B)) as determined under regulations prescribed by the Secretary, or 2 times 9 percent (3 percent in the case of taxable years beginning in 2005 and 2006, and 6 percent in the case of taxable years beginning in 2007, 2008, or 2009) of the QPAI computed taking into account only the items of the partnership allocated to the partner for the taxable year of the partnership. In determining a partner’s share of the W–2 wages of a partnership, allocations by the partnership of W–2 wages, otherwise meeting the requirements of § 704(b), shall be taken into account by the partner for purposes of § 199(d)(1)(B). Thus, a partner’s share of W–2 wages of the partnership is the lesser of the amount of W–2 wages allocated to the partner under § 704, or 2 times the applicable percentage of the QPAI computed taking into account only the items of the partnership allocated to the partner for the taxable year of the partnership, determined at the partner level, in accordance with section 4.06(1)(a)(i) and (ii), by reference to the partner’s distributive or allocable share of the partnership’s items of income, gain, loss or deduction (including gross receipts and costs of goods sold), allocated or attributable to qualified production activities, and expenses incurred directly by the partner which are allocated to the partnership’s qualified production activities, for the taxable year. Each partner must aggregate the W–2 wages allocated from the partnership with its W–2 wages from other sources for purposes of computing the partner’s § 199(b) limitation for the taxable year. However, if QPAI computed taking into account only the items of the partnership allocated to the partner for the taxable year is not greater than zero, the partner may not take into account any W–2 wages of the partnership for purposes of computing the wage limitation under § 199(b) for the taxable year.

(b) S corporations . (i) Determination at S corporation shareholder level . The § 199 deduction is determined at the shareholder level. As a result, each shareholder must compute its deduction separately.

a qualifying small taxpayer is a taxpayer that has average annual gross receipts (as described in section 4.05(5) of this notice) of $5,000,000 or less or a taxpayer that is eligible to use the cash method as provided in Rev. Proc. 2002–28, 2002–1 C.B. 815. (That is, any taxpayer with average annual gross receipts of $10,000,000 or less that is not prohibited from using the cash method under § 448, including a partnership, an S corporation, a C corporation, or an individual.)

(5) Average annual gross receipts . For purposes of the simplified deduction method in section 4.05(3)(d) of this notice and the small business simplified overall method in section 4.05(4), average annual gross receipts means the average annual gross receipts of the taxpayer for the 3 taxable years (or, if fewer, the taxable years during which the taxpayer was in existence) preceding the current taxable year, even if one or more of such taxable years began before the effective date of § 199. In the case of any taxable year of less than 12 months (a short taxable year), the gross receipts shall be annualized by (a) multiplying the gross receipts for the short period by 12 and (b) dividing the result by the number of months in the short period. Whether the members of an EAG may use the simplified deduction method or the small business simplified overall method is determined by reference to the average annual gross receipts of the EAG. To compute the average annual gross receipts of an EAG, the gross receipts of each member of the EAG for its taxable year that ends with or within the taxable year of the computing member (as defined in section 4.09(8) of this notice) are aggregated, regardless of whether the computing member or the non-computing member was a member of the EAG during its entire taxable year. A member of an EAG that qualifies to use the simplified deduction method or the small business simplified overall method may do so only if all members of the EAG agree to and use the same method.

.06 Application of § 199 to Pass-thru Entities . (1) Allocations to partners, shareholders, and similar interest hold- ers . (a) Partnerships . (i) Determination at partner level . The § 199 deduction is determined at the partner level. As a result, each partner must compute its deduction separately. Each partner is allocated,

in accordance with §§ 702 and 704, its share of items (including items of income, gain, loss, deduction, cost of goods sold allocated to such items of income, and gross receipts that are included in such items of income) allocated or attributable to the partnership’s activities described in § 199(c)(4) (qualified production activities), along with any other items of income, gain, loss, deduction or credit of the partnership. To determine its § 199 deduction for the taxable year, a partner aggregates its share of the items allocated or attributable to the partnership’s qualified production activities, any expenses incurred by the partner directly that are allocated to the partnership’s qualified production activities, and those items of the partner that are allocated or attributable to qualified production activities from sources other than the partnership. A partnership may specially allocate items of income, gain, loss, or deduction allocated or attributable to the partnership’s qualified production activities, subject to the rules of § 1.704–1(b), including the rules for determining substantial economic effect under § 1.704–1(b)(2)(iii).

(ii) Expenses . Each partner must take into account the partner’s distributive share of expenses allocated to the qualified production activities of the partnership, regardless of whether the partnership otherwise has taxable income. However, expenses of a partnership that otherwise would be taken into account for purposes of computing the partner’s § 199 deduction shall only be taken into account if and to the extent the partner’s distributive share of the losses and deductions from all of the partnership’s activities is not disallowed by §§ 465, 469, 704(d), or any other provision of the Code. In the event that only a portion of the partner’s distributive share of the losses or deductions are allowed for a taxable year, a proportionate share of the losses or deductions that reflect expenses allocated to the partnership’s qualified production activities, determined in a manner consistent with §§ 465, 469 and 704(d), shall be taken into account for purposes of computing the § 199 deduction for that taxable year. To the extent that any of the disallowed losses or deductions are allowed in a later taxable year, the partner shall take into account a proportionate share of the expenses reflected in those losses or deductions in

February 14, 2005 523 2005–7 I.R.B.

spective § 199 deductions for their taxable years ending December 31, 2006.

.07 Patrons of Agricultural and Horti- cultural Cooperatives . Section 199(d)(3) and this section 4.07 apply in the case of a cooperative (to which Part I of Subchapter T applies), that is engaged in (1) the MPGE in whole or in significant part of any agricultural or horticultural product, or (2) the marketing of agricultural or horticultural products. Under § 199(d)(3) and this section, if any amount of a patronage dividend or qualified per-unit retain allocation paid in qualified per-unit retain certificates described in § 1385 is received by a patron from such a cooperative, and such amount is allocable to QPAI of the cooperative that is deductible under § 199(a) and section 4.01 of this notice by the cooperative, then the amount is deductible from the gross income of the patron. Such an amount, however, does not reduce the taxable income of the cooperative under § 1382. In order for the member to qualify for the deduction, § 199(d)(3)(A)(ii) requires the cooperative to designate the patron’s portion of the income allocable to QPAI of the organization in a written notice mailed by the cooperative to its patron during the payment period described in § 1382(d) (that is, no later than the 15th day of the ninth month following the close of the taxable year). In determining the portion of the cooperative’s QPAI that would be deductible by the cooperative under § 199(a) and section 4.01, the cooperative’s taxable income is computed without taking into account any deduction allowable under § 1382(b) or (c) relating to patronage dividends, per-unit retain allocations, and nonpatronage distributions and, in the case of a cooperative engaged in the marketing of agricultural and horticultural products, the cooperative is treated as having MPGE in whole or in significant part any QPP marketed by the cooperative that its patrons have MPGE. For purposes of § 199, agricultural or horticultural products also include fertilizer, diesel fuel and other supplies used in agricultural or horticultural production that are MPGE by the cooperative.

.08 Individuals . In the case of individuals, § 199(d)(2) provides that the deduction is equal to the applicable percent of the lesser of the taxpayer’s (1) QPAI for the taxable year, or (2) adjusted gross income (AGI) for the taxable year determined after

Each shareholder is allocated, in accordance with § 1366, its pro rata share of items (including items of income, gain, loss, and deduction) allocated or attributable to the qualified production activities of the S corporation. To the extent that such items represent items relevant to the computation of the § 199 deduction (for example, DPGR, CGS, other items allocable to DPGR, or W–2 wages of the S corporation), the shareholder will take such items into account in computing its § 199 deduction. To compute its § 199 deduction for the taxable year, the shareholder will aggregate its pro rata share of items allocated or attributable to the S corporation’s qualified production activities, and those items of the shareholder that are allocated or attributable to qualified production activities from sources other than the S corporation.

(ii) Expenses . Each shareholder must take into account its pro rata share of expenses allocated to the qualified production activities of the S corporation, regardless of whether the S corporation otherwise has taxable income. However, expenses of the S corporation that otherwise would be taken into account for purposes of computing the shareholder’s § 199 deduction shall only be taken into account if and to the extent the shareholder’s pro rata share of the losses or deductions from all of the S corporation’s activities are not disallowed by §§ 465, 469, 1366(d), or any other provision of the Code. In the event that only a portion of the shareholder’s pro rata share of the losses or deductions is allowed for a taxable year, a proportionate share of the losses or deductions that reflect expenses allocated to the S corporation’s qualified production activities, determined in a manner consistent with §§ 465, 469, and 1366(d), shall be taken into account for purposes of computing the § 199 deduction for that taxable year. To the extent that any of the disallowed losses or deductions are allowed in a later taxable year, the shareholder shall take into account a proportionate share of the expenses reflected in those losses or deductions in computing its QPAI for that later taxable year.

(iii) W–2 wages . Under § 199(d)(1)(B), an S corporation shareholder’s share of W–2 wages of the S corporation for purposes of determining the shareholder’s § 199(b) limitation is the lesser of the

shareholder’s allocable share of the wages (without regard to § 199(d)(1)(B)) as determined under regulations prescribed by the Secretary, or 2 times 9 percent (3 percent in the case of taxable years beginning in 2005 and 2006, and 6 percent in the case of taxable years beginning in 2007, 2008, or 2009) of the QPAI computed taking into account only the items of the S corporation allocated to the shareholder for the taxable year. Each shareholder must aggregate the W–2 wages allocated from the S corporation with its W–2 wages from other sources for purposes of computing its § 199(b) limitation for the taxable year. However, if the shareholder is not allocated positive QPAI computed taking into account only the items of the S corporation allocated to the shareholder for the taxable year, the shareholder may not take into account any W–2 wages of the S corporation for purposes of computing the wage limitation under § 199(b) for the taxable year.

(2) Gain or loss from the disposition of an interest in a pass-thru entity . QPAI generally does not include gain or loss recognized on the sale, exchange, or other disposition of an interest in the entity. However, if § 751(a) or (b) applies, gain or loss allocable to assets of the partnership the sale, exchange, or other disposition of which would give rise to QPAI is taken into account in computing the partner’s § 199 deduction.

(3) Effective date of § 199 for pass-thru entities . Section 199(e) provides that § 199 applies for taxable years beginning on or after January 1, 2005. Accordingly, § 199 does not apply to taxable years of pass-thru entities that begin before January 1, 2005. For example, assume a pass-thru entity has a taxable year beginning July 1, 2004, and ending June 30, 2005, and the owners of the pass-thru entity have taxable years beginning January 1, 2005, and ending December 31, 2005. The provisions of § 199 do not apply to the pass-thru entity until the first date of its first taxable year beginning on or after January 1, 2005. Thus, § 199 applies to the pass-thru entity for its taxable year beginning July 1, 2005. The owners of the pass-thru entity include their allocable or pro rata share of items allocated or attributable to the qualified production activities of the pass-thru entity, for purposes of determining their re

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location of items must be made by using the pro rata allocation method described in section 4.09(6)(a)(i) of this notice. However, the corporation may elect to use the closing of the books method described in section 4.09(6)(a)(ii).

(i) Pro rata allocation method . Under the pro rata allocation method, an equal portion of each of the taxable income or loss, QPAI, and W–2 wages for the taxable year is assigned to each day of the corporation’s taxable year. Then, those items assigned to those days during which the corporation was a member of the EAG are aggregated.

(ii) Closing of the books method . Under the closing of the books method, taxable income or loss, QPAI, and W–2 wages for the period during which the corporation was a member of the EAG are computed by treating the corporation’s taxable year as two separate taxable years, the first of which ends at the close of the day on which the corporation’s status as a member of the EAG changes and the second of which begins at the beginning of the day after the corporation’s status as a member of the EAG changes.

(iii) Making the § 199 closing of the books election . A corporation makes the § 199 closing of the books election by making the following statement: “The § 199 closing of the books election is hereby made with respect to [insert name of corporation and its employer identification number] with respect to the following periods [insert dates of two periods between which items are allocated pursuant to the closing of the books method].” The statement must be filed with the corporation’s timely filed (including extensions) federal income tax return for the taxable year that includes the periods that are subject to the election. Once made, an election under this section 4.09(6)(a)(iii) is irrevocable.

(b) Coordination with rules relat- ing to the allocation of income under § 1.1502–76(b) . If § 1.1502–76 (relating to the taxable year of members of a consolidated group) applies to a corporation that is a member of an EAG, any allocation of items required under this section 4.09(6) is made only after the allocation of the corporation’s items pursuant to § 1.1502–76.

(7) Total § 199 deduction for a corpo- ration that is a member of an expanded af- filiated group for some or all of its taxable

applying §§ 86, 135, 137, 219, 221, 222, and 469, and without regard to § 199.

.09 Expanded Affiliated Groups . (1) In general . All members of an EAG are treated as a single corporation for purposes of § 199. An EAG is an affiliated group as defined in § 1504(a), determined by substituting “50 percent” for “80 percent” each place it appears, and without regard to § 1504(b)(2) and (4).

(2) Computation of expanded affiliated group’s § 199 deduction . (a) In general . The § 199 deduction for an EAG is determined by aggregating each member’s taxable income or loss, QPAI, and W–2 wages. For this purpose, a member’s QPAI is the member’s DPGR less the sum of the CGS allocable to such receipts and other costs required to be allocated under section 4.05 of this notice. For purposes of this determination, a member’s QPAI may be positive or negative. A member’s taxable income or loss and QPAI shall be determined by reference to the member’s method of accounting.

(b) Attribution of activities . Each member of an EAG is treated as conducting the activities conducted by each other member of the EAG. For example, Corporation A and Corporation B are members of the same EAG but do not file a consolidated return. A is engaged solely in the trade or business of manufacturing QPP in the United States. B is a reseller of the QPP manufactured by A. Without regard to the activities conducted by A, B would not qualify for the § 199 deduction. However, because B is a member of the EAG that includes A, B is treated as conducting A’s manufacturing activities. Accordingly, B’s gross receipts attributable to its sale of the QPP it purchases from A are DPGR (assuming all other requirements of § 199 are met).

(c) Anti-avoidance rule . If a transaction between members of an EAG is engaged in or structured with a principle purpose of qualifying for, or modifying the amount of, the § 199 deduction for one or more members of the EAG, adjustments must be made to eliminate the effect of the transaction on the computation of the § 199 deduction.

(3) Allocation of expanded affiliated group’s § 199 deduction . The EAG’s § 199 deduction is allocated among members of the EAG in proportion to each member’s QPAI, if any, regardless of

whether the EAG member has taxable income or loss for the taxable year and regardless of whether the EAG member has W–2 wages. For this purpose, if a member has negative QPAI, the QPAI of the member shall be treated as zero.

(4) Special rules for consolidated groups . For purposes of § 199, a consolidated group is treated as a single member of the EAG. Therefore, if an EAG includes corporations that are members of a consolidated group and corporations that are not members of a consolidated group, in computing the taxable income limitation of the EAG, the consolidated taxable income of the consolidated group, not the separate taxable income of the members of the consolidated group, is taken into account. If all of the members of an EAG are members of the same consolidated group, the consolidated group’s § 199 deduction is determined based on the group’s consolidated taxable income or loss, not the separate taxable income or loss of its members. The § 199 deduction of a consolidated group (or the § 199 deduction allocated to a consolidated group that is a member of an EAG) must be allocated to the members of the consolidated group in proportion to each consolidated group member’s QPAI, if any, regardless of whether the consolidated group member has separate taxable income or loss for the taxable year and regardless of whether the member has W–2 wages for the taxable year. For purposes of allocating the § 199 deduction of a consolidated group among its members, if a consolidated group member has negative QPAI, the QPAI of the member shall be treated as zero.

(5) Identification of members of the ex- panded affiliated group . A corporation must determine whether it is a member of an EAG on a daily basis. If a corporation becomes or ceases to be a member of an EAG, the corporation is treated as becoming or ceasing to be a member of the EAG at the end of the day on which its status as a member changes.

(6) Allocation of income and loss . (a) In general . A corporation that is a member of an EAG for only a portion of its taxable year must allocate its taxable income or loss, QPAI, and W–2 wages between the portion of the taxable year during which it is a member of the EAG and the portion of the taxable year during which it is not a member of the EAG. In general, this al

February 14, 2005 525 2005–7 I.R.B.

tion would have given rise to DPGR if leased, rented, licensed, sold, exchanged, or otherwise disposed of by the target corporation, then the assets will give rise to DPGR if leased, rented, licensed, sold, exchanged, or otherwise disposed of by the acquiring corporation (assuming all other requirements of § 199(c) are met).

(4) Taxpayers with a 52–53 week tax- able year . For purposes of applying § 1.441–2(c)(1) in the case of a taxpayer using a 52–53 week taxable year, any reference in § 199(a)(2) (the phase-in rule) to a taxable year “beginning after” a particular calendar year means a taxable year beginning after December 31st of that year. Similarly, any reference to a taxable year “beginning in” a particular calendar year means a taxable year beginning after December 31st of the preceding calendar year. For example, a 52–53 week taxable year that begins on December 26, 2004, is deemed to begin on January 1, 2005, and the transition percentage for that taxable year is 3 percent.