Industry Director Directive on Domestic Production Deduction (DPD)
LMSB-Control Number: LMSB-04-1206-018
Impacted IRM 4.51.2
Date: December 6, 2006
MEMORANDUM FOR INDUSTRY DIRECTORS
DIRECTOR, PREFILING AND TECHNICAL GUIDANCE
DIRECTOR, FIELD SPECIALISTS
FROM: Henry V. Singleton, /s/ Henry V. Singleton
Industry Director, Heavy Manufacturing and Transportation
SUBJECT: Tier I - Industry Director Directive on Domestic Production Deduction
This Directive is intended to provide direction to effectively utilize examination resources in relation to the taxpayers who claim the domestic production deduction on their tax returns. It reflects a management decision that balances resources and workload priorities. The Directive is not an official pronouncement of law, and cannot be used, cited, or relied upon as such.
The domestic production deduction, Section 199, is a provision enacted in the American Jobs Creations Act of 2004 that generally allows taxpayers to receive a deduction based on qualified production activities income resulting from domestic production. This issue has been designated as a tier one issue. The revenue impact of this provision is anticipated to be $76 billion over the first ten years of its life.
Due to the complexity of the law, there is the potential to spend substantial audit resources in an examination. In the initial years, 2005 and 2006, the deduction is 3% moving to 6% from 2007 to 2009 and then 9% thereafter. Qualifying domestic production includes the manufacture of tangible personal property; the production of computer software, sound recordings and certain films; the production of electricity, natural gas, or water; and construction, engineering, and architectural services. The purpose of this directive is to spell out minimum audit checks which will be employed when examining this issue and incorporated in a team’s risk analysis. There are many aspects of this new provision that allow the taxpayer to make determinations based on reasonable methods which become more difficult to adjust as time passes.
Planning and Examination Guidance:
As with any issue, a risk analysis should be performed to determine the level of examination of the issue. If the issue falls within the criteria of full examination, please go to the Domestic Production Web Site for audit assistance.
In addition to the assistance of the DPD technical advisor, there is a significant amount of support available from the CAS, engineering and international programs. Each of these programs has designated personnel to assist in key aspects of Section 199 germane to their programs. Use of the specialists’ referral system and identifying not only the nature of the issue but inserting the comment "Code section 199 domestic production deduction" will help ensure the referral is forwarded to a designated examiner. In addition, there are fourteen industry technical advisors assigned to the respective industries impacted by the DPD available to assist in areas unique to the industry. Once a risk analysis has been completed, the tools above and direction explained below should assist in crafting audit probes to fit the taxpayer’s situation.
The key challenge is determining what minimum audit steps need to be taken in addressing the DPD. In the earlier years, the 3% deduction amount might not have a significant impact and as a result the full audit tools shown above might not be warranted. If so, the minimum steps shown below will be followed. However, the DPD is not an accounting method that would permit teams to challenge the computation at any time. Allowing a taxpayer to utilize an accounting approach that does not comply with the Regulations makes audit challenges more difficult in later cycles especially if the taxpayer has used this inappropriate method consistently for multiple years.
It is expected that as part of the risk analysis the examiner will build in the audit probes below. The purpose of these probes is first, to achieve a comfort level with the taxpayer’s compliance level and second, to gather and provide the subsequent year examination teams a base for further review of the deduction. In some cases, these checks might cause adjustments and in others, simply provide feedback to the taxpayer as to changes needed in future years. Shown below the minimum audit checks is an attachment to a full document that provides information regarding why the checks are necessary and how to handle the various responses the agent may receive. The following checks need to be in the examiner’s audit plan or risk analysis:
Minimum Audit Checks:
Does the taxpayer’s business make sense with the activity requirements of the domestic production deduction?
Comparison of the domestic production gross receipts (DPGR) reported on Form 8903 to the gross receipts or sales less returns and allowances on the taxpayer’s tax return, line 1c of the Form 1120.
Is the taxpayer required to allocate gross receipts to remove nonqualified embedded service income, or determine the qualified income portion of a component of an item? If so, how did the taxpayer determine an allocation method?
If the taxpayer is required to use the Section 861 method to allocate and apportion deductions has the taxpayer used it and is it consistent with the application of Section 861 for purposes of the foreign tax credit, if applicable?
Has the taxpayer applied the wage and taxable income limitations?
Once the examiner has performed these minimum checks, decisions can be made to adjust the return, inform the taxpayer to change a portion of their return methodology in future years, or confirm their methodology. In each of these situations, the taxpayer is receiving feedback and there should be an audit trail for subsequent audit teams. If needed, a Form 5346, Examination Information Report, can be submitted to ensure future audits consider aspects of this DPD calculation. These actions will assist a future exam team, the Service in the case of future claims and provide the taxpayer with an understanding that the Service is being diligent in the application of this new tax law.
The following provides a brief regulatory framework and highlights portions of Section 199. Additional legal analysis is provided within the attached document.
Section 199 provides for a phase-in period in which the deduction begins at 3% of the lesser of qualified production activities income or taxable income and phases into 9%.
The regulations under Section 199 provide that the determination of DPGR must be made at the item level. Allocations may become necessary to determine the nonqualified service income or the qualified income related to a component of an item sold.
The regulations under Section 199 also require the use of the Section 861 method to allocate and apportion deductions. The taxpayer’s application of Section 861 for this purpose should be consistent with the methods utilized in the taxpayer’s Section 861 calculations for the foreign tax credit.
cc: Commissioner, LMSB
Deputy Commissioner, LMSB
Division Counsel, LMSB
Director, Performance, Quality and Audit Assistance