New Domestic Production Incentive Legislation

New ETI replacement legislation has been enacted as part of the American Jobs Creation Act of 2004 (the Act). This legislation was introduced in the House and the Senate during the summer to replace the WTO-outlawed ETI and FSC export tax incentive regimes. The replacement proposal, therefore, is designed to satisfy U.S. trading partners and meet WTO trade obligations, while providing comparable tax benefits to U.S. manufacturers.
After a brief overview, this article first examines the repeal of the extraterritorial income exclusion under Sec. 114 and phase-out benefits for 2005 and 2006. The remainder of the article examines the new domestic production deduction under Sec. 199 and outlines the limitations on benefits contained in the 5-year phase-in rules.

    Congress has come up with a new solution for an old problem: how can tax legislation be used to attract manufacturing jobs to the United States? For years, Congress enacted legislation for exporters - like the DISC, FSC and ETI provisions - on the premise that exports created U.S. manufacturing jobs. Most of these schemes, however, resulted in a permanent reduction of U.S. tax and were held to constitute an illegal export subsidy under the latest U.S. trade agreements with the World Trade Organization. The Interest-Charge Domestic International Sales Corporation (IC-DISC), which permits a deferral of U.S. tax on up to $10 million in export sales, has never been protested by the WTO and remains available to most U.S. exporters. The IC-DISC pays annual interest expense on its tax-deferred assets, so the WTO does not treat the deferral as a subsidy.
    Now, Congress has met the issue head-on and enacted tax breaks for manufacturing, software and film production, growing or extraction and construction profits derived from the United States. Thus, the focus is now on what companies are doing in the United States, not what they are exporting or moving overseas.
    The Domestic Production Deduction will benefit a much larger class of taxpayers than the former DISC, FSC or ETI provisions. New beneficiaries include U.S. companies involved in building big-ticket items, like ships and aircraft used mostly in the United States or commercial or residential building projects. In addition, although DPD benefits are lower than the existing (2004) ETI benefits for exports, the base on which the deduction is calculated is larger, since the entire amount of the domestic production income is included. Thus, manufacturers can claim a benefit on income from sales to U.S. customers, as well as export sales.

    As enacted, the Domestic Production Deduction (DPD) would permit a deduction of up to 9% of the domestic production income of a U.S. manufacturer, producer or construction company. This deduction will generate up to a 3.1 percentage point reduction in the U.S. corporate effective tax rate (9% x 35%). This benefit is lower than the 5.25 percentage point reduction in the U.S. effective tax rate (15% x 35%) permitted exporters under the pre-repeal ETI legislation.
    The new law contains a number of transition rules and limitations, however, so the full benefit of the DPD may not be realized even in 2010. In addition, since the income base on which the DPD is calculated is much larger, i.e., export and non-export sales, it is difficult to compare the amount of tax savings under each regime.
    The new replacement legislation is intended to preserve jobs and production activities in the United States. This incentive acts as a carrot, rather than a stick (e.g., anti-inversion provisions) for U.S. multinational manufacturers and software developers. In addition, tax benefits under the new legislation apply to C corporations, as well as S corporations, LLCs and partnerships, like the existing ETI exclusion under Sec. 114.

The act itself is divided into two main parts:

2) Enactment and phase-in of a deduction for income attributable to U.S. production activities

After a discussion of the repeal of the ETI regime and transition rules, this article will examine how the new deduction for production activities is computed.

Under Sec. 101(a), Title I of the Act, the extraterritorial income exclusion under Sec. 114 of the Code is repealed. This repeal is effective for transactions after December 31, 2004. This repeal provision contains some bad news and some good news for exporters.
The bad news for U.S. exporters is that they will lose the benefits of the ETI provisions, which provide a direct tax savings to most U.S. exporters. The good news for U.S. exporters is that the repeal of ETI contains transitional rules that will provide limited benefits for the next two years, or 2005 and 2006

Background on WTO Sanctions

The ETI rules were enacted in 2000 in response to the WTO findings that the Foreign Sales Corporation (FSC) legislation violated the anti-subsidy rules in the WTO Agreement. The ETI rules, as enacted under Sec. 114, exclude a portion of export (pre-tax) income from U.S. tax. The ETI legislation repealed the FSC rules but contained some transition relief through 2002. In 2001, however, the WTO also found that the ETI legislation violated the same anti-subsidy provisions of the WTO Agreement. In 2004, the EU began imposing punitive tariffs on U.S. products, as sanctioned by the WTO Dispute Resolution Panel in 2002.
The WTO has been following closely the actions taken by the U.S. Congress in repealing the Extraterritorial Income Exclusion (ETI) under Sec. 114. For the WTO, including the EU and other U.S. trading partners, the repeal of the ETI provisions represents a victory.
The new legislation in Congress contains incentives for U.S. manufacturing companies, which should satisfy the WTO objections to ETI and FSC. The transition rules, however, will annoy our trading partners in the EU.

How Transition Period Benefits are Computed - HR 4520

Under the Act, exporters can continue to receive full ETI benefits in 2004. Under Sec. 101(d) of the Act, a taxpayer can claim an ETI deduction in 2005 and 2006 but is required to add-back or include 20% of its ETI in income in 2005 and 40% in 2006.
Transition period deductions are equal to the ETI benefit calculated for the year, multiplied by the phase-out percentage. Table 1, below, illustrates the phaseout, as contained in the Act:

TABLE 1
ETI Phase-out Adjustments
Year	Phase-out (%)	Effective Tax Rate (%)
2004	0	29.8
2005	20	30.8
2006	40	31.9

Assuming X Corp. has an ETI deduction in 2005 and 2006 of $100,000, its transition deductions are shown in Table 2, below, in dollars:

TABLE 2
ETI Transition Period Benefits
Year	Base	Phaseout %	Deduction
2004	100,000	0	100,000
2005	100,000	20	80,000
2006	100,000	40	60,000

Summary of Benefits for Exporters

    Exporters should generate net tax savings from these transition period provisions. Not only do they get to keep their existing ETI benefits in 2004, but also they receive an ongoing benefit in 2005 and 2006. In addition, the amount of the ETI deduction is based on actual results in 2005 and 2006, not a base period or hypothetical results under earlier versions of the Act.
It is apparent that benefits should remain available for distributors and construction and engineering companies on foreign construction projects during the transition period, but it is not clear whether the domestic production incentive is available for companies other than the initial manufacturer. As a result, not all ETI/FSC beneficiaries may be eligible for the 9% production deduction in 2004.
    The DPD, discussed below, also contains indirect tax benefits for exporters. By keeping manufacturing and software development activities in the United States, exporters may claim a deduction for up to 15% of their income from qualified exports under the ETI provisions. Under the Phase-In rules, the DPD also may be available to manufacturers in 2005 and future years. There is no restriction on companies claiming benefits under both provisions during the transition period.
    Tax practitioners should take some time to analyze the effect of the new proposal on their company or clients. This analysis will vary for each client and from industry to industry. Clearly, big winners will include domestic construction businesses, including aircraft and ships, and film production companies.

The American Jobs Replacement Act of 2004 (the Act) adds a new Sec. 199, which provides for a deduction equal to 9% of an eligible taxpayer's income from qualified domestic production activities. This provision contains special rules for individuals and pass-through entities, such as a partnership, S corporation, LLC or co-operative.

Limitations on Deductibility

The Act contains a number of limitations on the amount of the deduction, including:
1) a 5-year transition period Phase-in limitation under Sec. 199(a)(2),
2) an annual limitation based on taxable income under Sec. 199(a)(1)(B), and
3) an annual limitation based on 50% of W-2 wages under Sec. 199(b).

The first limitation will expire in 5 years, but the two quantitative limitations are a permanent part of the DPD provisions.

Phase-In Relief
The full 9% DPD benefit under Sec. 199 is limited to tax years beginning in 2010. Until then, phase-in rules will limit the amount of the deduction based on the transition relief percentages contained in Sec. 199(a)(2), as follows:

TABLE 3
DPD - Transition Period Benefits
Years	Transition Benefits	Effective Tax Rate (%)
2005 & 2006	3%	34
2007 - 2009	6%	32.9

Once the new law is effective in 2005, however, there is nothing in the Act that would prevent an export company from double dipping, or claiming ETI transition relief as well as a domestic production incentive in 2005 and 2006.

Quantitative Limitations under the Statute

The statute also contains two caps on the amount of the deduction that can be claimed each year. First, the DPD is limited to 9% of the lower of:
· qualified production activities income or
· taxable income before the deduction.

This limitation is applicable where a taxpayer has non-production or foreign losses that would offset the amount of qualified production income. The rule is intended to prevent a taxpayer from creating a loss by claiming the DPD. In the event of pass-through entities, this limitation is determined at the individual, not the entity, level.
The other quantitative limitation is based on W-2 wages. Essentially, the domestic production deduction is limited to 50% of the taxpayers' employee wages for the year. The W-2 wage base appears to include production and non-production employees, including key executive officers and staff, in-house counsel, as well as research and marketing staff. The term "W-2 wages" is defined by reference in the statute to amounts reported under Sec. 6051(a)(3) and (8). Stock options are not included in the W-2 wage base, until exercised. Special rules will apply where a company acquires or disposes of all or part of a major trade or business during the year.

Determining Domestic Production Activity Income

    The amount of the Sec. 199 deduction is based on net income attributable to domestic production activities, as defined under Sec. 199(c). Net income is computed by reducing the taxpayer's domestic production receipts by the cost of goods sold, as well as direct and indirect expenses allocable to these receipts.
    The statute does not define production costs, but presumably these amounts include the amount of inventory costs under Sec. 471, including any inventoried amounts under Sec. 263A. In addition, the expense allocation rules under Reg. Sec. 1.861-8 would apply in determining indirect expenses and would treat domestic production receipts as a statutory class of income.
    Under Sec. 199(c)(3)(A), in computing the domestic cost of goods sold, imported components or services used in the production process are treated as acquired by purchase, so their cost is their value at importation. The cost for products exported by the taxpayer for further manufacturing is the difference between the value of the property when exported and the value of the property when re-imported.

Domestic Production Receipts and Qualified Property

    Domestic production receipts under Sec. 199(c)(4) include sales, leases or licenses of qualifying production property that must be manufactured, produced grown or extracted in whole or significant part by the taxpayer within the United States. Qualified receipts also include construction and architectural and engineering services performed and films produced in the United States.
    Qualified production property includes tangible personal property, computer software and films, tapes, records or similar reproductions. Qualified property also includes depreciable business assets under Sec. 168(f)(4).
    The statute does not define what constitutes manufactured or produced "in whole or significant part." It is not clear, therefore, if 80% is a "significant" part, or whether 50 or 60% would be considered significant. Presumably, some interim or final foreign assembly will be permitted, but these foreign costs will reduce the overall benefit under the domestic/foreign factor discussed below.
    Under Sec. 199(c)(6), films are treated as produced in the United States, if at least 50% of the total compensation paid for the film is paid to actors, production personnel, directors and producers as compensation for services performed in the United States. The statute is not clear if the 50% threshold for films applies to other qualified U.S. production property.

Application to Affiliated Groups

    The statute as drafted does not contain any grouping or ungrouping rules for products or product lines manufactured by an affiliated group. For example, assume a company has three product lines, but only one line is profitable for the year. Can a deduction be claimed for the profitable line only, or must the domestic production costs be calculated as if there is only one company?
    The new statute does contain special rules for affiliated groups under Sec. 199 (d)(4). These rules treat all members of an extended affiliated group as a single corporation for purposes of applying the DPD. An expanded affiliated group is defined as an affiliated group with a reduced 50%, rather than an 80%, vote or value ownership test. In addition, an expanded affiliated group includes insurance and Sec. 936 (Possessions) corporations. Thus, it would seem that ungrouping is not permitted.
    Under Sec. 199(c)(2), the IRS is delegated the authority to prescribe regulations for properly allocating items of income and deduction for purposes of determining income attributable to domestic production activities. Thus, we must expect some clarification from the IRS on whether or not taxpayers can allocate domestic manufacturing and production costs to product or product line sales.

    The statute contains a number of special rules applicable to pass-through entities, including S corporations, partnerships and patrons of agricultural and horticultural co-operatives. In general, these rules provide that the DPD is applied at the shareholder or partner level. The IRS is charged with prescribing anti-abuse rules restricting the allocation of the deduction to partners and imposing additional reporting requirements.
    In applying the DPD, partners, shareholders and other pass-through beneficiaries are treated as having been allocated W-2 wages from the entity in an amount equal to the lower of their allocable share of the wages or 2 times 9% of the qualified production activities income for the year. For individuals, the maximum DPD benefit (9%) is measured based on adjusted gross income, not taxable income under Sec. 199(d)(2).
    Patrons and members of agricultural co-operatives, involved in growing and marketing agricultural and horticultural products, also can benefit under the new DPD. Under Sec. 199(d)(3), in the event the patron or member receives a payment from a co-op, a deduction can be claimed for amounts attributable to the production activities of the co-op.

The Domestic Production Deduction appears to satisfy two key U.S. political objectives: satisfy the WTO objections to our tax law and provide a replacement tax regime that offers comparable tax savings for U.S. multinationals as the former FSC and current ETI provisions. The new proposal appeals to a much larger class of U.S. companies than just exporters and provides tax savings to U.S. taxpayers with a significant U.S. production base, which includes Puerto Rico. Thus, the big winners include automobile and truck manufacturers, real estate construction companies, aircraft and ship construction companies, electrical and computer manufacturers, medical and scientific testing and equipment manufacturers, office equipment manufacturers, mining companies, utilities and power producers, farmers and agricultural co-operatives.
The big losers under the domestic production deduction are non-manufacturing exporters, like U.S. distributors or export agents for U.S. companies and companies involved in foreign construction projects. Finally, like its predecessors, the new proposal leaves the tax deferral benefits of the IC-DISC intact. Thus, most closely-held exporters organized as an S corporation or LLC may prefer to maximize their cash flow savings using an IC-DISC for export tax benefits.