Section 199(a)(1) allows a deduction equal to 9 percent (3 percent in the case of taxable years beginning in 2005 or 2006, and 6 percent in the case of taxable years beginning in 2007, 2008, or 2009) of the lesser of (A) the qualified production activities income (QPAI) of the taxpayer for the taxable year, or (B) taxable income (determined without regard to section 199) for the taxable year (or, in the case of an individual, adjusted gross income (AGI)).

Section 199(b)(1) limits the deduction for a taxable year to 50 percent of the W-2 wages paid by the taxpayer during the calendar year that ends in such taxable year. For this purpose, section 199(b)(2) defines the term W-2 wages to mean, with respect to any person for any taxable year of such person, the sum of the amounts described in section 6051(a)(3) and (8) paid by such person with respect to employment of employees by such person during the calendar year ending during such taxable year. The term W-2 wages does not include any amount that is not properly included in a return filed with the Social Security Administration on or before the 60th day after the due date (including extensions) for the return. Section 199(b)(3) provides that the Secretary shall prescribe rules for the application of section 199(b) in the case of an acquisition or disposition of a major portion of either a trade or business or a separate unit of a trade or business during the taxable year.

Section 514(a) of TIPRA amended section 199(b)(2) by excluding from the term W-2 wages any amount that is not properly allocable to domestic production gross receipts (DPGR) for purposes of section 199(c)(1). The IRS and Treasury Department plan on issuing regulations on the amendments made to section 199(b)(2) by section 514 of TIPRA.

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 for such taxable year, over (B) the sum of (i) the cost of goods sold (CGS) that are allocable to such receipts; and (ii) other expenses, losses, or deductions (other than the deduction under section 199) that are properly allocable to such receipts.

Section 199(c)(2) provides that the Secretary shall prescribe rules for the proper allocation of items described in section 199(c)(1) for purposes of determining QPAI. Such rules shall provide for the proper allocation of items whether or not such items are directly allocable to DPGR.

Section 199(c)(3) provides special rules for determining costs in computing QPAI. Under these special rules, any item or service brought into the United States is treated as acquired by purchase, and its cost is treated as not less than its value immediately after it enters the United States. A similar rule applies in determining the adjusted basis of leased or rented property when the lease or rental gives rise to DPGR. If the property has been exported by the taxpayer for further manufacture, the increase in cost or adjusted basis must not exceed the difference between the value of the property when exported and its value when brought back into the United States after further manufacture.

Section 199(c)(4)(A) defines DPGR to mean the taxpayer’s gross receipts that are derived from: (i) any lease, rental, license, sale, exchange, or other disposition of (I) qualifying production property (QPP) that was manufactured, produced, grown, or extracted (MPGE) by the taxpayer in whole or in significant part within the United States; (II) any qualified film produced by the taxpayer; or (III) electricity, natural gas, or potable water (collectively, utilities) produced by the taxpayer in the United States; (ii) in the case of a taxpayer engaged in the active conduct of a construction trade or business, construction of real property performed in the United States by the taxpayer in the ordinary course of such trade or business; or (iii) in the case of a taxpayer engaged in the active conduct of an engineering or architectural services trade or business, engineering or architectural services performed in the United States by the taxpayer in the ordinary course of such trade or business with respect to the construction of real property in the United States.

Section 199(c)(4)(B) excepts from DPGR gross receipts of the taxpayer that are derived from: (i) the sale of food and beverages prepared by the taxpayer at a retail establishment; (ii) the transmission or distribution of utilities; or (iii) the lease, rental, license, sale, exchange, or other disposition of land.

Section 199(c)(4)(C) provides that gross receipts derived from the manufacture or production of any property described in section 199(c)(4)(A)(i)(I) shall be treated as meeting the requirements of section 199(c)(4)(A)(i) if (i) such property is manufactured or produced by the taxpayer pursuant to a contract with the Federal Government, and (ii) the Federal Acquisition Regulation requires that title or risk of loss with respect to such property be transferred to the Federal Government before the manufacture or production of such property is complete.

Section 199(c)(4)(D) provides that for purposes of section 199(c)(4), if all of the interests in the capital and profits of a partnership are owned by members of a single expanded affiliated group (EAG) at all times during the taxable year of such partnership, the partnership and all members of such group shall be treated as a single taxpayer during such period.

Section 199(c)(5) defines QPP to mean: (A) tangible personal property; (B) any computer software; and (C) any property described in section 168(f)(4) (certain sound recordings).

Section 199(c)(6) defines a qualified film to mean any property described in section 168(f)(3) if not less than 50 percent of the total compensation relating to production of the property is compensation for services performed in the United States by actors, production personnel, directors, and producers. The term does not include property with respect to which records are required to be maintained under 18 U.S.C. 2257 (generally, films, videotapes, or other matter that depict actual sexually explicit conduct and are produced in whole or in part with materials that have been mailed or shipped in interstate or foreign commerce, or are shipped or transported or are intended for shipment or transportation in interstate or foreign commerce).

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. However, DPGR may include such property if the property is held for sublease, sublicense, or rent, or is subleased, sublicensed, or rented, by the related person to an unrelated person for the ultimate use of the unrelated person. See footnote 29 of H.R. Conf. Rep. No. 755, 108th Cong. 2d Sess. 260 (2004) (Conference Report). A person is treated as related to another person if both persons are treated as a single employer under either section 52(a) or (b) (without regard to section 1563(b)), or section 414(m) or (o).

Section 199(d)(1)(A) provides that, in the case of a partnership or S corporation, (i) section 199 shall be applied at the partner or shareholder level, (ii) each partner or shareholder shall take into account such person’s allocable share of each item described in section 199(c)(1)(A) or (B) (determined without regard to whether the items described in section 199(c)(1)(A) exceed the items described in section 199(c)(1)(B)), and (iii) each partner or shareholder shall be treated for purposes of section 199(b) as having W-2 wages for the taxable year in an amount equal to the lesser of (I) such person’s allocable share of the W-2 wages of the partnership or S corporation for the taxable year (as determined under regulations prescribed by the Secretary), or (II) 2 times 9 percent (3 percent in the case of taxable years beginning in 2005 or 2006, and 6 percent in the case of taxable years beginning in 2007, 2008, or 2009) of so much of such person’s QPAI as is attributable to items allocated under section 199(d)(1)(A)(ii) for the taxable year.

Section 514(b) of TIPRA amended section 199(d)(1)(A)(iii) to provide instead that each partner or shareholder shall be treated for purposes of section 199(b) as having W-2 wages for the taxable year equal to such person’s allocable share of the W-2 wages of the partnership or S corporation for the taxable year (as determined under regulations prescribed by the Secretary). The IRS and Treasury Department plan on issuing regulations on the amendments made to section 199(d)(1)(A)(iii) by section 514 of TIPRA.

Section 199(d)(1)(B) provides that, in the case of a trust or estate, (i) the items referred to in section 199(d)(1)(A)(ii) (as determined therein) and the W-2 wages of the trust or estate for the taxable year, shall be apportioned between the beneficiaries and the fiduciary (and among the beneficiaries) under regulations prescribed by the Secretary, and (ii) for purposes of section 199(d)(2), AGI of the trust or estate shall be determined as provided in section 67(e) with the adjustments described in such paragraph.

Section 199(d)(1)(C) provides that the Secretary may prescribe rules requiring or restricting the allocation of items and wages under section 199(d)(1) and may prescribe such reporting requirements as the Secretary determines appropriate.

In the case of an individual, section 199(d)(2) provides that the deduction is equal to the applicable percent of the lesser of the taxpayer’s (A) QPAI for the taxable year, or (B) AGI for the taxable year determined after applying sections 86, 135, 137, 219, 221, 222, and 469, and without regard to section 199.

Section 199(d)(3)(A) provides that any person who receives a qualified payment from a specified agricultural or horticultural cooperative shall be allowed for the taxable year in which such payment is received a deduction under section 199(a) equal to the portion of the deduction allowed under section 199(a) to such cooperative which is (i) allowed with respect to the portion of the QPAI to which such payment is attributable, and (ii) identified by such cooperative in a written notice mailed to such person during the payment period described in section 1382(d).

Section 199(d)(3)(B) provides that the taxable income of a specified agricultural or horticultural cooperative shall not be reduced under section 1382 by reason of that portion of any qualified payment as does not exceed the deduction allowable under section 199(d)(3)(A) with respect to such payment.

Section 199(d)(3)(C) provides that, for purposes of section 199, the taxable income of a specified agricultural or horticultural cooperative shall be computed without regard to any deduction allowable under section 1382(b) or (c) (relating to patronage dividends, per-unit retain allocations, and nonpatronage distributions).

Section 199(d)(3)(D) provides that, for purposes of section 199, a specified agricultural or horticultural cooperative described in section 199(d)(3)(F)(ii) shall be treated as having MPGE in whole or in significant part any QPP marketed by the organization that its patrons have so MPGE.

Section 199(d)(3)(E) provides that, for purposes of section 199(d)(3), the term qualified payment means, with respect to any person, any amount that (i) is described in section 1385(a)(1) or (3), (ii) is received by such person from a specified agricultural or horticultural cooperative, and (iii) is attributable to QPAI with respect to which a deduction is allowed to such cooperative under section 199(a).

Section 199(d)(3)(F) provides that, for purposes of section 199(d)(3), the term specified agricultural or horticultural cooperative means an organization to which part I of subchapter T applies that is engaged (i) in the MPGE in whole or in significant part of any agricultural or horticultural product, or (ii) in the marketing of agricultural or horticultural products.

Section 199(d)(4)(A) provides that all members of an EAG are treated as a single corporation for purposes of section 199. Section 199(d)(4)(B) provides that an EAG is an affiliated group as defined in section 1504(a), determined by substituting “more than 50 percent” for “at least 80 percent” each place it appears and without regard to section 1504(b)(2) and (4).

Section 199(d)(4)(C) provides that, except as provided in regulations, the section 199 deduction is allocated among the members of the EAG in proportion to each member’s respective amount (if any) of QPAI.

Section 199(d)(5) provides that section 199 is applied by taking into account only items that are attributable to the actual conduct of a trade or business.

Section 199(d)(6) provides that, for purposes of determining the alternative minimum taxable income under section 55, (A) QPAI shall be determined without regard to any adjustments under sections 56 through 59, and (B) in the case of a corporation, section 199(a)(1)(B) shall be applied by substituting “alternative minimum taxable income” for “taxable income.”

Section 199(d)(7) provides that, for purposes of determining the tax imposed by section 511, section 199(a)(1)(B) shall be applied by substituting “unrelated business taxable income” for “taxable income.”

Section 199(d)(8) authorizes the Secretary to prescribe such regulations as are necessary to carry out the purposes of section 199, including regulations that prevent more than one taxpayer from being allowed a deduction under section 199 with respect to any activity described in section 199(c)(4)(A)(i).

The effective date of section 199 in section 102(e) of the Act was amended by section 403(a)(19) of the GOZA. Section 102(e)(1) of the Act provides that the amendments made by section 102 of the Act shall apply to taxable years beginning after December 31, 2004. Section 102(e)(2) of the Act provides that, in determining the deduction under section 199, items arising from a taxable year of a partnership, S corporation, estate, or trust beginning before January 1, 2005, shall not be taken into account for purposes of section 199(d)(1). Section 514(c) of TIPRA provides that the amendments made by section 514 apply to taxable years beginning after May 17, 2006, the enactment date of TIPRA.

The section 199 deduction is not taken into account in computing any net operating loss (NOL) or the amount of any NOL carryback or carryover. Thus, except as otherwise provided in §1.199-7(c)(2) of the final regulations (concerning the portion of a section 199 deduction allocated to a member of an EAG), the section 199 deduction cannot create, or increase, the amount of an NOL deduction.

For purposes of section 199(a)(1)(B), taxable income is determined without regard to section 199 and without regard to any amount excluded from gross income pursuant to section 114 of the Code or pursuant to section 101(d) of the Act. Thus, any extraterritorial income exclusion or amount excluded from gross income pursuant to section 101(d) of the Act does not reduce taxable income for purposes of section 199(a)(1)(B), even though such excluded amounts are taken into account in determining QPAI.

The final regulations give the Secretary authority to provide for methods of calculating W-2 wages. Contemporaneous with the publication of these final regulations, Rev. Proc. 2006-22, 2006-23 I.R.B. 1033, has been published and provides for taxable years beginning on or before May 17, 2006, the enactment date of TIPRA, the same three methods of calculating W-2 wages as were contained in Notice 2005-14 and the proposed regulations. It is expected that any new revenue procedure applicable for taxable years beginning after May 17, 2006, will contain methods for calculating W-2 wages similar to the three methods in Rev. Proc. 2006-22. The methods are included in a revenue procedure rather than the final regulations so that if changes are made to Form W-2, “Wage and Tax Statement,” a new revenue procedure can be issued reflecting those changes more promptly than an amendment to the final regulations.

Taxpayers have inquired whether remuneration paid to employees for domestic services in a private home of the employer, which remuneration may be reported on Schedule H (Form 1040), “Household Employment Taxes,” or, under certain conditions, on Form 941, “Employer’s QUARTERLY Federal Tax Return,” are included in W-2 wages. Such remuneration is generally excepted from wages for income tax withholding purposes by section 3401(a)(3) of the Code. Section 199(b)(5) provides that section 199 shall be applied by only taking into account items that are attributable to the actual conduct of a trade or business. Payments to employees of a taxpayer for domestic services in a private home of the taxpayer are not attributable to the actual conduct of a trade or business of the taxpayer. Accordingly, such payments are not included in W-2 wages for purposes of section 199(b)(2).

The IRS and Treasury Department have also received numerous inquiries concerning whether amounts paid to workers who receive Forms W-2 from professional employer organizations (PEOs), or employee leasing firms, may be included in the W-2 wages of the clients of the PEOs or employee leasing firms. In order for wages reported on a Form W-2 to be included in the determination of W-2 wages of a taxpayer, the Form W-2 must be for employment by the taxpayer. Employees of the taxpayer are defined in §1.199-2(a)(1) of the final regulations as including only common law employees of the taxpayer and officers of a corporate taxpayer. Thus, the issue of whether the payments to the employees are included in W-2 wages depends on an application of the common law rules in determining whether the PEO, the employee leasing firm, or the client is the employer of the worker. As noted in §1.199-2(a)(2) of the final regulations, taxpayers may take into account wages reported on Forms W-2 issued by other parties provided that the wages reported on the Forms W-2 were paid to employees of the taxpayer for employment by the taxpayer. However, with respect to individuals who taxpayers assert are their common law employees for purposes of section 199, taxpayers are reminded of their duty to file returns and apply the tax law on a consistent basis.

Commentators also raised the issue of whether an individual filing as part of a joint return may include wages paid by his or her spouse to employees of his or her spouse in determining the amount of the individual’s W-2 wages for purposes of the section 199 deduction. The example given was an individual who had a trade or business reported on Schedule C (Form 1040) with QPAI but no W-2 wages, and the individual’s spouse had W-2 wages in a second trade or business reported on Schedule C (Form 1040) but no QPAI. Section 1.199-2(a)(4) of the final regulations provides that married individuals who file a joint return are treated as one taxpayer for purposes of determining W-2 wages. Therefore, an individual filing as part of a joint return may take into account wages paid to employees of his or her spouse in determining the amount of W-2 wages provided the wages are paid in a trade or business of the spouse and the other requirements of the final regulations are met. In contrast, if the taxpayer and the taxpayer’s spouse file separate returns, the taxpayer may not use the spouse’s wages in determining the taxpayer’s W-2 wages for purposes of the taxpayer’s section 199 deduction because they are not considered one taxpayer.

Commentators suggested that rules similar to the de minimis rules provided in §§1.199-1(d)(2) (gross receipts allocation), 1.199-3(h)(4) (embedded services), 1.199-3(l)(1)(ii) (construction services), and 1.199-3(m)(4) (engineering or architectural services) of the proposed regulations, under which taxpayers may treat de minimis amounts of non-DPGR as DPGR, should be available in the opposite situation. Thus, for example, if a taxpayer’s gross receipts that are allocable to DPGR are less than 5 percent of its overall gross receipts for the taxable year, the commentators suggested that the final regulations allow the taxpayer to treat those gross receipts as non-DPGR. The IRS and Treasury Department agree with this suggestion, and the final regulations provide such rules for the provisions discussed above as well as under §1.199-3(l)(4)(iv)(B) for utilities.

Several comments were received regarding the burden imposed by the requirement in the proposed regulations that QPAI be computed on an item-by-item basis (rather than on a division-by-division, or product line-by-product line basis). Several commentators urged the IRS and Treasury Department to limit the item-by-item standard to the requirements of §1.199-3 in determining DPGR (that is, the lease, rental, license, sale, exchange, or other disposition requirement, the in-whole-or-in-significant-part requirement, etc.). Specifically, the commentators argued that the item-by-item standard is inconsistent with the cost allocation methods provided in §1.199-4. The IRS and Treasury Department agree with this comment. Therefore, the final regulations clarify that the item-by-item standard applies solely for purposes of the requirements of §1.199-3 noted above in determining whether the gross receipts derived from an item are DPGR. The final regulations also provide that a taxpayer must determine, using any reasonable method that is satisfactory to the Secretary based on all of the facts and circumstances, whether gross receipts qualify as DPGR on an item-by-item basis.

The proposed regulations provide that an item is defined as the property offered for lease, rental, license, sale, exchange or other disposition to customers that meets the requirements of section 199. The proposed regulations also provide several examples to illustrate this rule. Some commentators observed that the examples involving a manufacturer of toy cars that sold the cars to toy stores appear to imply that, in the case of property offered for lease, rental, license, sale, exchange or other disposition by a wholesaler, the item is defined with reference to the property offered for sale to retail consumers by the wholesaler’s customer. The rules for defining an item, and the related examples, have been clarified in the final regulations to provide that an item is defined with reference to the property offered by the taxpayer for lease, rental, license, sale, exchange or other disposition to the taxpayer’s customers in the normal course of the taxpayer’s business, whether the taxpayer is a wholesaler or a retailer.

The proposed regulations provide that, if the property offered for lease, rental, license, sale, exchange or other disposition by the taxpayer does not meet the requirements of section 199, then the taxpayer must treat as the item any portion of that property that does meet those requirements. In a case where two or more portions of the property meet the requirements of section 199, commentators inquired whether the two or more portions are properly treated as a single item or as two or more items. The final regulations generally are consistent with the rules of the proposed regulations, and provide that if the gross receipts derived from the lease, rental, license, sale, exchange or other disposition of the property offered in the normal course of a taxpayer’s business do not qualify as DPGR, then any component of such property is treated as the item, provided the gross receipts attributable to the component qualify as DPGR. Allowing more than one component to be treated as a single item would effectively permit taxpayers to define an item as any combination of components that, in the aggregate, meets the requirements of section 199, a result that the IRS and Treasury Department believe could lead to significant distortions. Thus, the IRS and Treasury Department believe that treating two or more components of the property offered for lease, rental, license, sale, exchange or other disposition by the taxpayer as separate items is the appropriate result. The final regulations clarify that, if the property offered for lease, rental, license, sale, exchange or other disposition by the taxpayer does not meet the requirements of section 199, then each component that meets the requirements of §1.199-3 must be treated as a separate item and such component may not be combined with a component that does not meet the requirements to be treated as an item. The final regulations provide examples illustrating this rule. It follows that the de minimis rule for embedded services and nonqualifying property, as well as any other de minimis exception that is applied at the item level, must be applied separately to each component of the property that is treated as a separate item.

The proposed regulations provide that gross receipts derived from a lease, rental, license, sale, exchange or other disposition of qualifying property constitute DPGR even if the taxpayer has already recognized gross receipts from a previous lease, rental, license, sale, exchange or other disposition of the property. The IRS and Treasury Department recognize that in some cases, such as where the original item (for example, steel) that was MPGE or produced by the taxpayer within the United States is disposed of by the taxpayer, and incorporated by another person into other property (for example, an automobile) that is subsequently acquired by the taxpayer, it would be extremely difficult for the taxpayer to identify the item the gross receipts of which constitute DPGR upon lease, rental, license, sale, exchange or other disposition of the acquired property. Therefore, the final regulations provide that if a taxpayer cannot reasonably determine without undue burden and expense whether the acquired property contains any of the original qualifying property, or the amount, grade, or kind of the original qualifying property, that the taxpayer MPGE or produced within the United States, then the taxpayer is not required to determine whether any portion of the acquired property qualifies as an item. In such cases, the taxpayer may treat any gross receipts derived from the disposition of the acquired property that are attributable to the original qualifying property as non-DPGR.

The proposed regulations provide that, for purposes of the requirement to allocate gross receipts between DPGR and non-DPGR, if a taxpayer can, without undue burden or expense, specifically identify where an item was manufactured, or if the taxpayer uses a specific identification method for other purposes, then the taxpayer must use that specific identification method to determine DPGR. One commentator observed that Notice 2005-14 applies a readily available rather than an undue burden or expense standard for this purpose, and questioned whether the proposed regulations were intended to impose a substantively different standard. The standard was changed in the proposed regulations in response to comments received on Notice 2005-14. The commentators were concerned that taxpayers would be required under Notice 2005-14 to use specific identification to allocate gross receipts under section 199 if their information systems contained the information necessary to use specific identification, even if capturing such information would require costly system reconfigurations. The undue burden and expense standard, however, was not intended to expand the scope of the requirement to use specific identification to include taxpayers for whom the information necessary to use that method is not readily available in their existing systems. Accordingly, the final regulations utilize both terms.

Commentators were concerned that the disposition of qualifying property would not give rise to DPGR if provided as part of a service related contract. However, the proposed regulations in Example 4 in §1.199-3(d)(5) already address this issue by illustrating a qualifying disposition resulting in DPGR as part of a service related contract. In that example, Y is hired to reconstruct and refurbish unrelated customers’ tangible personal property. Y installs the replacement parts (QPP) that Y MPGE within the United States. The example concludes that Y’s gross receipts from the MPGE of the replacement parts are DPGR. The final regulations retain this example and include other examples of service related contracts that also involve the disposition of qualifying property giving rise to DPGR if all of the other section 199 requirements are met.

The proposed regulations provide that, if a taxpayer recognizes and reports on a Federal income tax return for a taxable year gross receipts that the taxpayer identifies as DPGR, then the taxpayer must treat the CGS related to such receipts as relating to DPGR, even if they are incurred in a subsequent taxable year. The final regulations retain this rule in §1.199-4(b)(2). One commentator questioned whether this rule applies to CGS incurred in a taxable year to which section 199 applies, if the gross receipts were recognized in a taxable year prior to the effective date of section 199 but would have qualified as DPGR in that taxable year if section 199 had been in effect.  The IRS and Treasury Department believe that all gross receipts and costs must be allocated between DPGR and non-DPGR on a year-by-year basis, and the final regulations provide that for taxpayers using the section 861 method or the simplified deduction method, CGS that relates to gross receipts recognized in a taxable year prior to the effective date of section 199 must be allocated to non-DPGR.

For items that are disposed of under contracts that span two or more taxable years, the final regulations permit the use of historical data to allocate gross receipts between DPGR and non-DPGR. If a taxpayer makes allocations using historical data, and subsequently updates the data, then the taxpayer must use the more recent or updated data, starting in the taxable year in which the update is made.

Two commentators suggested that the final regulations permit taxpayers to classify multi-year contracts for purposes of section 199 with reference to their classification under section 460. For example, if a contract is classified as a construction contract under section 460, the commentators suggested that the contract also be classified as a construction contract under section 199. The IRS and Treasury Department have determined, however, that the statutory requirements under sections 199 and 460, and the regulations thereunder, are sufficiently different that it would not be appropriate for the final regulations to permit the classification of multi-year contracts under section 460 to determine whether the requirements of section 199 are met with respect to that contract. Accordingly, the final regulations do not adopt this suggestion.

One commentator suggested a simplifying convention to determine which party to a contract manufacturing arrangement has the benefits and burdens of ownership under Federal income tax principles. The commentator requested that the final regulations permit unrelated parties to a contract manufacturing arrangement to designate, through a written and signed agreement between the parties, which of them shall be treated for purposes of section 199 as engaging in MPGE activities conducted pursuant to the arrangement. The final regulations do not adopt the commentator’s suggestion. The IRS and Treasury Department continue to believe that the benefits and burdens of ownership must be determined based on all of the facts and circumstances and a designation of benefits and burdens would not be appropriate.

Section 403(a)(7) of the GOZA added new section 199(c)(4)(C), which contains a special rule for certain government contracts. The final regulations clarify that the special rule for government contracts also applies to gross receipts derived from certain subcontracts to manufacture or produce property for the Federal government. See The Joint Committee on Taxation Staff, Technical Explanation of the Revenue Provisions of H.R. 4440, The Gulf Opportunity Zone Act of 2005, 109th Cong., 1st Sess. 77 (2005).

The proposed regulations, like Notice 2005-14, provide generally that QPP is MPGE in whole or in significant part by the taxpayer within the United States only if the taxpayer’s MPGE activity in the United States is substantial in nature. Although some language in the section 199 substantial-in-nature requirement bears similarities to language in the definition of manufacture in §1.954-3(a)(4), the two standards are different both in purpose and in substance. Whether operations are substantial in nature is relevant under section 954 in determining whether manufacturing has occurred. By contrast, the substantial-in-nature requirement under section 199 is relevant in determining whether the MPGE activity, already determined to have occurred under the requirement provided in §1.199-3(d) of the proposed regulations (§1.199-3(e) of the final regulations), was performed in whole or in significant part by the taxpayer within the United States. Accordingly, as stated in the preamble to Notice 2005-14, case law and other precedent under section 954 are not relevant for purposes of the substantial-in-nature requirement under section 199. Nor are they relevant for purposes of determining whether an activity is an MPGE activity under section 199. Similarly, the regulations under section 199 are not relevant for purposes of section 954.

Because the substantial-in-nature requirement is generally applied by taking into account all of the facts and circumstances, both the proposed regulations and Notice 2005-14 provide a safe harbor under which the in-whole-or-in-significant-part requirement is satisfied if the taxpayer’s conversion costs (that is, direct labor and related factory burden) are 20 percent or more of the taxpayer’s CGS with respect to the property. Commentators expressed confusion concerning the related factory burden component of this safe harbor, and suggested that overhead be substituted for related factory burden in the final regulations. Commentators further noted that not all transactions yielding DPGR under section 199 involve CGS (for example, a lease, rental, or license of QPP). In response to these comments, the IRS and Treasury Department have changed the safe harbor in the final regulations. The final regulations provide that the in-whole-or-in-significant-part requirement is satisfied if the taxpayer’s direct labor and overhead to MPGE the QPP within the United States account for 20 percent or more of the taxpayer’s CGS, or in a transaction without CGS (for example, a lease, rental, or license) account for 20 percent or more of the taxpayer’s unadjusted depreciable basis of the QPP. No inference is intended regarding any similar safe harbor under the Code, including the safe harbor in §1.954-3(a)(4)(iii). For taxpayers subject to section 263A, overhead is all costs required to be capitalized under section 263A except direct materials and direct labor. For taxpayers not subject to section 263A, overhead may be computed using any reasonable method that is satisfactory to the Secretary based on all of the facts and circumstances, but may not include any cost, or amount of any cost, that would not be required to be capitalized under section 263A if the taxpayer were subject to section 263A. In no event are section 174 costs, and the cost of creating intangible assets, attributable to tangible personal property ever treated as direct labor and overhead, and taxpayers should exclude such costs from their CGS or unadjusted depreciable basis, as applicable.

However, the final regulations also clarify that, in the case of computer software and sound recordings, research and experimental expenditures under section 174 relating to the computer software or sound recordings, the cost of creating intangible assets for computer software or sound recordings, and (in the case of computer software) costs of developing the computer software that are described in Rev. Proc. 2000-50, 2000-2 C.B. 601 (software development costs), are included in both direct labor and overhead and CGS or unadjusted depreciable basis for purposes of the safe harbor, even if the costs are incurred in a prior taxable year. In addition, the final regulations also clarify that this is the case whether the computer software or sound recording is itself the item for purposes of section 199, or is affixed or added to tangible personal property and the taxpayer treats the combined property as computer software or a sound recording under the rules of §1.199-3(i)(5)).  In the case where the taxpayer produces computer software and manufactures part of the tangible personal property to which the computer software is affixed, the taxpayer may combine the direct labor and overhead for the computer software and tangible personal property produced or manufactured by the taxpayer in determining whether it meets the safe harbor.

The final regulations provide that, in applying the safe harbor to an item for the taxable year, all computer software development costs, any cost of creating intangible assets for computer software or sound recordings, and section 174 costs (for computer software or sound recordings), including those paid or incurred in a prior taxable year, must be allocated over the estimated number of units of the item of which the taxpayer expects to dispose. An example of this rule is provided in the final regulations.

The proposed regulations provide that an EAG member must take into account all of the previous MPGE or production activities of the other members of the EAG in determining whether its MPGE or production activities are substantial in nature. It has been suggested that this rule be modified to allow the EAG member to take into account all MPGE or production activities of the other EAG members rather than just the previous MPGE or production activities of the members. The final regulations do not adopt this suggestion because the IRS and Treasury Department believe that the EAG member must determine whether its MPGE or production activities meet the substantial-in-nature requirement at or before the time EAG member disposes of the property. Similar rules apply for purposes of the safe harbor under §1.199-3(g)(3)(i).

Section 3.04(5)(d) of Notice 2005-14 generally provides that design and development activities must be disregarded in applying the general substantial-in-nature requirement and the safe harbor for tangible personal property. The proposed regulations clarify that research and experimental activities under section 174 and the creation of intangibles do not qualify as substantial in nature. A commentator questioned whether, with respect to tangible personal property, activities that constitute both an MPGE activity as well as a section 174 activity must nonetheless be excluded from the determination of whether the taxpayer’s MPGE of the QPP is substantial in nature because all section 174 activities are disregarded in making such a determination. The IRS and Treasury Department continue to believe that, with the exception of computer software and sound recordings, it is not appropriate to include any section 174 activities in the determination of whether the MPGE of QPP is substantial in nature. However, the IRS and Treasury Department recognize that, although section 174 costs are not required to be capitalized under section 263A to the produced property, a taxpayer may capitalize such costs to the QPP under section 263A. Accordingly, the final regulations permit, as a matter of administrative convenience, a taxpayer to include such costs as CGS or unadjusted depreciable basis for purposes of the 20 percent safe harbor.

A commentator asked that the final regulations clarify that gross receipts relating to computer software updates that are provided as part of a computer software maintenance contract qualify as DPGR if all of the requirements of section 199(c)(4) are met. The final regulations include an example demonstrating that gross receipts relating to computer software updates may qualify as DPGR even if the computer software updates are provided pursuant to a computer software maintenance agreement.

The preamble to the proposed regulations states that the creation and licensing of copyrighted business information reports do not constitute the MPGE of QPP because the database is not QPP. However, it has come to the attention of the IRS and Treasury Department that some business information reports published by the taxpayer may qualify as QPP, for example, business information reports published by the taxpayer in books that qualify as QPP. Therefore, no inference should be drawn from the preamble to the proposed regulations as to whether business information reports qualify for the section 199 deduction.

The proposed regulations provide in §1.199-3(f)(2) that QPP will be treated as MPGE in significant part by the taxpayer within the United States if the MPGE of the QPP by the taxpayer within the United States is substantial in nature taking into account all of the facts and circumstances, including the relative value added by, and relative cost of, the taxpayer’s MPGE activity within the United States, the nature of the property, and the nature of the MPGE activity that the taxpayer performs within the United States.

One commentator suggested that, if a taxpayer manufactures a key component of QPP and purchases the rest of the components, the fact that the taxpayer manufactured the key component should satisfy the substantial-in-nature requirement with respect to the QPP that incorporates the key component. For example, X manufactures computer chips within the United States. X installs the computer chips that it manufactures in computers that X purchases from unrelated persons and sells the finished computers individually to customers. Although the computer chips are key components of the computers and the computers will not operate without them, the manufacture of the key components does not, by itself, satisfy the substantial-in-nature requirement with respect to the finished computers and the taxpayer’s activities with respect to the finished computers must meet either the substantial-in-nature requirement under §1.199-3(g)(2) or the safe harbor under §1.199-3(g)(3) of the final regulations. The final regulations contain an example to illustrate this rule.

In Example 4 in §1.199-3(f)(4) of the proposed regulations, X licenses a qualified film to Y for duplication of the film onto DVDs. Y purchases the DVDs from an unrelated person. The example concludes that unless Y satisfies the safe harbor under §1.199-3(f)(3) of the proposed regulations, Y’s income for duplicating X’s qualified film onto DVDs is non-DPGR because the duplication is not substantial in nature relative to the DVD with the film. One commentator disagreed with the conclusion in this example because duplicating a DVD may involve considerable activities. This example and other examples illustrating the substantial-in-nature requirement have been removed from the final regulations because the determination of what is substantial in nature is determined based on all the facts and circumstances. No inference should be drawn as to whether an activity is, or is not, substantial in nature by the removal of any example.

Section 1.199-3(h)(1) of the proposed regulations provides that applicable Federal income tax principles apply to determine whether a transaction is, in substance, a lease, rental, license, sale, exchange, or other disposition of QPP, whether it is a service, or whether it is some combination thereof. In the preamble to the proposed regulations, the IRS and Treasury Department acknowledge that the short-term nature of a transaction does not, by itself, render the transaction a service for purposes of section 199 and that many transactions include both service and property rental elements. The preamble further states that not every transaction in which property is used in connection with providing a service to customers, however, constitutes a mixture of services and rental for which allocation of gross receipts is appropriate and provides an example of a video arcade that features video game machines that the taxpayer MPGE. The machines remain in the taxpayer’s possession during the customers’ use. The example concludes that gross receipts derived from customers’ use of the machines at the taxpayer’s arcade are not derived from the lease, rental, license, sale, exchange, or other disposition of the machines. Rather, the machines are used to provide a service and, thus, the gross receipts are non-DPGR. While the general rule stated in §1.199-3(h)(1) of the proposed regulations is retained in the final regulations under §1.199-(3)(I)(1), the preamble example is not included in the final regulations because the determination of whether a transaction is a service or a rental is based upon all the facts and circumstances. No inference should be drawn as to whether the transaction constitutes a service or rental (or some combination thereof) by the removal of the example.

Section 1.199-3(h)(1) of the proposed regulations provides that the value of property received by a taxpayer in a taxable exchange of QPP MPGE in whole or in significant part within the United States, a qualified film produced by the taxpayer, or utilities produced by the taxpayer in the United States, for an unrelated person’s property is DPGR for the taxpayer. However, unless the taxpayer meets all of the requirements under section 199 with respect to any further MPGE by the taxpayer of the QPP or any further production by the taxpayer of the film or utilities received in the taxable exchange, any gross receipts derived from the sale by the taxpayer of the property received in the taxable exchange are non-DPGR, because the taxpayer did not MPGE or produce such property, even if the property was QPP, a qualified film, or utilities in the hands of the other party to the transaction.

A commentator requested that, with regard to certain taxable exchanges, the final regulations provide a safe harbor that would accommodate long-standing industry accounting practices for these exchanges. The final regulations provide a safe harbor whereby the gross receipts derived by the taxpayer from the sale of eligible property (as defined later) received in a taxable exchange, net of any adjustments between the parties involved in the taxable exchange to account for differences in the eligible property exchanged (for example, location differentials and product differentials), may be treated as the value of the eligible property received by the taxpayer in the taxable exchange.  In addition, if the taxpayer engages in any further MPGE or production activity with respect to the eligible property received in the taxable exchange, then, unless the taxpayer meets the in-whole-or-in significant-part requirement under §1.199-3(g)(1) with respect to the property sold, the taxpayer must also value the property sold without taking into account the gross receipts attributable to the further MPGE or production activity. The final regulations define eligible property as oil, natural gas, and petrochemicals, or products derived from oil, natural gas, petrochemicals, or any other property or product designated by publication in the Internal Revenue Bulletin. Under the safe harbor, the taxable exchange is deemed to occur on the date of the sale of the eligible property received in the exchange to the extent that the sale occurs no later than the last day of the month following the month in which the exchanged eligible property is received by the taxpayer.

The proposed regulations provide that, in the case of gross receipts derived from a lease of QPP or a qualified film, the entire amount of the lease income, including any interest that is not separately stated, is considered derived from the lease of the QPP or qualified film. Commentators noted that many leases of personal property separately state a finance or interest component. The IRS and Treasury Department believe that Congress intended for all financing or interest components of a lease of qualifying property to be considered DPGR (assuming all the other requirements of section 199 are met). Accordingly, the final regulations provide that all financing and interest components of a lease of qualifying property are considered to be derived from the lease of such qualifying property.

Section 1.199-3(h)(4) of the proposed regulations provides exceptions to the general rule that DPGR does not include gross receipts derived from services or nonqualifying property. The exceptions are for embedded qualified warranties, delivery, operating manuals, and installation. The final regulations retain these exceptions and provide a new exception for embedded computer software maintenance contracts. None of these exceptions, which allow gross receipts attributable to such embedded services and nonqualifying property to be treated as DPGR, is available if, in the normal course of the taxpayer’s trade or business, the price for the service or nonqualifying property is separately stated or is separately offered to the customer.

One commentator asked for clarification concerning the meaning of the term normal course of a taxpayer’s trade or business and when something would be considered to be separately stated or separately offered to a customer. The purpose of the exceptions is to reduce the burden on a taxpayer of having to allocate a portion of its gross receipts to these commonly occurring types of services and property if the taxpayer does not normally price or offer such items separately. Whether a taxpayer separately offers or states the price for such an item in the normal course of its trade or business depends on the facts and circumstances. If, for example, a taxpayer separately states the price for installation for a few of its customers on a case by case basis, then the taxpayer may be considered to have not separately stated the price of installation in the normal course of its trade or business. The requirements have been changed in the final regulations to clarify that the normal-course-of-trade-or-business requirement applies to both the separately stated price prong and the separately offered prong of the embedded services and nonqualifying property rules.

Several comments were received concerning the rule in the proposed regulations under which gross receipts attributable to advertising in newspapers, magazines, telephone directories, or periodicals may qualify as DPGR to the extent that the gross receipts, if any, derived from the disposition of those printed materials qualifies as DPGR. The final regulations clarify that this list is not limited to these four types of printed materials, and that the rule applies to other similar printed materials.

Section 3 of Notice 2005-14 explains that the basis for the rule relating to advertising income is that such income is inextricably linked to the gross receipts (if any) derived from the disposition of the printed materials listed in the proposed regulations. After considering the comments received, the IRS and Treasury Department believe that the same reasoning applies in the case of a qualified film (for example, a television program). Accordingly, the rule for advertising has been extended in the final regulations to apply to qualified films. The wording of the advertising rule has been changed to clarify that the amount of gross receipts attributable to the disposition of the printed materials or qualified film does not limit the amount of gross receipts attributable to the advertising that may be treated as DPGR under the rule. In addition, the final regulations clarify that there need be no gross receipts attributable to the disposition of the printed materials or qualified film for the gross receipts from the advertising to qualify as DPGR.

One commentator requested that the final regulations recognize that gross receipts derived from the sale of advertising slots in live or delayed television broadcasts (that are produced by the taxpayer and that otherwise meet the requirements for a qualified film) are DPGR.  While live and delayed television programming may otherwise meet the requirements to be treated as a qualified film, in order for the gross receipts derived from advertising slots to be DPGR, there must also be a qualifying disposition of the qualified film. The IRS and Treasury Department continue to believe that a live or delayed television broadcast of a qualified film is not a lease, rental, license, sale, exchange or other disposition of the qualified film. Commentators noted, however, that if the live or delayed television programming is licensed to an unrelated cable company, then the license of the programming is a qualifying disposition that gives rise to DPGR and if the rule for advertising were extended to qualified films, then the portion of the advertising receipts relating to the license of the qualified film would also be DPGR. The IRS and Treasury Department agree with these comments, and the final regulations provide examples to clarify these points.

Under §1.199-3(i)(5)(i) of the proposed regulations, if a taxpayer MPGE computer software or sound recordings that is affixed or added to tangible personal property by the taxpayer (for example, a computer diskette or an appliance), then the taxpayer may treat the tangible personal property as computer software or sound recordings, as applicable. A commentator questioned whether this rule should apply if, for example, a taxpayer hires an unrelated person to affix computer software or sound recordings produced by the taxpayer to a compact disc. In response to this comment, the final regulations have dropped the by-the-taxpayer requirement in this context. A similar rule has been provided for qualified films.

Section §1.199-3(j)(1) of the proposed regulations provides that, a qualified film means any motion picture film or video tape under section 168(f)(3), or live or delayed television programming, if not less than 50 percent of the total compensation paid to all actors, production personnel, directors, and producers relating to the production of the motion picture film, video tape, or television programming is compensation for services performed in the United States by those individuals. One commentator was concerned that the list of production personnel described under §1.199-3(j)(1) of the proposed regulations diminishes the general rule under §1.199-3(j)(5) that compensation for services includes all direct and indirect compensation costs required to be capitalized under section 263A for film producers under §1.263A-1(e)(2) and (3). The commentator also stated that it may be difficult to determine which persons are production personnel. The final regulations under §1.199-3(k)(1) clarify that the list of production personnel is not exclusive, and that compensation for services includes all direct and indirect compensation costs required to be capitalized under §1.263A-1(e)(2) and (3).

In response to questions received by the IRS and Treasury Department, the final regulations clarify that actors may include players, newscasters, or any other persons performing in a qualified film. The final regulations also clarify that the not-less-than-50-percent-of-the-total-compensation requirement is determined by reference to all compensation paid in the production of the film and is calculated using a fraction. The numerator of the fraction is the compensation paid by the taxpayer to actors, production personnel, directors, and producers for services relating to the production of the film (production services) performed in the United States, and the denominator is the sum of the total compensation paid by the taxpayer to all such individuals regardless of where the production services are performed and the total compensation paid by others to all such individuals regardless of where the production services are performed. The final regulations provide an example of this calculation.

Commentators requested that the final regulations define tangible personal property and real property for purposes of section 199. The final regulations define tangible personal property as any tangible property other than land, real property described in the construction rules in §1.199-3(m)(1), computer software described in §1.199-3(j)(3), sound recordings described in §1.199-3(j)(4), a qualified film described in §1.199-3(k)(1), and utilities described in §1.199-3(l). In response to commentators’ suggestions, the final regulations further define tangible personal property as also including any gas (other than natural gas described in §1.199-3(l)(2)), chemicals, and similar property, for example, steam, oxygen, hydrogen, and nitrogen.

The final regulations define the term real property to mean buildings (including items that are structural components of such buildings), inherently permanent structures (as defined in §1.263A-8(c)(3)) other than machinery (as defined in §1.263A-8(c)(4)) (including items that are structural components of such inherently permanent structures), inherently permanent land improvements, oil and gas wells, and infrastructure (as defined in §1.199-3(m)(4)). Property MPGE by a taxpayer that is not real property in the hands of such taxpayer, but that may be incorporated into real property by another taxpayer, is not treated as real property by the producing taxpayer (for example, bricks, nails, paint, and windowpanes). Structural components of buildings and inherently permanent structures include property such as walls, partitions, doors, wiring, plumbing, central air conditioning and heating systems, pipes and ducts, elevators and escalators, and other similar property. In addition, an entire utility plant including both the shell and the interior will be treated as an inherently permanent structure.

One commentator recommended that DPGR derived from the construction of real property as well as DPGR from engineering and architectural services for a construction project include W-2 wages earned as an employee. At the time the taxpayer performs construction activities, or engineering or architectural services, the taxpayer must be engaged in a trade or business that is considered construction, engineering or architectural services for purposes of the North American Industry Classification System (NAICS). W-2 wages earned by an employee are not earned in connection with a trade or business that is considered construction, or engineering or architectural services, for purposes of the NAICS. Consequently, this recommendation has not been adopted in the final regulations.

The proposed regulations include within the definition of construction services activities relating to drilling an oil well and mining pursuant to which the taxpayer could deduct intangible drilling and development costs under section 263(c) and §1.612-4, and development expenditures for a mine or natural deposit under section 616. The IRS and Treasury Department are aware that in many situations taxpayers provide these services with respect to property owned by another party, and therefore such taxpayers are ineligible to claim the deductions for such costs under the provisions described above. The language of the final regulations has been changed to clarify that taxpayers providing such services are engaging in construction services that may qualify under section 199.

The preamble to the proposed regulations states that commentators requested that qualifying construction activities include construction activities related to oil and gas wells. The preamble further states that the proposed regulations provide as a matter of administrative grace that qualifying construction activities include activities relating to drilling an oil well. Similarly, under §1.199-3(l)(2) of the proposed regulations, construction activities include activities relating to drilling an oil well. A commentator noted the inadvertent omission of gas wells and the final regulations correct the omission.

The proposed regulations provide that DPGR does not include gross receipts attributable to the sale or other disposition of land (including zoning, planning, entitlement costs, and other costs capitalized into the land such as grading and demolition of structures under section 280B). Commentators contended that grading and demolition are construction-related activities, and that gross receipts attributable to these activities should qualify as DPGR. After considering the comments, the IRS and Treasury Department believe it is appropriate to apply to grading and demolition activities the same rule that the proposed regulations apply to other construction activities, such as landscaping and painting. Accordingly, services such as grading, demolition, clearing, excavating, and any other activities that physically transform the land are activities constituting construction only if these services 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 IRS and Treasury Department continue to believe that gross receipts attributable to the sale or other disposition of land (including zoning, planning, and entitlement costs) are properly considered gross receipts attributable to the land, not to a qualifying construction activity, and, therefore, are non-DPGR.

In response to a suggestion by a commentator, the final regulations provide that a taxpayer engaged in a construction activity must make a reasonable inquiry or a reasonable determination whether the activity relates to the erection or substantial renovation of real property in the United States.

The proposed regulations contain an example of an electrical contractor who purchases wires, conduits, and other electrical materials that the contractor installs in construction projects in the United States and that are considered structural components. The example concludes that the gross receipts that the contractor derives from installing these materials are derived from construction, but that the gross receipts attributable to the purchased materials are not. Commentators objected to this result, contending that it places an unreasonable administrative burden on taxpayers performing construction activities. The final regulations, including the example, provide that, in such circumstances, the taxpayer performing the construction services is not required to allocate gross receipts to the purchased materials and treat such gross receipts as non-DPGR, provided the materials and supplies are consumed in the construction project or become part of the constructed real property.

Section 199(c)(4)(A), as amended by the GOZA, requires that a taxpayer be engaged in the active conduct of a construction trade or business for the taxpayer’s construction activity to qualify under section 199. The proposed regulations provide that a taxpayer may not treat as DPGR gross receipts derived from construction unless the taxpayer is engaged in a construction trade or business on a regular and ongoing basis. Commentators expressed concern that this requirement would preclude construction project-specific joint ventures or partnerships, a common business structure in the construction industry, from qualifying under section 199. Typically, such entities are formed for the purpose of a specific construction project, and are terminated or dissolved when the project is completed. The final regulations continue to require that a taxpayer be engaged in a regular and ongoing construction trade or business, but provide a safe harbor rule under which entities formed specifically for purposes of a particular construction project may qualify. Under the safe harbor rule, if a taxpayer is engaged in a construction trade or business, then the taxpayer will be considered to be engaged in such trade or business on a regular and ongoing basis if the taxpayer derives gross receipts from an unrelated person by selling or exchanging the constructed real property within 60 months of the date on which construction is complete.

Commentators also expressed concern that taxpayers would not meet the requirement of being engaged in a construction business on a regular and ongoing basis if the taxpayer is newly-formed or otherwise is in the first taxable year of a new construction trade or business. Although some taxpayers may meet the regular-and-ongoing-business requirement under the safe harbor rule discussed previously, the final regulations provide that, in the case of a newly-formed trade or business or a taxpayer in its first taxable year, the taxpayer will satisfy the regular-and-ongoing-basis requirement if it reasonably expects to be engaged in a construction trade or business on a regular and ongoing basis.

The IRS and Treasury Department received a comment requesting clarification of the land safe harbor of §1.199-3(l)(5)(ii) of the proposed regulations. Under the land safe harbor, the taxpayer is permitted to allocate gross receipts between real property other than land, and land, according to a formula. The taxpayer must reduce gross receipts by the costs of the land and any other costs capitalized to the land, plus a percentage of those costs, and costs related to DPGR must be reduced by the costs of the land and any other costs capitalized to the land. The percentage ranges from 5 to 15 percent, depending upon the length of time the taxpayer held the land. The commentator asked whether the holding period of a previous owner of the land would be attributed to the new owner, and what rules apply for purposes of computing the new owner’s cost basis. Generally, if an existing provision of the Code or regulations would apply to require attribution of the holding period of a previous owner of property to a new owner, the same rules will apply in the case of a previous owner’s holding period in land for purposes of the land safe harbor rule of section 199. For example, the holding period of the previous owner (P) would carry over to the new owner (N) under existing Federal income tax principles if P were a partner in partnership N, and P contributed the land to N. The same result would apply if, instead, the land was distributed by partnership P to N, its partner. In the case of partnership or other pass-thru entity, the land safe harbor is applied at the partnership or other pass-thru entity level and is not applied at the partner or owner level.

With regard to the land safe harbor discussed in the preceding paragraph, the proposed regulations state that the length of time a taxpayer is deemed to hold the land begins on the date the taxpayer acquires the land, including the date the taxpayer enters into the first option to acquire all or a portion of the land, and ends on the date the taxpayer sells each item of real property on the land. Commentators stated that development of the land generally does not begin until the land is acquired and any option to acquire land is based on the land’s fair market value. Because developers are paying fair market value, the commentators suggested that the period for determining the percentage should not include any option period. The IRS and Treasury Department generally agree with the commentator’s suggestion, and the final regulations do not include the option period except where the option does not include provisions to adjust the purchase price to approximate fair market value.

Example 1 in §1.199-3(m)(5)(iii) of the proposed regulations provides that X, who is in a construction trade or business under NAICS Code 23 on a regular and ongoing basis, purchases a building and retains Y, a general contractor, to perform construction services in connection with a substantial renovation of the building. The example concludes that X’s gross receipts derived from the disposition of the building are non-DPGR, and that Y’s gross receipts from amounts paid to it by X are DPGR. In addition, the example illustrates that gross receipts of subcontractors hired by Y qualify as DPGR. Some commentators inferred from this example that the taxpayer must, at a minimum, be a legally designated general contractor before its gross receipts may qualify as DPGR. The example was not intended to imply that a taxpayer must be a licensed general contractor. The final regulations clarify that activities constituting construction include activities typically performed by a general contractor, or that constitute general contractor-level work, such as activities relating to management and oversight of the construction process (for example, approvals, periodic inspection of the progress of the construction project, and required job modifications). The example has been modified in the final regulations to illustrate that the person hired by the building owner, although not a licensed general contractor, qualifies as engaging in construction activities by virtue of providing management and oversight of the construction process.

Several commentators recommended that the final regulations provide that, for purposes of the de minimis exception of §1.199-3(l)(5)(ii) (regarding construction services), gross receipts attributable to land be disregarded for purposes of calculating the de minimis exception. In response to the comments, the final regulations clarify that, if a taxpayer applies the land safe harbor, then the gross receipts excluded under the land safe harbor are excluded in determining total gross receipts under the de minimis exception. The final regulations also provide that, if a taxpayer does not apply the land safe harbor and uses any reasonable method (for example, an appraisal of the land) to allocate gross receipts attributable to the land to non-DPGR, then a taxpayer applies the de minimis exception by excluding such gross receipts derived from the sale, exchange, or other disposition of the land from total gross receipts.

A commentator requested that the definition of construction activities not be limited to direct activities an