A Deduction for All Seasons?

A Deduction for All Seasons?
Conference Probes New Tax Provision

Over the coming year, CPAs and their business clients should take a close look at their domestic production gross receipts and see whether they qualify for a newly created federal deduction. Chances are they probably do, according to one expert in the field.

This deduction, known as the domestic production deduction, is one of the major new provisions of the American Jobs Creation Act of 2004, which Congress enacted to help stymie the flow of outsourcing, among other reasons. This deduction effectively represents a replacement of the Extraterritorial Income Exclusion, which the World Trade Organization ruled illegal and which the act repeals.

“I think a lot of people will benefit from this deduction,” said Mitchell Sorkin, tax partner with Smallberg Sorkin & Company LLP, who served as one of the guest speakers at the Jan. 12 International Taxation Conference.

The deduction could apply to a wide swath of businesses, from construction contractors to engineering or architectural firms undertaking U.S. projects. It also covers qualified film, electricity, natural gas or potable water produced in the U.S, and qualified production property manufactured, produced, grown or extracted in the U.S.

In fact, the exemption is so broad that it raises questions both for CPAs who are trying to determine if their clients qualify and for government regulators who are in the process of issuing guidance. During his presentation, Sorkin noted that because of the provision’s wording, it’s even conceivable that a business that manufactures abroad could still be eligible for the deduction.

“What is the definition of domestic manufacturing?” asked John J. Merrick, special counsel to the associate chief counsel (international) of the Internal Revenue Service.

According to Merrick, who also spoke at the conference, domestic, or 199, manufacturing is “something the tax code has wrestled with for years.” He added that “there are a lot of different places you could go” for a definition. Consequently, the IRS recognizes the need to get out guidance on the provision as soon as possible, Merrick said.

Illustrating this necessity, Sorkin gave the example of a national coffee chain and the difficulty of determining whether the business qualifies for the deduction. Under the act, food retailers are not eligible for the tax break. However, Sorkin pointed out, the case could be made that the coffee chain is a manufacturing operation as much as it is a food retail operation.

There are other limitations to the exemption as well. The deduction must be taken from taxable income, and it only applies to businesses with W-2 wages. Therefore, a sole proprietorship or a limited liability corporation with no W-2 income would not qualify. The tax break does not apply to the transmission of electricity, natural gas or potable water, either.

Still, with so many potential loose ends surrounding the deduction, Sorkin advised the CPAs in attendance to start researching the provision now, notifying taxpayers who they believe might qualify.

A Guiding Hand

Other guidance that is taking precedence at the IRS and the Treasury concerns Section 965 of the new tax act, pertaining to the dividends received deduction. Unlike the domestic manufacturing relief, which should be around for years, the dividend repatriation provision, which provides for an 85 percent deduction for cash dividends received from controlled foreign corporations, is “unusual” in that it has a one-year window of opportunity, effective from the date of enactment.

Tax authorities, Merrick said, are in the process of issuing serial notices on Section 965, which likely will address how management should adopt a domestic reinvestment plan—a requirement for the deduction—as well as clarification on a permissible plan.

Merrick also mentioned that proposed cross-border regulations affecting mergers involving foreign operations, among other things, came out in early January.

The NYSSCPA’s International Taxation Committee, chaired by Bruce I. Panock, sponsored the Foundation for Accounting Education conference. Committee member Cristina N. Wolff chaired the event.