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Domestic Production Activities Deduction: Not an Easy Calculation to Compute

By: Margaret P. Amsden, CPA, MST

The American Jobs Creation Act of 2004 provided a new deduction available to those who produce goods. The intent of this new deduction is twofold. First, it is meant to replace the extraterritorial income exclusion (EIE). The EIE is being phased out due to complaints from the World Trade Organization that the EIE was an improper subsidy to American companies. Second, it is meant to equate to an approximate 1.5% tax rate reduction for American producers.

In technical terms, the deduction applies for taxable years beginning after December 31, 2004, and is equal to 3% of the lesser of qualified production activities income, or taxable income for the year.

The deduction is limited to 50% of wages paid during the taxable year and is only available to the extent that the production activities were performed "in significant part" within the United States.

This being said, it is clear that there are several issues that must be considered in determining the deduction.

1. It is necessary to determine what "qualified production activities income" is. At first blush, it would seem clear that a taxpayer must be producing something. However, the legislation defines gross receipts that qualify very broadly including such things as engineering and architectural services related to the construction of a product. So the fact that a company does not produce an end product for sale to a customer does not necessarily mean that it won’t qualify
2. It is necessary to determine what portion of a company’s gross income and expenses relate to these production activities
3. It is necessary that these production activities do in fact generate net income for the companies

Some of the most complex issues will arise for companies that are involved in mixed production and service activities. Making the necessary determinations will require various internal company revenue and cost allocations, data accumulation challenges, and questions regarding interpretation and application of the Internal Revenue Code and related regulations to be addressed. As with all new legislation, we look to the Internal Revenue Service to issue guidance on how to implement these new computations. Currently, they have issued some limited guidance and are expected to issue temporary regulations by this summer. However, they have also stated that it will be at least a year (April 2006) before they expect to have issued any final regulations that will give taxpayers direction in how these computations should be completed.

For more information on this new deduction, please contact Margaret Amsden at 248.208.8860.

248.208.8860 | 2000 Town Center, Suite 1800 | Southfield, MI 48075

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