Internal Revenue Bulletin 2006-25 (PDF rendition): IRS Revenue Rulings

Preserve advance releases and the authoritative Internal Revenue Bulletin rendition; directory timestamps are file-publication metadata, not legal effective dates. HTML bulletins begin June 2003; earlier available issues require full PDF parsing. Whole bulletin rendition: numbered items are identified below; other legal material and publisher context remain included. This is not a new standalone advance release.

Bulletin No. 200
6-25
June 19, 2006
HIGHLIGHTS
OF THIS ISSUE
These synopses are intended only as aids to the reader in
identifying the subject matter covered. They may not be
relied upon as authoritative interpretations.
INCOME TAX
Rev. Rul. 2006–30, page 1134.
Interest rates; underpayments and overpayments.The
rate of interest determined under section 6621 of the Code
for the calendar quarter beginning July 1, 2006, will be 8 per-
cent for overpayments (7 percent in the case of a corporation),
8 percent for underpayments, and 10 percent for large corpo-
rate underpayments. The rate of interest paid on the portion of
a corporate overpayment exceeding $10,000 will be 5.5 per-
cent.
Rev. Rul.
2006–31, page 1133.
Regulate
d investment company (RIC).This ruling modifies
Rev. Rul.
2006–1 to extend until September 30, 2006, the
transiti
on period provided by that ruling, and clarifies that Rev.
Rul. 2006
–1 was not intended to preclude a conclusion that
income f
rom certain instruments (such as structured notes)
that cre
ate a commodity exposure for the holder is qualifying
income u
nder section 851(b)(2) of the Code. Rev. Rul. 2006–1
modifie
d and clarified.
T.D. 9263, page 1063.
Final regulations under section 199 of the Code relate to the
deduction for income attributable to domestic production activ-
ities. Section 199 was enacted as part of the American Jobs
Creation Act (AJCA) of 2004, and allows a deduction equal to 3
percent (for 2005 and 2006) of the lesser of the qualified pro-
duction activities income of the taxpayer for the taxable year, or
the taxable income of the taxpayer for the taxable year, subject
to certain limits. The applicable percentage rises to 6 percent
for 2007, 2008, and 2009, and 9 percent for 2010 and sub-
sequent years. Notice 2005–14 obsoleted for taxable years
beginning on or after June 1, 2006.
Notice 2006–51, page 1144.
Renewable electricity production and refined coal pro-
duction; calendar year 2006 inflation adjustment factor
and reference prices.This notice announces the calendar
year 2006 inflation adjustment factor and reference prices for
the renewable electricity production credit and refined coal pro-
duction credit under section 45 of the Code.
Rev. Proc. 2006–28, page 1147.
Guidance is provided to individuals who fail to meet the eligi-
bility requirements of section 911(d)(1) of the Code because
adverse conditions in a foreign country preclude the individu-
als from meeting those requirements. A list of the country for
tax year 2005 and the date that country is subject to the sec-
tion 911(d)(4) waiver is provided.
EMPLOYEE PLANS
Notice 2006–55, page 1146.
Weighted average interest rate update; 30-year Trea-
sury securities.The weighted average interest rate for June
2006 and the resulting permissible range of interest rates used
to calculate current liability and to determine the required con-
tribution are set forth.
EXCISE TAX
Notice 2006–50, page 1141.
This notice announces that the Service will follow the holding of
Am. Bankers Ins. Group v. United States, 408 F.3d 1328 (11th
Cir. 2005). The notice provides related guidance to taxpayers
and collectors. Notice 2005–79 revoked.
Fi
nding Lists begin on page ii.

The IRS Mission
Provide America’s taxpayers top quality service by helping
them understand and meet their tax responsibilities and by
applying the tax law with integrity and fairness to all.
Introduction
The Internal Revenue Bulletin is the authoritative instrument of
the Commissioner of Internal Revenue for announcing official
rulings and procedures of the Internal Revenue Service and for
publishing Treasury Decisions, Executive Orders, Tax Conven-
tions, legislation, court decisions, and other items of general
interest. It is published weekly and may be obtained from the
Superintendent of Documents on a subscription basis. Bulletin
contents are compiled semiannually into Cumulative Bulletins,
which are sold on a single-copy basis.
It is the policy of the Service to publish in the Bulletin all sub-
stantive rulings necessary to promote a uniform application of
the tax laws, including all rulings that supersede, revoke, mod-
ify, or amend any of those previously published in the Bulletin.
All published rulings apply retroactively unless otherwise indi-
cated. Procedures relating solely to matters of internal man-
agement are not published; however, statements of internal
practices and procedures that affect the rights and duties of
taxpayers are published.
Revenue rulings represent the conclusions of the Service on the
application of the law to the pivotal facts stated in the revenue
ruling. In those based on positions taken in rulings to taxpayers
or technical advice to Service field offices, identifying details
and information of a confidential nature are deleted to prevent
unwarranted invasions of privacy and to comply with statutory
requirements.
Rulings and procedures reported in the Bulletin do not have the
force and effect of Treasury Department Regulations, but they
may be used as precedents. Unpublished rulings will not be
relied on, used, or cited as precedents by Service personnel in
the disposition of other cases. In applying published rulings and
procedures, the effect of subsequent legislation, regulations,
court decisions, rulings, and procedures must be considered,
and Service personnel and others concerned are cautioned
against reaching the same conclusions in other cases unless
the facts and circumstances are substantially the same.
The Bulletin is divided into four parts as follows:
Part I.—19
86 Code.
This part i
ncludes rulings and decisions based on provisions of
the Intern
al Revenue Code of 1986.
Part II.—Treaties and Tax Legislation.
This part is divided into two subparts as follows: Subpart A,
Tax Conventions and Other Related Items, and Subpart B, Leg-
islation and Related Committee Reports.
Part III.—Administrative, Procedural, and Miscellaneous.
To the extent practicable, pertinent cross references to these
subjects are contained in the other Parts and Subparts. Also
included in this part are Bank Secrecy Act Administrative Rul-
ings. Bank Secrecy Act Administrative Rulings are issued by
the Department of the Treasury’s Office of the Assistant Sec-
retary (Enforcement).
Part IV
.—Items of General Interest.
This par
t includes notices of proposed rulemakings, disbar-
ment an
d suspension lists, and announcements.
The last Bulletin for each month includes a cumulative index
for the matters published during the preceding months. These
monthly indexes are cumulated on a semiannual basis, and are
published in the last Bulletin of each semiannual period.
The c
ontents of this publication are not copyrighted and may be reprinted freely. A citation of the Internal Revenue Bulletin as the source would be appropriate.
For sale by the Superintendent of Documents, U.S.Government Printing Office, Washington, DC 20402.
June 19, 20062006–25 I.R.B.

Part I. Rulings and Decisions Under the Internal Revenue Code
of 1986
Section 199.—Income
Attributable to Domestic
Production Activities
26 CFR 1.199–1: Income attributable to domestic
production activities.
T.D. 9263
DEPARTMENT OF
THE TREASURY
Internal Revenue Service
26 CFR Parts 1 and 602
Income Attributable to
Domestic Production Activities
AGENCY: Internal Revenue Service
(IRS), Treasury.
ACTION: Final regulations.
SUMMARY: This document contains fi-
nal regulations concerning the deduction
for income attributable to domestic pro-
duction activities under section 199 of the
Internal Revenue Code. Section 199 was
enacted as part of the American Jobs Cre-
ation Act of 2004 (Act). The regulations
will affect taxpayers engaged in certain do-
mestic production activities.
DATES:Effective Date:These regulations
are effective June 1, 2006.
Date of Applicability:For date of appli-
cability, see §§1.199–8(i) and 1.199–9(k).
FOR FURTHER INFORMATION
CONTACT: Concerning §§1.199–1,
1.199–3, 1.199–6, and 1.199–8,
Paul Handleman or Lauren Ross
Taylor, (202) 622–3040; concern-
ing §1.199–2, Alfred Kelley, (202)
622–6040; concerning §1.199–4(c)
and (d), Richard Chewning, (202)
622–3850; concerning all other pro-
visions of §1.199–4, Jeffery Mitchell,
(202) 622–4970; concerning §1.199–7,
Ken Cohen, (202) 622–7790; concern-
ing §1.199–9, Martin Schaffer, (202)
622–3080 (not toll-free numbers).
SUPPLEMENTARY INFORMATION:
Paperwork Reduction Act
The collection of information con-
tained in these final regulations has been
reviewed and approved by the Office
of Management and Budget in accor-
dance with the Paperwork Reduction Act
(44 U.S.C. 3507) under control number
1545–1966. Responses to this collec-
tion of information are mandatory so that
patrons of agricultural and horticultural
cooperatives may claim the section 199
deduction.
An agency may not conduct or sponsor,
and a person is not required to respond
to, a collection of information unless the
collection of information displays a valid
control number assigned by the Office of
Management and Budget.
The estimated annual burden per re-
spondent varies from 15 minutes to 10
hours, depending on individual circum-
stances, with an estimated average of 3
hours.
Comments concerning the accuracy
of this burden estimate and sugges-
tions for reducing this burden should
be sent to theInternal Revenue Service,
Attn: IRS Reports Clearance Officer,
SE:W:CAR:MP:T:T:SP, Washington, DC
20224, and to theOffice of Manage-
ment and Budget, Attn: Desk Officer for
the Department of the Treasury, Office
of Information and Regulatory Affairs,
Washington, DC 20503.
Books or records relating to this col-
lection of information must be retained as
long as their contents may become mate-
rial in the administration of any internal
revenue law. Generally, tax returns and tax
return information are confidential, as re-
quired by 26 U.S.C. 6103.
Background
This document amends 26 CFR part
1 to provide rules relating to the deduc-
tion for income attributable to domestic
production activities under section 199
of the Internal Revenue Code (Code).
Section 199 was added to the Code by
section 102 of the American Jobs Creation
Act of 2004 (Public Law 108–357, 118
Stat. 1418) (Act), and amended by section
403(a) of the Gulf Opportunity Zone Act
of 2005 (Public Law 109–135, 119 Stat.
25) (GOZA) and section 514 of the Tax
Increase Prevention and Reconciliation
Act of 2005 (Public Law 109–222, 120
Stat. 345) (TIPRA). On January 19, 2005,
the IRS and Treasury Department issued
Notice 2005–14, 2005–1 C.B. 498, provid-
ing interim guidance on section 199. On
November 4, 2005, the IRS and Treasury
Department published in theFederal Reg-
isterproposed regulations under section
199 (REG–105847–05, 2005–47 I.R.B.
987 [70 FR 67220]) (proposed regula-
tions). On January 11, 2006, the IRS and
Treasury Department held a public hearing
on the proposed regulations. Written and
electronic comments responding to the
proposed regulations were received. This
preamble describes the most significant
comments received by the IRS and Trea-
sury Department. Because of the large
volume of comments received, however,
the IRS and Treasury Department are not
able to address all of the comments in this
preamble. After consideration of all of
the comments, the proposed regulations
are adopted as amended by this Trea-
sury decision. Contemporaneous with
the publication of these final regulations,
temporary (T.D. 9262, 2006–24 I.R.B.
1040) and proposed (REG–111578–06,
2006–24 I.R.B. 1060) regulations have
been published involving the treatment
under section 199 of computer software
provided to customers over the Internet.
General Overview
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 ac-
tivities income (QPAI) of the taxpayer for
the taxable year, or (B) taxable income (de-
termined without regard to section 199) for
the taxable year (or, in the case of an indi-
vidual, adjusted gross income (AGI)).
Section 199(b)(1) limits the deduction
for a taxable year to 50 percent of the W–2
2006–25 I.R.B.1063June 19, 2006

wages paid by the taxpayer during the cal-
endar year that ends in such taxable year.
For this purpose, section 199(b)(2) defines
the termW–2 wagesto 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 em-
ployees by such person during the calen-
dar year ending during such taxable year.
The termW–2 wagesdoes not include any
amount that is not properly included in a
return filed with the Social Security Ad-
ministration 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 ap-
plication of section 199(b) in the case of an
acquisition or disposition of a major por-
tion of either a trade or business or a sep-
arate unit of a trade or business during the
taxable year.
Section 514(a) of TIPRA amended sec-
tion 199(b)(2) by excluding from the term
W–2 wagesany amount that is not prop-
erly allocable to domestic production gross
receipts (DPGR) for purposes of section
199(c)(1). The IRS and Treasury Depart-
ment plan on issuing regulations on the
amendments made to section 199(b)(2) by
section 514 of TIPRA.
Qualified Production Activities Income
Section 199(c)(1) defines QPAI for any
taxable year as an amount equal to the ex-
cess (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 al-
locable to such receipts; and (ii) other ex-
penses, losses, or deductions (other than
the deduction under section 199) that are
properly allocable to such receipts.
Section 199(c)(2) provides that the Sec-
retary 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 im-
mediately after it enters the United States.
A similar rule applies in determining the
adjusted basis of leased or rented prop-
erty 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 pro-
duced 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 con-
struction 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 servicesperformedinthe
United States by the taxpayer in the ordi-
nary 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 manufac-
ture or production of any property de-
scribed 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 prop-
erty 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 part-
nership are owned by members of a sin-
gle expanded affiliated group (EAG) at all
times during the taxable year of such part-
nership, 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 per-
cent 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 transporta-
tion 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, li-
censed, 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
relatedpersontoanunrelatedpersonfor
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 ei-
ther section 52(a) or (b) (without regard to
section 1563(b)), or section 414(m) or (o).
Pass-thru Entities
Section 199(d)(1)(A) provides that, in
the case of a partnership or S corpora-
tion, (i) section 199 shall be applied at the
partner or shareholder level, (ii) each part-
ner or shareholder shall take into account
such person’s allocable share of each item
June 19, 200610642006–25 I.R.B.

describedinsection199(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 wagesof 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 in-
stead 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 al-
locable share of the W–2 wages of the
partnership or S corporation for the tax-
able 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 benefi-
ciaries 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 es-
tate shall be determined as provided in sec-
tion 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.
Individuals
In the case of an individual, sec-
tion 199(d)(2) provides that the deduc-
tion is equal to the applicable percent
of the lesser of the taxpayer’s (A) QPAI
forthetaxableyear,or(B)AGIforthe
taxable year determined after applying
sections 86, 135, 137, 219, 221, 222, and
469, and without regard to section 199.
Patrons of Certain Cooperatives
Section 199(d)(3)(A) provides that any
person who receives a qualified payment
from a specified agricultural or horticul-
tural cooperative shall be allowed for the
taxable year in which such payment is re-
ceived a deduction under section 199(a)
equal to the portion of the deduction al-
lowed under section 199(a) to such coop-
erative which is (i) allowed with respect to
the portion of the QPAI to which such pay-
ment is attributable, and (ii) identified by
such cooperative in a written notice mailed
to such person during the payment period
describedinsection1382(d).
Section 199(d)(3)(B) provides that the
taxable income of a specified agricultural
or horticultural cooperative shall not be re-
duced 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 in-
come of a specified agricultural or hor-
ticultural cooperative shall be computed
without regard to any deduction allowable
under section 1382(b) or (c) (relating to pa-
tronage dividends, per-unit retain alloca-
tions, and nonpatronage distributions).
Section 199(d)(3)(D) provides that,
for purposes of section 199, a specified
agricultural or horticultural cooperative
describedinsection199(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 paymentmeans, with respect
to any person, any amount that (i) is de-
scribed 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 re-
spect 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 co-
operativemeans an organization to which
part I of subchapter T applies that is en-
gaged (i) in the MPGE in whole or in sig-
nificant part of any agricultural or horti-
cultural product, or (ii) in the marketing of
agricultural or horticultural products.
Expanded Affiliated Group
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 substitut-
ing “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, ex-
cept as provided in regulations, the sec-
tion 199 deduction is allocated among the
members of the EAG in proportion to each
member’s respective amount (if any) of
QPAI.
Trade or Business Requirement
Section 199(d)(5) provides that sec-
tion 199 is applied by taking into account
only items that are attributable to the ac-
tual conduct of a trade or business.
Alternative Minimum Tax
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.”
Unrelated Business 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 in-
come.”
2006–25 I.R.B.1065June 19, 2006

Authority to Prescribe Regulations
Section 199(d)(8) authorizes the Secre-
tary to prescribe such regulations as are
necessary to carry out the purposes of sec-
tion 199, including regulations that pre-
vent more than one taxpayer from being al-
lowed a deduction under section 199 with
respect to any activity described in section
199(c)(4)(A)(i).
Effective Date
The effective date of section 199 in
section 102(e) of the Act was amended
by section 403(a)(19) of the GOZA. Sec-
tion 102(e)(1) of the Act provides that the
amendments made by section 102 of the
Act shall apply to taxable years begin-
ning after December 31, 2004. Section
102(e)(2) of the Act provides that, in de-
termining the deduction under section 199,
items arising from a taxable year of a part-
nership, S corporation, estate, or trust be-
ginning before January 1, 2005, shall not
be taken into account for purposes of sec-
tion 199(d)(1). Section 514(c) of TIPRA
provides that the amendments made by
section 514 apply to taxable years begin-
ning after May 17, 2006, the enactment
date of TIPRA.
Summary of Comments and
Explanation of Provisions
Taxable Income
The section 199 deduction is not taken
into account in computing any net operat-
ing 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 por-
tion 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 re-
gard to section 199 and without regard
to any amount excluded from gross in-
come pursuant to section 114 of the Code
or pursuant to section 101(d) of the Act.
Thus, any extraterritorial income exclu-
sion or amount excluded from gross in-
come pursuant to section 101(d) of the Act
does not reduce taxable income for pur-
poses of section 199(a)(1)(B), even though
such excluded amounts are taken into ac-
count in determining QPAI.
Wage Limitation
The final regulations give the Secretary
authority to provide for methods of cal-
culating W–2 wages. Contemporaneous
with the publication of these final regu-
lations, Rev. Proc. 2006–22, 2006–23
I.R.B. 1033, has been published and pro-
vides for taxable years beginning on or be-
fore May 17, 2006, the enactment date of
TIPRA, the same three methods of calcu-
lating W–2 wages as were contained in
Notice 2005–14 and the proposed regula-
tions. It is expected that any new revenue
procedure applicablefor taxable years be-
ginning after May 17, 2006, will contain
methods for calculating W–2 wages sim-
ilar 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 re-
flecting those changes more promptly than
an amendment to the final regulations.
Taxpayers have inquired whether remu-
neration 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 in-
cluded in W–2 wages. Such remuneration
is generally excepted from wages for in-
come 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 pay-
ments are not included in W–2 wages for
purposes of section 199(b)(2).
The IRS and Treasury Department have
also received numerous inquiries concern-
ing whether amounts paid to workers who
receive Forms W–2 from professional em-
ployer organizations (PEOs), or employee
leasing firms, may be included in the W–2
wages of the clients of the PEOs or em-
ployee leasing firms. In order for wages
reportedonaFormW–2tobeincluded
in the determination of W–2 wages of a
taxpayer, the Form W–2 must be for em-
ployment 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 de-
pends 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 re-
ported on Forms W–2 issued by other par-
ties provided that the wages reported on
the Forms W–2 were paid to employees of
the taxpayer for employment by the tax-
payer. However, with respect to individu-
als 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 consis-
tent 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 regu-
lations provides that married individuals
who file a joint return are treated as one
taxpayer for purposes of determining W–2
wages. Therefore, anindividual filing as
part of a joint return may take into ac-
count 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.
June 19, 200610662006–25 I.R.B.

Domestic Production Gross Receipts
Commentators suggested that rules
similar to thede minimisrules provided
in §§1.199–1(d)(2) (gross receipts alloca-
tion), 1.199–3(h)(4) (embedded services),
1.199–3(l)(1)(ii) (construction services),
and 1.199–3(m)(4) (engineering or archi-
tectural services) of the proposed regula-
tions, under which taxpayers may treatde
minimisamounts of non-DPGR as DPGR,
should be available in the opposite situ-
ation. 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 commen-
tators suggested that the final regulations
allow the taxpayer to treat those gross
receipts as non-DPGR. The IRS and Trea-
sury Department agree with this sugges-
tion, 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 re-
garding the burden imposed by the re-
quirement in the proposed regulations that
QPAI be computed on an item-by-item
basis (rather than on a division-by-di-
vision, or product line-by-product line
basis). Several commentators urged the
IRS and Treasury Department to limit
the item-by-item standard to the require-
ments of §1.199–3 in determining DPGR
(that is, the lease, rental, license, sale,
exchange, or other disposition require-
ment, the in-whole-or-in-significant-part
requirement, etc.). Specifically, the com-
mentators argued that the item-by-item
standard is inconsistent with the cost al-
location 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 tocustomers that meets
the requirements of section 199. The pro-
posed regulations also provide several ex-
amples to illustrate this rule. Some com-
mentators observed that the examples in-
volving a manufacturer of toy cars that
sold the cars to toy stores appear to im-
ply 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 prop-
erty offered for sale to retail consumers by
the wholesaler’s customer. The rules for
defining an item, and the related exam-
ples, have been clarified in the final reg-
ulations 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 tax-
payer’s customers in the normal course of
the taxpayer’s business, whether the tax-
payer is a wholesaler or a retailer.
The proposed regulations provide that,
if the property offered for lease, rental,
license, sale, exchange or other disposi-
tion by the taxpayer does not meet the re-
quirements of section 199, then the tax-
payer must treat as the item any portion
of that property that does meet those re-
quirements. In a case where two or more
portions of the property meet the require-
ments of section 199, commentators in-
quired whether the two or more portions
are properly treated as a single item or
as two or more items. The final regu-
lations generally are consistent with the
rules of the proposed regulations, and pro-
vide 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 com-
ponent of such property is treated as the
item, provided the gross receipts attribut-
able 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 ag-
gregate, meets the requirements of section
199, a result that the IRS and Treasury De-
partment 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 sepa-
rate items is the appropriate result. The fi-
nal regulations clarify that, if the property
offered for lease, rental, license, sale, ex-
change 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 thede minimisrule for embed-
ded services and nonqualifying property,
as well as any otherde minimisexception
that is applied at the item level, must be ap-
plied 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 dispo-
sition 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 tax-
payer, and incorporated by another person
into other property (for example, an au-
tomobile) 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, ex-
change or other disposition of the acquired
property. Therefore, the final regulations
provide that if a taxpayer cannot reason-
ably 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 allo-
cate gross receipts between DPGR and
non-DPGR, if a taxpayer can, without un-
due burden or expense, specifically iden-
2006–25 I.R.B.1067June 19, 2006

tify where an item was manufactured, or if
the taxpayer uses a specific identification
method for other purposes, then the tax-
payer must use that specific identification
method to determine DPGR. One com-
mentator observed that Notice 2005–14
applies a readily available rather than an
undue burden or expense standard for this
purpose, and questioned whether the pro-
posed regulations were intended to impose
a substantively different standard. The
standard was changed in the proposed reg-
ulations 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 infor-
mation systems contained the information
necessary to use specific identification,
even if capturing suchinformation 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 inExample 4in
§1.199–3(d)(5) already address this issue
by illustrating a qualifying disposition re-
sulting in DPGR as part of a service re-
lated contract. In that example, Y is hired
to reconstruct and refurbish unrelated cus-
tomers’ tangible personal property. Y in-
stalls the replacement parts (QPP) that Y
MPGE within the United States. The ex-
ample 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 giv-
ing 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 identi-
fies as DPGR, then the taxpayer must treat
the CGS related to such receipts as relat-
ing to DPGR, even if they are incurred in
a subsequent taxable year. The final reg-
ulations 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 fi-
nal regulations provide that for taxpayers
using the section 861 method or the simpli-
fied 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 tax-
payer 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 clas-
sify multi-year contracts for purposes of
section 199 with reference to their clas-
sification under section 460. For exam-
ple, if a contract is classified as a con-
struction contract under section 460, the
commentators suggested that the contract
also be classified as a construction con-
tract under section 199. The IRS and Trea-
sury Department have determined, how-
ever, that the statutory requirements un-
der sections 199 and 460, and the regula-
tions thereunder, are sufficiently different
that it would not be appropriate for the fi-
nal 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 regula-
tions do not adopt this suggestion.
By the Taxpayer
One commentator suggested a simplify-
ing 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 reg-
ulations permit unrelated parties to a con-
tract manufacturing arrangement to desig-
nate, through a written and signed agree-
ment 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 reg-
ulations do not adopt the commentator’s
suggestion. The IRS and Treasury Depart-
ment continue to believe that the benefits
and burdens of ownership must be deter-
mined based on all of the facts and circum-
stances and a designation of benefits and
burdens would not be appropriate.
Government Contracts
Section 403(a)(7) of the GOZA added
new section 199(c)(4)(C), which contains
a special rule for certain government con-
tracts. 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 gov-
ernment. 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).
In Whole or in Significant Part
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. Al-
though 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 un-
der section 954 in determining whether
manufacturing has occurred. By contrast,
the substantial-in-nature requirement un-
der section 199 is relevant in determin-
ing 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,
June 19, 200610682006–25 I.R.B.

case law and other precedent under sec-
tion 954 are not relevant for purposes of
the substantial-in-nature requirement un-
der section 199. Nor are they relevant
for purposes of determining whether an
activity is an MPGE activity under section
199. Similarly, the regulations under sec-
tion 199 are not relevant for purposes of
section 954.
Because the substantial-in-nature re-
quirement is generally applied by taking
into account all of the facts and circum-
stances, both the proposed regulations
and Notice 2005–14 provide a safe harbor
under which the in-whole-or-in-signifi-
cant-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. Commenta-
tors 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 fur-
ther 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 reg-
ulations. 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 exam-
ple, a lease, rental, or license) account for
20 percent or more of the taxpayer’s un-
adjusted 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 tax-
payers 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 satis-
factory to the Secretary based on all of the
facts and circumstances, but may not in-
clude 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 un-
adjusted depreciable basis, as applicable.
However, the final regulations also clar-
ify that, in the case of computer software
and sound recordings, research and exper-
imental expenditures under section 174 re-
lating to the computer software or sound
recordings, the cost of creating intangi-
ble assets for computer software or sound
recordings, and (in the case of computer
software) costs of developing the com-
puter software that are described in Rev.
Proc. 2000–50, 2000–2 C.B. 601 (soft-
ware 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 addi-
tion, the final regulations also clarify that
this is the case whether the computer soft-
ware 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 record-
ing under the rules of §1.199–3(i)(5)). In
the case where the taxpayer produces com-
puter 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 per-
sonal 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 devel-
opment costs, any cost of creating intangi-
ble assets for computer software or sound
recordings, and section 174 costs (for com-
puter software or sound recordings), in-
cluding 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 activ-
ities of the other members of the EAG in
determining whether its MPGE or produc-
tion activities are substantial in nature. It
has been suggested that this rule be modi-
fied 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 activi-
ties 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 be-
fore 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 devel-
opment activities must be disregarded in
applying the general substantial-in-nature
requirement and the safe harbor for tangi-
ble personal property. The proposed reg-
ulations clarify that research and exper-
imental activities under section 174 and
the creation of intangibles do not qual-
ify as substantial in nature. A commen-
tator questioned whether, with respect to
tangible personal property, activities that
constitute both an MPGE activity as well
as a section 174 activity must nonethe-
less 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 Trea-
sury Department continue to believe that,
with the exception of computer software
and sound recordings, it is not appropri-
ate 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 recog-
nize that, although section 174 costs are
not required to be capitalized under sec-
tion 263A to the produced property, a tax-
payer may capitalize such costs to the QPP
under section 263A. Accordingly, the fi-
nal regulations permit, as a matter of ad-
ministrative convenience, a taxpayer to in-
clude such costs as CGS or unadjusted de-
preciable basis for purposes of the 20 per-
cent safe harbor.
A commentator asked that the final reg-
ulations clarify that gross receipts relating
to computer software updates that are pro-
vided as part of a computer software main-
tenance contract qualify as DPGR if all of
the requirements of section 199(c)(4) are
met. The final regulations include an ex-
ample demonstrating that gross receipts re-
lating to computer software updates may
qualify as DPGR even if the computer
2006–25 I.R.B.1069June 19, 2006

software updates are provided pursuant to
a computer software maintenance agree-
ment.
The preamble to the proposed regula-
tions states that the creation and licens-
ing 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 tax-
payer 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 regu-
lations as to whether business information
reports qualify for the section 199 deduc-
tion.
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 na-
ture 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 compo-
nents, the fact that the taxpayer manufac-
tured the key component should satisfy the
substantial-in-nature requirement with re-
spect 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 man-
ufactures in computers that X purchases
from unrelated persons and sells the fin-
ished computers individually to customers.
Although the computer chips are key com-
ponents of the computers and the com-
puters will not operate without them, the
manufacture of the key components does
not, by itself, satisfy the substantial-in-na-
ture requirement with respect to the fin-
ished computers and the taxpayer’s activi-
ties 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 fi-
nal regulations. The final regulations con-
tain an example to illustrate this rule.
InExample 4in §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 exam-
ple concludes that unless Y satisfies the
safe harbor under §1.199–3(f)(3) of the
proposed regulations, Y’s income for du-
plicating 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 ex-
ample because duplicating a DVD may
involve considerable activities. This ex-
ample and other examples illustrating the
substantial-in-nature requirement have
been removed from the final regulations
because the determination of what is sub-
stantial in nature is determined based on
all the facts and circumstances. No in-
ference should be drawn as to whether an
activity is, or is not, substantial in nature
by the removal of any example.
Derived From a Lease, Rental, License,
Sale, Exchange, or Other Disposition
Section 1.199–3(h)(1) of the pro-
posed 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 pream-
ble 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 ser-
vice 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 alloca-
tion 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 cus-
tomers’ 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, li-
cense, 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 determi-
nation 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 prop-
erty 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. How-
ever, unless the taxpayer meets all of the
requirements under section 199 with re-
spect 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 ex-
changes. The final regulations provide a
safe harbor whereby the gross receipts de-
rived by the taxpayer from the sale of eligi-
ble 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 differ-
entials), 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
June 19, 200610702006–25 I.R.B.

the in-whole-or-in significant-part require-
ment 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 prop-
erty 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 en-
tire 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 prop-
erty separately state a finance or interest
component. The IRS and Treasury De-
partment 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). Ac-
cordingly, the final regulations provide
that all financing and interest components
of a lease of qualifying property are con-
sidered to be derived from the lease of
such qualifying property.
Section 1.199–3(h)(4) of the proposed
regulations provides exceptions to the gen-
eral rule that DPGR does not include gross
receipts derived from services or nonqual-
ifying 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 embed-
ded computer software maintenance con-
tracts. None of these exceptions, which al-
low gross receipts attributable to such em-
bedded services and nonqualifying prop-
erty 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 clarifica-
tion 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 sepa-
rately offered to a customer. The purpose
of the exceptions is to reduce the bur-
denonataxpayerofhavingtoallocate
a portion of its gross receipts to these
commonly occurring types of services
and property if the taxpayer does not nor-
mally 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 de-
pends 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 re-
quirement applies to both the separately
stated price prong and the separately of-
fered prong of the embedded services and
nonqualifying property rules.
Several comments were received con-
cerning the rule in the proposed regula-
tions under which gross receipts attribut-
able to advertising in newspapers, maga-
zines, telephone directories, or periodicals
may qualify as DPGR to the extent that the
gross receipts, if any, derived from the dis-
position of those printed materials quali-
fies as DPGR. The final regulations clar-
ify 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 adver-
tising income is that such income is inex-
tricably linked to the gross receipts (if any)
derived from the disposition of the printed
materials listed in the proposed regula-
tions. After considering the comments re-
ceived, 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 dispo-
sition of the printed materials or qualified
film does not limit the amount of gross re-
ceipts 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 re-
ceipts derived from thesaleofadvertising
slots in live or delayed television broad-
casts (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 advertis-
ing 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 De-
partment agree with these comments, and
the final regulations provide examples to
clarify these points.
Qualifying Production Property
Under §1.199–3(i)(5)(i) of the pro-
posed regulations, if a taxpayer MPGE
computer software or sound recordings
that is affixed or added to tangible per-
sonal property by the taxpayer (for exam-
ple, 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
2006–25 I.R.B.1071June 19, 2006

in this context. A similar rule has been
provided for qualified films.
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 de-
layed 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 individu-
als. 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 indi-
rect 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 regula-
tions under §1.199–3(k)(1) clarify that the
list of production personnel is not exclu-
sive, and that compensation for services
includes all direct and indirect compensa-
tion 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-to-
tal-compensation requirement is deter-
mined by reference to all compensation
paid in the production of the film and is
calculated using a fraction. The numer-
ator 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 suchindividuals regard-
less 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 per-
formed. The final regulations provide an
example of this calculation.
Tangible Personal Property and Real
Property
Commentators requested that the fi-
nal regulations define tangible personal
property and real property for purposes
of section 199. The final regulations de-
fine tangible personal property as any
tangible property other than land, real
property described in the construction
rules in §1.199–3(m)(1), computer soft-
ware 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 tan-
gible personal property as also including
any gas (other than natural gas described
in §1.199–3(l)(2)), chemicals, and simi-
lar property, for example, steam, oxygen,
hydrogen, and nitrogen.
The final regulations define the term
real property to mean buildings (includ-
ing 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 inher-
ently 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, el-
evators 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.
Construction of Real Property
One commentator recommended that
DPGR derived from the construction of
real property as well as DPGR from en-
gineering 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 construc-
tion, engineering or architectural services
for purposes of the North American In-
dustry Classification System (NAICS).
W–2wagesearnedbyanemployeeare
notearnedinconnectionwithatradeor
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 ser-
vices activities relating to drilling an oil
well and mining pursuant to which the tax-
payer could deduct intangible drilling and
development costs under section 263(c)
and §1.612–4, and development expendi-
tures for a mine or natural deposit under
section 616. The IRS and Treasury De-
partment are aware that in many situations
taxpayers provide these services with re-
spect to property owned by another party,
and therefore such taxpayers are ineligible
to claim the deductions for such costs un-
der the provisions described above. The
language of the final regulations has been
changed to clarify that taxpayers providing
such services are engaginginconstruction
services that may qualify under section
199.
The preamble to the proposed regula-
tions states that commentators requested
that qualifying construction activities in-
clude construction activities related to oil
and gas wells. The preamble further states
that the proposed regulations provide as a
matter of administrative grace that quali-
fying construction activities include activ-
ities relating to drilling an oil well. Simi-
larly, 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 omis-
sion of gas wells and the final regulations
correct the omission.
The proposed regulations provide that
DPGR does not include gross receipts at-
tributable to the sale or other disposition
of land (including zoning, planning, enti-
tlement costs, and other costs capitalized
into the land such as grading and demo-
June 19, 200610722006–25 I.R.B.

lition of structuresunder section 280B).
Commentators contended that grading
and demolition are construction-related
activities, and that gross receipts attribut-
able 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 con-
struction activities, such as landscaping
and painting. Accordingly, services such
as grading, demolition, clearing, excavat-
ing, and any other activities that physically
transform the land are activities constitut-
ing construction only if these services are
performed in connection with other activi-
ties (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 at-
tributable to the land, not to a qualifying
construction activity, and, therefore, are
non-DPGR.
In response to a suggestion by a com-
mentator, the final regulations provide that
a taxpayer engaged in a construction ac-
tivity must make a reasonable inquiry or a
reasonable determination whether the ac-
tivity relates to the erection or substantial
renovation of real property in the United
States.
The proposed regulations contain an ex-
ample of an electrical contractor who pur-
chases wires, conduits, and other electrical
materials that the contractor installs in con-
struction projects in the United States and
that are considered structural components.
The example concludes that the gross re-
ceipts that the contractor derives from in-
stalling these materials are derived from
construction, but thatthe gross receipts at-
tributable to the purchased materials are
not. Commentators objected to this result,
contending that it places an unreasonable
administrative burden on taxpayers per-
forming construction activities. The final
regulations, including the example, pro-
vide that, in such circumstances, the tax-
payer 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 con-
struction trade or business for the tax-
payer’s construction activity to qualify
under section 199. The proposed regu-
lations provide that a taxpayer may not
treat as DPGR gross receipts derived from
construction unless the taxpayer is en-
gaged in a construction trade or business
on a regular and ongoing basis. Com-
mentators expressed concern that this
requirement would preclude construction
project-specific joint ventures or partner-
ships, a common business structure in the
construction industry, from qualifying un-
der 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 require-
ment 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 con-
struction trade or business. Although some
taxpayers may meet the regular-and-on-
going-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 tax-
payer 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 clar-
ification of the land safe harbor of
§1.199–3(l)(5)(ii) of the proposed reg-
ulations. 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 per-
cent, depending upon the length of time
the taxpayer held the land. The commen-
tator 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 regula-
tions 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
holdingperiodinlandforpurposesofthe
land safe harbor rule of section 199. For
example, the holding period of the previ-
ous owner (P) would carry over to the new
owner (N) under existing Federal income
tax principles if P were a partner in part-
nership 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 har-
bor 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 dis-
cussed in the preceding paragraph, the pro-
posed 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 prop-
erty on the land. Commentators stated that
development of the land generally does not
begin until the land is acquired and any op-
tion to acquire land is based on the land’s
fair market value. Because developers are
paying fair market value, the commenta-
tors suggested that the period for deter-
mining the percentage should not include
any option period. The IRS and Treasury
Department generally agree with the com-
mentator’s suggestion, and the final reg-
2006–25 I.R.B.1073June 19, 2006

ulations 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 1in §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 construc-
tion services in connection with a substan-
tial renovation of the building. The exam-
ple concludes that X’s gross receipts de-
rived 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. Somecommentators in-
ferred from this example that the taxpayer
must, at a minimum, be a legally desig-
nated general contractor before its gross
receipts may qualify as DPGR. The ex-
ample was not intended to imply that a
taxpayer must be a licensed general con-
tractor. The final regulations clarify that
activities constituting construction include
activities typically performed by a gen-
eral contractor, or that constitute general
contractor-level work, such as activities
relating to management and oversight of
the construction process (for example, ap-
provals, periodic inspection of the progress
of the construction project, and required
job modifications). The example has been
modified in the final regulations to illus-
trate that the person hired by the build-
ing owner, although not a licensed gen-
eral contractor, qualifies as engaging in
construction activities by virtue of provid-
ing management and oversight of the con-
struction process.
Several commentators recommended
that the final regulations provide that, for
purposes of thede minimisexception of
§1.199–3(l)(5)(ii) (regarding construc-
tion services), gross receipts attributable
to land be disregarded for purposes of
calculating thede minimisexception. In
response to the comments, the final reg-
ulations clarify that, if a taxpayer applies
the land safe harbor, then the gross re-
ceipts excluded underthe land safe harbor
are excluded in determining total gross
receipts under thede minimisexception.
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 thede minimisexception by ex-
cluding such gross receipts derived from
the sale, exchange, or other disposition of
the land from total gross receipts.
A commentator requested that the defi-
nition of construction activities not be lim-
ited to direct activities and should include
services incidental to the performance
of such activities. As an administrative
convenience, the final regulations provide
that construction activities include certain
administrative support services such as
billing and secretarial services performed
by the taxpayer. The final regulations
provide a similar rule for engineering and
architectural services.
Engineering and Architectural Services
A commentator suggested that the defi-
nition of engineering and architectural ser-
vices include services related to the inspec-
tion or evaluation of real property after
construction has been completed. The fi-
nal regulations do not adopt this sugges-
tion because engineering and architectural
services relating to post-construction ac-
tivities are not activities constituting con-
struction.
Allocation of Cost of Goods Sold and
Deductions
A commentator requested clarification
as to whether a taxpayer’s CGS allocable
to DPGR is determined using the methods
of accounting used to compute CGS for the
taxpayer’s books or financial statements or
the methods of accounting used to com-
pute CGS in determining Federal taxable
income. Section 1.199–4(b) of the pro-
posed regulations provides that CGS is de-
termined under the methods of accounting
that the taxpayer uses to compute Federal
taxable income. Accordingly, this section
has not been modified and the final regu-
lations continue to provide that, in deter-
mining CGS allocable to DPGR, CGS is
determined using the methods of account-
ing that the taxpayer uses to compute its
Federal taxable income.
Consistent with both the proposed reg-
ulations and Notice 2005–14, the final reg-
ulations continue to provide three methods
for allocating and apportioning deductions
(that is, the section 861 method, the simpli-
fied deduction method, and the small busi-
ness simplified overall method). However,
modifications have been made in the fi-
nal regulations to the qualification require-
ments of the simplified deduction method.
Under the simplified deduction method,
a taxpayer’s expenses, losses, or deduc-
tions (deductions) (other than a net op-
erating loss deduction) are apportioned
between DPGR and non-DPGR based
on relative gross receipts. The proposed
regulations permit a taxpayer to use the
simplified deduction method if it has aver-
age annual gross receipts of $25,000,000
or less, or total assets at the end of the tax-
able year of $10,000,000 or less. Several
commentators requested that the aver-
age annual gross receipts threshold for
the simplified deduction method be ei-
ther increased or removed. In response
to these comments, the IRS and Treasury
Department have modified the eligibility
requirements for the simplified deduction
method. Under the final regulations, a
taxpayer may use the simplified deduc-
tion method if it has average annual gross
receipts of $100,000,000 or less, or total
assets at the end of the taxable year of
$10,000,000 or less. The IRS and Trea-
sury Department continue to believe that
for taxpayers above these thresholds the
section 861 method is the appropriate
method for allocating and apportioning
deductions for purposes of determining
QPAI.
Under the land safe harbor provided
in §1.199–3(l)(5)(ii) of the proposed reg-
ulations, a taxpayer may allocate gross
receipts between the proceeds from the
sale, exchange, or other disposition of
real property constructed by the taxpayer
and land by reducing its costs related to
DPGR under §1.199–4 by the cost of land
and other costs capitalized to the land
(land costs) and reducing its DPGR by
those land costs plus a percentage. Un-
der the small business simplified overall
method, a taxpayer’s CGS and deductions
are apportioned between DPGR and other
receipts based on relative gross receipts.
Commentators have questioned whether
a taxpayer that uses the small business
simplified overall method would have to
reallocate land costs using the allocation
formula provided by that method even
though such costs have already been al-
located in accordancewith the land safe
June 19, 200610742006–25 I.R.B.

harbor. The final regulations clarify that
a taxpayer that uses the land safe harbor
to allocate gross receipts between real
property constructed by the taxpayer and
land does not take into account under the
small business simplified overall method
provided in §1.199–4(f) the costs that have
already been taken into account for pur-
poses of section 199 pursuant to the land
safe harbor.
Expanded Affiliated Groups
The proposed regulations provide gen-
erally that if a member of an EAG (the
disposing member) derives gross receipts
from the lease, rental, license, sale, ex-
change, or other disposition of QPP, a
qualified film, or utilities MPGE or pro-
duced by another member or members of
the same EAG, the disposing member is
treated as conducting the activities con-
ducted by each other member of the EAG
with respect to the QPP, qualified film, or
utilities in determining whether its gross
receipts are DPGR. A question arose as to
when the determination of whether corpo-
rations are members of the same EAG for
purposes of the attribution of activities is
to be made. The final regulations clarify
that attribution of activities between mem-
bers of the same EAG is tested at the time
that the disposing member disposes of the
QPP, qualified film, or utilities. Examples
are provided to illustrate this provision.
Section 1.199–1(d) of the proposed reg-
ulations provides ade minimisrule that
allows a taxpayer to treat all of its gross
receipts as DPGR if less than 5 percent
of the taxpayer’s total gross receipts are
non-DPGR. The proposed regulations pro-
vide that the 5 percent threshold is deter-
mined at the corporation level, rather than
at the EAG or consolidated group level.
Several commentators requested that the
IRS and Treasury Department reconsider
this position and apply the threshold at the
EAG or consolidated group level.
Thede minimisrule is intended to elim-
inate the burden to a taxpayer of allocat-
ing gross receipts between DPGR and non-
DPGR when less than 5 percent of its to-
tal gross receipts are non-DPGR. Apply-
ing thisde minimisrule at the EAG level
would create many burdensome issues for
the EAG and its members, including addi-
tional information reporting and circular-
ity problems that could require members
to compute QPAI twice and, thus, would
not further the policy goals of providing
de minimisrules to ease a taxpayer’s ad-
ministrative burdens. As a result, the IRS
and Treasury Department continue to be-
lieve that, with respect to a corporation that
is a member of an EAG but not a member
of a consolidated group, the application of
this threshold at the EAG member level is
appropriate.
However, with respect to a consolidated
group, §1.1502–13(c)(1)(i) and (c)(4) re-
quires that the separate entity attributes of
a company’s intercompany items or cor-
responding items must be redetermined to
the extent necessary to produce the effect
as if the consolidated group members en-
gaged in an intercompany transaction were
divisions of a single corporation. If thede
minimisrule were applied at the consoli-
dated group member level, then a differ-
ent result could apply to the consolidated
group than would apply if the consolidated
group members were divisions of a single
corporation. Accordingly, with respect to
a consolidated group, the final regulations
provide that thede minimisrule is applied
at the consolidated group level, rather than
at the consolidated group member level.
Similarly, with respect to a corporation
that is a member of an EAG but not a mem-
ber of a consolidated group, the newde
minimisrule that allows a taxpayer to treat
all of its gross receipts as non-DPGR if
less than 5 percent of the taxpayer’s to-
tal gross receipts are DPGR is determined
at the EAG member level, rather than at
the EAG group level. However, with re-
spect to a consolidated group, the final reg-
ulations provide that thisde minimisrule
is applied at the consolidated group level,
rather than at the consolidated group mem-
ber level.
Consolidated Groups
A commentator was concerned that
the license of an intangible asset between
members of a consolidated group could
reduce the section 199 deduction available
to the members of a consolidated group,
because the licensee member’s royalty
expense would reduce the group’s QPAI,
but the licensor member’s royalty in-
come from the licensewould not increase
the group’s QPAI. The commentator re-
quested that language be added to the
final regulations to provide that the inter-
company transaction rules of §1.1502–13
shall be taken intoaccount for purposes
of determining the QPAI and DPGR of a
consolidated group.
As specifically noted in the preamble
to the proposed regulations, the regula-
tions under §1.1502–13(c) already ensure
that the section 199 deduction cannot be
reduced on account of an intercompany
transaction. As discussed above concern-
ing the application of thede minimisrules
that allow treatment of gross receipts as
DPGR or non-DPGR, §1.1502–13(c)(1)(i)
and (c)(4) requires that the separate en-
tity attributes of a company’s intercom-
pany items or corresponding items must
be redetermined to the extent necessary to
produce the effect as if the consolidated
group members engaged in an intercom-
pany transaction were divisions of a single
corporation. There is nothing in the pro-
posed regulations that would prevent this
rule from applying. In fact, several ex-
amples specifically illustrate the applica-
tion of these rules. An additional exam-
ple concerning the license of an intangible
between members of a consolidated group
has been added to the final regulations.
Another commentator requested clarifi-
cation of the application of §1.199–7(b)(2)
of the proposed regulations where the
EAG is comprised of more than one con-
solidated group. Section 1.199–7(b)(2) of
the proposed regulations (§1.199–7(b)(3)
of the final regulations) provides that,
in determining the taxable income of an
EAG, if a member of an EAG has an
NOL carryback or carryover to the taxable
year, then the amount of the NOL used
to offset taxable income cannot exceed
the taxable income of that member. The
final regulations continue to treat a con-
solidated group as a single member of
the EAG. Accordingly, if a consolidated
group has a consolidated NOL (CNOL)
carryback or carryover, the amount of
the CNOL used to offset taxable income
cannot exceed the consolidated group’s
taxable income, and may not be used to
offset taxable income of other members of
the EAG, whether separate corporations
or consolidated groups. An example has
been provided to illustrate this provision.
Trade or Business Requirement
Pursuant to section 199(d)(5),
§§1.199–1 through 1.199–9 are applied
2006–25 I.R.B.1075June 19, 2006

by taking into account only items that are
attributable to the actual conduct of a trade
or business. An individual engaged in
the actual conduct of a trade or business
must apply §§1.199–1 through 1.199–9
by taking into account in computing QPAI
only items that are attributable to that
trade or business (or trades or businesses)
and any items allocated from a pass-thru
entity engaged in a trade or business.
Compensation received by an individual
employee for services performed as an
employee is not considered gross receipts
for purposes of computing QPAI under
§§1.199–1 through 1.199–9. Similarly,
any costs or expenses paid or incurred by
an individual employee with respect to
those services performed as an employee
are not considered CGS or deductions of
that employee for purposes of computing
QPAI under §§1.199–1 through 1.199–9.
For purposes of the trade-or-business re-
quirement, a trust or estate is treated as an
individual.
Pass-thru Entities
As noted above, section 514(b) of
TIPRA amended section 199(d)(1)(A)(iii)
with respect to a partner’s or shareholder’s
share of W–2 wages from a partnership or
S corporation for taxable years beginning
after May 17, 2006. Section 1.199–9 of
the final regulations contains guidance
for pass-thru entities with taxable years
beginning on or before May 17, 2006. A
taxpayer must apply §1.199–9 to a taxable
year beginning on or before May 17, 2006,
if that taxpayer applies §§1.199–1 through
1.199–8 to the taxable year. The portions
of §1.199–3 relating to qualifying in-kind
partnerships and EAG partnerships, and
all of §1.199–5 relating to pass-thru enti-
ties, in the final regulations are reserved
for taxable years beginning after May 17,
2006. The IRS and Treasury Department
intend to issue regulations that take into
account the amendments made to section
199(d)(1)(A)(iii) for pass-thru entities.
Section 199 applies at the owner level
in a manner consistent with the economic
arrangement of the owners of the pass-thru
entity. Under the proposed regulations,
each owner computes its section 199 de-
duction by taking into account its distribu-
tive or proportionate share of the pass-thru
entity’s items (including items of income
and gain, as well as items of loss and de-
duction not otherwise disallowed by the
Code), CGS allocated to such items of in-
come, and gross receipts included in such
items of income. Generally, section 199 is
applied at the shareholder, partner, or sim-
ilar level. For a non-grantor trust or estate,
this level may refer to one or more benefi-
ciaries, the trust or estate, or both.
Section 199(d)(1)(A)(iii), however,
limits the amount of W–2 wages from a
partnership or S corporation that may be
used by each partner or shareholder to
compute the partner’s or shareholder’s
section 199 deduction. Pursuant to the
authority granted in section 199(d)(1)(C),
the final regulations provide that this wage
limitation will apply to non-grantor trusts
and estates in the same way it applies to
partnerships and S corporations. Thus, for
all purposes of this wage limitation, refer-
ences in the final regulations to pass-thru
entities include not only partnerships and
S corporations, but also all non-grantor
trusts and estates.
The final regulations clarify that the
section 199 deduction has no effect on a
shareholder’s adjusted basis in the stock of
an S corporation or a partner’s adjusted ba-
sis in an interest in a partnership because
the section 199 deduction is not described
in section 1367(a) or section 705(a). How-
ever, the shareholder’s or partner’s propor-
tionate or distributive share of the S cor-
poration or partnership items that are in-
cluded in computing the shareholder’s or
partner’s section 199 deduction will affect
the shareholder’s or partner’s adjusted ba-
sis under the rules of section 1367(a) or
section 705(a).
The proposed regulations provide that
deductions of a partnership that otherwise
would be taken into account in comput-
ing the partner’s section 199 deduction are
taken into account only if and to the extent
the partner’s distributive share of those de-
ductions from all of the partnership’s ac-
tivities is not disallowed by section 465,
469, or 704(d), or any other provision of
the Code. If only a portion of the partner’s
distributive share of the losses or deduc-
tions is allowed for a taxable year, a pro-
portionate share of those allowable losses
or deductions that are allocated to the part-
ner’s share of the partnership’s qualified
production activities, determined in a man-
ner consistent with sections 465, 469, and
704(d), and any other applicable provision
of the Code (disallowed losses), is taken
into account in computing the section 199
deduction for that taxable year. To the ex-
tent that any of the disallowed losses are
allowed in a later taxable year, the partner
takes into account a proportionate share of
those losses in computing its QPAI for that
later taxable year.
In response to comments received, the
IRS and Treasury Department intend to
issue separate guidance by publication in
the Internal Revenue Bulletin regarding
the treatment of disallowed losses in de-
termining a taxpayer’s section 199 deduc-
tion. As a matter of administrative conve-
nience and to reduce complexity for tax-
payers, the final regulations clarify that
disallowed losses of the taxpayer that are
disallowed for taxable years beginning on
or before December 31, 2004, are not taken
into account in a later taxable year for pur-
poses of computing the taxpayer’s QPAI
for that later taxable year regardless of
whether the disallowed losses are allowed
for other purposes. The final regulations
provide that similar rules concerning dis-
allowed losses apply to taxpayers that are
not partners or S corporation shareholders.
See §1.199–8(h).
Generally, in the case of a pass-thru
entity, the calculations required to de-
termine QPAI (that is, the allocation or
apportionment of gross receipts, CGS, or
deductions) are performed at the owner
level. Notice 2005–14 and the proposed
regulations provide that a partnership or
S corporation that is a qualifying small
taxpayer may use the small business
simplified overall method to apportion
CGS and deductions between DPGR and
non-DPGR. This rule is not included in the
final regulations, except that §1.199–9(k)
permits a partnership or S corporation that
is a qualifying small taxpayer to use the
small business simplified overall method
to apportion CGS and deductions between
DPGR and non-DPGR at the entity level
under §1.199–4(f) of the proposed regula-
tions. In addition, §1.199–9(b)(1)(ii) and
(c)(1)(ii) of the final regulations provides
that the Secretary may, by publication in
the Internal Revenue Bulletin, permit a
partnership or S corporation to calculate a
partner’s or shareholder’s share of QPAI
at the entity level.
If a partnership or S corporation cal-
culates a partner’s or shareholder’s share
of QPAI at the entity level, the owner’s
share of QPAI and W–2 wages from the
June 19, 200610762006–25 I.R.B.

partnership or S corporation are combined
with the owner’s QPAI and W–2 wages
from other sources. The final regulations
also clarify that, if a pass-thru entity cal-
culates QPAI at the entity level, then gen-
erally the owner of the pass-thru entity is
not permitted to use another cost alloca-
tion method to reallocate the costs of the
pass-thru entity regardless of the method
used by the pass-thru entity’s owner to
allocate or apportion costs. A taxpayer
that receives QPAI from a partnership or
S corporation does not take into account
any gross receipts, income, assets, deduc-
tions, or other items of the partnership or
S corporation when the taxpayer allocates
and apportions deductions to determine the
taxpayer’s QPAI from other sources.
Regarding the rule allowing partner-
ships that extract, refine, or process oil
or natural gas to attribute these activities
to their partners, some commentators re-
quested that the rule be expanded to other
industries that operate in a substantially
similar manner. The exception for the
oil and gas industry was provided in the
proposed regulationsto prevent a clearly
qualifying activity from being disquali-
fied under section 199 because of several
decades-long industry practices. Among
the historical industry practices taken into
account by the IRS and Treasury De-
partment in establishing the oil and gas
exception was the fact that for decades
the oil and gas industry generally has
operated in a business model in which a
partnership produces qualifying property
and distributes such property in-kind to its
partners (generally engaged themselves in
the production of oil and gas), generally
the partnership does not derive any gross
receipts from the produced property, the
property is marketed and sold exclusively
and separately by each partner as competi-
tors, and generally there is no marketing
or sale by the partnership of the produced
property, and no joint marketing or sale of
the distributed property by any of the part-
ners. In addition, the partnership typically
qualifies to elect out of subchapter K.
In response to the requests that this attri-
bution rule be expanded to industries that
historically have operated in a manner sub-
stantially similar to the oil and gas indus-
try, the final regulations provide that, if a
partnership that MPGE or produces prop-
erty is a qualifying in-kind partnership (as
defined later), then each partner may be
treated as MPGE or producing the prop-
erty MPGE or produced by the partnership
that is distributed to that partner. If a part-
ner of a qualifying in-kind partnership de-
rives gross receipts from the lease, rental,
license, sale, exchange, or other disposi-
tion of the property that was MPGE or pro-
duced by the qualifying in-kind partner-
ship, then, provided such partner is a part-
ner of the qualifying in-kind partnership at
the time the partner disposes of the prop-
erty, the partner is treated as conducting
the MPGE or production activities previ-
ously conducted by the qualifying in-kind
partnership with respect to that property.
For this purpose, a qualifying in-kind part-
nership is defined in §1.199–9(i)(2) of the
final regulations to include only certain
partnerships operating solely in a desig-
nated industry: oil and gas, petrochemical,
or electricity generation. Partnerships in
other industries with substantially similar
historical industry practices may be desig-
nated by the IRS and Treasury Department
as qualifying in-kind partnerships by pub-
lication in the Internal Revenue Bulletin.
The proposed regulations provide that,
if an EAG partnership (as defined in
§1.199–9(j)(2) of the final regulations)
MPGE or produces property and dis-
tributes, leases, rents, licenses, sells, ex-
changes, or otherwise disposes of that
property to a member of an EAG of which
the partners of the EAG partnership are
members, then the MPGE or production
activity conducted by the EAG partnership
will be treated as having been conducted
by the disposing member of the EAG.
Similarly, if one or more members of an
EAG of which the partners of an EAG
partnership are members MPGE or pro-
duces property and contributes, leases,
rents, licenses, sells, exchanges, or other-
wise disposes of that property to the EAG
partnership, then the MPGE or production
activity conducted by the EAG member
(or members) will be treated as having
been conducted by the EAG partnership.
A question arose as to when a corporation
needs to be a member of an EAG of which
the partners of the EAG partnership are
members for attribution of MPGE or pro-
duction activities to take place. The final
regulations clarify that attribution of such
activities between an EAG partnership and
members of the EAG of which the partners
of the EAG partnership are members is
determined at the time that the EAG part-
nership disposes of the property (in the
case of property MPGE or produced by an
EAGmemberormembers)oratthetime
that the member or members of the EAG of
which the partners of the EAG partnership
are members dispose of the property (in
the case of property MPGE or produced
by the EAG partnership). Attribution is
effective only for those taxable years that
the disposing or producing member is a
member of the EAG of which the partners
of the EAG partnership are members for
the entire taxable year of the EAG partner-
ship. The final regulations also clarify that
EAG partnerships, the partners of which
are members of the same EAG, may at-
tribute their production activities between
themselves on a similar basis, provided
that the producing EAG partnership and
the disposing EAG partnership are owned
by members of the same EAG for the
entire taxable year of the respective EAG
partnership that includes the date on which
the disposing EAG partnership disposes
of the property.
Because the sale of an interest in a pass-
thru entity does not reflect the realization
of DPGR by that entity, DPGR generally
does not include gain or loss recognized on
the sale, exchange orother disposition of
an interest in the entity. However, consis-
tent with Notice 2005–14 and the proposed
regulations, if section 751(a) or (b) applies,
then gain or loss attributable to partnership
assets giving rise to ordinary income under
section 751(a) or (b), the sale, exchange, or
other disposition of which would give rise
to an item of DPGR, is taken into account
in computing the partner’s section 199 de-
duction.
One commentator stated that many
commercial real estate developers dispose
of commercial real property by selling in-
terests in special purpose partnerships that
hold commercial realproperty. Because a
sale, exchange or other disposition of the
commercial real property may result in
section 1231 gain rather than ordinary in-
come, the commentator suggested that the
definition of inventory items be expanded
for purposes of §1.199–9(e) by treating
section 751(d) as not containing the words
“and other than property described in sec-
tion 1231.” As a result, a sale or exchange
of an interest in a partnership that holds
commercial real property would gener-
ate DPGR if a sale or exchange of the
commercial real property would gener-
2006–25 I.R.B.1077June 19, 2006

ate DPGR regardless of whether the sale
or exchange would result in ordinary in-
come. The final regulations do not include
the commentator’s suggestion because
the rule in §1.199–9(e) applies aggregate
treatmenttoasaleorexchangeofapart-
nership interest only to the extent section
751 specifically allows such treatment.
Modifying the explicit terms of section
751(d) as suggested would be inconsistent
with the purposes of section 751 and sec-
tion 199.
Statistical Sampling
In the preamble to the proposed regu-
lations, the IRS and Treasury Department
invited taxpayers to submit comments on
issues relating to section 199 including
whether taxpayers can apply statistical
sampling to section 199, what specific
areas of section 199 statistical sampling
could be applied to, and whether appli-
cation of statistical sampling should be
limited to specific areas of section 199.
Comments were received on statistical
sampling and the IRS and Treasury De-
partment are considering those comments
and intend to issue subsequent guidance
addressing the application of statistical
sampling for purposes of section 199.
Elections under the Section 861
Regulations
The preamble to the proposed regula-
tions states that, because the provisions
of section 199 may cause taxpayers to
reconsider previously made elections un-
der §§1.861–8 through 1.861–17 and
§§1.861–8T through 1.861–14T (the sec-
tion 861 regulations), the IRS and Trea-
sury Department intend to issue a revenue
procedure granting taxpayers automatic
consent to change certain of those elec-
tions. In the proposed regulations, the
IRS and Treasury Department requested
comments on which elections should be
included in such a revenue procedure and
the appropriate time period during which
the automatic consent should apply. Sev-
eral commentators urged promulgation
of such a revenue procedure, and several
comments specifically requested that the
revenue procedure provide taxpayers au-
tomatic consent for more than one taxable
year to change previously made elections.
The IRS and Treasury Department in-
tend to issue a revenue procedure that
provides taxpayers automatic consent to
change certain elections relating to the
apportionment of interest expense and
research and experimental expenditures
under the section 861 regulations. It is
intended that the automatic consent af-
forded under the revenue procedure will
provide taxpayers the consent required by
§§1.861–8T(c)(2) and 1.861–9(i)(2), with
respect to the apportionment of interest
expense, and by §1.861–17(e), with re-
spect to the apportionment of research and
experimental expenditures, to change an
election, effective for a taxpayer’s first
taxable year beginning after December 31,
2004 (the taxpayer’s 2005 taxable year).
In addition, it is intended that the revenue
procedure will provide taxpayers the con-
sent required by those regulations for a
taxpayer’s taxable year immediately fol-
lowing the taxpayer’s 2005 taxable year,
but, in such case, a taxpayer would not be
provided automatic consent to change any
election that first took effect with respect
to the taxpayer’s 2005 taxable year.
Financial and Administrative Burden
Several commentators objected to the
complexity of the proposed regulations,
and to the financial and administrative bur-
den that the commentators believe the reg-
ulations will impose on taxpayers (particu-
larly on small businesses). The complexity
and burden of the regulations are a func-
tion of the statutory language and frame-
work of section 199, which are complex
and contain many requirements. For ex-
ample, with the exception of a few specific
services (namely, construction, architec-
ture, and engineering) only gross receipts
derived from certain dispositions of certain
property qualify under the statute. In ad-
dition, in the case of manufacturing activ-
ities, the property must be manufactured
by the taxpayer in whole or in significant
part within the United States. Also, un-
der section 199, costs must be allocated be-
tween qualifying and nonqualifying gross
receipts. All of these statutory require-
ments (and others) potentially necessitate
that taxpayers obtain information, make
determinations and computations, and re-
tain records that might not otherwise be re-
quired for business purposes. In the case of
partnerships and S corporations, the statute
requires that the deduction be computed
at the owner level, necessitating the shar-
ing between entity and owner of informa-
tion that might not be needed for purposes
other than section 199. Both the proposed
and the final regulations provide a number
of safe harbors andde minimisrules that
are intended to balance the need for com-
pliance with these statutory requirements
against the burden imposed on taxpayers.
In the preamble to the proposed regu-
lations, the IRS and Treasury Department
certify that the collection of information
required under the proposed regulations
(relating to information to be provided by
cooperatives to their patrons) will not have
a significant economic impact on a sub-
stantial number of small entities, and there-
fore that a Regulatory Flexibility Analy-
sis is not required by the Regulatory Flex-
ibility Act (RFA). One commentator as-
serted that the certification did not provide
sufficient information for small entities to
determine the impact the regulations will
have on their businesses. The commenta-
tor also contended that the IRS and Trea-
sury Department, in making the certifica-
tion, failed to consider burdens imposed by
the proposed regulations on other small en-
tities, such as partnerships and S corpora-
tions, that are required under the regula-
tions to provide certain information to their
owners.
The IRS and Treasury Department be-
lieve that the certification for the proposed
regulations, as well as for these final reg-
ulations, is appropriate and complies with
the requirements of the RFA. With respect
to cooperatives, the regulations provide
cooperatives with specific rules about the
information they must provide to patrons
under section 199. The IRS and Trea-
sury Department believe that cooperatives
have the necessary information to com-
ply with this requirement. The IRS and
Treasury Department continue to believe
that this requirement is the only collec-
tion of information in the regulations that
is within the scope of the RFA. Certain
other recordkeeping and reporting require-
ments of the regulations relating to infor-
mation sharing between pass-thru entities
(partnerships and S corporations) and their
owners are subsumed within other existing
income tax regulations that currently re-
quire that such entities report to their own-
ers all information that is necessary for the
owners to determine their tax liability.
June 19, 200610782006–25 I.R.B.

Effective Date
Section 199 applies to taxable years
beginning after December 31, 2004. Sec-
tions 1.199–1 through 1.199–8 are appli-
cable for taxable years beginning on or
after June 1, 2006. For a taxable year
beginning on or before May 17, 2006,
the enactment date of TIPRA, a taxpayer
may apply §§1.199–1 through 1.199–9
provided that the taxpayer applies all pro-
visions in §§1.199–1 through 1.199–9 to
the taxable year. For a taxable year begin-
ning after May 17, 2006, and before June
1, 2006, a taxpayer may apply §§1.199–1
through 1.199–8 provided that the tax-
payer applies all provisions in §§1.199–1
through 1.199–8 to the taxable year. Sec-
tion 1.199–9 may not be applied to a
taxable year that begins after May 17,
2006.
For a taxpayer who chooses not to rely
on these final regulations for a taxable
year beginning before June 1, 2006, the
guidance on section 199 that applies to
such taxable year is contained in Notice
2005–14, 2005–1 C.B. 498. In addition,
a taxpayer also may rely on the provisions
of REG–105847–05, 2005–47 I.R.B. 987
(see §601.601(d)(2)) for a taxable year
beginning before June 1, 2006. If Notice
2005–14 and REG–105847–05 include
different rules for the same particular is-
sue, then a taxpayer may rely on either the
rule set forth in Notice 2005–14 or the rule
set forth in REG–105847–05. However,
if REG–105847–05 includes a rule that
was not included in Notice 2005–14, then
a taxpayer is not permitted to rely on the
absence of a rule to apply a rule contrary
to REG–105847–05. For taxable years
beginning after May 17, 2006, and before
June 1, 2006, a taxpayer may not apply
Notice 2005–14, REG–105847–05, or any
other guidance under section 199 in a man-
ner inconsistent with amendments made to
section 199 by section 514 of TIPRA. 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). Members of an EAG
that are not members of a consolidated
group may each apply the effective date
rules without regard to how other mem-
bers of the EAG apply the effective date
rules.
EFFECT ON OTHER DOCUMENTS
Notice 2005–14, 2005–1 C.B. 498, is
obsolete for taxable years beginning on or
after June 1, 2006.
Special Analyses
It has been determined that this Trea-
sury decision is not a significant regula-
tory action as defined in Executive Or-
der 12866. Therefore, a regulatory assess-
ment is not required. It is hereby certified
that the collection of information in this
regulation will not have a significant eco-
nomic impact on a substantial number of
small entities. This certification is based
upon the fact that any burden on cooper-
atives is minimal. Accordingly, a Regula-
tory Flexibility Analysis under the Regula-
tory Flexibility Act (5 U.S.C. chapter 6) is
not required. Pursuant to section 7805(f)
of the Code, the notice of proposed rule-
making was submitted to the Chief Coun-
sel for Advocacy of the Small Business
Administration for comment on its impact
on small business.
Drafting Information
The principal authors of these reg-
ulations are Paul Handleman and
Lauren Ross Taylor, Office of the As-
sociate Chief Counsel (Passthroughs and
Special Industries), IRS. However, other
personnel from the IRS and Treasury
Department participated in their develop-
ment.
*****
Adoption of Amendments to the
Regulations
Accordingly, 26 CFR parts 1 and 602
are amended as follows:
PART 1—INCOME TAXES
Paragraph 1. The authority citation for
part 1 is amended by adding entries to read,
in part, as follows:
Authority: 26 U.S.C. 7805 * * *
Section 1.199–1 also issued under
26 U.S.C. 199(d).
Section 1.199–2 also issued under
26 U.S.C. 199(d).
Section 1.199–3 also issued under
26 U.S.C. 199(d).
Section 1.199–4 also issued under
26 U.S.C. 199(d).
Section 1.199–5 also issued under
26 U.S.C. 199(d).
Section 1.199–6 also issued under
26 U.S.C. 199(d).
Section 1.199–7 also issued under
26 U.S.C. 199(d).
Section 1.199–8 also issued under
26 U.S.C. 199(d).
Section 1.199–9 also issued under
26 U.S.C. 199(d). * * *
Par. 2. Sections 1.199–0 through
1.199–9 are added to read as follows:
§1.199–0 Table of contents.
This section lists the section headings
that appear in §§1.199–1 through 1.199–9.
§1.199–1 Income attributable to domestic
production activities.
(a) In general.
(b) Taxable income and adjusted gross
income.
(1) In general.
(2) Examples.
(c) Qualified production activities in-
come.
(d) Allocation of gross receipts.
(1) In general.
(2) Reasonable method of allocation.
(3)De minimisrules.
(i) DPGR.
(ii) Non-DPGR.
(4) Example.
(e) Certain multiple-year transactions.
(1) Use of historical data.
(2) Percentage of completion method.
(3) Examples.
§1.199–2 Wage limitation.
(a) Rules of application.
(1) In general.
(2) Wages paid by entity other than
common law employer.
(3) Requirement that wages must be re-
ported on return filed with the Social Se-
curity Administration.
(i) In general.
(ii) Corrected return filed to correct a
return that was filed within 60 days of the
due date.
(iii) Corrected return filed to correct a
return that was filed later than 60 days after
the due date.
(4) Joint return.
2006–25 I.R.B.1079June 19, 2006

(b) Application in the case of a taxpayer
with a short taxable year.
(c) Acquisition or disposition of a trade
or business (or major portion).
(d) Non-duplication rule.
(e) Definition of W–2 wages.
(1) In general.
(2) Limitation on W–2 wages for tax-
able years beginningafter May 17, 2006,
the enactment date of the Tax Increase Pre-
vention and Reconciliation Act of 2005.
[Reserved].
(3) Methods for calculating W–2
wages.
§1.199–3 Domestic production gross
receipts.
(a) In general.
(b) Related persons.
(1) In general.
(2) Exceptions.
(c) Definition of gross receipts.
(d) Determining domestic production
gross receipts.
(1) In general.
(2) Special rules.
(3) Exception.
(4) Examples.
(e) Definition of manufactured, pro-
duced, grown, or extracted.
(1) In general.
(2) Packaging, repackaging, labeling,
or minor assembly.
(3) Installing.
(4) Consistency with section 263A.
(5) Examples.
(f) Definition of by the taxpayer.
(1) In general.
(2) Special rule for certain government
contracts.
(3) Subcontractor.
(4) Examples.
(g) Definition of in whole or in signifi-
cant part.
(1) In general.
(2) Substantial in nature.
(3) Safe harbor.
(i) In general.
(ii) Unadjusted depreciable basis.
(iii) Computer software and sound
recordings.
(4) Special rules.
(i) Contract with unrelated persons.
(ii) Aggregation.
(5) Examples.
(h) Definition of United States.
(i) Derived from the lease, rental, li-
cense, sale, exchange, or other disposition.
(1) In general.
(i) Definition.
(ii) Lease income.
(iii) Income substitutes.
(iv) Exchange of property.
(A) Taxable exchanges.
(B) Safe harbor.
(C) Eligible property.
(2) Examples.
(3) Hedging transactions.
(i) In general.
(ii) Currency fluctuations.
(iii) Effect of identification and non-
identification.
(iv) Other rules.
(4) Allocation of gross receipts.
(i) Embedded services and non-quali-
fied property.
(A) In general.
(B) Exceptions.
(ii) Non-DPGR.
(iii) Examples.
(5) Advertising income.
(i) Tangible personal property.
(ii) Qualified film.
(iii) Examples.
(6) Computer software.
(i) In general.
(ii) through (v) [Reserved].
(7) Qualifying in-kind partnership for
taxable years beginning after May 17,
2006, the enactment date of the Tax In-
crease Prevention and Reconciliation Act
of 2005. [Reserved].
(8) Partnerships owned by members of
a single expanded affiliated group for tax-
able years beginning after May 17, 2006,
the enactment date of the Tax Increase Pre-
vention and Reconciliation Act of 2005.
[Reserved].
(9) Non-operating mineral interests.
(j) Definition of qualifying production
property.
(1) In general.
(2) Tangible personal property.
(i) In general.
(ii) Local law.
(iii) Intangible property.
(3) Computer software.
(i) In general.
(ii) Incidental and ancillary rights.
(iii) Exceptions.
(4) Sound recordings.
(i) In general.
(ii) Exception.
(5) Tangible personal property with
computer software or sound recordings.
(i) Computer software and sound
recordings.
(ii) Tangible personal property.
(k) Definition of qualified film.
(1) In general.
(2) Tangible personal property with a
film.
(i) Film not produced by a taxpayer.
(ii) Film produced by a taxpayer.
(A) Qualified film.
(B) Nonqualified film.
(3) Derived from a qualified film.
(i) In general.
(ii) Exceptions.
(4) Compensation for services.
(5) Determination of 50 percent.
(6) Exception.
(7) Examples.
(l) Electricity, natural gas, or potable
water.
(1) In general.
(2) Natural gas.
(3) Potable water.
(4) Exceptions.
(i) Electricity.
(ii) Natural gas.
(iii) Potable water.
(iv)De minimisexception.
(A) DPGR.
(B) Non-DPGR.
(5) Example.
(m) Definition of construction per-
formed in the United States.
(1) Construction of real property.
(i) In general.
(ii) Regular and ongoing basis.
(A) In general.
(B) New trade or business.
(iii)De minimisexception.
(A) DPGR.
(B) Non-DPGR.
(2) Activities constituting construction.
(i) In general.
(ii) Tangential services.
(iii) Other construction activities.
(iv) Administrative support services.
(v) Exceptions.
(3) Definition of real property.
(4) Definition of infrastructure.
(5) Definition of substantial renovation.
(6) Derived from construction.
(i) In general.
(ii) Qualified construction warranty.
(iii) Exceptions.
(iv) Land safe harbor.
(A) In general.
June 19, 200610802006–25 I.R.B.

(B) Determining gross receipts and
costs.
(v) Examples.
(n) Definition of engineering and archi-
tectural services.
(1) In general.
(2) Engineering services.
(3) Architectural services.
(4) Administrative support services.
(5) Exceptions.
(6)De minimisexception for perfor-
mance of services in the United States.
(i) DPGR.
(ii) Non-DPGR.
(7) Example.
(o) Sales of certain food and beverages.
(1) In general.
(2)De minimisexception.
(3) Examples.
(p) Guaranteed payments.
§1.199–4 Costs allocable to domestic
production gross receipts.
(a) In general.
(b) Cost of goods sold allocable to do-
mestic production gross receipts.
(1) In general.
(2) Allocating cost of goods sold.
(i) In general.
(ii) Gross receipts recognized in an ear-
lier taxable year.
(3) Special rules for imported items or
services.
(4) Rules for inventories valued at mar-
ket orbona fideselling prices.
(5) Rules applicable to inventories ac-
counted for under the last-in, first-out
(LIFO) inventory method.
(i) In general.
(ii) LIFO/FIFO ratio method.
(iii) Change in relative base-year cost
method.
(6) Taxpayers using the simplified
production method or simplified resale
method for additional section 263A costs.
(7) Examples.
(c) Other deductions properly allocable
to domestic production gross receipts or
gross income attributable to domestic pro-
duction gross receipts.
(1) In general.
(2) Treatment of net operating losses.
(3) W–2 wages.
(d) Section 861 method.
(1) In general.
(2) Deductions for charitable contribu-
tions.
(3) Research and experimental expen-
ditures.
(4) Deductions allocated or apportioned
to gross receipts treated as domestic pro-
duction gross receipts.
(5) Treatment of items from a pass-thru
entity reporting qualified production activ-
ities income.
(6) Examples.
(e) Simplified deduction method.
(1) In general.
(2) Eligible taxpayer.
(3) Total assets.
(i) In general.
(ii) Members of an expanded affiliated
group.
(4) Members of an expanded affiliated
group.
(i) In general.
(ii) Exception.
(iii) Examples.
(f) Small business simplified overall
method.
(1) In general.
(2) Qualifying small taxpayer.
(3) Total costs for the current taxable
year.
(i) In general.
(ii) Land safe harbor.
(4) Members of an expanded affiliated
group.
(i) In general.
(ii) Exception.
(iii) Examples.
(5) Trusts and estates.
(g) Average annual gross receipts.
(1) In general.
(2) Members of an expanded affiliated
group.
§1.199–5 Application of section 199
to pass-thru entities for taxable years
beginning after May 17, 2006, the
enactment date of the Tax Increase
Prevention and Reconciliation Act of
2005.[Reserved].
§1.199–6 Agricultural and horticultural
cooperatives.
(a) In general.
(b) Cooperative denied section 1382 de-
duction for portion of qualified payments.
(c) Determining cooperative’s taxable
income.
(d) Special rule for marketing coopera-
tives.
(e) Qualified payment.
(f) Specified agricultural or horticul-
tural cooperative.
(g) Written notice to patrons.
(h) Additional rules relating to
passthrough of section 199 deduction.
(i) W–2 wages.
(j) Recapture of section 199 deduction.
(k) Section is exclusive.
(l) No double counting.
(m) Examples.
§1.199–7 Expanded affiliated groups.
(a) In general.
(1) Definition of expanded affiliated
group.
(2) Identification of members of an ex-
panded affiliated group.
(i) In general.
(ii) Becoming or ceasing to be a mem-
ber of an expanded affiliated group.
(3) Attribution of activities.
(i) In general.
(ii) Special rule.
(4) Examples.
(5) Anti-avoidance rule.
(b) Computation of expanded affiliated
group’s section 199 deduction.
(1) In general.
(2) Example.
(3) Net operating loss carrybacks and
carryovers.
(c) Allocation of an expanded affili-
ated group’s section 199 deduction among
members of the expanded affiliated group.
(1) In general.
(2) Use of section 199 deduction to cre-
ate or increase a net operating loss.
(d) Special rules for members of the
same consolidated group.
(1) Intercompany transactions.
(2) Attribution of activities in the con-
struction of real property and the perfor-
mance of engineering and architectural
services.
(3) Application of the simplified deduc-
tion method and the small business simpli-
fied overall method.
(4) Determining the section 199 deduc-
tion.
(i) Expanded affiliated group consists
of consolidated group and non-consoli-
dated group members.
(ii) Expanded affiliated group consists
only of members of a single consolidated
group.
2006–25 I.R.B.1081June 19, 2006

(5) Allocation of the section 199 de-
duction of a consolidated group among its
members.
(e) Examples.
(f) Allocation of income and loss by a
corporation that is a member of the ex-
panded affiliated group for only a portion
of the year.
(1) In general.
(i)Pro rataallocation method.
(ii) Section 199 closing of the books
method.
(iii) Making the section 199 closing of
the books election.
(2) Coordination with rules relat-
ing to the allocation of income under
§1.1502–76(b).
(g) Total section 199 deduction for a
corporation that is a member of an ex-
panded affiliated group for some or all of
its taxable year.
(1) Member of the same expanded affil-
iated group for the entire taxable year.
(2) Member of the expanded affiliated
group for a portion of the taxable year.
(3) Example.
(h) Computation of section 199 deduc-
tion for members of an expanded affiliated
group with different taxable years.
(1) In general.
(2) Example.
§1.199–8 Other rules.
(a) In general.
(b) Individuals.
(c) Trade or business requirement.
(1) In general.
(2) Individuals.
(3) Trusts and estates.
(d) Coordination with alternative mini-
mum tax.
(e) Nonrecognition transactions.
(1) In general.
(i) Sections 351, 721, and 731.
(ii) Exceptions.
(A) Section 708(b)(1)(B).
(B) Transfers by reason of death.
(2) Section 1031 exchanges.
(3) Section 381 transactions.
(f) Taxpayers with a 52–53 week tax-
able year.
(g) Section 481(a) adjustments.
(h) Disallowed losses or deductions.
(i) Effective dates.
(1) In general.
(2) Pass-thru entities.
(3) Non-consolidated EAG members.
(4) Computer software provided to cus-
tomers over the Internet. [Reserved].
§1.199–9 Application of section 199
to pass-thru entities for taxable years
beginning on or before May 17, 2006,
the enactment date of the Tax Increase
Prevention and Reconciliation Act of
2005.
(a) In general.
(b) Partnerships.
(1) In general.
(i) Determination at partner level.
(ii) Determination at entity level.
(2) Disallowed losses or deductions.
(3) Partner’s share of W–2 wages.
(4) Transition percentage rule for W–2
wages.
(5) Partnerships electing out of sub-
chapter K.
(6) Examples.
(c) S corporations.
(1) In general.
(i) Determination at shareholder level.
(ii) Determination at entity level.
(2) Disallowed losses or deductions.
(3) Shareholder’s share of W–2 wages.
(4) Transition percentage rule for W–2
wages.
(d) Grantor trusts.
(e) Non-grantor trusts and estates.
(1) Allocation of costs.
(2) Allocation among trust or estate and
beneficiaries.
(i) In general.
(ii) Treatment of items from a trust or
estate reporting qualified production activ-
ities income.
(3) Beneficiary’s share of W–2 wages.
(4) Transition percentage rule for W–2
wages.
(5) Example.
(f) Gain or loss from the disposition of
an interest in a pass-thru entity.
(g) Section 199(d)(1)(A)(iii) wage lim-
itation and tiered structures.
(1) In general.
(2) Share of W–2 wages.
(3) Example.
(h) No attribution of qualified activities.
(i) Qualifying in-kind partnership.
(1) In general.
(2) Definition of qualifying in-kind
partnership.
(3) Special rules for distributions.
(4) Other rules.
(5) Example.
(j) Partnerships owned by members of
a single expanded affiliated group.
(1) In general.
(2) Attribution of activities.
(i) In general.
(ii) Attribution between EAG partner-
ships.
(iii) Exception to attribution.
(3) Special rules for distributions.
(4) Other rules.
(5) Examples.
(k) Effective dates.
§1.199–1 Income attributable to domestic
production activities.
(a)In general. A taxpayer may deduct
an amount 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 the taxpayer’s qual-
ified production activities income (QPAI)
(as defined in paragraph (c) of this section)
for the taxable year, or the taxpayer’s tax-
able income for the taxable year (or, in the
case of an individual, adjusted gross in-
come). The amount of the deduction al-
lowable under this paragraph (a) for any
taxable year cannot exceed 50 percent of
the W–2 wages of the employer for the tax-
able year (as determined under §1.199–2).
The provisions of this section apply solely
for purposes of section 199 of the Internal
Revenue Code.
(b)Taxable income and adjusted gross
income—(1)In general. For purposes of
paragraph (a) of this section, the definition
of taxable income under section 63 applies,
except that taxable income is determined
without regard to section 199 and with-
out regard to any amount excluded from
gross income pursuant to section 114 or
pursuant to section 101(d) of the Ameri-
can Jobs Creation Act of 2004, Public Law
108–357, 118 Stat. 1418 (Act). In the
case of individuals, adjusted gross income
for the taxable year is determined after ap-
plying sections 86, 135, 137, 219, 221,
222, and 469, and without regard to sec-
tion 199 and without regard to any amount
excluded from gross income pursuant to
section 114 or pursuant to section 101(d)
of the Act. For purposes of determining
the tax imposed by section 511, paragraph
(a) of this section is applied using unre-
lated business taxable income. Except as
provided in §1.199–7(c)(2), the deduction
June 19, 200610822006–25 I.R.B.

under section 199 is not taken into account
in computing any net operating loss or the
amount of any net operating loss carryback
or carryover.
(2)Examples. The following examples
illustrate the application of this paragraph
(b):
Example 1. X, a corporation that is not part of
an expanded affiliated group (EAG) (as defined in
§1.199–7), engages in production activities that gen-
erate QPAI and taxable income (without taking into
account the deduction under this section and an NOL
deduction) of $600 in 2010. During 2010, X incurs
W–2 wages as defined in §1.199–2(e) of $300. X has
an NOL carryover to 2010 of $500. X’s deduction un-
der this section for 2010 is $9 (.09 x (lesser of QPAI
of $600 and taxable income of $100 ($600 taxable in-
come - $500 NOL)). Because the wage limitation is
$150 (50% x $300), X’s deduction is not limited.
Example 2.(i)Facts.X,acorporationthatisnot
part of an EAG, engages in production activities that
generate QPAI and taxable income (without taking
into account the deduction under this section and an
NOL deduction) of $100 in 2010. X has an NOL car-
ryover to 2010 of $500 that reduces its taxable income
for 2010 to $0. X’s deduction under this section for
2010is$0(.09x(lesserofQPAIof$100andtaxable
income of $0)).
(ii)Carryover to 2011. X’s taxable income for
purposes of determining its NOL carryover to 2011
is $100. Accordingly, X’s NOL carryover to 2011 is
$400 ($500 NOL carryover to 2010 - $100 NOL used
in 2010).
(c)Qualified production activities in-
come. QPAI for any taxable year is an
amount equal to the excess (if any) of the
taxpayer’s domestic production gross re-
ceipts (DPGR) (as defined in §1.199–3)
over the sum of—
(1) The cost of goods sold (CGS) that is
allocable to such receipts; and
(2) Other expenses, losses, or deduc-
tions (other than the deduction allowed un-
der this section) that are properly alloca-
ble to such receipts. See §§1.199–3 and
1.199–4.
(d)Allocation of gross receipts—(1)In
general. A taxpayer must determine the
portion of its gross receipts for the tax-
able year that is DPGR and the portion of
its gross receipts that is non-DPGR. Ap-
plicable Federal income tax principles ap-
ply to determine whether a transaction is,
in substance, a lease, rental, license, sale,
exchange, or other disposition the gross
receipts of which may constitute DPGR
(assuming all the other requirements of
§1.199–3 are met), whether it is a service
the gross receipts of which may constitute
non-DPGR, or some combination thereof.
For example, if a taxpayer leases quali-
fying production property (QPP) (as de-
fined in §1.199–3(j)(1)) and in connection
with that lease, also provides services, the
taxpayer must allocate its gross receipts
from the transaction using any reasonable
method that is satisfactory to the Secre-
tary based on all of the facts and circum-
stances and that accurately identifies the
gross receipts that constitute DPGR and
non-DPGR.
(2)Reasonable method of allocation.
Factors taken into consideration in deter-
mining whether the taxpayer’s method of
allocating gross receipts between DPGR
and non-DPGR is reasonable include
whether the taxpayer uses the most accu-
rate information available; the relationship
between the gross receipts and the method
used; the accuracy of the method chosen
as compared with other possible methods;
whether the method is used by the tax-
payer for internal management or other
business purposes; whether the method is
used for other Federal or state income tax
purposes; the time, burden, and cost of us-
ing alternative methods; and whether the
taxpayer applies the method consistently
from year to year. Thus, if a taxpayer has
the information readily available and can,
without undue burden or expense, specif-
ically identify whether the gross receipts
derivedfromanitemareDPGR,thenthe
taxpayer must use that specific identifi-
cation to determine DPGR. If a taxpayer
does not have information readily avail-
able to specifically identify whether the
gross receipts derived from an item are
DPGR or cannot, without undue burden
or expense, specifically identify whether
the gross receipts derived from an item are
DPGR, then the taxpayer is not required
to use a method that specifically identifies
whether the gross receipts derived from an
item are DPGR.
(3)De minimis rules—(i)DPGR.All
of a taxpayer’s gross receipts may be
treated as DPGR if less than 5 percent
of the taxpayer’s total gross receipts are
non-DPGR (after application of the ex-
ceptions provided in §1.199–3(i)(4)(i)(B),
(l)(4)(iv)(A), (m)(1)(iii)(A), (n)(6)(i), and
(o)(2) that may result in gross receipts
being treated as DPGR). If the amount
of the taxpayer’s gross receipts that are
non-DPGR equals orexceeds 5 percent of
the taxpayer’s total gross receipts, then,
except as provided in paragraph (d)(3)(ii)
of this section, the taxpayer is required
to allocate all gross receipts between
DPGR and non-DPGR in accordance with
paragraph (d)(1) of this section. If a cor-
poration is a member of an EAG, but is
not a member of a consolidated group,
then the determination of whether less
than 5 percent of the taxpayer’s total gross
receipts are non-DPGR is made at the
corporation level. If a corporation is a
member of a consolidated group, then the
determination of whether less than 5 per-
cent of the taxpayer’s total gross receipts
are non-DPGR is made at the consolidated
group level. In the case of an S corpora-
tion, partnership, trust (to the extent not
described in §1.199–9(d)) or estate, or
other pass-thru entity,the determination of
whether less than 5 percent of the pass-thru
entity’s total grossreceipts are non-DPGR
is made at the pass-thru entity level. In
the case of an owner of a pass-thru entity,
the determination of whether less than 5
percent of the owner’s total gross receipts
are non-DPGR is made at the owner level,
taking into account all gross receipts of
the owner from its other trade or business
activities and the owner’s share of the
gross receipts of the pass-thru entity.
(ii)Non-DPGR. All of a taxpayer’s
gross receipts may be treated as
non-DPGR if less than 5 percent of the
taxpayer’s total gross receipts are DPGR
(after application of the exceptions pro-
vided in §1.199–3(i)(4)(ii), (l)(4)(iv)(B),
(m)(1)(iii)(B), and (n)(6)(ii) that may
result in gross receipts being treated as
non-DPGR). If a corporation is a mem-
ber of an EAG, but is not a member of a
consolidated group, then the determina-
tion of whether less than 5 percent of the
taxpayer’s total gross receipts are DPGR
is made at the corporation level. If a cor-
poration is a member of a consolidated
group, then the determination of whether
less than 5 percent of the taxpayer’s total
gross receipts are DPGR is made at the
consolidated group level. In the case of
an S corporation, partnership, trust (to the
extent not described in §1.199–9(d)) or
estate, or other pass-thru entity, the deter-
mination of whether less than 5 percent
of the pass-thru entity’s total gross re-
ceipts are DPGR is made at the pass-thru
entity level. In the case of an owner of
a pass-thru entity, the determination of
whether less than 5 percent of the owner’s
total gross receipts are DPGR is made at
the owner level, taking into account all
gross receipts of the owner from its other
2006–25 I.R.B.1083June 19, 2006

trade or business activities and the owner’s
share of the gross receipts of the pass-thru
entity.
(4)Example. The following example
illustrates the application of this para-
graph (d):
Example. X derives its gross receipts from the
sale of gasoline refined by X within the United States
and the sale of refined gasoline that X acquired by
purchase from an unrelated person. If at least 5% of
X’s gross receipts are derived from gasoline refined
by X within the United States (that qualify as DPGR
if all the other requirements of §1.199–3 are met) and
at least 5% of X’s gross receipts are derived from the
resale of the acquired gasoline (that do not qualify as
DPGR), then X does not qualify for thede minimis
rules under paragraphs (d)(3)(i) and (ii) of this sec-
tion, and X must allocate its gross receipts between
the gross receipts derivedfrom the sale of gasoline
refined by X within the United States and the gross
receipts derived from the resale of the acquired gaso-
line. If less than 5% of X’s gross receipts are derived
from the resale of the acquired gasoline, then, X may
either allocate its gross receipts between the gross re-
ceipts derived from the gasoline refined by X within
the United States and the gross receipts derived from
the resale of the acquired gasoline, or, pursuant to
paragraph (d)(3)(i) of this section, X may treat all of
its gross receipts derived from the sale of the refined
gasoline as DPGR. If X’s gross receipts attributable
to the gasoline refined by X within the United States
constitute less than 5% of X’s total gross receipts,
then, X may either allocate its gross receipts between
the gross receipts derivedfrom the gasoline refined
by X within the United States and the gross receipts
derived from the resale of the acquired gasoline, or,
pursuant to paragraph (d)(3)(ii) of this section, X may
treat all of its gross receipts derived from the sale of
the refined gasoline as non-DPGR.
(e)Certain multiple-year transac-
tions—(1)Use of historical data.Ifa
taxpayer recognizes and reports gross re-
ceipts from advance payments or other
similar payments on a Federal income tax
return for a taxable year, then the tax-
payer’s use of historical data in making an
allocation of gross receipts from the trans-
action between DPGR and non-DPGR
may constitute a reasonable method. If a
taxpayer makes allocations using histor-
ical data, and subsequently updates the
data, then the taxpayer must use the more
recent or updated data, starting in the tax-
able year in which the update is made.
(2)Percentage of completion method.
A taxpayer using a percentage of comple-
tion method under section 460 must deter-
mine the ratio of DPGR and non-DPGR
using a reasonable method that is satis-
factory to the Secretary based on all of
the facts and circumstances that accurately
identifies the gross receipts that constitute
DPGR. See paragraph (d)(2) of this sec-
tion for the factors taken into considera-
tion in determining whether the taxpayer’s
method is reasonable.
(3)Examples. The following examples
illustrate the application of this paragraph
(e):
Example 1. On December 1, 2007, X, a calen-
dar year accrual method taxpayer, sells for $100 a
one-year computer software maintenance agreement
that provides for (i) computer software updates that X
expects to produce in the United States, and (ii) cus-
tomer support services. At the end of 2007, X uses a
reasonable method that is satisfactory to the Secretary
based on all of the facts and circumstances to allocate
60% of the gross receipts ($60) to the computer soft-
ware updates and 40% ($40) to the customer support
services. X treats the $60 as DPGR in 2007. At the
expiration of the one-yearagreement on November
30, 2008, no computer software updates are provided
by X. Pursuant to paragraph (e)(1) of this section, be-
cause X used a reasonable method that is satisfactory
to the Secretary based on all of the facts and circum-
stances to identify gross receipts as DPGR, X is not
required to make any adjustments to its 2007 Federal
income tax return (for example, by amended return)
or in 2008 for the $60 that was properly treated as
DPGR in 2007, even though no computer software
updates were provided under the contract.
Example 2. X manufactures automobiles within
the United States and sells 5-year extended warranties
to customers. The sales price of the warranty is based
on historical data that determines what repairs and
services are performed onan automobile during the
5-year period. X sells the 5-year warranty to Y for
$1,000 in 2007. Under X’s method of accounting,
X recognizes warranty revenue when received. Us-
ing historical data, X concludes that 60% of the gross
receipts attributable to a 5-year warranty will be de-
rived from the sale of parts (QPP) that X manufac-
tures within the United States, and 40% will be de-
rived from the sale of purchased parts X did not man-
ufacture and non-qualifying services. X’s method of
allocating its gross receipts with respect to the 5-year
warranty between DPGR and non-DPGR is a reason-
able method that is satisfactory to the Secretary based
on all of the facts and circumstances. Therefore, X
properly treats $600 as DPGR in 2007.
Example 3. The facts are the same as inExample
2except that in 2009 X updates its historical data.
The updated historical data show that 50% of the
gross receipts attributable to a 5-year warranty will
be derived from the sale of parts (QPP) that X man-
ufactures within the United States and 50% will be
derived from the sale of purchased parts X did not
manufacture and non-qualifying services. In 2009, X
sells a 5-year warranty for $1,000 to Z. Under all of
the facts and circumstances, X’s method of allocation
is still a reasonable method. Relying on its updated
historical data, X properly treats $500 as DPGR in
2009.
Example 4. The facts are the same as inExam-
ple 2except that Y pays for the 5-year warranty over
time ($200 a year for 5 years). Under X’s method
of accounting, X recognizes each $200 payment as
it is received. In 2009, X updates its historical data
and the updated historical data show that 50% of the
gross receipts attributable to a 5-year warranty will
be derived from the sale of QPP that X manufac-
tures within the United States and 50% will be de-
rived from the sale of purchased parts X did not man-
ufacture and non-qualifying services. Under all of the
facts and circumstances, X’s method of allocation is
still a reasonable method. When Y makes its $200
payment for 2009, X, relying on its updated histori-
cal data, properly treats $100 as DPGR in 2009.
§1.199–2 Wage limitation.
(a)Rules of application—(1)In gen-
eral. The provisions of this section ap-
ply solely for purposes of section 199 of
the Internal Revenue Code. The amount of
the deduction allowable under §1.199–1(a)
(section 199 deduction) to a taxpayer for
any taxable year shall not exceed 50 per-
cent of the W–2 wages (as defined in para-
graph (e) of this section) of the taxpayer.
For this purpose, except as provided in
paragraph (a)(3) of this section and para-
graph (b) of this section, the Forms W–2,
“Wage and Tax Statement,” used in deter-
mining the amount of W–2 wages are those
issued for the calendar year ending dur-
ing the taxpayer’s taxable year for wages
paid to employees (or former employees)
of the taxpayer for employment by the tax-
payer. For purposes of this section, em-
ployees of the taxpayer are limited to em-
ployees of the taxpayer as defined in sec-
tion 3121(d)(1) and (2) (that is, officers
of a corporate taxpayer and employees of
the taxpayer under the common law rules).
See paragraph (a)(3) of this section for the
requirement that W–2 wages must have
beenincludedinareturnfiledwiththeSo-
cial Security Administration (SSA) within
60 days after the due date (including exten-
sions) of the return.
(2)Wages paid by entity other than
common law employer. In determining
W–2 wages, a taxpayer may take into ac-
count any wages paid by another entity and
reported by the other entity on Forms W–2
with the other entity as the employer listed
in Box c of the Forms W–2, provided that
the wages were paid to employees of the
taxpayer for employment by the taxpayer.
If the taxpayer is treated as an employer
described in section 3401(d)(1) because
of control of the payment of wages (that
is, the taxpayer is not the common law
employer of the payee of the wages), the
payment of wages may not be included in
determining W–2 wages of the taxpayer.
If the taxpayer is paying wages as an agent
of another entity to individuals who are
not employees of the taxpayer, the wages
June 19, 200610842006–25 I.R.B.

may not be included in determining the
W–2 wages of the taxpayer.
(3)Requirement that wages must be
reported on return filed with the Social
Security Administration—(i)In general.
The termW–2 wagesshall not include any
amount that is not properly included in a
return filed with SSA on or before the 60th
day after the due date (including exten-
sions) for such return. Under §31.6051–2
of this chapter, each Form W–2 and the
transmittal Form W–3, “Transmittal of
Wage and Tax Statements,” together con-
stitute an information return to be filed
with SSA. Similarly, each Form W–2c,
“Corrected Wage and Tax Statement,”
and the transmittal Form W–3 or W–3c,
“Transmittal of Corrected Wage and Tax
Statements,” together constitute an infor-
mation return to be filed with SSA. In
determining whether any amount has been
properly included in a return filed with
SSA on or before the 60th day after the
due date (including extensions) for such
return, each Form W–2 together with its
accompanying Form W–3 shall be con-
sidered a separate information return and
each Form W–2c together with its accom-
panying Form W–3 or Form W–3c shall
be considered a separate information re-
turn. Section 31.6071(a)–1(a)(3) of this
chapter provides that each information
return in respect of wages as defined in the
Federal Insurance Contributions Act or of
income tax withheld from wages which
is required to be made under §31.6051–2
of this chapter shall be filed on or before
the last day of February (March 31 if filed
electronically) of theyear following the
calendar year for which it is made, except
that if a tax return under §31.6011(a)–5(a)
of this chapter is filed as a final return for
a period ending prior to December 31, the
information statement shall be filed on or
before the last day of the second calendar
monthfollowingtheperiodforwhichthe
tax return is filed. Corrected Forms W–2
are required to be filed with SSA on or
before the last day of February (March
31 if filed electronically) of the year fol-
lowing the year in which the correction
is made, except that if a tax return under
§31.6011(a)–5(a) is filed as a final return
for a period ending prior to December 31
for the period in which the correction is
made, the corrected Forms W–2 are re-
quired to be filed by the last day of the
second calendar month following the pe-
riod for which the final return is filed.
(ii)Corrected return filed to correct a
return that was filed within 60 days of the
due date. If a corrected information re-
turn (Return B) is filed with SSA on or
before the 60th day after the due date (in-
cluding extensions) of Return B to correct
an information return (Return A) that was
filed with SSA on or before the 60th day
after the due date (including extensions)
of the information return (Return A) and
paragraph (a)(3)(ii) of this section does not
apply, then the wage information on Re-
turn B must be included in determining
W–2 wages. If a corrected information re-
turn (Return D) is filed with SSA later than
the 60th day after the due date (including
extensions) of Return D to correct an in-
formation return (Return C) that was filed
with SSA on or before the 60th day after
the due date (including extensions) of the
informationreturn(ReturnC),thenifRe-
turn D reports an increase (or increases) in
wages included in determining W–2 wages
from the wage amounts reported on Return
C, then such increase (or increases) on Re-
turn D shall be disregarded in determining
W–2 wages (and only the wage amounts
on Return C may be included in determin-
ing W–2 wages). If Return D reports a de-
crease (or decreases) in wages included in
determining W–2 wages from the amounts
reported on Return C, then, in determining
W–2 wages, the wages reported on Return
C must be reduced by the decrease (or de-
creases) reflected on Return D.
(iii)Corrected return filed to correct a
return that was filed later than 60 days af-
ter the due date. If an information return
(Return F) is filed to correct an informa-
tion return (Return E) that was not filed
with SSA on or before the 60th day after
the due date (including extensions) of Re-
turn E, then Return F (and any subsequent
information returns filed with respect to
Return E) will not be considered filed on
or before the 60th day after the due date
(including extensions) of Return F (or the
subsequent corrected information return).
Thus, if a Form W–2c (or corrected Form
W–2) is filed to correct a Form W–2 that
was not filed with SSA on or before the
60th day after the due date (including ex-
tensions) of the information return includ-
ing the Form W–2 (or to correct a Form
W–2c relating to a information return in-
cluding a Form W–2 that had not been filed
with SSA on or before the 60th day af-
ter the due date (including extensions) of
the information return including the Form
W–2), then the information return includ-
ing this Form W–2c (or corrected Form
W–2) shall not be considered to have been
filed with SSA on or before the 60th day
after the due date (including extensions)
for this information return including the
Form W–2c (or corrected Form W–2), re-
gardless of when the information return in-
cluding the Form W–2c (or corrected Form
W–2) is filed.
(4)Joint return. An individual and his
or her spouse are considered one taxpayer
for purposes of determining the amount of
W–2 wages for a taxable year, provided
that they file a joint return for the taxable
year. Thus, an individual filing as part of
a joint return may include the wages of
employees of his or her spouse in deter-
mining W–2 wages, provided the employ-
ees are employed in a trade or business
of the spouse and the other requirements
of this section are met. However, a mar-
ried taxpayer filing a separate return from
his or her spouse for the taxable year may
not include the wages of employees of the
taxpayer’s spouse in determining the tax-
payer’s W–2 wages for the taxable year.
(b)Application in the case of a taxpayer
with a short taxable year. In the case of
a taxpayer with a short taxable year, sub-
ject to the rules of paragraph (a) of this sec-
tion, the W–2 wages of the taxpayer for the
short taxable year shall include only those
wages paid during the short taxable year
to employees of the taxpayer, only those
elective deferrals (within the meaning of
section 402(g)(3)) made during the short
taxable year by employees of the taxpayer
and only compensation actually deferred
under section 457 during the short taxable
year with respect to employees of the tax-
payer. The Secretary shall have the au-
thority to issue published guidance setting
forth the method that is used to calculate
W–2 wages in case of a taxpayer with a
short taxable year. See paragraph (e)(3) of
this section.
(c)Acquisition or disposition of a trade
or business (or major portion).Ifatax-
payer (a successor) acquires a trade or
business, the major portion of a trade or
business, or the major portion of a separate
unit of a trade or business from another
taxpayer (a predecessor), then, for pur-
poses of computing the respective section
2006–25 I.R.B.1085June 19, 2006

199 deduction of the successor and of the
predecessor, the W–2 wages paid for that
calendar year shall be allocated between
the successor and the predecessor based
on whether the wages are for employment
by the successor or for employment by the
predecessor. Thus, in this situation, the
W–2 wages are allocated based on whether
the wages are for employment for a period
during which the employee was employed
by the predecessor or for employment for
a period during which the employee was
employed by the successor, regardless of
which permissible method for Form W–2
reporting is used.
(d)Non-duplication rule. Amounts that
are treated as W–2 wages for a taxable
year under any method shall not be treated
as W–2 wages of any other taxable year.
Also, an amount shall not be treated as
W–2 wages by more than one taxpayer.
(e)Definition of W–2 wages—(1)In
general. Under section 199(b)(2), the term
W–2 wagesmeans, with respect to any per-
son for any taxable year of such person,
the sum of the amounts described in sec-
tion 6051(a)(3) and (8) paid by such per-
son with respect to employment of em-
ployees by such person during the calen-
dar year ending during such taxable year.
Thus, the term W–2 wages includes the
total amount of wages as defined in sec-
tion 3401(a); the total amount of elec-
tive deferrals (within the meaning of sec-
tion 402(g)(3)); the compensation deferred
under section 457; and for taxable years
beginning after December 31, 2005, the
amount of designated Roth contributions
(as defined in section 402A).
(2)Limitation on W–2 wages for tax-
able years beginning after May 17, 2006,
the enactment date of the Tax Increase Pre-
vention and Reconciliation Act of 2005.
[Reserved].
(3)Methods for calculating W–2 wages.
The Secretary may provide by publication
in the Internal Revenue Bulletin (see
§601.601(d)(2)(ii)(b) of this chapter) for
methods to be used in calculating W–2
wages, including W–2 wages for short
taxable years. For example, see Rev.
Proc. 2006–22, 2006–23 I.R.B. 1033) (see
§601.601(d)(2) of this chapter).
§1.199–3 Domestic production gross
receipts.
(a)In general. The provisions of this
section apply solely for purposes of sec-
tion 199 of the Internal Revenue Code
(Code). Domestic production gross re-
ceipts (DPGR) are the gross receipts (as
defined in paragraph (c) of this section) of
the taxpayer that are—
(1) Derived from any lease, rental, li-
cense, sale, exchange, or other disposition
(as defined in paragraph (i) of this section)
of—
(i) Qualifying production property
(QPP) (as defined in paragraph (j)(1) of
this section) that is manufactured, pro-
duced, grown, or extracted (MPGE) (as
defined in paragraph (e) of this section)
by the taxpayer (as defined in paragraph
(f) of this section) in whole or in signifi-
cant part (as defined in paragraph (g) of
this section) within the United States (as
defined in paragraph (h) of this section);
(ii) Any qualified film (as defined in
paragraph (k) of this section) produced by
the taxpayer; or
(iii) Electricity, natural gas, or potable
water (as defined in paragraph (l) of this
section) (collectively, utilities) produced
by the taxpayer in the United States;
(2) Derived from, in the case of a tax-
payer engaged in the active conduct of a
construction trade or business, construc-
tion of real property (as defined in para-
graph (m) of this section) performed in the
United States by the taxpayer in the ordi-
nary course of such trade or business; or
(3) Derived from, in the case of a tax-
payer engaged in the active conduct of an
engineering or architectural services trade
or business, engineering or architectural
services (as defined in paragraph (n) of this
section) 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.
(b)Related persons—(1)In general.
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. A person
is treated as related to another person if
both persons are treated as a single em-
ployer under either section 52(a) or (b)
(without regard to section 1563(b)), or
section 414(m) or (o). Any other person
is an unrelated person for purposes of
§§1.199–1 through 1.199–9.
(2)Exceptions. Notwithstanding para-
graph (b)(1) of this section, gross receipts
derived from any QPP or qualified film
leased or rented by the taxpayer to a re-
lated person may qualify as DPGR if the
QPP or qualified film is held for sublease
or rent, or is subleased or rented, by the re-
lated person to an unrelated person for the
ultimate use of the unrelated person. Sim-
ilarly, notwithstanding paragraph (b)(1) of
this section, gross receipts derived from
the license of QPP or a qualified film to
a related person for reproduction and sale,
exchange, lease, rental, or sublicense to an
unrelated person for the ultimate use of the
unrelated person may qualify as DPGR.
(c)Definition of gross receipts.The
termgross receiptsmeans the taxpayer’s
receipts for the taxable year that are rec-
ognized under the taxpayer’s methods of
accounting used for Federal income tax
purposes for the taxable year. If the gross
receipts are recognized in an intercom-
pany transaction within the meaning of
§1.1502–13, see also §1.199–7(d). For this
purpose, gross receipts include total sales
(net of returns and allowances) and all
amounts received for services. In addition,
gross receipts include any income from
investments and from incidental or out-
side sources. For example, gross receipts
include interest (including original issue
discount and tax-exempt interest within
the meaning of section 103), dividends,
rents, royalties, and annuities, regardless
of whether the amounts are derived in the
ordinary course of the taxpayer’s trade of
business. Gross receipts are not reduced
by cost of goods sold (CGS) or by the
cost of property sold if such property is
described in section 1221(a)(1), (2), (3),
(4), or (5). Gross receipts do not include
the amounts received in repayment of a
loan or similar instrument (for example,
a repayment of the principal amount of a
loan held by a commercial lender) and,
except to the extent of gain recognized,
do not include gross receipts derived from
a non-recognition transaction, such as a
section 1031 exchange. Finally, gross re-
ceipts do not include amounts received by
the taxpayer with respect to sales tax or
other similar state and local taxes if, under
the applicable state or local law, the tax
is legally imposed on the purchaser of the
good or service and the taxpayer merely
June 19, 200610862006–25 I.R.B.

collects and remits the tax to the taxing au-
thority. If, in contrast, the tax is imposed
on the taxpayer under the applicable law,
then gross receipts include the amounts
received that are allocable to the payment
of such tax.
(d)Determining domestic production
gross receipts—(1)In general. For pur-
poses of §§1.199–1 through 1.199–9, a
taxpayer determines, using any reasonable
method that is satisfactory to the Secretary
based on all of the facts and circum-
stances, whether gross receipts qualify as
DPGR on an item-by-item basis (and not,
for example, on a division-by-division,
product line-by-product line, or transac-
tion-by-transaction basis).
(i) The termitemmeans the property of-
fered by the taxpayer in the normal course
of the taxpayer’s business for lease, rental,
license, sale, exchange, or other disposi-
tion (for purposes of this paragraph (d),
collectively referred to as disposition) to
customers, if the gross receipts from the
disposition of such property qualify as
DPGR; or
(ii) If paragraph (d)(1)(i) of this sec-
tion does not apply to the property, then
any component of the property described
in paragraph (d)(1)(i) of this section is
treated as the item, provided that the gross
receipts from the disposition of the prop-
erty described in paragraph (d)(1)(i) of
this section that are attributable to such
component qualify as DPGR. Each com-
ponent that meets the requirements under
this paragraph (d)(1)(ii) must be treated
as a separate item and a component that
meets the requirements under this para-
graph (d)(1)(ii) may not be combined with
a component that does not meet these re-
quirements.
(2)Special rules. The following spe-
cial rules apply for purposes of paragraph
(d)(1) of this section:
(i) For purposes of paragraph (d)(1)(i)
of this section, in no event may a single
item consist of two or more properties un-
less those properties are offered for dis-
position, in the normal course of the tax-
payer’s business, as a single item (regard-
less of how the properties are packaged).
(ii) In the case of property customarily
sold by weight or by volume, the item is
determined using the custom of the indus-
try (for example, barrels of oil).
(iii) In the case of construction activi-
ties and services or engineering and archi-
tectural services, a taxpayer may use any
reasonable method that is satisfactory to
the Secretary based onall of the facts and
circumstances to determine what construc-
tion activities and services or engineering
or architectural services constitute an item.
(3)Exception. If a taxpayer MPGE
QPP within the United States or produces
a qualified film or produces utilities in the
United States that it disposes of, and the
taxpayer leases, rents, licenses, purchases,
or otherwise acquires property that con-
tains or may contain the QPP, qualified
film, or the utilities (or a portion thereof),
and the taxpayer cannot reasonably de-
termine, without undue burden and ex-
pense, whether the acquired property con-
tains any of the original QPP, qualified
film, or utilities MPGE or produced by the
taxpayer, then the taxpayer is not required
to determine whether any portion of the
acquired property qualifies as an item for
purposes of paragraph (d)(1) of this sec-
tion. Therefore, thegross receipts derived
from the disposition of the acquired prop-
erty may be treated as non-DPGR. Simi-
larly, the preceding sentences shall apply if
the taxpayer can reasonably determine that
the acquired property contains QPP, a qual-
ified film, or utilities (or a portion thereof)
MPGE or produced by the taxpayer, but
cannot reasonably determine, without un-
due burden or expense, how much, or what
type, grade, etc., of the QPP, qualified film,
or utilities MPGE or produced by the tax-
payer the acquired property contains.
(4)Examples. The following examples
illustrate the application of paragraph (d)
of this section:
Example 1. Q manufactures leather and rubber
shoe soles in the United States. Q imports shoe up-
pers, which are the parts of the shoe above the sole.
Q manufactures shoes for sale by sewing or otherwise
attaching the soles to the imported uppers. Q offers
the shoes for sale to customers in the normal course
of Q’s business. If the gross receipts derived from the
sale of the shoes do not qualify as DPGR under this
section, then under paragraph (d)(1)(ii) of this sec-
tion, Q must treat the sole as the item if the gross
receipts derived from the sale of the sole qualify as
DPGR under this section.
Example 2. The facts are the same as inExam-
ple 1except that Q also buys some finished shoes
from unrelated persons and resells them to retail shoe
stores. Q offers all shoes (manufactured and pur-
chased) for sale to customers, in the normal course
of Q’s business, in individual pairs, and requires no
minimum quantity order. Q ships the shoes in boxes,
eachboxcontainingasmanyas50pairsofshoes.A
full, or partially full, box may contain some shoes that
Q manufactured, and somethat Q purchased. Under
paragraph (d)(2)(i) of this section, Q cannot treat a
box of 50 (or fewer) pairs of shoes as an item, be-
cause Q offers the shoes for sale in the normal course
of Q’s business in individual pairs.
Example 3. R manufactures toy cars in the United
States. R also purchases cars that were manufactured
by unrelated persons. R offers the cars for sale to
customers, in the normal course of R’s business, in
sets of three, and requires no minimum quantity or-
der. R sells the three-car sets to toy stores. A three-car
set may contain some cars manufactured by R and
some cars purchased by R. If the gross receipts de-
rived from the sale of the three-car sets do not qualify
as DPGR under this section, then, under paragraph
(d)(1)(ii) of this section, R must treat a toy car in the
three-car set as the item, provided the gross receipts
derived from the sale of the toy car qualify as DPGR
under this section.
Example 4. The facts are the same asExample 3
except that R offers the toy cars for sale individually
to customers in the normal course of R’s business,
rather than in sets of three. R’s customers resell the
individual toy cars at three for $10. Frequently, this
results in retail customers purchasing three individual
cars in one transaction. In determining R’s DPGR,
under paragraph (d)(2)(i)of this section, each toy car
is an item and R cannot treat three individual toy cars
as one item, because the individual toy cars are not
offered for sale in sets of three by R in the normal
course of R’s business.
Example 5.ThefactsarethesameasinExample
3except that R offers the toy cars for sale to customers
in the normal course of R’s business both individually
and in sets of three. The results are the same asEx-
ample 3with respect to the three-car sets. The results
are the same as inExample 4with respect to the indi-
vidual toy cars that are not included in the three-car
sets and offered for sale individually. Thus, R has two
items, an individual toy car and a set of three toy cars.
Example 6. S produces television sets in the
United States. S also produces the same model of
television set outside the United States. In both
cases, S packages the sets one to a box. S sells the
television sets to large retail consumer electronics
stores. S requires that itscustomers purchase a min-
imum of 100 television sets per order. With respect
to a particular order by a customer of 100 television
sets, some were manufactured by S in the United
States, and some were manufactured by S outside
the United States. Under paragraph (d)(2)(i) of this
section, a minimum order of 100 television sets is the
item provided that the gross receipts derived from
the sale of the 100 television sets qualify as DPGR.
Example 7. T produces in bulk form in the
United States the active ingredient for a pharmaceu-
tical product. T sells the active ingredient in bulk
form to FX, a foreign corporation. This sale qualifies
as DPGR assuming all the other requirements of this
section are met. FX uses the active ingredient to
produce the finished dosage form drug. FX sells the
drug in finished dosage to T, which sells the drug to
customers. Assume that T knows how much of the
active ingredient is in the finished dosage. Under
paragraph (d)(1)(ii) of this section, if T’s gross re-
ceipts derived from the sale of the finished dosage do
not qualify as DPGR under this section, then T must
treat the active ingredient component as the item
because the gross receipts attributable to the active
ingredient qualify as DPGR under this section. The
exception in paragraph (d)(3) of this section does not
2006–25 I.R.B.1087June 19, 2006

apply because T can reasonably determine without
undue burden or expense that the finished dosage
contains the active ingredient and the quantity of the
active ingredient in the finished dosage.
Example 8. U produces steel within the United
States and sells its steel to a variety of customers, in-
cludingV,anunrelatedperson, who uses the steel for
the manufacture of equipment. V also purchases steel
from other steel producers. For its steel operations, U
purchases equipment from V that may contain steel
produced by U. U sells the equipment after 5 years.
If U cannot reasonably determine without undue bur-
den and expense whether the equipment contains any
steel produced by U, then, under paragraph (d)(3) of
this section, U may treat the gross receipts derived
from sale of the equipment as non-DPGR.
Example 9. The facts are the same as inExample
8except that U knows that the equipment purchased
from V does contain some amount of steel produced
by U. If U cannot reasonably determine without un-
due burden and expense how much steel produced
by U the equipment contains, then, under paragraph
(d)(3) of this section, U may treat the gross receipts
derived from sale of the equipment as non-DPGR.
Example 10. W manufactures sunroofs, stereos,
and tires within the United States. W purchases auto-
mobiles from unrelated persons and installs the man-
ufactured components in the automobiles. W, in the
normal course of W’s business, sells the automobiles
with the components to customers. If the gross re-
ceipts derived from the sale of the automobiles with
the components do not qualify as DPGR under this
section, then under paragraph (d)(1)(ii) of this sec-
tion, W must treat each component (sunroofs, stereos,
and tires) that it manufactures as a separate item if the
gross receipts derived from the sale of each compo-
nent qualify as DPGR under this section.
Example 11. X manufacturers leather soles
within the United States. X purchases shoe uppers,
metal eyelets, and laces. X manufactures shoes by
sewing or otherwise attaching the soles to the uppers;
attaching the metal eyelets to the shoes; and thread-
ing the laces through the eyelets. X, in the normal
course of X’s business, sells the shoes to customers.
If the gross receipts derived from the sale of the
shoes do not qualify as DPGR under this section,
then under paragraph (d)(1)(ii) of this section, X
must treat the sole as the item if the gross receipts
derived from the sale of the sole qualify as DPGR
under this section. X may not treat the shoe upper,
metal eyelets or laces as part of the item because
under paragraph (d)(1)(ii) of this section the sole is
the component that is treated as the item.
Example 12. Y manufactures glass windshields
for automobiles within the United States. Y pur-
chases automobiles from unrelated persons and in-
stalls the windshields in the automobiles. Y, in the
normal course of Y’s business, sells the automobiles
with the windshields to customers. If the automobiles
with the windshields do not meet the requirements for
being an item, then, under paragraph (d)(1)(ii) of this
section, Y must treat each windshield that it manu-
factures as an item if the gross receipts derived from
the sale of the windshield qualify as DPGR under this
section. Y may not treat any other portion of the au-
tomobile as part of the item because under paragraph
(d)(1)(ii) of this section the windshield is the compo-
nent.
(e)Definition of manufactured, pro-
duced, grown, or extracted—(1)In gen-
eral. Except as provided in paragraphs
(e)(2) and (3) of this section, the term
MPGEincludes manufacturing, produc-
ing, growing, extracting, installing, de-
veloping, improving, and creating QPP;
making QPP out of scrap, salvage, or junk
material as well as from new or raw mate-
rial by processing, manipulating, refining,
or changing the form of an article, or by
combining or assembling two or more
articles; cultivating soil, raising livestock,
fishing, and mining minerals. The term
MPGEalso includes storage, handling,
or other processing activities (other than
transportation activities) within the United
States related to the sale, exchange, or
other disposition of agricultural products,
provided the products are consumed in
connection with or incorporated into the
MPGE of QPP, whether or not by the tax-
payer. Pursuant to paragraph (f)(1) of this
section, the taxpayer must have the bene-
fits and burdens of ownership of the QPP
under Federal income tax principles dur-
ing the period the MPGE activity occurs
in order for gross receipts derived from
the MPGE of QPP to qualify as DPGR.
(2)Packaging, repackaging, labeling,
or minor assembly. If a taxpayer pack-
ages, repackages, labels, or performs mi-
nor assembly of QPP and the taxpayer en-
gages in no other MPGE activity with re-
spect to that QPP, the taxpayer’s packag-
ing, repackaging, labeling, or minor as-
sembly does not qualify as MPGE with re-
spect to that QPP.
(3)Installing. If a taxpayer installs
QPP and engages in no other MPGE ac-
tivity with respect to the QPP, the tax-
payer’s installing activity does not qual-
ify as an MPGE activity. Notwithstanding
paragraph (i)(4)(i)(B)(4) of this section, if
the taxpayer installs QPP MPGE by the
taxpayer and, except as provided in para-
graph (f)(2) of this section, the taxpayer
has the benefits and burdens of ownership
of the QPP under Federal income tax prin-
ciples during the period the installing ac-
tivity occurs, then the portion of the in-
stalling activity that relates to the QPP is
an MPGE activity.
(4)Consistency with section 263A.A
taxpayer that has MPGE QPP for the tax-
able year should treat itself as a producer
under section 263A with respect to the
QPP unless the taxpayer is not subject to
section 263A. A taxpayer that currently is
not properly accounting for its production
activities under section 263A, and wishes
to change its method of accounting to
comply with the producer requirements
of section 263A, must follow the appli-
cable administrative procedures issued
under §1.446–1(e)(3)(ii) for obtaining
the Commissioner’s consent to a change
in accounting method (for further guid-
ance, for example, see Rev. Proc. 97–27,
1997–1 C.B. 680, or Rev. Proc. 2002–9,
2002–1 C.B. 327, whichever applies (see
§601.601(d)(2) of this chapter)).
(5)Examples. The following examples
illustrate the application of this paragraph
(e):
Example 1. A, B, and C are unrelated persons and
are not cooperatives to which Part I of subchapter T
of the Code applies. B grows agricultural products in
the United States and sells them to A, who owns agri-
cultural storage bins in the United States. A stores the
agricultural products and has the benefits and burdens
of ownership under Federal income tax principles of
the agricultural products while they are being stored.
A sells the agricultural products to C, who processes
them into refined agricultural products in the United
States. The gross receipts from A’s, B’s, and C’s ac-
tivities are DPGR from the MPGE of QPP.
Example 2.ThefactsarethesameasinEx-
ample 1except that B grows the agricultural prod-
ucts outside the United States and C processes them
into refined agricultural products outside the United
States. Pursuant to paragraph (e)(1) of this section,
the gross receipts derivedby A from its sale of the
agricultural products to C are DPGR from the MPGE
of QPP within the United States. B’s and C’s re-
spective MPGE activities occur outside the United
States and, therefore, their respective gross receipts
are non-DPGR.
Example 3. Y is hired to reconstruct and refur-
bish unrelated customers’ tangible personal property.
As part of the reconstruction and refurbishment, Y
installs purchased replacement parts that constitute
QPP in the customers’ property. Y’s installation
of purchased replacement parts does not qualify as
MPGE pursuant to paragraph (e)(3) of this section
because Y did not MPGE the replacement parts.
Example 4.ThefactsarethesameasinExample
3except that Y manufacturesthe replacement parts it
uses for the reconstruction and refurbishment of cus-
tomers’ tangible personal property. Y has the bene-
fits and burdens of ownership under Federal income
tax principles of the replacement parts during the re-
construction and refurbishment activity and while in-
stalling the parts. Y’s gross receipts derived from
the MPGE of the replacement parts and Y’s gross re-
ceipts derived from the installation of the replacement
parts, which is an MPGE activity pursuant to para-
graph (e)(3) of this section, are DPGR (assuming all
the other requirements of this section are met).
Example 5. Z MPGE QPP within the United
States. The following activities are performed by
Z as part of the MPGE of the QPP while Z has the
benefits and burdens of ownership under Federal
income tax principles: materials analysis and selec-
June 19, 200610882006–25 I.R.B.

tion, subcontractor inspections and qualifications,
testing of component parts, assisting customers in
their review and approval of the QPP, routine produc-
tion inspections, product documentation, diagnosis
and correction of system failure, and packaging for
shipment to customers. Because Z MPGE the QPP,
these activities performed by Z are part of the MPGE
of the QPP.
Example 6. X purchases automobiles from
unrelated persons and customizes them by adding
ground effects, spoilers, custom wheels, specialized
paint and decals, sunroofs, roof racks, and similar
accessories. X does not manufacture any of the
accessories. X’s activity is minor assembly under
paragraph (e)(2) of this section which is not an
MPGE activity.
Example 7. Y manufactures furniture in the
United States that it sells to unrelated persons. Y
also engraves customers’ names on pens and pencils
purchased from unrelated persons and sells the pens
and pencils to such customers. Although Y’s sales
of furniture qualify as DPGR if all the other require-
ments of this section are met, Y must determine
whether its gross receipts derived from the sale of
the pens and pencils qualify as DPGR. Y’s status as
a manufacturer of furniture in the United States does
not carry over to its other activities.
Example 8. X produces computer software within
the United States. In 2007, X enters into an agree-
ment with Y, an unrelated person, under which X will
manage Y’s networks using computer software that
X produced. Pursuant to theterms of the agreement,
X also provides to Y for Y’s use on Y’s own hard-
ware computer software that X produced (additional
computer software). Assume that, based on all of the
facts and circumstances, the transaction between X
and Y relating to the additional computer software is
a lease or sale of the additional computer software.
Y pays X monthly fees of $100 under the agreement
during 2007. No separate charge for the additional
computer software is stated in the agreement or in the
monthly invoices that X provides to Y. The portion
of X’s gross receipts that is derived from the lease or
sale of the additional computer software is DPGR (as-
suming all the other requirements of this section are
met).
(f)Definition of by the taxpayer—(1)
In general. With the exception of the rules
applicable to an expanded affiliated group
(EAG) under §1.199–7, qualifying in-kind
partnerships under §1.199–9(i), EAG part-
nerships under §1.199–9(j), and govern-
ment contracts under paragraph (f)(2) of
this section, only one taxpayer may claim
the deduction under §1.199–1(a) with
respect to any qualifying activity under
paragraphs (e)(1), (k)(1), and (l)(1) of this
section performed in connection with the
same QPP, or the production of a qualified
film or utilities. If one taxpayer performs a
qualifying activity under paragraph (e)(1),
(k)(1), or (l)(1) of this section pursuant to
a contract with another party, then only
the taxpayer that has the benefits and bur-
dens of ownership of the QPP, qualified
film, or utilities under Federal income
tax principles during the period in which
the qualifying activity occurs is treated as
engaging in the qualifying activity.
(2)Special rule for certain government
contracts. Gross receipts derived from the
MPGE of QPP in whole or in significant
part within the United States will be treated
as gross receipts derived from the lease,
rental, license, sale, exchange, or other dis-
position of QPP MPGE by the taxpayer
in whole or in significant part within the
United States notwithstanding the require-
ments of paragraph (f)(1) of this section
if—
(i) The QPP is MPGE by the taxpayer
within the United States pursuant to a con-
tract with the Federal government; and
(ii) The Federal Acquisition Regulation
(Title 48, Code of Federal Regulations) re-
quires that title or risk of loss with respect
to the QPP be transferred to the Federal
government before the MPGE of the QPP
is completed.
(3)Subcontractor. If a taxpayer (sub-
contractor) enters into a contract or agree-
ment to MPGE QPP on behalf of a tax-
payer to which paragraph (f)(2) of this sec-
tion applies, and the QPP under the con-
tract or agreement is subject to paragraph
(f)(2)(ii) of this section, then, notwith-
standing the requirements of paragraph
(f)(1) of this section, the subcontractor’s
gross receipts derived from the MPGE of
the QPP in whole or in significant part
within the United States will be treated
as gross receipts derived from the lease,
rental, license, sale, exchange, or other
disposition of QPP MPGE by the sub-
contractor in whole or in significant part
within the United States.
(4)Examples. The following examples
illustrate the application of this paragraph
(f):
Example 1. X designs machines that it uses in its
trade or business. X contracts with Y, an unrelated
person, for the manufacture of the machines. The
contract between X and Y is a fixed-price contract.
The contract specifies that the machines will be man-
ufactured in the United States using X’s design. X
owns the intellectual property attributable to the de-
sign and provides it to Y with a restriction that Y may
only use it during the manufacturing process and has
no right to exploit the intellectual property. The con-
tract specifies that Y controls the details of the man-
ufacturing process while the machines are being pro-
duced; Y bears the risk of loss or damage during man-
ufacturing of the machines; and Y has the economic
loss or gain upon the sale of the machines based on
the difference between Y’s costs and the fixed price.
Y has legal title during the manufacturing process and
legal title to the machines is not transferred to X until
final manufacturing of the machines has been com-
pleted. Based on all of the facts and circumstances,
pursuant to paragraph (f)(1) of this section Y has the
benefits and burdens of ownership of the machines
under Federal income tax principles during the period
the manufacturing occurs and, as a result, Y is treated
as the manufacturer of the machines.
Example 2. X designs and engineers machines
that it sells to customers. X contracts with Y, an un-
related person, for the manufacture of the machines.
The contract between X and Y is a cost-reimbursable
type contract. Assume that X has the benefits and
burdens of ownership of the machines under Federal
income tax principles during the period the manufac-
turing occurs except that legal title to the machines is
not transferred to X until final manufacturing of the
machines is completed. Based on all of the facts and
circumstances, X is treated as the manufacturer of the
machines under paragraph (f)(1) of this section.
Example 3. X manufactures machines within the
United States pursuant to acontract with the Federal
government and the Federal Acquisition Regulation
requires that the title or risk of loss with respect to the
machines be transferred to the Federal government
before X completes manufacture of the machines. X
subcontracts with Y, an unrelated person, for the man-
ufacture of components for the machines that Y man-
ufactures within the United States. Assume that the
machines manufactured by X,and the components for
the machines manufactured by Y, are QPP. Both the
machines and components are subject to the Federal
Acquisition Regulation that requires title or risk of
loss with respect to the machines and components be
transferred to the Federal government before manu-
facturing of the machines and components are com-
plete. Under paragraph (f)(2) of this section, the gross
receipts derived by X from the manufacture within
the United States of the machines for the Federal gov-
ernment are treated as having been derived from the
lease, rental, license, sale, exchange, or other dispo-
sition of the machines manufactured by X in whole
or in significant part within the United States. Under
paragraph (f)(3) of this section, the gross receipts de-
rived by Y from the manufacture within the United
States of the components for X are also treated as
having been derived from the lease, rental, license,
sale, exchange, or other disposition of the compo-
nents manufactured by Y in whole or in significant
part within the United States.
(g)Definition of in whole or in signif-
icant part—(1)In general.QPPmustbe
MPGE in whole or in significant part by
the taxpayer and in whole or in significant
part within the United States to qualify un-
der section 199(c)(4)(A)(i)(I). If a taxpayer
enters into a contract with an unrelated per-
son for the unrelated person to MPGE QPP
for the taxpayer and the taxpayer has the
benefits and burdens of ownership of the
QPP under applicable Federal income tax
principles during the period the MPGE ac-
tivity occurs, then, pursuant to paragraph
(f)(1) of this section, the taxpayer is con-
sidered to MPGE the QPP under this sec-
tion. The unrelated person must perform
2006–25 I.R.B.1089June 19, 2006

the MPGE activity on behalf of the tax-
payer in whole or in significant part within
the United States in order for the taxpayer
to satisfy the requirements of this para-
graph (g)(1).
(2)Substantial in nature.QPPwill
be treated as MPGE in significant part
by the taxpayer within the United States
for purposes of paragraph (g)(1) of this
section if the MPGE of the QPP by the
taxpayer within the United States is sub-
stantial 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 QPP,
and the nature of the MPGE activity that
the taxpayer performs within the United
States. The MPGE of a key component of
QPP does not, in itself, meet the substan-
tial-in-nature requirement with respect to
the QPP under this paragraph (g)(2). In
the case of tangible personal property (as
defined in paragraph (j)(2) of this section),
research and experimental activities under
section 174 and the creation of intangi-
ble assets are not taken into account in
determining whether the MPGE of QPP
is substantial in nature for any QPP other
than computer software (as defined in
paragraph (j)(3) of this section) and sound
recordings (as definedin paragraph (j)(4)
of this section). Thus, for example, a tax-
payer may take into account its design and
development activities when determining
whether its MPGE of computer software
is substantial in nature.
(3)Safe harbor—(i)In general.Atax-
payer will be treated as having MPGE QPP
in whole or in significant part within the
United States for purposes of paragraph
(g)(1) of this section if, in connection with
the QPP, the direct labor and overhead of
such taxpayer to MPGE the QPP within
the United States account for 20 percent or
more of the taxpayer’s CGS of the QPP,
or in a transaction without CGS (for ex-
ample, a lease, rental, or license) account
for 20 percent or more of the taxpayer’s
unadjusted depreciable basis(as defined
in paragraph (g)(3)(ii) of this section) in
the QPP. For taxpayers subject to section
263A, overhead is all costs required to be
capitalized under section 263A except di-
rect materials and direct labor. For taxpay-
ers 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 tax-
payer were subject to section 263A. Re-
search and experimental expenditures un-
der section 174 and the costs of creating
intangible assets are not taken into account
in determining direct labor or overhead for
any tangible personal property. However,
for a special rule regarding computer soft-
ware and sound recordings, see paragraph
(g)(3)(iii) of this section. In the case of
tangible personal property (as defined in
paragraph (j)(2) of this section), research
and experimental expenditures under sec-
tion 174 and any other costs incurred in
the creation of intangible assets may be
excluded from CGS or unadjusted depre-
ciable basis for purposes of determining
whether the taxpayer meets the safe harbor
under this paragraph (g)(3).
(ii)Unadjusted depreciable basis.The
termunadjusted depreciable basismeans
the basis of property for purposes of sec-
tion 1011 without regard to any adjust-
ments described in section 1016(a)(2) and
(3). This basis does not reflect the reduc-
tion in basis for—
(A) Any portion of the basis the tax-
payer properly elects to treat as an expense
under section 179 or 179C; or
(B) Any adjustments to basis provided
by other provisions of the Code and the
regulations under the Code (for example,
areductioninbasisbytheamountofthe
disabled access credit pursuant to section
44(d)(7)).
(iii)Computer software and sound
recordings. In determining direct labor
and overhead under paragraph (g)(3)(i) of
this section, the costs of direct labor and
overhead for developing computer soft-
ware as described in Rev. Proc. 2000–50,
2000–2 C.B. 601 (see §601.601(d)(2) of
this chapter), research and experimental
expenditures under section 174, and any
other costs of creating intangible assets for
computer softwareand sound recordings
are treated as direct labor and overhead.
These costs must be included in the tax-
payer’s CGS or unadjusted depreciable
basis of computer software and sound
recordings for purposes of determining
whether the taxpayer meets the safe harbor
under paragraph (g)(3)(i) of this section. If
the taxpayer expects to lease, rent, license,
sell, exchange, or otherwise dispose of
computer software or sound recordings
over more than one taxable year, the costs
of developing computer software as de-
scribed in Rev. Proc. 2000–50, 2000–2
C.B. 601, research and experimental ex-
penditures under section 174, and any
other costs of creating intangible assets
for computer software and sound record-
ings must be allocated over the estimated
number of units that the taxpayer expects
to lease, rent, license, sell, exchange, or
otherwise dispose of.
(4)Special rules—(i)Contract with an
unrelated person. If a taxpayer enters into
a contract with an unrelated person for the
unrelatedpersontoMPGEQPPwithinthe
United States for the taxpayer, and the tax-
payer is considered to MPGE the QPP pur-
suant to paragraph (f)(1) of this section,
then, for purposes of the substantial-in-na-
ture requirement under paragraph (g)(2)
of this section and the safe harbor un-
der paragraph (g)(3)(i) of this section, the
taxpayer’s MPGE or production activities
or direct labor and overhead shall include
both the taxpayer’s MPGE or production
activities or direct labor and overhead to
MPGE the QPP within the United States as
well as the MPGE or production activities
or direct labor and overhead of the unre-
latedpersontoMPGEtheQPPwithinthe
United States under the contract.
(ii)Aggregation.In determining
whether the substantial-in-nature require-
ment under paragraph (g)(2) of this section
or the safe harbor underparagraph (g)(3)(i)
of this section is met at the time the tax-
payerdisposesofanitemofQPP—
(A) An EAG member must take into ac-
count all of the previous MPGE or produc-
tion activities or direct labor and overhead
of the other members of the EAG;
(B) An EAG partnership (as defined in
§1.199–9(j)) must take into account all of
the previous MPGE or production activ-
ities or direct labor and overhead of all
members of the EAG in which the partners
of the EAG partnership are members (as
well as the previous MPGE or production
activities of any other EAG partnerships
owned by members of the same EAG);
(C) A member of an EAG in which
the partners of an EAG partnership are
members must take into account all of the
previous MPGE or production activities
or direct labor and overhead of the EAG
partnership (as well as those of any other
members of the EAG and any previous
June 19, 200610902006–25 I.R.B.

MPGE or production activities of any
other EAG partnerships owned by mem-
bers of the same EAG); and
(D)Apartnerofaqualifyingin-kind
partnership (as defined in §1.199–9(i))
must take into account all of the previous
MPGE or production activities or direct la-
bor and overhead of the qualifying in-kind
partnership.
(5)Examples. The following examples
illustrate the application of this paragraph
(g):
Example 1. X purchases from Y, an unrelated per-
son, unrefined oil extracted outside the United States.
X refines the oil in the United States. The refining of
the oil by X is an MPGE activity that is substantial in
nature.
Example 2. X purchases gemstones and precious
metal from outside the United States and then uses
these materials to produce jewelry within the United
States by cutting and polishing the gemstones, melt-
ing and shaping the metal, and combining the finished
materials. X’s MPGE activities are substantial in na-
ture under paragraph (g)(2) of this section. Therefore,
X has MPGE the jewelry in significant part within the
United States.
Example 3.(i)Facts. X operates an automobile
assembly plant in the United States. In connection
with such activity, X purchases assembled engines,
transmissions, and certain other components from Y,
an unrelated person, and X assembles all of the com-
ponent parts into an automobile. X also conducts
stamping, machining, and subassembly operations,
and X uses tools, jigs, welding equipment, and other
machinery and equipment in the assembly of automo-
biles. On a per-unit basis, X ’s selling price and costs
of such automobiles are as follows:
Selling price: $2,500
Cost of goods sold:
Material — Acquired from Y: $1,475
Direct labor and overhead: $325
Total cost of goods sold: $1,800
Gross profit: $700
Administrative and selling expenses: $300
Taxable income: $400
(ii)
Analysis. Although X’s direct labor and over-
head are less than 20% of total CGS ($325/$1,800,
or 18%) and X is not within the safe harbor under
para
graph (g)(3)(i) of this section, the activities con-
ducted by X in connection with the assembly of an
automobile are substantial in nature under paragraph
(g)
(2) of this section taking into account the nature
of X’s activity and the relative value of X’s activity.
Therefore, X’s automobiles will be treated as MPGE
in s
ignificant part by X within the United States for
purposes of paragraph (g)(1) of this section.
Example 4. X imports into the United States
QPP
that is partially manufactured. Assume that X
completes the manufacture of the QPP within the
United States and X’s completion of the manufac-
tu
ring of the QPP within the United States satisfies
the in-whole-or-in-significant-part requirement un-
der paragraph (g)(1) of this section. Therefore, X’s
gr
oss receipts from the lease, rental, license, sale,
exchange, or other disposition of the QPP qualify as
DPGR if all other applicable requirements under this
s
ection are met.
Example 5. X manufactures QPP in significant
part within the United States and exports the QPP for
f
urther manufacture outside the United States. X re-
tains title to the QPP while the QPP is being further
manufactured outside the United States. Assuming
X
meets all the requirements under this section for
the QPP after the further manufacturing, X’s gross
receipts derived from the lease, rental, license, sale,
exchange, or other disposition of the QPP will be con-
sidered DPGR, regardless of whether the QPP is im-
ported back into the United States prior to the lease,
rental, license, sale, exchange, or other disposition of
the QPP.
Example 6. X is a retailer within the United States
that sells cigars and pipe tobacco that X purchases
from an unrelated person. While being displayed and
offered for sale by X, the cigars and pipe tobacco age
on X’s shelves in a room with controlled temperature
and humidity. Although X’s cigars and pipe tobacco
may become more valuable as they age, the gross re-
ceipts derived by X from the sale of the cigars and
pipe
tobacco are non-DPGR because the aging of the
cigars and pipe tobacco while being displayed and of-
fered for sale by X does not qualify as an MPGE ac-
tivi
ty that is substantial in nature.
Example 7. X incurs $1,000,000 in computer
software development costs in direct labor and over-
head
to develop computer software. X begins pro-
ducing the computer software and expects to license
one million copies of the computer software. In de-
ter
mining its direct labor and overhead for the com-
puter software under paragraph (g)(3)(i) of this sec-
tion, X must allocate under paragraph (g)(3)(iii) of
thi
s section the $1,000,000 to the computer software
X expects to produce. Thus, for each copy of the
computer software produced by X, $1 ($1,000,000 in
co
mputer software development costs/one million es-
timated number of units to be licensed) in computer
software development costs are treated as direct labor
an
d overhead.
Example 8. X creates computer software for mi-
crowave ovens. X also manufactures the electric mo-
to
rs used in the ovens. X purchases the other compo-
nents of the microwave ovens from unrelated persons.
X sells each microwave oven individually to cus-
t
omers. Assume that X’s assembly of the finished mi-
crowave ovens is not minor assembly. To determine
whether the manufacture of the microwave ovens sat-
i
sfies the safe harbor under paragraph (g)(3)(i) of this
section, X’s direct labor and overhead include X’s
direct labor and overhead for creating the computer
software, manufacturing theelectric motors, and as-
sembling the finished microwave ovens that are of-
fered for sale.
Example 9. X designs shirts within the United
States, but X cuts and sews the shirts outside of the
United States. Because X’s design activity is the cre-
ation of an intangible, its design activity is not taken
into account in determining whether the manufacture
of the shirts is substantial in nature under paragraph
(g)(2) of this section, and the costs X incurs in creat-
ing the design of the shirts are not direct labor or over-
head under paragraph (g)(3)(i) of this section. There-
fore
, X has not MPGE the shirts in significant part
within the United States.
Example 10. X manufactures computer chips
with
in the United States. X installs the computer
chips that it manufactures in computers that X pur-
chases from unrelated persons and sells the finished
comp
uters individually to customers. The computer
chips are key components of the computers and
the computers will not operate without them. The
man
ufacture of the computer chips is not, in itself,
substantial in nature with respect to the finished
computers. Therefore, the taxpayer’s MPGE ac-
tiv
ities must meet either the substantial-in-nature
requirement under paragraph (g)(2) of this section,
or the safe harbor under paragraph (g)(3) of this sec-
ti
on, in order to qualify with respect to the finished
computers.
(h)Definition of United States.For
purposes of this section, the termUnited
Statesincludes the 50 states, the District
of Columbia, the territorial waters of the
United States, and the seabed and subsoil
of those submarine areas that are adjacent
to the territorial waters of the United States
and over which the United States has ex-
clusive rights, in accordance with interna-
tional law, with respect to the exploration
and exploitation of natural resources. The
termUnited Statesdoes not include pos-
sessions and territories of the United States
or the airspace or space over the United
States and these areas.
(i)Derived from the lease, rental, li-
cense, sale, exchange, or other disposi-
tion—(1)In general—(i)Definition.The
termderived from the lease, rental, license,
sale, exchange, or other dispositionis de-
fined as, and limited to, the gross receipts
directly derived from the lease, rental, li-
2006–25 I.R.B.1091June 19, 2006

cense, sale, exchange, or other disposition
of QPP, a qualified film, or utilities, even if
the taxpayer has already recognized gross
receipts from a previous lease, rental, li-
cense, sale, exchange, or other disposition
of the same QPP, qualified film, or utili-
ties. Applicable Federal income tax prin-
ciples apply to determine whether a trans-
action is, in substance, a lease, rental, li-
cense, sale, exchange, or other disposition,
whether it is a service, or whether it is some
combination thereof.
(ii)Lease income. The financing and
interest components of a lease of QPP or a
qualified film are considered to be derived
from the lease of such QPP or qualified
film. However, any portion of the lease
income that is attributable to services or
non-qualified property as defined in para-
graph (i)(4) of this section is not derived
fromtheleaseofQPPoraqualifiedfilm.
(iii)Income substitutes. The proceeds
from business interruption insurance, gov-
ernmental subsidies,and governmental
payments not to produce are treated as
gross receipts derived from the lease,
rental, license, sale, exchange, or other
disposition to the extent that they are
substitutes for grossreceipts that would
qualify as DPGR.
(iv)Exchange of property—(A)Tax-
able exchanges. Except as provided in
paragraph (i)(1)(iv)(B) of this section, the
value of property received by a taxpayer
in a taxable exchange of QPP MPGE in
whole or in significant part by the taxpayer
within the United States, a qualified film
produced by the taxpayer, or utilities pro-
duced by the taxpayer within the United
States is DPGR for the taxpayer (assuming
all the other requirements of this section
are met). However, unless the taxpayer
meets all of the requirements under this
section with respect to any further MPGE
bythetaxpayeroftheQPPoranyfurther
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, be-
cause the taxpayer did not MPGE or pro-
duce such property, even if the property
was QPP, a qualified film, or utilities in the
hands of the other party to the transaction.
(B)Safe harbor. For purposes of para-
graph (i)(1)(iv)(A) of this section, the
gross receipts derived by the taxpayer
from the sale of eligible property (as de-
fined in paragraph (i)(1)(iv)(C) of this
section) received in a taxable exchange,
net of any adjustments between the par-
ties 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. For purposes of the
preceding sentence, the taxable exchange
is deemed to occur on the date of the
sale of the eligible property received in
the taxable exchange by the taxpayer, to
the extent 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. 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-signif-
icant-part requirement under paragraph
(g)(1) of this section with respect to the
property sold, for purposes of this para-
graph (i)(1)(iv)(B), the taxpayer must also
value the property sold without taking into
account the gross receipts attributable to
the further MPGE or production activity.
(C)Eligible property. For purposes of
paragraph (i)(1)(iv)(B) of this section, eli-
gible property is—
(1) Oil, natural gas (as described in
paragraph (l)(2) of this section), or petro-
chemicals, or products derived from oil,
natural gas, or petrochemicals; or
(2) Any other property or product des-
ignated by publication in the Internal Rev-
enue Bulletin (see §601.601(d)(2)(ii)(b)of
this chapter).
(2)Examples. The following exam-
ples illustrate the application of paragraph
(i)(1) of this section:
Example 1. X MPGE QPP in whole or in signif-
icant part within the United States and uses the QPP
in its business. After several years X sells the QPP
that it MPGE to Y. The gross receipts derived from
thesaleoftheQPPtoYareDPGR(assumingallthe
other requirements of this section are met).
Example 2. X MPGE QPP within the United
States and sells the QPP to Y, an unrelated person. Y
leases the QPP for 3 years to Z, a taxpayer unrelated
to both X and Y, and shortly after Y enters into the
lease with Z, X repurchases the QPP from Y subject
to the lease. At the end of the lease term, Z purchases
the QPP from X. X’s proceeds derived from the sale
of the QPP to Y, from the lease to Z (including any
financing and interest components of the lease), and
from the sale of the QPP to Z all qualify as DPGR
(assuming all the other requirements of this section
are met).
Example 3. X MPGE QPP within the United
States and sells the QPP to Y, an unrelated person,
for $25,000. X finances Y’s purchase of the QPP and
receives total payments of$35,000, of which $10,000
relates to interest and finance charges. The $25,000
qualifies as DPGR, but the $10,000 in interest and
finance charges do not qualify as DPGR because the
$10,000 is not derived from the MPGE of QPP within
the United States, but rather from X’s lending activ-
ity.
Example 4. Cable company X charges sub-
scribers $15 a month for its basic cable television. Y,
an unrelated person, produces a qualified film within
the meaning of paragraph (k)(1) of this section that
it licenses to X for $.10 per subscriber per month.
The gross receipts derived by Y are derived from the
license of a qualified film produced by Y and are
DPGR (assuming all the other requirements of this
section are met).
Example 5. X manufactures cars within the
United States. X also manufactures replacement
parts within the United States. The replacement parts
are QPP under paragraph (j)(1) of this section. X
offers extended warranties to its customers. X sells
a car to Y. Y purchases an extended warranty and
brings the car to X’s service department for mainte-
nance. X repairs the car and replaces damaged parts
with replacement parts that X manufactured within
the United States. The portion of X’s gross receipts
derived from the sale of the extended warranty relat-
ing to the manufactured parts are DPGR.
(3)Hedging transactions—(i)In gen-
eral. For purposes of this section, pro-
vided that the risk being hedged relates
to QPP described in section 1221(a)(1)
or relates to property described in section
1221(a)(8) consumed in an activity giv-
ingrisetoDPGR,andprovidedthatthe
transaction is a hedging transaction within
the meaning of section 1221(b)(2)(A) and
§1.1221–2(b) and is properly identified as
a hedging transaction in accordance with
§1.1221–2(f), then—
(A) In the case of a hedge of pur-
chases of property described in section
1221(a)(1), gain or loss on the hedging
transaction must be taken into account in
determining CGS;
(B) In the case of a hedge of sales of
property described in section 1221(a)(1),
gain or loss on the hedging transaction
must be taken into account in determining
DPGR; and
(C) In the case of a hedge of pur-
chases of property described in section
1221(a)(8), gain or loss on the hedging
transaction must be taken into account in
determining DPGR.
(ii)Currency fluctuations.Forpur-
poses of this section, in the case of a trans-
action that manages the risk of currency
June 19, 200610922006–25 I.R.B.

fluctuations, the determination of whether
the transaction is a hedging transaction
within the meaning of §1.1221–2(b) is
made without regard to whether the trans-
action is a section 988 transaction. See
§1.1221–2(a)(4). Thepreceding sentence
applies only to the extent that §1.988–5(b)
does not apply.
(iii)Effect of identification and non-
identification. If a taxpayer does not make
an identification that satisfies all of the re-
quirements of §1.1221–2(f) but the tax-
payer has no reasonable grounds for treat-
ing the transaction as other than a hedging
transaction, then a loss from the transac-
tion is taken into account under this para-
graph (i)(3). If the inadvertent identifica-
tion rule of §1.1221–2(g)(1)(ii) or the in-
advertent error rule of §1.1221–2(g)(2)(ii)
applies, then the taxpayer is treated as not
having identified the transaction as a hedg-
ing transaction or as having identified the
transaction as a hedging transaction, as the
case may be. If a taxpayer identifies a
transaction as a hedging transaction in ac-
cordance with §1.1221–2(f)(1), then—
(A) That identification is binding with
respect to loss for purposes of this para-
graph (i)(3), whether or not all of the
requirements of §1.1221–2(f) are satis-
fied and whether or not the transaction is
in fact a hedging transaction within the
meaning of section 1221(b)(2)(A) and
§1.1221–2(b), and
(B) This paragraph (i)(3) does not ap-
ply to require gain to be taken into ac-
count in determining CGS or DPGR, if
the transaction is not in fact a hedging
transaction within the meaning of section
1221(b)(2)(A) and §1.1221–2(b).
(iv)Other rules. See §1.1221–2(e) for
rules applicable to hedging by members
of a consolidated group and §1.446–4 for
rules regarding the timing of income, de-
ductions, gains, or losses with respect to
hedging transactions.
(4)Allocation of gross receipts—(i)
Embedded services and non-qualified
property—(A)In general. Except as oth-
erwise provided in paragraph (i)(4)(i)(B),
paragraph (m) (relatingtoconstruction),
and paragraph (n) (relating to engineer-
ing and architectural services) of this
section, gross receipts derived from the
performance of services do not qualify as
DPGR.Inthecaseofanembeddedser-
vice, that is, a service the price of which,
in the normal course of the taxpayer’s
business, is not separately stated from
the amount charged for the lease, rental,
license, sale, exchange, or other disposi-
tion of QPP, a qualified film, or utilities,
DPGR include only the gross receipts de-
rived from the lease, rental, license, sale,
exchange, or other disposition of QPP, a
qualified film, or utilities (assuming all
the other requirements of this section are
met) and not any receipts attributable to
the embedded service. In addition, DPGR
does not include the gross receipts derived
from the lease, rental, license, sale, ex-
change, or other disposition of property
that does not meet all of the requirements
under this section (non-qualified prop-
erty). The allocation of the gross receipts
attributable to the embedded services or
non-qualified property will be deemed
to be reasonable if the allocation reflects
the fair market value of the embedded
services or non-qualified property. For
example, gross receipts derived from the
lease, rental, license, sale, exchange, or
other disposition of a replacement part that
is non-qualified property does not qualify
as DPGR. In addition, see §1.199–1(e)
for other instances when an allocation of
gross receipts attributable to embedded
services or non-qualified property will be
deemed reasonable.
(B)Exceptions. There are six ex-
ceptions to the rulesunder paragraph
(i)(4)(i)(A) of this section regarding em-
bedded services and non-qualified prop-
erty. A taxpayer may include in DPGR, if
all the other requirements of this section
are met with respect to the underlying
item of QPP, qualified films, or utilities to
which the embedded services or non-qual-
ified property relate, the gross receipts
derived from—
(1) A qualified warranty, that is, a
warranty (other than a computer software
maintenance agreement described in para-
graph (i)(4)(i)(B)(5) of this section) that
is provided in connection with the lease,
rental, license, sale, exchange, or other
disposition of QPP, a qualified film, or
utilities if, in the normal course of the
taxpayer’s business—
(i) The price for the warranty is not sep-
arately stated from the amount charged for
the lease, rental, license, sale, exchange,
or other disposition of the QPP, qualified
film, or utilities; and
(ii) The warranty is neither separately
offered by the taxpayer nor separately bar-
gained for with customers (that is, a cus-
tomer cannot purchase the QPP, qualified
film, or utilities without the warranty);
(2) A qualified delivery, that is, a de-
livery or distribution service that is pro-
vided in connection with the lease, rental,
license, sale, exchange, or other disposi-
tion of QPP if, in the normal course of the
taxpayer’s business—
(i) The price for the delivery or distri-
bution service is not separately stated from
the amount charged for the lease, rental, li-
cense, sale, exchange, or other disposition
of the QPP; and
(ii) The delivery or distribution service
is neither separately offered by the tax-
payer nor separately bargained for with
customers (that is, a customer cannot pur-
chase the QPP without the delivery or dis-
tribution service);
(3) A qualified operating manual, that
is, a manual of instructions (including elec-
tronic instructions) that is provided in con-
nection with the lease, rental, license, sale,
exchange, or other disposition of QPP, a
qualified film or utilities if, in the normal
course of the taxpayer’s business—
(i) The price for the manual is not sep-
arately stated from the amount charged for
the lease, rental, license, sale, exchange,
or other disposition of the QPP, qualified
film, or utilities;
(ii) The manual is neither separately of-
fered by the taxpayer nor separately bar-
gained for with customers (that is, a cus-
tomer cannot purchase the QPP, qualified
film, or utilities without the manual); and
(iii) The manual is not provided in
connection with a training course for cus-
tomers;
(4) A qualified installation, that is, an
installation service (including minor as-
sembly) for tangible personal property that
is provided in connection with the lease,
rental, license, sale, exchange, or other dis-
position of the tangible personal property
if, in the normal course of the taxpayer’s
business—
(i) The price for the installation service
is not separately stated from the amount
charged for the lease, rental, license, sale,
exchange, or other disposition of the tan-
gible personal property; and
(ii) The installation is neither separately
offered by the taxpayer nor separately bar-
gained for with customers (that is, a cus-
tomer cannot purchase the tangible per-
2006–25 I.R.B.1093June 19, 2006

sonal property without the installation ser-
vice);
(5) Services performed pursuant to a
qualified computer software maintenance
agreement. A qualified computer software
maintenance agreement is an agreement
provided in connection with the lease,
rental, license, sale, exchange, or other
disposition of the computer software that
entitles the customer to receive future
updates, cyclical releases, rewrites of the
underlying software, or customer support
services for the computer software if, in
the normal course of the taxpayer’s busi-
ness—
(i) The price for the agreement is not
separately stated from the amount charged
for the lease, rental, license, sale, ex-
change, or other disposition of the com-
puter software; and
(ii) The agreement is neither separately
offered by the taxpayer nor separately bar-
gained for with customers (that is, a cus-
tomer cannot purchase the computer soft-
ware without the agreement); and
(6)Ade minimisamount of gross re-
ceipts from embedded services and non-
qualified property for each item of QPP,
qualified films, or utilities. For purposes
of the preceding sentence, ade minimis
amount of gross receipts from embedded
services and non-qualified property is less
than 5 percent of the total gross receipts de-
rived from the lease, rental, license, sale,
exchange, or other disposition of each item
of QPP, qualified films, or utilities. In
the case of gross receipts derived from the
lease, rental, license, sale, exchange, or
other disposition of QPP, a qualified film,
or utilities that are received over a period
of time (for example, a multi-year lease or
installment sale), thisde minimisexcep-
tion is applied by taking into account the
total gross receipts for the entire period de-
rived (and to be derived) from the lease,
rental, license, sale, exchange, or other
disposition of the item of QPP, qualified
films, or utilities. For purposes of the pre-
ceding sentence, if a taxpayer treats gross
receipts as DPGR under thisde minimis
exception, then the taxpayer must treat the
gross receipts recognized in each taxable
year consistently as DPGR. The gross re-
ceipts that the taxpayer treats as DPGR un-
der paragraphs (i)(4)(i)(B)(1), (2), (3), (4),
and (5)and(l)(4)(iv)(A)ofthissectionare
treated as DPGR for purposes of applying
thisde minimisexception. Thisde minimis
exception does not apply if the price of a
service or non-qualified property is sepa-
rately stated by the taxpayer, or if the ser-
vice or non-qualified property is separately
offered or separately bargained for with the
customer (that is, the customer can pur-
chase the QPP, qualified film, or utilities
without the service or non-qualified prop-
erty).
(ii)Non-DPGR. All of a taxpayer’s
gross receipts derived from the lease,
rental, license, sale, exchange or other dis-
position of an item of QPP, qualified films,
or utilities may be treated as non-DPGR
if less than 5 percent of the taxpayer’s
total gross receipts derived from the lease,
rental, license, sale, exchange or other
disposition of that item are DPGR. In the
case of gross receipts derived from the
lease, rental, license, sale, exchange, or
other disposition of QPP, a qualified film,
and utilities that are received over a period
of time (for example, a multi-year lease or
installment sale), this paragraph (i)(4)(ii)
is applied by taking into account the total
gross receipts for the entire period derived
(and to be derived) from the lease, rental,
license, sale, exchange, or other disposi-
tion of the item of QPP, qualified films,
or utilities. For purposes of the preceding
sentence, if a taxpayer treats gross receipts
as non-DPGR under thisde minimisex-
ception, then the taxpayer must treat the
gross receipts recognized in each taxable
year consistently as non-DPGR.
(iii)Examples. The following examples
illustrate the application of this paragraph
(i)(4):
Example 1. X MPGE QPP within the United
States. As part of the sale of the QPP to Z, X trains
Z’s employees on how to use and operate the QPP. No
other services or property are provided to Z in con-
nection with the sale of the QPP to Z. In the normal
course of X’s business, the QPP and training services
are separately stated in the sales contract. Because,
in the normal course of the X’s business, the training
services are separately stated, the training services are
not treated as embedded services under thede min-
imisexception in paragraph (i)(4)(i)(B)(6) of this sec-
tion.
Example 2. The facts are the same as inExam-
ple 1except that, in the normal course of X’s busi-
ness, the training services are not separately stated in
the sales contract and thecustomer cannot purchase
the QPP without the training services. If the gross re-
ceipts for the embedded training services are less than
5% of the gross receipts derived from the sale of X’s
QPP to Z, after applying the exceptions under para-
graphs (i)(4)(i)(B)(1) through (5) of this section, then
the gross receipts may be included in DPGR under
thede minimisexception in paragraph (i)(4)(i)(B)(6)
of this section.
Example 3. X MPGE QPP within the United
States. As part of the sale of the QPP to retailers,
X charges a fee for delivering the QPP. In the nor-
mal course of X’s business, the price of the QPP and
the delivery fee are separately stated in X’s sales con-
tracts. Because, in the normal course of X’s busi-
ness, the delivery fee is separately stated, the deliv-
ery fee does not qualify as DPGR under the qualified
delivery exception in paragraph (i)(4)(i)(B)(2)ofthis
section or thede minimisexception under paragraph
(i)(4)(i)(B)(6) of this section. The result would be the
same even if the retailer’s customers cannot purchase
the QPP without paying the delivery fee.
Example 4.(i)Facts. X manufactures indus-
trial sewing machines within the United States that
X offers for sale individually to customers. X en-
ters into a single, lump-sum priced contract with Y,
an unrelated person, and the contract has the follow-
ing terms: X will manufacture industrial sewing ma-
chines within the United States for Y; X will deliver
the industrial sewing machines to Y; X will provide a
one-year warranty on the industrial sewing machines;
X will provide operating manuals with the industrial
sewing machines; X will provide 100 hours of train-
ing and training manuals to Y’s employees on the use
and maintenance of the industrial sewing machines;
X will provide purchased spare parts for the industrial
sewing machines; and X will provide a 3-year service
agreement for the industrial sewing machines. In the
normal course of X’s business, none of the services or
property described above are separately stated, sepa-
rately offered or separately bargained for.
(ii)Analysis. The receipts for the manufacture
of the industrial sewing machines are DPGR under
paragraphs (e)(1) and (g) of this section (assuming
all the other requirements of this section are met). X
may include in DPGR the gross receipts derived from
delivering the industrial sewing machines, which is
a qualified delivery under paragraph (i)(4)(i)(B)(2)
of this section; the gross receipts derived from the
one-year warranty, which is a qualified warranty
under paragraph (i)(4)(i)(B)(1)ofthissection;and
the gross receipts derived from the operating man-
uals, which is a qualified operating manual under
paragraph (i)(4)(i)(B)(3) of this section. If the gross
receipts allocable to each industrial sewing machine
for the embedded services consisting of the employee
training and 3-year service agreement, and for the
non-qualified property consisting of the purchased
spare parts and the employee training manuals, which
are not qualified operating manuals, are in total less
than 5% of the gross receipts derived from the sale
of each industrial sewing machine to Y (after apply-
ing the exceptions under paragraphs (i)(4)(i)(B)(1
)
through (5) of this section), then those gross receipts
may be included in DPGR under thede minimis
exception in paragraph (i)(4)(i)(B)(6) of this section.
If, however, the gross receipts allocable to each
industrial sewing machine for the embedded services
and non-qualified property consisting of employee
training, the 3-year service agreement, purchased
spare parts, and employee training manuals equal
or exceed, in total, 5% of the gross receipts derived
from the sale of each industrial sewing machine to
Y (after applying the exceptions under paragraphs
(i)(4)(i)(B)(1) through (5) of this section), then those
gross receipts do not qualify as DPGR under thede
minimisexception in paragraph (i)(4)(i)(B)(6)ofthis
June 19, 200610942006–25 I.R.B.

section (and X must allocate gross receipts between
DPGR and non-DPGR under §1.199–1(d)(1)).
(5)Advertising income—(i)Tangible
personal property. A taxpayer’s gross
receipts that are derived from the lease,
rental, license, sale, exchange, or other
disposition of newspapers, magazines,
telephone directories, periodicals, and
other similar printed publications that are
MPGE in whole or in significant part
within the United States include advertis-
ing income from advertisements placed in
those media, but only if the gross receipts,
if any, derived from the lease, rental, li-
cense, sale, exchange, or other disposition
of the newspapers, magazines, telephone
directories, or periodicals are (or would
be) DPGR.
(ii)Qualified film. A taxpayer’s gross
receipts that are derived from the lease,
rental, license, sale, exchange, or other dis-
position of a qualified film include adver-
tising income and product-placement in-
come with respect to that qualified film,
that is, compensation for placing or inte-
grating advertising or a product into the
qualified film, but only if the gross re-
ceipts, if any, derived from the qualified
film are (or would be) DPGR.
(iii)Examples. The following examples
illustrate the application of this paragraph
(i)(5):
Example 1. X MPGE, and sells, newspapers
within the United States. X’s gross receipts from
the newspapers include gross receipts derived from
the sale of newspapers to customers and payments
from advertisers to publish display advertising or
classified advertisements in X’s newspapers. X’s
gross receipts described above are DPGR derived
from the sale of X’s newspapers.
Example 2. ThefactsarethesameasinExam-
ple 1except that X disposes of the newspapers free
of charge to customers, rather than selling them. X’s
gross receipts from the display advertising or classi-
fied advertisements are DPGR.
Example 3. X produces two live television pro-
grams that are qualified films. X licenses the first
television program to Y’s television station and X li-
censes the second television program to Z’s televi-
sion station. Z broadcasts the second television pro-
gram on its station. Both television programs con-
tain product placements and advertising for which X
received compensation. X and Y are unrelated per-
sons. X and Z are non-consolidated members of an
EAG. The gross receipts derived by X from licensing
the first television program to Y are DPGR. As a re-
sult, pursuant to paragraph (i)(5)(ii) of this section, all
of X’s product placement and advertising income for
the first television program is treated as gross receipts
that are derived from the license of the qualified film.
The gross receipts derivedby X from licensing the
second television program to Z are non-DPGR under
paragraph (b)(1) of this section. Paragraph (b)(2) of
this section does not apply because Z’s broadcast of
the second television program on Z’s television sta-
tion is not a lease, rental, license, sale, exchange, or
other disposition of the second television program.
As a result, pursuant to paragraph (i)(5)(ii) of this sec-
tion, none of X’s product placement and advertising
income for the second television program is treated
as gross receipts derived from the qualified film.
Example 4. The facts are the same as inExample
3except that Z sublicenses to an unrelated person the
television program instead of broadcasting the tele-
vision program on its station. The gross receipts de-
rived by X from licensing the television program to Z
are DPGR under paragraph (b)(2) of this section. As
a result, pursuant to paragraph (i)(5)(ii) of this sec-
tion, X’s product placement and advertising income
for the television program licensed to Z is treated as
gross receipts derived from the qualified film. In ad-
dition, Z’s receipts from the sublicense of the quali-
fied film are DPGR under §1.199–7(a)(3)(i).
Example 5. X produces television programs that
are qualified films. X licenses the qualified films
to Y, an unrelated person, and the license agreement
provides that X will receive advertising time slots as
part of its payments from Y under the license agree-
ment. X’s gross receipts derived from the license of
the qualified films to Y include income attributable to
the advertising time slots and are DPGR under para-
graph (b)(2) of this section.
(6)Computer software—(i)In general.
DPGR include the gross receipts of the
taxpayer that are derived from the lease,
rental, license, sale, exchange, or other dis-
position of computer software MPGE by
the taxpayer in whole or in significant part
within the United States. Such gross re-
ceipts qualify as DPGR even if the cus-
tomer provides the computer software to
its employees or others over the Internet.
(ii) through (v). [Reserved]. For further
guidance, see §1.199–3T(i)(6)(ii) through
(v).
(7)Qualifying in-kind partnership for
taxable years beginning after May 17,
2006, the enactment date of the Tax In-
crease Prevention and Reconciliation Act
of 2005. [Reserved].
(8)Partnerships owned by members of
a single expanded affiliated group for tax-
able years beginning after May 17, 2006,
the enactment date of the Tax Increase Pre-
vention and Reconciliation Act of 2005.
[Reserved].
(9)Non-operating mineral interests.
DPGR does not include gross receipts de-
rived from non-operating mineral interests
(for example, interests other than operat-
ing mineral interests within the meaning
of §1.614–2(b)).
(j)Definition of qualifying production
property—(1)In general.QPPmeans—
(i) Tangible personal property (as de-
fined in paragraph (j)(2) of this section);
(ii) Computer software (as defined in
paragraph (j)(3) of this section); and
(iii) Sound recordings (as defined in
paragraph (j)(4) of this section).
(2)Tangible personal property—(i)In
general.Thetermtangible personal prop-
ertyis any tangible property other than
land, real property described in paragraph
(m)(3) of this section, and any property de-
scribed in paragraph (j)(3), (j)(4), (k)(1),
or (l) of this section. For purposes of
the preceding sentence, tangible personal
property also includes any gas (other than
natural gas described in paragraph (l)(2)
of this section), chemical, and similar
property, for example, steam, oxygen, hy-
drogen, and nitrogen. Property such as
machinery, printing presses, transporta-
tion and office equipment, refrigerators,
grocery counters, testing equipment, dis-
play racks and shelves, and neon and other
signs that are contained in or attached to
a building constitutes tangible personal
property for purposes of this paragraph
(j)(2)(i). Except as provided in paragraphs
(j)(5)(ii) and (k)(2)(i) of this section, com-
puter software, sound recordings, and
qualified films are not treated as tangible
personal property regardless of whether
they are affixed to a tangible medium.
However, the tangible medium to which
such property may be affixed (for exam-
ple, a videocassette, a computer diskette,
or other similar tangible item) is tangible
personal property.
(ii)Local law. In determining whether
property is tangible personal property, lo-
cal law is not controlling.
(iii)Intangible property.Thetermtan-
gible personal propertydoes not include
property in a form other than in a tangi-
ble medium. For example, mass-produced
books are tangible personal property, but
neither the rights to the underlying manu-
script nor an online version of the book is
tangible personal property.
(3)Computer software—(i)In general.
The termcomputer softwaremeans any
program or routine or any sequence of
machine-readable code that is designed
to cause a computer to perform a de-
sired function or set of functions, and the
documentation required to describe and
maintain that program or routine. Thus,
for example, an electronic book available
online or for download is not computer
2006–25 I.R.B.1095June 19, 2006

software. For purposes of this paragraph
(j)(3), computer software also includes the
machine-readable code for video games
and similar programs, for equipment that
is an integral part of other property, and
for typewriters, calculators, adding and
accounting machines, copiers, duplicating
equipment, and similarequipment, regard-
less of whether the code is designed to op-
erate on a computer (as defined in section
168(i)(2)(B)). Computer programs of all
classes, for example, operating systems,
executive systems, monitors, compilers
and translators, assembly routines, and
utility programs, as well as application
programs, are included. Except as pro-
vided in paragraph (j)(5) of this section,
if the medium in which the software is
contained, whether written, magnetic, or
otherwise, is tangible, then such medium
is considered tangible personal property
for purposes of this section.
(ii)Incidental and ancillary rights.
Computer software also includes any
incidental and ancillary rights that are
necessary to effect the acquisition of the
title to, the ownership of, or the right to
use the computer software, and that are
used only in connection with that specific
computer software. Such incidental and
ancillary rights are not included in the
definition of trademark or trade name un-
der §1.197–2(b)(10)(i). For example, a
trademark or trade name that is ancillary
to the ownership or use of a specific com-
puter software program in the taxpayer’s
trade or business and is not acquired for
the purpose of marketing the computer
software is included in the definition of
computer software and is not included in
the definition of trademark or trade name.
(iii)Exceptions. Computer software
does not include any data or information
base unless the data or information base
is in the public domain and is incidental
to a computer program. For this purpose,
a copyrighted or proprietary data or infor-
mation base is treated as in the public do-
main if its availability through the com-
puter program does not contribute signif-
icantly to the cost of the program. For ex-
ample, if a word-processing program in-
cludes a dictionary feature that may be
used to spell-check a document or any
portion thereof, then the entire program
(including the dictionary feature) is com-
puter software regardless of the form in
which the dictionary feature is maintained
or stored.
(4)Sound recordings—(i)In general.
The termsound recordingsmeans any
works that result from the fixation of a
series of musical, spoken, or other sounds
under section 168(f)(4). The definition of
sound recordings is limited to the master
copy of the recordings(or other copy from
which the holder is licensed to make and
produce copies), and, except as provided
in paragraph (j)(5) of this section, if the
medium (such as compact discs, tapes,
or other phonorecordings) in which the
sounds may be embodied is tangible, then
the medium is considered tangible per-
sonal property for purposes of paragraph
(j)(2) of this section.
(ii)Exception.Thetermsound record-
ingsdoes not include the creation of copy-
righted material in a form other than a
sound recording, such as lyrics or music
composition.
(5)Tangible personal property with
computer software or sound record-
ings—(i)Computer software and sound
recordings. If a taxpayer MPGE in whole
or in significant part computer software
or sound recordings within the United
States that is affixed or added to tangible
personal property (for example, a com-
puter diskette, or an appliance), whether
or not the taxpayer MPGE such tangible
personal property in whole or in signifi-
cant part within the United States, then for
purposes of this section—
(A) The computer software and the tan-
gible personal property may be treated by
the taxpayer as computer software. If the
taxpayer treats the computer software and
the tangible personal property as computer
software, activities the cost of which are
described in Rev. Proc. 2000–50, 2000–2
C.B. 601, activities giving rise to research
and experimental expenditures under sec-
tion 174, and the creation of intangible
assets for computer software are consid-
ered in determining whether the taxpayer’s
MPGE activity is substantial in nature un-
der paragraph (g)(2) of this section. In de-
termining direct labor and overhead under
paragraph (g)(3)(i) of this section, the costs
of direct labor and overhead for develop-
ing the computer software as described in
Rev. Proc. 2000–50, 2000–2 C.B. 601, re-
search and experimental expenditures un-
der section 174, and any other costs of
creating intangible assets for the computer
software are treated as direct labor and
overhead. These costs must be included in
the taxpayer’s CGS of the computer soft-
ware for purposes of determining whether
the taxpayer meets the safe harbor under
paragraph (g)(3)(i) of this section. How-
ever, any costs under section 174, and the
costs to create intangible assets, attribut-
able to the tangible personal property are
not considered in determining whether the
taxpayer’s activity is substantial in nature
under paragraph (g)(2) of this section and
are not direct labor and overhead under
paragraph (g)(3)(i) of this section; and
(B) The sound recordings and the tan-
gible personal property with the sound
recordings may be treated by the taxpayer
as sound recordings. If the taxpayer treats
the sound recordings and the tangible
personal property as sound recordings,
activities giving rise to research and ex-
perimental expenditures under section 174
and the creation of intangible assets for
sound recordings are considered in de-
termining whether the taxpayer’s MPGE
activity is substantial in nature under para-
graph (g)(2) of this section. In determining
direct labor and overhead under paragraph
(g)(3)(i) of this section, research and ex-
perimental expenditures under section 174
and any other costs of creating intangible
assets for sound recordings are treated as
direct labor and overhead. These costs
must be included in the taxpayer’s CGS
of sound recordings for purposes of de-
termining whether the taxpayer meets the
safe harbor under paragraph (g)(3)(i) of
this section. However, any costs under
section 174, and the costs to create intan-
gible assets, attributable to the tangible
personal property are not considered in
determining whether the taxpayer’s activ-
ity is substantial in nature under paragraph
(g)(2) of this section and are not direct la-
bor and overhead under paragraph (g)(3)(i)
of this section.
(ii)Tangible personal property.Ifatax-
payer MPGE tangible personal property
(for example, a computer diskette or an
appliance) in whole or in significant part
within the United States but not the com-
puter software or sound recordings that
is affixed or added to such tangible per-
sonal property, then for purposes of this
section the tangible personal property with
the computer software or sound recordings
may be treated by the taxpayer as tangible
personal property under paragraph (j)(2)
June 19, 200610962006–25 I.R.B.

of this section. Any costs under section
174, and the costs to create intangible as-
sets, attributable to the tangible personal
property are not considered in determin-
ing whether the taxpayer’s activity is sub-
stantial in nature under paragraph (g)(2) of
this section and are not direct labor or over-
head under paragraph (g)(3)(i) of this sec-
tion. For purposes of paragraph (g)(3) of
this section, the taxpayer’s CGS (or unad-
justed depreciable basis, if applicable) for
each item of tangible personal property in-
cludes the taxpayer’s cost of leasing, rent-
ing, licensing, buying, or otherwise acquir-
ing the computer software or sound record-
ings.
(k)Definition of qualified film—(1)In
general.Thetermqualified filmmeans
any motion picture film or video tape un-
der section 168(f)(3), or live or delayed
television programming, if not less than
50 percent of the total compensation paid
to actors, production personnel, directors,
and producers relating to the production
of the motion picture film, video tape, or
television programming is compensation
paid by the taxpayer for services relating
to the production of the film performed
in the United States by those individuals.
For purposes of this paragraph (k), ac-
tors include players, newscasters, or any
other persons performing in a qualified
film. The termproduction personnelin-
cludes, for example, writers, choreogra-
phers and composers providing services
during the production of a film, casting
agents, camera operators, set designers,
lighting technicians, make-up artists, and
others whose activities are directly related
to the production of the film. Except as
provided in paragraph (k)(2) of this sec-
tion, the definition ofqualified filmdoes
not include tangible personal property em-
bodying the qualified film, such as DVDs
or videocassettes.
(2)Tangible personal property with a
film—(i)Film not produced by a taxpayer.
If a taxpayer MPGE tangible personal
property (for example, a DVD) in whole
or in significant part in the United States
and a film not produced by a taxpayer is
affixed to the tangible personal property,
then the taxpayer may treat the tangible
personal property with the affixed film
as tangible personal property, regardless
of whether the film is a qualified film.
The determination of whether the gross
receipts of such a taxpayer derived from
the lease, rental, license, sale, exchange,
or other disposition of the tangible per-
sonal property with the affixed film are
DPGR is made under the rules of this sec-
tion. For purposes of paragraph (g)(2) of
this section, in determining whether the
taxpayer’s MPGE activity is substantial
in nature, the taxpayer must consider the
value of the licensed film. For purposes
of paragraph (g)(3) of this section, the
taxpayer’s CGS (or unadjusted deprecia-
ble basis, as applicable) for each item of
tangible personal property includes the
taxpayer’s cost of leasing, renting, licens-
ing, buying, or otherwise acquiring the
film.
(ii)Film produced by a taxpayer.Ifa
taxpayer produces a film and the film is
affixed to tangible personal property (for
example, a DVD), then for purposes of this
section—
(A)Qualified film. If the film is a
qualified film, the taxpayer may treat the
tangible personal property, whether or not
the taxpayer MPGE such tangible personal
property, to which the qualified film is af-
fixed as part of the qualified film; and
(B)Nonqualified film. If the film is
not a qualified film (nonqualified film), a
taxpayer cannot treat the tangible personal
property to which the nonqualified film is
affixed as part of the nonqualified film.
(3)Derived from a qualified film—(i)
In general. DPGR include the gross re-
ceipts of a taxpayer that are derived from
any lease, rental, license, sale, exchange,
or other disposition of any qualified film
produced by such taxpayer.
(ii)Exceptions. The showing of a qual-
ified film (for example, in a movie theater
or by broadcast on a television station) by a
taxpayer is not a lease, rental, license, sale,
exchange, or other disposition of the qual-
ifiedfilmbysuchtaxpayer. Ticketsales
for viewing a qualified film do not con-
stitute DPGR because the gross receipts
are not derived from the lease, rental, li-
cense, sale, exchange, or other disposi-
tion of a qualified film. Because a tax-
payer that merely writes a screenplay or
other similar material is not considered to
have produced a qualified film under para-
graph (k)(1) of this section, the amounts
that the taxpayer receives from the sale
of the script or screenplay, even if the
script is developed into a qualified film, are
not gross receipts derived from a qualified
film. In addition, revenue from the sale of
film-themed merchandise is revenue from
the sale of tangible personal property and
not gross receipts derived from a qualified
film. Gross receipts derived from a license
of the right to use or exploit the film char-
acters are not gross receipts derived from
a qualified film.
(4)Compensation for services.The
termcompensation for servicesmeans all
payments for services performed by actors
(as described in paragraph (k)(1) of this
section), production personnel, directors,
and producers, including participations
and residuals. In the case of a taxpayer
that uses the income forecast method of
section 167(g) and capitalizes participa-
tions and residuals into the adjusted basis
of the qualified film, the taxpayer must
use the same estimate of participations
and residuals for services performed by
actors, production personnel, directors,
and producers for purposes of this section.
In the case of a taxpayer that excludes
participations and residuals from the ad-
justed basis of the qualified film under
section 167(g)(7)(D)(i), the taxpayer must
determine the compensation expected to
be paid for services performed by ac-
tors, production personnel, directors, and
producers as participations and residu-
als based on the total forecasted income
used in determining income forecast de-
preciation. Compensation for services
includes all direct and indirect compensa-
tion costs required to be capitalized under
section 263A for film producers under
§1.263A–1(e)(2) and (3). Compensation
for services is not limited to W–2 wages
and includes compensation paid to inde-
pendent contractors.
(5)Determination of 50 percent.
The not-less-than–50-percent-of-the-to-
tal-compensation requirement under para-
graph(k)(1)ofthissection is determined
by reference to all compensation paid in
the production of the film and is calcu-
lated using a fraction. The numerator of
the fraction is the compensation paid by
the taxpayer to actors, production person-
nel, directors, and producers for services
relating to the production of the film (pro-
duction services) performed in the United
States, and the denominator is the sum
of the total compensation paid by the
taxpayer to all such individuals regard-
less of where the production services are
performed and the total compensation
paid by others to all such individuals re-
2006–25 I.R.B.1097June 19, 2006

gardless of where the production services
are performed. A taxpayer may use any
reasonable method that is satisfactory to
the Secretary basedon all of the facts
and circumstances, including all historic
information available, to determine the
compensation for services performed in
the United States by actors (as described in
paragraph (k)(1) of this section), produc-
tion personnel, directors, and producers,
andthetotalcompensationpaidtothose
individuals for services relating to the pro-
duction of the film. Among the factors
to be considered in determining whether
a taxpayer’s method of allocating com-
pensation is reasonable is whether the
taxpayer uses that method consistently
from one taxable year to another.
(6)Exception.Aqualified filmdoes
not include property with respect to which
records are required to be maintained un-
der 18 U.S.C. 2257. Section 2257 of Title
18 requires maintenance of certain records
with respect to any book, magazine, pe-
riodical, film, videotape, or other matter
that—
(i) Contains one or more visual depic-
tions made after November 1, 1990, of ac-
tual sexually explicit conduct; and
(ii) Is produced in whole or in part with
materials that have been mailed or shipped
in interstate or foreign commerce, or is
shipped or transported or is intended for
shipment or transportation in interstate or
foreign commerce.
(7)Examples. The following examples
illustrate the application of this paragraph
(k):
Example 1. X produces a qualified film and du-
plicates the film onto purchased DVDs. X sells the
DVDs with the qualified film to customers. Under
paragraph (k)(2)(ii)(A) of this section, X treats the
DVD with the qualified film as a qualified film. Ac-
cordingly, X’s gross receipts derived from the sale of
the qualified film to customers are DPGR (assuming
all the other requirements of this section are met).
Example 2. The facts are the same as inExample
1except that the film is a nonqualified film because
the film does not satisfy the not-less-than–50-per-
cent-of-the-total-compensation requirement under
(k)(1) of this section and X manufactures the DVDs
in the United States. Under paragraph (k)(2)(ii)(B)
of this section, X cannot treat the DVD as part of the
nonqualified film. X’s gross receipts (not including
the gross receipts attributable to the nonqualified
film) derived from the sale of the tangible personal
property are DPGR (assuming all the other require-
ments of this section are met).
Example 3. X produces live television programs
that are qualified films. X shows the programs on its
own television station. X sells advertising time slots
to advertisers for the television programs. Because
showing a qualified film on a television station is not
a lease, rental, license, sale, exchange, or other dispo-
sition pursuant to paragraph (k)(3)(ii) of this section,
the advertising income X receives from advertisers
is not derived from the lease, rental, license, sale, ex-
change, or other disposition of the qualified films and
is non-DPGR.
Example 4. The facts are the same as inExample
3except that X also licenses the qualified films to Y,
an unrelated cable company that broadcasts X’s qual-
ified films. As part of the license agreement, X can
sell advertising time slots. Because X’s gross receipts
from Y are derived from the licensing of qualified
films pursuant to paragraph (k)(3)(i) of this section,
X’s gross receipts derived from licensing the quali-
fied film are DPGR. In addition, the gross receipts
derived from the advertising income X receives that
is related to the qualified films licensed to Y is DPGR
pursuant to paragraph (i)(5)(ii) of this section. Be-
cause showing a qualified film on a television station
is not a lease, rental, license, sale, exchange, or other
disposition pursuant to paragraph (k)(3)(ii) of this
section, the portion of the advertising income X de-
rives from advertisers for the qualified films it broad-
casts on its own television station is not derived from
the lease, rental, license, sale, exchange, or other dis-
position of the qualified films and is non-DPGR.
Example 5. X produces a qualified film and con-
tracts with Y, an unrelated person, to duplicate the
film onto DVDs. Y manufactures blank DVDs within
the United States, duplicates X’s film onto the DVDs
in the United States, and sells the DVDs with the
qualified film to X who then sells them to customers.
Y has all of the benefits and burdens of ownership un-
der Federal income tax principles of the DVDs dur-
ing the MPGE and duplication process. Assume Y’s
activities relating to manufacture of the blank DVDs
and duplicating the film onto the DVDs collectively
satisfy the safe harbor under paragraph (g)(3) of this
section. Y’s gross receipts from manufacturing the
DVDs and duplicating the film onto the DVDs are
DPGR (assuming all the other requirements of this
section are met). X’s gross receipts from the sale of
the DVDs to customers are DPGR (assuming all the
other requirements of this section are met).
Example 6. X creates a television program in
the United States that includes scenes from films li-
censed by X from unrelated persons Y and Z. Assume
that Y and Z produced the films licensed by X. The
not-less-than–50-percent-of-the-total-compensation
requirement under paragraph (k)(1) of this section is
determined by reference to all compensation paid in
the production of the television program, including
the films licensed by X from Y and Z, and is cal-
culated using a fraction as described in paragraph
(k)(5) of this section. The numerator of the fraction
is the compensation paid by X to actors, production
personnel, directors, and producers for production
services performed in the United States, and the
denominator is the sum of the total compensation
paid by X to such individuals regardless of where
the production services are performed and the total
compensationpaidbyYandZtoactors,production
personnel, directors, and producers relating to the
production of the films licensed by X (regardless
of where the services are performed). However, for
purposes of calculating the denominator, in deter-
mining the total compensation paid by Y and Z, X
need only include the total compensation paid by Y
and Z to actors, production personnel, directors, and
producers for the production of the scenes used by X
in creating its television program.
(l)Electricity, natural gas, or potable
water—(1)In general. DPGR include
gross receipts derived from any lease,
rental, license, sale, exchange, or other
disposition of utilities produced by the
taxpayer in the United States if all other
requirements of this section are met. In the
case of an integrated producer that both
produces and delivers utilities, see para-
graph (l)(4) of this section that describes
certain gross receipts that do not qualify
as DPGR.
(2)Natural gas.Thetermnatural gas
includes only natural gas extracted from a
natural deposit and does not include, for
example, methane gas extracted from a
landfill. In the case of natural gas, pro-
duction activities include all activities
involved in extracting natural gas from
the ground and processing the gas into
pipeline quality gas.
(3)Potable water.Thetermpotable
watermeans unbottled drinking water. In
the case of potable water, production ac-
tivities include the acquisition, collection,
and storage of raw water (untreated water),
transportation of raw water to a water treat-
ment facility, and treatment of raw water
at such a facility. Gross receipts attribut-
able to any of these activities are included
in DPGR if all other requirements of this
section are met.
(4)Exceptions—(i)Electricity.Gross
receipts attributable to the transmission of
electricity from the generating facility to
a point of local distribution and gross re-
ceipts attributable to the distribution of
electricity to customers are non-DPGR.
(ii)Natural gas. Gross receipts attrib-
utable to the transmission of pipeline qual-
ity gas from a natural gas field (or, if treat-
ment at a natural gas processing plant is
necessary to produce pipeline quality gas,
from a natural gas processing plant) to a
local distribution company’s citygate (or
to another customer) are non-DPGR. Like-
wise, gross receipts of a local gas distri-
bution company attributable to distribution
from the citygate to the local customers are
non-DPGR.
(iii)Potable water. Gross receipts at-
tributable to the storage of potable wa-
ter after completion of treatment of the
potable water, as well as gross receipts at-
June 19, 200610982006–25 I.R.B.

tributable to the transmission and distribu-
tion of potable water, are non-DPGR.
(iv)De minimis exception—(A)DPGR.
Notwithstanding paragraphs (l)(4)(i), (ii),
and (iii) of this section, if less than 5 per-
cent of a taxpayer’s gross receipts derived
from a sale, exchange, or other disposi-
tion of utilities are attributable to the trans-
mission or distribution of the utilities and
the storage of potable water after comple-
tion of treatment of the potable water, then
the gross receipts derived from the lease,
rental, license, sale, exchange, or other dis-
position of the utilities that are attributable
to the transmission and distribution of the
utilities and the storage of potable water af-
ter completion of treatment of the potable
water may be treated as being DPGR (as-
suming all other requirements of this sec-
tion are met). In the case of gross receipts
derived from the lease, rental, license, sale,
exchange, or other disposition of utilities
that are received over a period of time (for
example, a multi-year lease or installment
sale), thisde minimisexception is applied
by taking into account the total gross re-
ceipts for the entire period derived (and to
be derived) from the lease, rental, license,
sale, exchange, or other disposition of the
utilities. For purposes of the preceding
sentence, if a taxpayer treats gross receipts
as DPGR under thisde minimisexception,
then the taxpayer must treat the gross re-
ceipts recognized in each taxable year con-
sistently as DPGR.
(B)Non-DPGR. If less than 5 percent of
a taxpayer’s gross receipts derived from a
sale, exchange, or other disposition of util-
ities are DPGR, then the gross receipts de-
rived from the sale, exchange, or other dis-
position of the utilities may be treated as
non-DPGR. In the case of gross receipts
derived from the lease, rental, license, sale,
exchange, or other disposition of utilities
that are received over a period of time (for
example, a multi-year lease or installment
sale), thisde minimisexception is applied
by taking into account the total gross re-
ceipts for the entire period derived (and
to be derived) from the lease, rental, li-
cense, sale, exchange, or other disposition
of the utilities. For purposes of the preced-
ing sentence, if a taxpayer treats gross re-
ceipts as non-DPGR under thisde minimis
exception, then the taxpayer must treat the
gross receipts recognized in each taxable
year consistently as non-DPGR.
(5)Example. The following example
illustrates the application of this paragraph
(l):
Example. X owns a wind turbine in the United
States that generates electricity and Y owns a high
voltage transmission line that passes near X’s wind
turbine and ends near the system of local distribu-
tion lines of Z. X sells the electricity produced at
the wind turbine to Z and contracts with Y to trans-
mit the electricity produced at the wind turbine to Z
who sells the electricity to customers using Z’s dis-
tribution network. Thegross receipts received by X
from the sale of electricity produced at the wind tur-
bine are DPGR. The gross receipts of Y derived from
transporting X’s electricity to Z are non-DPGR under
paragraph (l)(4)(i) of this section. Likewise, the gross
receipts of Z derived from distributing the electricity
are non-DPGR under paragraph (l)(4)(i) of this sec-
tion. If X made direct sales of electricity to customers
in Z’s service area and Z receives remuneration for
the distribution of electricity, the gross receipts of Z
are non-DPGR under paragraph (l)(4)(i) of this sec-
tion. If X, Y, and Z are related persons (as defined in
paragraph (b) of this section), then X, Y, and Z must
allocate gross receipts among the production activi-
ties (that are DPGR), and the transmission and distri-
bution activities (that are non-DPGR).
(m)Definition of construction per-
formed in the United States—(1)Con-
struction of real property—(i)In general.
The termconstructionmeans activities
and services relatingto the construction
or erection of real property (as defined in
paragraph (m)(3) of this section) in the
United States by a taxpayer that, at the
time the taxpayer constructs the real prop-
erty, is engaged in a trade or business (but
not necessarily its primary, or only, trade
or business) that is considered construc-
tion for purposes of the North American
Industry Classification System (NAICS)
on a regular and ongoing basis. A trade
or business that is considered construction
under the NAICS means a construction
activity under the two-digit NAICS code
of 23 and any other construction activity
in any other NAICS code provided the
construction activity relates to the con-
struction of real property such as NAICS
code 213111 (drilling oil and gas wells)
and 213112 (support activities for oil and
gas operations). For purposes of this para-
graph (m), the termconstruction project
means the construction activities and ser-
vices treated as the item under paragraph
(d)(2)(iii) of this section. Tangible per-
sonal property (for example, appliances,
furniture, and fixtures) that is sold as part
of a construction project is not considered
real property for purposes of this para-
graph (m)(1)(i). In determining whether
property is real property, the fact that
property is real property under local law
is not controlling. Conversely, property
may be real property for purposes of this
paragraph (m)(1)(i) even though under lo-
cal law the property is considered tangible
personal property.
(ii)Regular and ongoing basis—(A)
In general. For purposes of paragraph
(m)(1)(i) of this section, a taxpayer en-
gaged in a construction trade or business
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
described in paragraph (m)(3) of this sec-
tion within 60 months of the date on which
construction is complete (for example, on
the date a certificate of occupancy is is-
sued for the property).
(B)New trade or business. In the case
of a newly-formed trade or business or a
taxpayer in its first taxable year, the tax-
payer is considered to be engaged in a trade
or business on a regular and ongoing basis
if the taxpayer reasonably expects that it
will engage in a trade or business on a reg-
ular and ongoing basis.
(iii)De minimis exception—(A)DPGR.
Forpurposesofparagraph(m)(1)(i)ofthis
section, if less than 5 percent of the total
gross receipts derived by a taxpayer from a
construction project (as described in para-
graph (m)(1)(i) of thissection) are derived
from activities other than the construction
of real property in the United States (for
example, from non-construction activities
or the sale of tangible personal property or
land), then the total gross receipts derived
by the taxpayer from the project may be
treated as DPGR from construction. If a
taxpayer applies the land safe harbor un-
der paragraph (m)(6)(iv) of this section,
for a construction project (as described in
paragraph (m)(1)(i) of this section), then
the gross receipts excluded under the land
safe harbor are excluded in determining
total gross receipts under this paragraph
(m)(1)(iii)(A). If a taxpayer does not apply
the land safe harbor and uses any reason-
able method (for example, an appraisal of
the land) to allocate gross receipts attribut-
able to the land to non-DPGR, then a tax-
payer applies this paragraph (m)(1)(iii)(A)
by excluding such gross receipts derived
from the sale, exchange, or other disposi-
tion of the land from total gross receipts.
In the case of gross receipts derived from
2006–25 I.R.B.1099June 19, 2006

construction that are received over a pe-
riod of time (for example, an installment
sale), thisde minimisexception is applied
by taking into account the total gross re-
ceipts for the entire period derived (and to
be derived) from construction. For pur-
poses of the preceding sentence, if a tax-
payer treats grossreceipts as DPGR un-
der thisde minimisexception, then the tax-
payer must treat the gross receipts recog-
nized in each taxable year consistently as
DPGR.
(B)Non-DPGR. For purposes of para-
graph (m)(1)(i) of this section, if less than
5 percent of the total gross receipts de-
rived by a taxpayer from a construction
project qualify as DPGR, then the total
gross receipts derived by the taxpayer from
the construction project may be treated as
non-DPGR. In the case of gross receipts
derived from construction that are received
over a period of time (for example, an in-
stallment sale), thisde minimisexception
is applied by taking into account the to-
tal gross receipts forthe entire period de-
rived (and to be derived) from construc-
tion. For purposes ofthe preceding sen-
tence, if a taxpayer treats gross receipts as
non-DPGR under thisde minimisexcep-
tion, then the taxpayer must treat the gross
receipts recognized in each taxable year
consistently as non-DPGR.
(2)Activities constituting construc-
tion—(i)In general. Activities constitut-
ing construction areactivities performed
in connection with a project to erect or sub-
stantially renovate real property, including
activities performed by a general contrac-
tor or that constitute activities typically
performed by a general contractor, for ex-
ample, activities relating to management
and oversight of the construction process
such as approvals, periodic inspection of
the progress of the construction project,
and required job modifications.
(ii)Tangential services. Activities con-
stituting construction do not include tan-
gential services such as hauling trash and
debris, and delivering materials, even if the
tangential services are essential for con-
struction. However, if the taxpayer per-
forming construction also, in connection
with the construction project, provides tan-
gential services such as delivering materi-
als to the construction site and removing
its construction debris, then the gross re-
ceipts derived from the tangential services
are DPGR.
(iii)Other construction activities.Im-
provements to land that are not capitaliz-
able to the land (for example, landscap-
ing) and painting are activities constitut-
ing construction only if these activities are
performed in connection with other activi-
ties (whether or not by the same taxpayer)
that constitute the erection or substantial
renovation of real property and provided
the taxpayer meets the requirements under
paragraph (m)(1) of this section. Services
such as grading, demolition (including de-
molition of structures under section 280B),
clearing, excavating, and any other activi-
ties 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
and provided the taxpayer meets the re-
quirements under paragraph (m)(1) of this
section. A taxpayer engaged in these ac-
tivities must make a reasonable inquiry or
a reasonable determination as to whether
the activity relates to the erection or sub-
stantial renovation of real property in the
United States. Construction activities also
include activities relating to drilling an oil
or gas well and mining and include any
activities the cost of which are intangible
drilling and development costs within the
meaning of §1.612–4 or development ex-
penditures for a mine or natural deposit un-
der section 616.
(iv)Administrative support services.If
the taxpayer performing construction ac-
tivities also provides, in connection with
the construction project, administrative
support services (for example, billing and
secretarial services) incidental and nec-
essary to such construction project, then
these administrative support services are
considered construction activities.
(v)Exceptions. The lease, license, or
rental of equipment, for example, bulldoz-
ers, generators, or computers, for use in
the construction of real property is not a
construction activity under this paragraph
(m)(2). The termconstructiondoes not in-
clude any activity that is within the defini-
tion ofengineering and architectural ser-
vicesunder paragraph (n) of this section.
(3)Definition of real property.The
termreal propertymeans buildings (in-
cluding items that are structural com-
ponents 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)) (includ-
ing items that are structural components
of such inherently permanent structures),
inherently permanent land improvements,
oil and gas wells, and infrastructure (as de-
fined in paragraph (m)(4) of this section).
For purposes of the preceding sentence,
an entire utility plant including both the
shell and the interior will be treated as an
inherently permanent structure. Property
produced by a taxpayer that is not real
property in the hands of that 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 window-
panes). For purposes of this paragraph
(m)(3), structural components of build-
ings and inherently permanent structures
include property such as walls, partitions,
doors, wiring, plumbing, central air con-
ditioning and heating systems, pipes and
ducts, elevators andescalators, and other
similar property.
(4)Definition of infrastructure.The
terminfrastructureincludes roads, power
lines, water systems, railroad spurs, com-
munications facilities, sewers, sidewalks,
cable, and wiring. The term also includes
inherently permanent oil and gas plat-
forms.
(5)Definition of substantial renovation.
The termsubstantial renovationmeans the
renovation of a major component or sub-
stantial structural part of real property that
materially increases the value of the prop-
erty, substantially prolongs the useful life
of the property, or adapts the property to a
new or different use.
(6)Derived from construction—(i)In
general. Assuming all the requirements
of this section are met, DPGR derived
from the construction of real property
performed in the United States includes
the proceeds from the sale, exchange, or
other disposition of real property con-
structed by the taxpayer in the United
States (whether or not the property is sold
immediately after construction is com-
pleted and whether or not the construction
project is completed). DPGR derived
from the construction of real property in-
cludes compensation for the performance
of construction services by the taxpayer
in the United States. DPGR derived from
the construction of real property includes
gross receipts derived from materials and
June 19, 200611002006–25 I.R.B.

supplies consumed in the construction
project or that become part of the con-
structed real property, assuming all the
requirements of this section are met.
(ii)Qualified construction warranty.
DPGR derived from the construction of
real property includes gross receipts from
any qualified construction warranty, that
is, a warranty that is provided in connec-
tion with the constructed real property
if, in the normal course of the taxpayer’s
business—
(A) The price for the construction war-
ranty is not separately stated from the
amount charged for the constructed real
property; and
(B) The construction warranty is nei-
ther separately offered by the taxpayer nor
separately bargained for with customers
(that is, the customer cannot purchase the
constructed real property without the con-
struction warranty).
(iii)Exceptions. DPGR derived from
the construction of real property per-
formed in the United States does not
include gross receipts derived from the
sale, exchange, or other disposition of
real property acquired by the taxpayer
even if the taxpayer originally constructed
the property. In addition, DPGR derived
from the construction of real property
does not include gross receipts from the
lease or rental of real property constructed
by the taxpayer or, except as provided
in paragraph (m)(2)(iii) of this section,
gross receipts derived from the sale or
other disposition of land (including zon-
ing, planning, entitlement costs, and other
costs capitalized to the land).
(iv)Land safe harbor—(A)In general.
For purposes of paragraph (m)(6)(i) of this
section, a taxpayer may allocate gross re-
ceipts between the gross receipts derived
from the sale, exchange, or other disposi-
tion of real property constructed by the tax-
payer and the gross receipts derived from
the sale, exchange, or other disposition of
land by reducing its costs related to DPGR
under §1.199–4 by the costs of the land
and any other costs capitalized to the land
(collectively, land costs) (including zon-
ing, planning, entitlement costs, and other
costs capitalized to the land (except costs
for activities listed in paragraph (m)(2)(iii)
of this section) and land costs in any com-
mon improvements as defined in section
2.01 of Rev. Proc. 92–29, 1992–1 C.B.
748, (see §601.601(d)(2) of this chapter))
and by reducing its DPGR by those land
costs plus a percentage. Generally, the per-
centage is based on the number of months
that elapse between the date the taxpayer
acquires the land (not including any op-
tions to acquire the land) and ends on the
date the taxpayer sells each item of real
property on the land. However, a taxpayer
will be deemed, for purposes of this para-
graph (m)(6)(iv)(A), to acquire the land on
the date the taxpayer entered into an option
agreement to acquire the land if the tax-
payer acquired the land pursuant to such
option agreement and the purchase price of
the land under the option agreement does
not approximate the fair market value of
the land. In the case of a sale or dispo-
sition of land between related persons (as
defined in paragraph (b)(1) of this section)
for less than fair market value, for pur-
poses of determining the percentage, the
purchaser or transferee of the land must
include the months during which the land
was held by the seller or transferor. The
percentage is 5 percent for land held not
more than 60 months, 10 percent for land
held more than 60 months but not more
than 120 months, and 15 percent for land
held more than 120 months but not more
than 180 months. Land held by a taxpayer
for more than 180 months is not eligible
for the safe harbor under this paragraph
(m)(6)(iv)(A).
(B)Determining gross receipts and
costs. In the case of a taxpayer that uses the
small business simplified overall method
of cost allocation under §1.199–4(f), gross
receipts derived fromthe sale, exchange,
or other disposition of land, and costs at-
tributable to the land, pursuant to the land
safe harbor under paragraph (m)(6)(iv)(A)
of this section, are not taken into account
for purposes of computing QPAI under
§§1.199–1 through 1.199–9 except that
the gross receipts are taken into account
for determining eligibility for that method
of cost allocation. All other taxpayers
must treat the gross receipts derived from
the sale, exchange, or other disposition
of land, pursuant to the land safe har-
bor under paragraph (m)(6)(iv)(A) of this
section, as non-DPGR. In the case of a
pass-thru entity, if the pass-thru entity
would be eligible to use the small busi-
ness simplified overall method of cost
allocation if the method were applied at
the pass-thru entity level, then the gross
receipts derived fromthe sale, exchange,
or other disposition of land, and costs al-
located to the land, pursuant to the land
safe harbor under paragraph (m)(6)(iv)(A)
of this section, are not taken into account
by the pass-thru entity or its owner or
owners for purposes of computing QPAI
under §§1.199–1 through 1.199–9. For
purposes of the preceding sentence, in
determining whether the pass-thru entity
would be eligible for the small business
simplified overall method of cost alloca-
tion, the gross receipts excluded pursuant
to the land safe harbor under paragraph
(m)(6)(iv)(A) of this section are taken
into account for determining eligibility for
that method of cost allocation. All other
pass-thru entities (including all trusts and
estates described in §1.199–9(e)) must
treat the gross receipts attributable to the
sale, exchange, or other disposition of
land, pursuant to the land safe harbor
under paragraph (m)(6)(iv)(A) of this sec-
tion, as non-DPGR.
(v)Examples. The following examples
illustrate the application of this paragraph
(m)(6):
Example 1. A, who is in the trade or business
of construction under NAICS code 23 on a regular
and ongoing basis, purchases a building in the United
States and retains B, an unrelated person, to oversee
a substantial renovation of the building (within the
meaning of paragraph (m)(5) of this section). Al-
though not licensed as a general contractor, B per-
forms general contractor level work and activities re-
lating to management and oversight of the construc-
tion process such as approvals, periodic inspection of
the progress of the construction project, and required
job modifications. B retains C (a general contractor)
to oversee day-to-day operations and hire subcontrac-
tors. C hires D (a subcontractor) to install a new elec-
trical system in the building as part of that substan-
tial renovation. The amounts that B receives from A
for construction services,the amounts that C receives
from B for construction services, and the amounts
that D receives from C for construction services qual-
ify as DPGR under paragraph (m)(6)(i) of this section
provided B, C, and D meet all of the requirements of
paragraph (m)(1) of this section. The gross receipts
that A receives from the subsequent sale of the build-
ing do not qualify as DPGR because A did not engage
in any activity constituting construction under para-
graph (m)(2) of this section even though A is in the
trade or business of construction. The results would
bethesameifA,B,C,andDweremembersofthe
same EAG under §1.199–7(a). However, if A, B, C,
and D were members of the same consolidated group,
see §1.199–7(d)(2).
Example 2. X is engaged as an electrical con-
tractor under NAICS code 238210 on a regular and
ongoing basis. X purchases the wires, conduits, and
other electrical materials that it installs in construc-
tion projects in the United States. In a particular con-
struction project, all of the wires, conduits, and other
electrical materials installed by X for the operation
2006–25 I.R.B.1101June 19, 2006

of that building are considered structural components
of the building. X’s grossreceipts derived from in-
stalling that property are derived from the construc-
tion of real property under paragraph (m)(1) of this
section. In addition, pursuant to paragraph (m)(6)(i)
of this section, X’s gross receipts derived from the
purchased materials qualify as DPGR because the
wires, conduits, and other electrical materials are con-
sumed during the construction of the building or be-
come structural components of the building.
Example 3. X is engaged in a trade or business on
a regular and ongoing basis that is considered con-
struction under the two-digit NAICS code of 23. X
buys unimproved land in the United States. X gets the
land zoned for residential housing through an entitle-
ment process. X grades the land and sells the land to
home builders who construct houses on the land. The
gross receipts that X derives from the sale of the land
that are attributable to the grading qualify as DPGR
under paragraphs (m)(2)(iii) and (6)(i) of this section
because those services are undertaken in connection
with a construction project in the United States. X’s
gross receipts derived fromthe land including cap-
italized costs of entitlements (including zoning) do
not qualify as DPGR under paragraph (m)(6)(i) of
this section because the gross receipts are not derived
from the construction of real property.
Example 4. The facts are the same as inExample
3except that X constructs roads, sewers, and side-
walks, and installs power and water lines on the land.
X conveys the roads, sewers, sidewalks, and power
and water lines to the local government and utilities.
The gross receipts that X derives from the sale of
lots that are attributable to grading, and the construc-
tion of the roads, sewers, sidewalks, and power and
water lines (that qualify as infrastructure under para-
graph (m)(4) of this section) are DPGR. X’s gross
receipts derived from the land including capitalized
costs of entitlements (including zoning) do not qual-
ify as DPGR under paragraph (m)(6)(i) of this sec-
tion because the gross receipts are not derived from
the construction of real property.
Example 5.(i)Facts. X, who is engaged in the
trade or business of construction under NAICS code
23 on a regular and ongoing basis, constructs housing
that is real property under paragraph (m)(3) of this
section. On June 1, 2007, X pays $50,000,000 and
acquires 1,000 acres of land that X will develop as a
new housing development. In November 2007, after
the expenditure of $10,000,000 for entitlement costs,
X receives permits to begin construction. After this
expenditure, X’s land costs total $60,000,000. The
development consists of 1,000 houses to be built on
half-acre lots over 5 years. On January 31, 2012, the
first house is sold for $300,000. Construction costs
for each house are $170,000. Common improve-
ments consisting of streets, sidewalks, sewer lines,
playgrounds, clubhouses, tennis courts, and swim-
ming pools that X is contractually obligated or re-
quired by law to provide cost $55,000 per lot. The
common improvements of $55,000 per lot include
$30,000 in land costs underlying the common im-
provements.
(ii)Land safe harbor. Pursuant to the land safe
harbor under paragraph (m)(6)(iv) of this section, X
calculates the basis for each house sold as $195,000
(total costs of $255,000 ($170,000 in construction
costs plus $55,000 in common improvements (in-
cluding $30,000 in land costs) plus $30,000 in land
costs for the lot), which are reduced by land costs
of $60,000). X calculates the DPGR for each house
sold by taking the gross receipts of $300,000 and
reducing that amount by land costs of $60,000 plus
a percentage of $60,000. As X acquired the land
on June 1, 2007, for each house sold on the land
between January 31, 2012, and June 1, 2012, the
percentage reduction for X is 5% because X has held
the land for not more than 60 months from the date
of acquisition. Thus, X’s DPGR for each house is
$237,000 ($300,000 - $60,000 - $3,000) with costs
for each house of $195,000($255,000 -$60,000).
For each house sold on the land between June 2,
2012 and June 1, 2017, the percentage reduction
for X is 10% because X has held the land for more
than 60 months but not more than 120 months from
the date of acquisition. Thus, of the $300,000 of
gross receipts, X’s DPGR for each house is $234,000
($300,000 - $60,000 - $6,000) with costs for each
house of $195,000 ($255,000 - $60,000).
Example 6. The facts are the same as inExample
5except that on December 31, 2007, after X received
the permits to begin construction, X sold the entitled
land to Y, an unrelated corporation, for $75,000,000.
Y is engaged in a trade or business on a regular
and ongoing basis that is considered construction
under NAICS code 23. Y subsequently incurred
the construction costs and the costs of the common
improvements, and Y sold the houses. Because X
did not perform any construction activities, none of
X’s $75,000,000 in gross receipts derived from Y are
DPGR and none of X’s costs are allocable to DPGR.
Pursuant to the land safe harbor under paragraph
(m)(6)(iv) of this section, Y calculates the basis for
each house sold as $195,000 (total costs of $270,000
($170,000 in construction costs plus $62,500 in
common improvements (including $37,500 in land
costs) plus $37,500 in land costs for the lot), which
are reduced by land costs of $75,000). Y calculates
the DPGR for each house sold by taking the gross re-
ceipts of $300,000 and reducing that amount by land
costs of $75,000 plus a percentage of $75,000. As
Y acquired the land on December 31, 2007, for the
houses sold on the land between January 31, 2012,
and December 31, 2012, the percentage reduction for
Y is 5% because Y held the land for not more than
60 months from the date of acquisition. Thus, of the
$300,000 of gross receipts, the DPGR for each house
is $221,250 ($300,000 - $75,000 - $3,750) with costs
for each house of $195,000. For the houses sold on
the land between January 1, 2013, and December 31,
2017, the percentage reduction for Y is 10% because
Y held the land for more than 60 months but not more
than 120 months from the date of acquisition. Thus,
of the $300,000 of gross receipts, the DPGR for each
house is $217,500 ($300,000 - $75,000 - $7,500)
with costs for each house of $195,000. The results
would be the same if X and Y were members of the
same EAG, provided X and Y were not members of
the same consolidated group.
Example 7. The facts are the same as inExam-
ple 6except that Y is a member of the same consol-
idated group as X. Pursuant to §1.1502–13(c)(1)(ii),
Y’s holding period in the land includes the period of
time X held the land. In order to produce the same
effect as if X and Y were divisions of a single corpo-
ration (see §1.1502–13(c)(1)(i)), for each house sold
between January 31, 2012, and June 1, 2012, Y’s
DPGR are redetermined to be $237,000, the same as
X’s DPGR for houses sold between January 31, 2012,
and June 1, 2012, inExample 5. Y’s costs for each
house do not have to be redetermined because Y’s
costs are $195,000, the same as the costs would be if
X and Y were divisions of a single corporation. For
each house sold between June 2, 2012, and June 1,
2017, Y’s DPGR are redetermined to be $234,000,
the same as X’s DPGR for each house sold between
June 2, 2012, and June 1, 2017, inExample 5.Y’s
costs for each house do not have to be redetermined
because Y’s costs are $195,000, the same as the costs
would be if X and Y were divisions of a single cor-
poration.
Example 8. X, who is engaged in the trade or
business of construction under NAICS code 23 on a
regular and ongoing basis, purchases land for devel-
opment and builds an office building on the land. Y
enters into a contract with X to purchase the office
building. As part of the contract, X is required to fur-
nish the office space with desks, chairs, and lamps.
Upon completion of the sale of the building, X uses
the land safe harbor under paragraph (m)(6)(iv) of
this section to account forthe land. After applica-
tion of the land safe harbor, X uses thede minimis
exception under paragraph (m)(1)(iii)(A) of this sec-
tion in determining whether the gross receipts derived
from the sale of the desks, chairs, and lamps qualify
as DPGR. If the gross receipts derived from the sale
of the desks, chairs, and lamps are less than 5% of
the total gross receipts derived by X from the sale of
the furnished office building (excluding any gross re-
ceipts taken into accountunder the land safe harbor
pursuant to paragraph (m)(6)(iv)(B) of this section),
then all of the gross receipts derived from the sale of
the furnished office building, after the reduction un-
der the land safe harbor, may be treated as DPGR.
(n)Definition of engineering and archi-
tectural services—(1)In general.DPGR
include gross receipts derived from en-
gineering or architectural services per-
formed in the United States for a con-
struction project described in paragraph
(m)(1)(i) of this section. At the time
the taxpayer performs the engineering
or architectural services, the taxpayer
must be engaged in a trade or business
(but not necessarily its primary, or only,
trade or business) thatis considered engi-
neering or architectural services for pur-
poses of the NAICS, for example NAICS
codes 541330 (engineering services) or
541310 (architecturalservices), on a reg-
ular and ongoing basis. In the case of a
newly-formed trade or business or a tax-
payer in its first taxable year, a taxpayer
is considered to be engaged in a trade or
business on a regular and ongoing basis
if the taxpayer reasonably expects that it
will engage in a trade or business on a
regular and ongoing basis. DPGR include
gross receipts derived from engineering
or architectural services, including fea-
sibility studies for a construction project
June 19, 200611022006–25 I.R.B.

in the United States, even if the planned
construction project is not undertaken or
is not completed.
(2)Engineering services. Engineering
services in connection with any con-
struction project include any professional
services requiring engineering educa-
tion, training, and experience and the
application of special knowledge of the
mathematical, physical, or engineering
sciences to those professional services
such as consultation, investigation, eval-
uation, planning, design, or responsible
supervision of construction (for the pur-
pose of assuring compliance with plans,
specifications, and design) or erection, in
connection with any construction project.
(3)Architectural services. Architec-
tural services in connection with any
construction project include the offering
or furnishing of any professional services
such as consultation,planning, aesthetic
and structural design, drawings and spec-
ifications, or responsible supervision of
construction (for the purpose of assuring
compliance with plans,specifications, and
design) or erection, in connection with any
construction project.
(4)Administrative support services.
If the taxpayer performing engineering
or architectural services also provides ad-
ministrative support services (for example,
billing and secretarial services) inciden-
tal and necessary to such engineering or
architectural services, then these admin-
istrative support services are considered
engineering or architectural services.
(5)Exceptions. Engineering or archi-
tectural services do not include post-con-
struction services such as annual audits
and inspections.
(6)De minimis exception for perfor-
mance of services in the United States—(i)
DPGR. If less than 5 percent of the to-
tal gross receipts derived by a taxpayer
from engineering or architectural services
performed in the United States for a con-
struction project (described in paragraph
(m)(1)(i) of this section) are derived from
services not relating to a construction
project (for example, the services are per-
formed outside the United States or in
connection with property other than real
property), then the total gross receipts de-
rived by the taxpayer may be treated as
DPGR from engineering or architectural
services performed in the United States
for the construction project. In the case
of gross receipts derived from engineering
or architectural services that are received
over a period of time (for example, an in-
stallment sale), thisde minimisexception
is applied by taking into account the total
gross receipts for the entire period derived
(and to be derived) from engineering or
architectural services. For purposes of the
preceding sentence, if a taxpayer treats
gross receipts as DPGR under thisde min-
imisexception, then the taxpayer must
treat the gross receipts recognized in each
taxable year consistently as DPGR.
(ii)Non-DPGR. If less than 5 percent
of the total gross receipts derived by a
taxpayer from engineering or architectural
services performed in the United States for
a construction project qualify as DPGR,
then the total gross receipts derived by the
taxpayer from engineering or architectural
services performed in the United States for
the construction project may be treated as
non-DPGR. In the case of gross receipts
derived from engineering or architectural
services that are received over a period
of time (for example, an installment sale),
thisde minimisexception is applied by tak-
ing into account the total gross receipts
for the entire period derived (and to be
derived) from engineering or architectural
services. For purposes of the preceding
sentence, if a taxpayer treats gross receipts
as non-DPGR under thisde minimisex-
ception, then the taxpayer must treat the
gross receipts recognized in each taxable
year consistently as non-DPGR.
(7)Example. The following example
illustrates the application of this paragraph
(n):
Example. X is engaged in the trade or business
of providing engineering services under NAICS code
541330 on a regular and ongoing basis. Y buys unim-
proved land. Y hires X to provide engineering ser-
vices for roads, sewers, sidewalks, and power and wa-
ter lines that qualify as infrastructure under paragraph
(m)(4) of this section and that will be constructed on
Y’s land. X’s gross receipts from engineering ser-
vices for the infrastructure are DPGR. X’s gross re-
ceipts from engineering services relating to land (ex-
cept as provided in paragraph (m)(2)(iii) of this sec-
tion) do not qualify as DPGR under paragraph (n)(1)
of this section because the gross receipts are not de-
rived from engineering services for a construction
project described in paragraph (m)(1)(i) of this sec-
tion.
(o)Sales of certain food and bever-
ages—(1)In general.DPGRdoesnotin-
clude gross receipts of the taxpayer that
are derived from the sale of food or bev-
erages prepared by the taxpayer at a re-
tail establishment. A retail establishment
is defined as tangible property (both real
and personal) owned, leased, occupied, or
otherwise used by the taxpayer in its trade
or business of selling food or beverages to
the public at which retail sales are made.
In addition, a facility that prepares food
and beverages for take out service or deliv-
ery is a retail establishment (for example,
a caterer). If a taxpayer’s facility is a retail
establishment, then, for purposes of this
section, the taxpayer may allocate its gross
receipts between the gross receipts derived
from the retail sale of the food and bever-
ages prepared and sold at the retail estab-
lishment (that are non-DPGR) and gross
receipts derived from the wholesale sale of
the food and beverages prepared and sold
at the retail establishment (that are DPGR
assuming all the other requirements of sec-
tion 199 are met). Wholesale sales are de-
fined as food and beverages held for resale
by the purchaser. The exception for sales
of certain food and beverages also applies
to food and beverages for non-human con-
sumption. A retail establishment does not
include the bonded premises of a distilled
spirits plant or wine cellar, or the premises
of a brewery (other than a tavern on the
brewery premises). See Chapter 51 of Ti-
tle 26 of the United States Code and the
implementing regulations thereunder.
(2)De minimis exception. A taxpayer
may treat a facility at which food or bev-
erages are prepared as not being a retail
establishment if less than 5 percent of the
gross receipts derivedfrom the sale of food
or beverages at that facility during the tax-
able year are attributable to retail sales.
(3)Examples. The following examples
illustrate the application of this paragraph
(o):
Example 1. X buys coffee beans and roasts those
beans at a facility in the United States, the only activ-
ity of which is the roasting and packaging of coffee
beans. X sells the roasted coffee beans through a va-
riety of unrelated third-party vendors and also sells
roasted coffee beans at X’s retail establishments. At
X’s retail establishments, X prepares brewed coffee
and other foods. To the extent that the gross receipts
of X’s retail establishments are derived from the sale
of coffee beans roasted at the facility, the receipts are
DPGR (assuming all the other requirements of this
section are met). To the extent the gross receipts of
X’s retail establishments are derived from the retail
sale of brewed coffee or food prepared at the retail es-
tablishments, the receipts are non-DPGR. However,
pursuant to §1.199–1(d)(1)(ii), X must allocate part
of the receipts from the retail sale of the brewed cof-
fee as DPGR to the extent of the value of the coffee
2006–25 I.R.B.1103June 19, 2006

beans that were roasted at the facility and that were
used to brew coffee.
Example 2. Y operates a bonded winery within
the United States. Bottles of wine produced by Y at
the bonded winery are sold to consumers at the tax-
paid premises. Pursuant to paragraph (o)(1) of this
section, the bonded premises is not considered a re-
tail establishment and is treated as separate and apart
from the taxpaid premises, which is considered a re-
tail establishment for purposes of paragraph (o)(1) of
this section. Accordingly, the wine produced by Y in
the bonded premises and sold by Y from the taxpaid
premises is not considered to have been produced at
a retail establishment, and the gross receipts derived
from the sales of the wine are DPGR (assuming all
the other requirements of this section are met).
(p)Guaranteed payments.DPGR
does not include guaranteed payments
under section 707(c). Thus, partners,
including partners in partnerships de-
scribed in §1.199–9(i) and (j), may not
treat guaranteed payments as DPGR. See
§1.199–9(b)(6)Example 5.
§1.199–4 Costs allocable to domestic
production gross receipts.
(a)In general. The provisions of this
section apply solely for purposes of sec-
tion 199 of the Internal Revenue Code
(Code). To determineits qualified produc-
tion activities income (QPAI) (as defined
in §1.199–1(c)) for a taxable year, a tax-
payer must subtract from its domestic
production gross receipts (DPGR) (as de-
fined in §1.199–3(a)) the cost of goods
sold (CGS) allocable to DPGR and other
expenses, losses, or deductions (deduc-
tions), other than the deduction allowed
under section 199, that are properly allo-
cable to such receipts. Paragraph (b) of
this section provides rules for determining
CGS allocable to DPGR. Paragraph (c) of
this section provides rules for determining
the deductions that are properly allocable
to DPGR. Paragraph (d) of this section
provides that a taxpayer generally must
determine deductions allocable to DPGR
or to gross income attributable to DPGR
using §§1.861–8 through 1.861–17 and
§§1.861–8T through 1.861–14T (the sec-
tion 861 regulations), subject to the rules
in paragraph (d) of this section (the section
861 method). Paragraph (e) of this sec-
tion provides that certain taxpayers may
apportion deductions to DPGR using the
simplified deduction method. Paragraph
(f) of this section provides a small business
simplified overall method that a qualifying
small taxpayer may use to apportion CGS
and deductions to DPGR.
(b)Cost of goods sold allocable to do-
mestic production gross receipts—(1)In
general. When determining its QPAI, a
taxpayer must subtract from DPGR the
CGS allocable to DPGR. A taxpayer de-
termines its CGS allocable to DPGR in
accordance with this paragraph (b) or, if
applicable, paragraph (f) of this section.
In the case of a sale, exchange, or other
disposition of inventory, CGS is equal
to beginning inventory plus purchases
and production costs incurred during the
taxable year and included in inventory
costs, less ending inventory. CGS is de-
termined under the methods of accounting
that the taxpayer uses to compute taxable
income. See sections 263A, 471, and
472. If section 263A requires a taxpayer
to include additional section 263A costs
(as defined in §1.263A–1(d)(3)) in inven-
tory, additional section 263A costs must
be included in determining CGS. CGS
allocable to DPGR alsoincludes inventory
valuation adjustments such as writedowns
under the lower of cost or market method.
In the case of a sale, exchange, or other
disposition (including, for example, theft,
casualty, or abandonment) of non-inven-
tory property, CGS for purposes of this
section includes the adjusted basis of the
property. CGS allocable to DPGR for a
taxable year may include the inventory
cost and adjusted basis of qualifying pro-
duction property (QPP) (as defined in
§1.199–3(j)(1)), a qualified film (as de-
fined in §1.199–3(k)(1)), or electricity,
natural gas, and potable water (as defined
in §1.199–3(l)) (collectively, utilities) that
will generate (or have generated) DPGR
notwithstanding thatthe gross receipts at-
tributable to the sale, lease, rental, license,
exchange, or other disposition of the QPP,
qualified film, or utilities will be, or have
been, included in the computation of gross
income for a different taxable year. For ex-
ample, advance payments that are DPGR
may be included in gross income under
§1.451–5(b)(1)(i) in a different taxable
year than the related CGS allocable to
that DPGR. If gross receipts are treated
as DPGR pursuant to §1.199–1(d)(3)(i)
or §1.199–3(i)(4)(i)(B)(6), (l)(4)(iv)(A),
(m)(1)(iii)(A), (n)(6)(i), or (o)(2), then
CGS must be allocated to such DPGR.
Similarly, if gross receipts are treated as
non-DPGR pursuant to §1.199–1(d)(3)(ii)
or §1.199–3(i)(4)(ii), (l)(4)(iv)(B),
(m)(1)(iii)(B), or (n)(6)(ii), then CGS
must be allocated to such non-DPGR. See
§1.199–3(m)(6)(iv) for rules relating to
treatment of certain costs in the case of
a taxpayer that uses the land safe harbor
under that paragraph.
(2)Allocating cost of goods sold—(i)In
general. A taxpayer must use a reasonable
method that is satisfactory to the Secretary
based on all of the facts and circumstances
to allocate CGS between DPGR and non-
DPGR. Whether an allocation method is
reasonable is based on all of the facts and
circumstances including whether the tax-
payer uses the most accurate information
available; the relationship between CGS
and the method used; the accuracy of the
method chosen as compared with other
possible methods; whether the method is
used by the taxpayer for internal manage-
ment or other business purposes; whether
the method is used for other Federal or
state income tax purposes; the availability
of costing information; the time, burden,
and cost of using alternative methods; and
whether the taxpayer applies the method
consistently from year to year. Depend-
ing on the facts and circumstances, reason-
able methods may include methods based
on gross receipts, number of units sold,
number of units produced, or total produc-
tion costs. Ordinarily, if a taxpayer uses a
method to allocate gross receipts between
DPGR and non-DPGR, then the use of a
different method to allocate CGS that is
not demonstrably more accurate than the
method used to allocate gross receipts will
not be considered reasonable. However, if
a taxpayer has information readily avail-
able to specifically identify CGS allocable
to DPGR and can specifically identify that
amount without undue burden or expense,
CGS allocable to DPGR is that amount ir-
respective of whether the taxpayer uses an-
other allocation method to allocate gross
receipts between DPGR and non-DPGR.
A taxpayer that does not have information
readily available to specifically identify
CGS allocable to DPGR and that cannot,
without undue burden or expense, specif-
ically identify that amount is not required
to use a method that specifically identifies
CGS allocable to DPGR.
(ii)Gross receipts recognized in an ear-
lier taxable year. If a taxpayer (other than
a taxpayer that uses the small business sim-
plified overall method of paragraph (f) of
this section) recognizes and reports gross
receipts on a Federal income tax return for
June 19, 200611042006–25 I.R.B.

a taxable year, and incurs CGS related to
such gross receipts in a subsequent taxable
year, then regardless of whether the gross
receipts ultimately qualify as DPGR, the
taxpayer must allocate the CGS to—
(A) DPGR if the taxpayer identified the
related gross receipts as DPGR in the prior
taxable year; or
(B) Non-DPGR if the taxpayer iden-
tified the related gross receipts as non-
DPGR in the prior taxable year or if the
taxpayer recognized under the taxpayer’s
methods of accounting those gross receipts
in a taxable year to which section 199 does
not apply.
(3)Special rules for imported items
or services. The cost of any item or ser-
vice brought into the United States (as
defined in §1.199–3(h)) without an arm’s
length transfer price may not be treated
as less than its value immediately after
it entered the United States for purposes
of determining the CGS to be used in the
computation of QPAI. Similarly, the ad-
justed basis of leased or rented property
that gives rise to DPGR that has been
brought into the United States (as defined
in §1.199–3(h)) without an arm’s length
transfer price may not be treated as less
than its value immediately after it entered
the United States. When an item or ser-
vice is imported into the United States
that had been exported by the taxpayer for
further manufacture, the increase in cost
may not exceed the difference between the
value of the property when exported and
the value of the property when imported
back into the United States after further
manufacture. For this purpose, the value
of property is its customs value as defined
in section 1059A(b)(1).
(4)Rules for inventories valued at mar-
ket or bona fide selling prices.Ifpart
of CGS is attributable to inventory valu-
ation adjustments, then CGS allocable to
DPGR includes inventory adjustments to
QPP that is MPGE in whole or in sig-
nificant part within the United States, a
qualified film produced by the taxpayer,
or utilities produced by the taxpayer in the
United States. Accordingly, taxpayers that
value inventory under §1.471–4 (invento-
ries at cost or market, whichever is lower)
or §1.471–2(c) (subnormal goods atbona
fideselling prices) must allocate a proper
share of such adjustments (for example,
writedowns) to DPGR based on a reason-
able method that is satisfactory to the Sec-
retary based on all of the facts and cir-
cumstances. Factors taken into account
in determining whether the method is rea-
sonable include whether the taxpayer uses
the most accurate information available;
the relationship between the adjustment
and the allocation base chosen; the accu-
racy of the method chosen as compared
with other possible methods; whether the
method is used by the taxpayer for in-
ternal management or other business pur-
poses; whether the method is used for other
Federal or state income tax purposes; the
time, burden, and cost of using alterna-
tive methods; and whether the taxpayer ap-
plies the method consistently from year to
year. If a taxpayer has information read-
ily available to specifically identify the
proper amount of inventory valuation ad-
justments allocable to DPGR, then the tax-
payer must allocate that amount to DPGR.
A taxpayer that does not have information
readily available tospecifically identify
the proper amount of inventory valuation
adjustments allocable to DPGR and that
cannot, without undue burden or expense,
specifically identify the proper amount of
inventory valuation adjustments allocable
to DPGR, is not required to use a method
that specifically identifies inventory valu-
ations adjustments to DPGR.
(5)Rules applicable to inventories ac-
counted for under the last-in, first-out
(LIFO) inventory method—(i)In gen-
eral. This paragraph applies to inventories
accounted for using the specific goods
last-in, first-out (LIFO) method or the
dollar-value LIFO method. Whenever a
specific goods grouping or a dollar-value
pool contains QPP, qualified films, or
utilities that produces DPGR and goods
that do not, the taxpayer must allocate
CGS attributable to that grouping or pool
between DPGR and non-DPGR using a
reasonable method that is satisfactory to
the Secretary based on all of the facts
and circumstances. Whether a method
of allocating CGS between DPGR and
non-DPGR is reasonable must be deter-
mined in accordance with paragraph (b)(2)
of this section. In addition, this paragraph
(b)(5) provides methods that a taxpayer
may use to allocate CGS for inventories
accounted for using the LIFO method.
If a taxpayer uses the LIFO/FIFO ratio
method provided in paragraph (b)(5)(ii)
of this section or the change in relative
base-year cost method provided in para-
graph (b)(5)(iii) of this section, then the
taxpayer must use that method for all in-
ventory accounted for under the LIFO
method.
(ii)LIFO/FIFO ratio method.Atax-
payer using the specific goods LIFO
method or the dollar-value LIFO method
may use the LIFO/FIFO ratio method.
The LIFO/FIFO ratio method is applied
with respect to all LIFO inventory of a
taxpayer on a grouping-by-grouping or
pool-by-pool basis. Under the LIFO/FIFO
ratio method, a taxpayer computes the
CGS of a grouping or pool allocable to
DPGR by multiplying the CGS of QPP,
qualified films, or utilities in the grouping
or pool that produced DPGR computed
using the first-in, first-out (FIFO) method
by the LIFO/FIFO ratio of the grouping or
pool. The LIFO/FIFO ratio of a grouping
or pool is equal to the total CGS of the
grouping or pool computed using the LIFO
method over the total CGS of the grouping
or pool computed using the FIFO method.
(iii)Change in relative base-year cost
method. A taxpayer using the dollar-value
LIFO method may use the change in rela-
tive base-year cost method. The change in
relative base-year cost method is applied
with respect to all LIFO inventory of a tax-
payer on a pool-by-pool basis. The change
in relative base-year cost method deter-
mines the CGS allocable to DPGR by in-
creasing or decreasing the total production
costs (section 471 costs and additional sec-
tion 263A costs) of QPP, a qualified film,
or utilities that generate DPGR by a por-
tion of any increment or liquidation of the
dollar-value pool. The portion of an incre-
ment or liquidation allocable to DPGR is
determined by multiplying the LIFO value
of the increment or liquidation (expressed
as a positive number) by the ratio of the
change in total base-year cost (expressed
as a positive number) of the QPP, qualified
film, or utilities that will generate DPGR
in ending inventory to the change in to-
tal base-year cost (expressed as a positive
number) of all goods in the ending inven-
tory. The portion of an increment or liq-
uidation allocable to DPGR may be zero
but cannot exceed the amount of the incre-
ment or liquidation. Thus, a ratio in excess
of 1.0 must be treated as 1.0.
(6)Taxpayers using the simplified
production method or simplified resale
method for additional section 263A costs.
A taxpayer that uses the simplified produc-
2006–25 I.R.B.1105June 19, 2006

tion method or simplified resale method
to allocate additional section 263A costs,
as defined in §1.263A–1(d)(3), to end-
ing inventory must follow the rules in
paragraph (b)(2) of this section to deter-
mine the amount of additional section
263A costs allocable to DPGR. Alloca-
ble additional section 263A costs include
additional section 263A costs included in
beginning inventory as well as additional
section 263A costs incurred during the
taxable year. Ordinarily, if a taxpayer uses
the simplified production method or the
simplified resale method, the additional
section 263A costs should be allocated in
the same proportion as section 471 costs
are allocated.
(7)Examples. The following examples
illustrate the application of this paragraph
(b) and assume that the taxpayer does not
use the small business simplified overall
method provided in paragraph (f) of this
section:
Example 1.Advance payments. T, a calendar year
taxpayer, is a manufacturer of furniture in the United
States. Under its method of accounting, T includes
advance payments and other gross receipts derived
from the sale of furniture in gross income when the
payments are received. In December 2007, T receives
an advance payment of $5,000 from X with respect
to an order of furniture to be manufactured for a to-
tal price of $20,000. In 2008, T produces and sells
the furniture to X. In 2008, T incurs $14,000 of sec-
tion 471 and additional section 263A costs to produce
the furniture ordered by X. T receives the remaining
$15,000 of the contract price from X in 2008. As-
suming that in 2007, T can reasonably determine that
all the requirements of §§1.199–1 and 1.199–3 will
be met with respect to the furniture, the advance pay-
ment qualifies as DPGR in 2007. Assuming further
that all the requirements of §§1.199–1 and 1.199–3
are met with respect to the furniture in 2008, the re-
maining $15,000 of the contract price must be in-
cluded in income and DPGR when received by T
in 2008. T must include the $14,000 it incurred to
produce the furniture in CGS and CGS allocable to
DPGR in 2008. See §1.199–4(b)(2)(ii) for rules re-
garding gross receipts and costs recognized in differ-
ent taxable years.
Example 2.Use of standard cost method.X,a
calendar year taxpayer, manufactures item A in a fac-
tory located in the United States and item B in a fac-
tory located in Country Y. Item A is produced by X
within the United States and the sale of A generates
DPGR. X uses the FIFO inventory method to account
for its inventory and determines the cost of item A
using a standard cost method. At the beginning of
its 2007 taxable year, X’s inventory contains 2,000
units of item A at a standard cost of $5 per unit. X
did not incur significantcost variances in previous
taxable years. During the 2007 taxable year, X pro-
duces 8,000 units of item A at a standard cost of $6
per unit. X determines that with regard to its pro-
duction of item A it has incurred a significant cost
variance. When X reallocates the cost variance to the
units of item A that it has produced, the production
cost of item A is $7 per unit. X sells 7,000 units of
item A during the taxable year. X can identify from
its books and records that CGS related to the sales of
item A during the taxable year are $45,000 ((2,000 x
$5) + (5,000 x $7)). Accordingly, X has CGS alloca-
ble to DPGR of $45,000.
Example 3.Change in relative base-year cost
method. (i) Y elects, beginning with the calendar
year 2007, to compute its inventories using the dol-
lar-value, LIFO method under section 472. Y estab-
lishes a pool for items A and B. Y produces item A
within the United States and the sales of item A gen-
erate DPGR. Y does not produce item B within the
United States and the sale of item B does not gener-
ate DPGR. The composition of the inventory for the
pool at the base date, January 1, 2007, is as follows:
I
temUnitUnitcostTotalcost
A2,000
$5.00$10,000
B
1,250
4.00
5,000
Total
$15,000
(ii) Y uses a standard cost method to allocate all
direct and indirect costs (section 471 and additional
section 263A costs) to the units of item A and item
B that it produces. During 2007, Y incurs $52,500 of
section 471 costs and additional section 263A costs
to produce 10,000 units of item A and $114,000 of
section 471 costs and additional section 263A costs
to produce 20,000 units of item B.
(iii) The closing inventory of the pool at Decem-
ber 31, 2007, contains 3,000 units of item A and 2,500
units of item B. The closing inventory of the pool
at December 31, 2007, shown at base-year and cur-
rent-year cost is as follows:
I
temQuantity
Base-year
c
ostAmount
Current-year
c
ostAmount
A3,000
$5.00$15,000$5.25$15,750
B
2,500
4.0010,000
5.7014,250
Totals
$25,000$30,000
(iv) The base-year costof the closing LIFO in-
ventory at December 31, 2007, amounts to $25,000,
and exceeds the $15,000 base-year cost of the open-
ing inventory for the taxable year by $10,000 (the
increment stated at base-year cost). The increment
valued at current-year cost is computed by multiply-
ing the increment stated at base-year cost by the ratio
of the current-year cost of the pool to total base-year
cost of the pool (that is, $30,000/$25,000, or 120%).
The increment stated at current-year cost is $12,000
($10,000 x 120%).
(v) The change in relative base-year cost of item
A is $5,000 ($15,000 - $10,000). The change in rel-
ative base-year cost (theincrement stated at base-
year cost) of the total inventory is $10,000 ($25,000
- $15,000). The ratio of the change in base-year cost
of item A to the change in base-year cost of the total
inventory is 50% ($5,000/$10,000).
(vi) CGS allocable to DPGR is $46,500, com-
puted as follows:
Current-year production costs related to DPGR
$52,500
Less:Increment stated at current-year cost
$12,000
Ratio
50%
Total( 6,000)
Total
$46,500
June 19, 200611062006–25 I.R.B.

Example 4.Change in relative base-year cost
method. (i) The facts are the same as inExample 3
except that, during the calendar year 2008, Y expe-
riences an inventory decrement. During 2008, Y in-
curs $66,000 of section 471 costs and additional sec-
tion 263A costs to produce 12,000 units of item A and
$150,000 of section 471 costs and additional section
263A costs to produce 25,000 units of item B.
(ii) The closing inventory of the pool at December
31, 2008, contains 2,000 units of item A and 2,500
units of item B. The closing inventory of the pool at
December 31, 2008, shown at base-year and current-
year cost is as follows:
I
temQuantity
Base-year
c
ostAmount
Current-year
c
ostAmount
A2,000
$5.00$10,000$5.50$11,000
B
2,500
4.0010,0006.00
15,000
Totals
$20,000$26,000
(iii) The base-year cost of the closing LIFO inven-
tory at December 31, 2008,amounts to $20,000, and
is less than
the $25,000 base-year cost of the opening
inventory for that taxable year by $5,000 (the decre-
ment stated at base-year cost). This liquidation is
reflected b
y reducing the most recent layer of incre-
ment. The LIFO value of the inventory at December
31, 2008 is:
B
asecostIndexLIFOvalue
January 1, 2008, base cost
$15,000
1.00
$15,000
December 31
, 2008, increment
5,000
1.206,000
Total
$21,000
(iv) The change in relative base-year cost of item
A is $5,000 ($15,000 - $10,000). The change in rel-
ative base-year cost of the total inventory is $5,000
($25,000 - $20,000). The ratio of the change in base-
year cost of item A to the change in base-year cost of
the total inventory is 100% ($5,000/$5,000).
(v) CGS allocable to DPGR is $72,000, computed
as follows:
Current-year production costs related to DPGR
$66,000
Plus:LIFO value of decrement
$6,000
Ratio100%
Total6,000
Total
$72,000
Example 5.LIFO/FIFO ratio method.(i)The
facts are the same as inExample 3except that Y uses
the LIFO/FIFO ratio method to determine its CGS
allocable to DPGR.
(ii) Y’s CGS related to item A on a FIFO basis is
$46,750 ((2,000 units at $5) + (7,000 units at $5.25)).
(iii) Y’s total CGS computed on a LIFO basis is
$154,500 (beginning inventory of $15,000 plus total
production costs of $166,500 less ending inventory of
$27,000).
(iv) Y’s total CGS computed on a FIFO basis is
$151,500 (beginning inventory of $15,000 plus total
production costs of $166,500 less ending inventory of
$30,000).
(v) The ratio of Y’s CGS computed using the
LIFO method to its CGS computed using the FIFO
method is 102% ($154,500/$151,500). Y’s CGS re-
lated to DPGR computed using the LIFO/FIFO ratio
method is $47,685 ($46,750 x 102%).
Example 6.LIFO/FIFO ratio method.(i)The
facts are the same as inExample 4except that Y uses
the LIFO/FIFO ratio method to compute CGS alloca-
ble to DPGR.
(ii) Y’s CGS related to item A on a FIFO basis
is $70,750 ((3,000 units at $5.25) + (10,000 units at
$5.50)).
(iii) Y’s total CGS computed on a LIFO basis is
$222,000 (beginning inventory of $27,000 plus total
production costs of $216,000 less ending inventory of
$21,000).
(iv) Y’s total CGS computed on a FIFO basis is
$220,000 (beginning inventory of $30,000 plus total
production costs of $216,000 less ending inventory of
$26,000).
(v) The ratio of Y’s CGS computed using the
LIFO method to its CGS computed using the FIFO
method is 101% ($222,000/$220,000). Y’s CGS re-
lated to DPGR computed using the LIFO/FIFO ratio
method is $71,457 ($70,750 x 101%).
(c)Other deductions properly alloca-
ble to domestic production gross receipts
or gross income attributable to domestic
production gross receipts—(1)In general.
In determining its QPAI, a taxpayer must
subtract from its DPGR, in addition to its
CGS allocable to DPGR, the deductions
that are properly allocable to DPGR. A tax-
payer generally must allocate and appor-
tion these deductions using the rules of the
section861method. Inlieuofthesec-
tion 861 method, certain taxpayers may ap-
portion these deductions using the simpli-
fied deduction method provided in para-
graph (e) of this section. Paragraph (f) of
this section provides a small business sim-
plified overall method that may be used
by a qualifying small taxpayer, as defined
in that paragraph. A taxpayer using the
simplified deduction method or the small
business simplified overall method must
use that method for all deductions. A tax-
payer eligible to use the small business
simplified overall method may choose at
any time for any taxable year to use the
small business simplified overall method,
the simplified deduction method, or the
section 861 method for a taxable year. A
taxpayer eligible to use the simplified de-
duction method may choose at any time for
any taxable year to use the simplified de-
duction method or the section 861 method
for a taxable year.
(2)Treatment of net operating losses.A
deduction under section 172 for a net op-
erating loss is not allocated or apportioned
to DPGR or gross income attributable to
DPGR.
2006–25 I.R.B.1107June 19, 2006

(3)W–2 wages. Although only W–2
wages as described in §1.199–2 are taken
into account in computing the W–2 wage
limitation, all wages paid (or incurred in
the case of an accrual method taxpayer)
in a taxpayer’s trade or business during
the taxable year are taken into account in
computing QPAI for that taxable year.
(d)Section 861 method—(1)In gen-
eral. Under the section 861 method, a
taxpayer must allocate and apportion its
deductions using the allocation and appor-
tionment rules provided under the section
861 regulations under which section 199
is treated as an operative section de-
scribed in §1.861–8(f). Accordingly, the
taxpayer applies the rules of the section
861 regulations to allocate and appor-
tion deductions (including, if applicable,
its distributive share of deductions from
pass-thru entities) to gross income attrib-
utable to DPGR. Gross receipts that are
allocable to land underthe safe harbor pro-
vided in §1.199–3(m)(6)(iv) are treated as
non-DPGR. See §1.199–3(m)(6)(iv)(B).
If the taxpayer applies the allocation and
apportionment rules of the section 861
regulations for section 199 and another
operative section, then the taxpayer must
use the same method of allocation and
the same principles of apportionment for
purposes of all operative sections (subject
to the rules provided in paragraphs (c)(2)
and (d)(2) and (3) of this section). See
§1.861–8(f)(2)(i).
(2)Deductions for charitable contribu-
tions. Deductions for charitable contribu-
tions (as allowed under section 170 and
section 873(b)(2) or 882(c)(1)(B)) must be
ratably apportioned between gross income
attributable to DPGR and gross income at-
tributable to non-DPGR based on the rela-
tive amounts of gross income.
(3)Research and experimental expendi-
tures. Research and experimental expendi-
tures must be allocated and apportioned in
accordance with §1.861–17 without taking
into account the exclusive apportionment
rule of §1.861–17(b).
(4)Deductions allocated or ap-
portioned to gross receipts treated
as domestic production gross re-
ceipts. If gross receipts are treated as
DPGR pursuant to §1.199–1(d)(3)(i) or
§1.199–3(i)(4)(i)(B)(6),(l)(4)(iv)(A),
(m)(1)(iii)(A), (n)(6)(i), or (o)(2), then
deductions must be allocated or appor-
tioned to the gross income attributable to
such DPGR. Similarly, if gross receipts
are treated as non-DPGR pursuant to
§1.199–1(d)(3)(ii) or §1.199–3(i)(4)(ii),
(l)(4)(iv)(B), (m)(1)(iii)(B), or (n)(6)(ii),
then deductions must be allocated or ap-
portioned to the gross income attributable
to such non-DPGR.
(5)Treatment of items from a pass-thru
entity reporting qualified production
activities income.If, pursuant to
§1.199–9(e)(2) or to the authority granted
in §1.199–9(b)(1)(ii) or (c)(1)(ii), a tax-
payer must combine QPAI and W–2 wages
from a partnership, S corporation, trust (to
the extent not described in §1.199–9(d)) or
estate with the taxpayer’s total QPAI and
W–2 wages from other sources, then for
purposes of apportioning the taxpayer’s
interest expense under this paragraph
§1.199–4(d), the taxpayer’s interest in
such partnership (and, where relevant
in apportioning the taxpayer’s interest
expense, the partnership’s assets), the tax-
payer’s shares in such S corporation, or
the taxpayer’s interest in such trust shall
be disregarded.
(6)Examples. The following examples
illustrate the operation of the section 861
method. Assume in the following exam-
ples that all corporations are calendar year
taxpayers, that all taxpayers have suffi-
cient W–2 wages as defined in §1.199–2(e)
so that the section 199 deduction is not
limited under section 199(b)(1), and that,
with respect to the allocation and appor-
tionment of interest expense, §1.861–10T
does not apply.
Example 1.Section 861 method and no EAG.(i)
Facts. X, a United States corporation that is not a
member of an expanded affiliated group (EAG) (as
defined in §1.199–7), engages in activities that gener-
ate both DPGR and non-DPGR. All of X’s production
activities that generate DPGR are within Standard
Industrial Classification (SIC) Industry Group AAA
(SIC AAA). All of X’s production activities that gen-
erate non-DPGR are within SIC Industry Group BBB
(SIC BBB). X is able to specifically identify CGS al-
locable to DPGR and to non-DPGR. X incurs $900
of research and experimentation expenses (R&E) that
are deductible under section 174, $300 of which are
performed with respect to SIC AAA and $600 of
which are performed with respect to SIC BBB. None
of the R&E is legally mandated R&E as described in
§1.861–17(a)(4) and none of the R&E is included in
CGS. X incurs section 162 selling expenses that are
not includible in CGS and are definitely related to all
of X’s gross income. For 2010, the adjusted basis of
X’s assets is $5,000, $4,000 of which generates gross
income attributable to DPGR and $1,000 of which
generates gross income attributable to non-DPGR.
For 2010, X’s taxable income is $1,380 based on the
following Federal income tax items:
DPGR (all from sales of products within SIC AAA) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$3,000
Non-DPGR(allfromsalesofproductswithinSICBBB).................................................
$3,000
CGSallocabletoDPGR ..........................................................................
($600)
CGSallocabletonon-DPGR.......................................................................
($1,800)
Section162sellingexpenses.......................................................................
($840)
Section174R&E-SICAAA.......................................................................
($300)
Section174R&E-SICBBB........................................................................
($600)
Interestexpense(notincludedinCGS)...............................................................
($300)
Charitablecontributions...........................................................................
($180)
X’staxableincome ..............................................................................
$1,380
(ii)X’s QPAI. X allocates and apportions its de-
duc
tions to gross income attributable to DPGR un-
der the section 861 method of this paragraph (d). In
this case, the section 162 selling expenses are defi-
ni
tely related to all of X’s gross income. Based on
the facts and circumstances of this specific case, ap-
portionment of those expenses between DPGR and
non
-DPGR on the basis of X’s gross receipts is appro-
priate. For purposes of apportioning R&E, X elects
to use the sales method as described in §1.861–17(c).
Xe
lects to apportion interest expense under the tax
book value method of §1.861–9T(g). X has $2,400 of
gross income attributable to DPGR (DPGR of $3,000
-CG
S of $600 allocated based on X’s books and
records). X’s QPAI for 2010 is $1,320, as shown be-
low:
June 19, 200611082006–25 I.R.B.

DPGR (all from sales of products within SIC AAA) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$3,000
CGSallocabletoDPGR ..........................................................................
($600)
Section 162 selling expenses
($840x($3,000DPGR/$6,000totalgrossreceipts)) ................................................ ($420)
Interest expense (not included in CGS)
($300 x ($4,000 (X’s DPGR assets)/
$5,000(X’stotalassets)))..................................................................... ($240)
Charitable contributions (not included in CGS)
($180 x ($2,400 gross income attributable to DPGR/
$3,600totalgrossincome)).................................................................... ($120)
Section174R&E-SICAAA.......................................................................
($300)
X’sQPAI......................................................................................
$1,320
(iii)Sect
ion 199 deduction determination.X’s
tentative deduction under §1.199–1(a) is $119 (.09
x (lesser of QPAI of $1,320 and taxable income of
$1,380))
. Because the facts of this example assume
that X’s W–2 wages as defined in §1.199–2(e) are
sufficient to avoid a limitation on the section 199 de-
duction,
X’s section 199 deduction for 2010 is $119.
Example 2.Section 861 method and EAG.(i)
Facts. The facts are the same as inExample 1ex-
cept that
X owns stock in Y, a United States corpora-
tion, equal to 75% of the total voting power of stock
of Y and 80% of the total value of stock of Y. X
and Y are no
t members of an affiliated group as de-
fined in section 1504(a). Accordingly, the rules of
§1.861–14T do not apply to X’s and Y’s selling ex-
penses, R
&E, and charitable contributions. X and Y
are, however, members of an affiliated group for pur-
poses of allocating and apportioning interest expense
(see §1.8
61–11T(d)(6)) and are also members of an
EAG. For 2010, the adjusted basis of Y’s assets is
$45,000, $21,000 of which generates gross income
attribu
table to DPGR and $24,000 of which generates
gross income attributable to non-DPGR. All of Y’s
activities that generate DPGR are within SIC Indus-
try Group A
AA (SIC AAA). All of Y’s activities that
generate non-DPGR are within SIC Industry Group
BBB (SIC BBB). None of X’s and Y’s sales are to
each othe
r. Y is not able to specifically identify CGS
allocable to DPGR and non-DPGR. In this case, be-
cause CGS is definitely related under the facts and
circumst
ances to all of Y’s gross receipts, apportion-
ment of CGS between DPGR and non-DPGR based
on gross receipts is appropriate. For 2010, Y’s tax-
able inc
ome is $1,910 based on the following Federal
income tax items:
DPGR (all from sales of products within SIC AAA) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$3,000
Non-DPGR(allfromsalesofproductswithinSICBBB).................................................
$3,000
CGS allo
catedtoDPGR ..........................................................................
($1,200
)
CGSallocatedtonon-DPGR.......................................................................
($1,200)
Section162sellingexpenses.......................................................................
($840)
Sectio
n174R&E-SICAAA.......................................................................
($100)
Section174R&E-SICBBB........................................................................
($200)
Interest expense (not included in CGS and not subject to
§1.86
1–10T)................................................................................
($500
)
Charitablecontributions...........................................................................
($50)
Y’staxableincome ..............................................................................
$1,910
(ii)QPAI.(A)X’s QPAI. Determination of X’s
QPAI is the same as inExample 1except that interest
is apportioned to gross income attributable to DPGR
based on the combined adjusted bases of X’s and Y’s
assets. See §1.861–11T(c). Accordingly, X’s QPAI
for 2010 is $1,410, as shown below:
DPGR (all from sales of products within SIC AAA) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$3,000
CGSallocatedtoDPGR ..........................................................................
($600)
Section 162 selling expenses
($840x($3,000DPGR/$6,000totalgrossreceipts)) ................................................ ($420)
Interest expense (not included in CGS and not subject to
§1.861–10T) ($300 x ($25,000 (tax book value of X’s
and Y’s DPGR assets)/$50,000 (tax book value
ofX’sandY’stotalassets)))...................................................................
($150)
Charitable contributions (not included in CGS)
($180 x ($2,400 gross income attributable to DPGR/
$3,600totalgrossincome)).................................................................... ($120)
Section174R&E-SICAAA.......................................................................
($300)
X’sQPAI......................................................................................
$1,410
(B)Y’s QPAI. Y makes the same elections under
the section 861 method as does X. Y has $1,800 of
gross income attributable to DPGR (DPGR of $3,000
- CGS of $1,200 allocated based on Y’s gross re-
ceipts). Y’s QPAI for 2010 is $1,005, as shown be-
low:
2006–25 I.R.B.1109June 19, 2006

DPGR (all from sales of products within SIC AAA) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$3,000
CGSallocatedtoDPGR ..........................................................................
($1,200)
Section 162 selling expenses
($840x($3,000DPGR/$6,000totalgrossreceipts)) ................................................ ($420)
Interest expense (not included in CGS and not subject to
§1.861–10T) ($500 x ($25,000 (tax book value of X’s
and Y’s DPGR assets)/$50,000 (tax book value of X’s
andY’stotalassets))) ........................................................................
($250)
Charitable contributions (not included in CGS)
($50 x ($1,800 gross income attributable to DPGR/
$3,600totalgrossincome))....................................................................($25)
Section174R&E-SICAAA.......................................................................
($100)
Y’sQPAI......................................................................................
$1,005
(iii)Section 199 deduction determination.The
section 199 deduction of the X and Y EAG is de-
term
ined by aggregating the separately determined
QPAI, taxable income, and W–2 wages of X and Y.
See §1.199–7(b). Accordingly, the X and Y EAG’s
ten
tative section 199 deduction is $217 (.09 x (lesser
of combined taxable incomes of X and Y of $3,290
(X’s taxable income of $1,380 plus Y’s taxable in-
com
e of $1,910) and combined QPAI of $2,415 (X’s
QPAI of $1,410 plus Y’s QPAI of $1,005)). Because
the facts of this example assume that the W–2 wages
of
X and Y are sufficient to avoid a limitation on the
section 199 deduction, X and Y EAG’s section 199
deduction for 2010 is $217. The $217 is allocated to
Xa
nd Y in proportion to their QPAI. See §1.199–7(c).
(e
)Simplified deduction method—(1)
In
general. An eligible taxpayer may use
th
e simplified deduction method to ap-
p
ortion deductions between DPGR and
n
on-DPGR. The simplified deduction
m
ethod does not apply to CGS. Under the
s
implified deduction method, a taxpayer’s
d
eductions (except the net operating loss
deduction as provided in paragraph (c)(2)
of this section) are ratably apportioned
between DPGR and non-DPGR based
on relative gross receipts. Accordingly,
the amount of deductions for the cur-
rent taxable year apportioned to DPGR
is equal to the same proportion of the
total deductions for the current taxable
year that the amount of DPGR bears to
total gross receipts. Gross receipts that are
allocable to land underthe safe harbor pro-
vided in §1.199–3(m)(6)(iv) are treated as
non-DPGR. See §1.199–3(m)(6)(iv)(B).
Whether a trust (to the extent not de-
scribed in §1.199–9(d)) or an estate may
use the simplified deduction method is
determined at the trust or estate level. If
a trust or estate qualifies to use the sim-
plified deduction method, the simplified
deduction method must be applied at the
trust or estate level, taking into account
the trust’s or estate’s DPGR, non-DPGR,
and other items from all sources, includ-
ing its distributive or allocable share of
those items of any lower-tier entity, prior
to any charitable or distribution deduction.
Whether the owner of a pass-thru entity
may use the simplified deduction method
is determined at the level of the entity’s
owner. If the owner of a pass-thru entity
qualifies and uses the simplified deduc-
tion method, then the simplified deduction
method is applied at the level of the owner
of the pass-thru entity taking into account
the owner’s DPGR, non-DPGR, and other
items from all sources including its dis-
tributive or allocable share of those items
of the pass-thru entity.
(2)Eligible taxpayer. For purposes of
this paragraph (e), an eligible taxpayer is—
(i) A taxpayer that has average annual
gross receipts (as defined in paragraph (g)
of this section) of $100,000,000 or less; or
(ii) A taxpayer that has total assets (as
defined in paragraph (e)(3) of this section)
of $10,000,000 or less.
(3)Total assets—(i)In general.For
purposes of the simplified deduction
method, total assets means the total as-
sets the taxpayer has at the end of the
taxable year. In the case of a C corpo-
ration, the corporation’s total assets at
the end of the taxable year is the amount
requiredtobereportedonScheduleLof
Form 1120, “United States Corporation
Income Tax Return,” in accordance with
the Form 1120 instructions.
(ii)Members of an expanded affiliated
group. To compute the total assets of an
EAG, the total assets at the end of the
taxable year of each corporation that is a
memberoftheEAGattheendofthetax-
able year that ends with or within the tax-
able year of the computing member (as
described in §1.199–7(h)) are aggregated.
For purposes of this paragraph, a consol-
idated group is treated as one member of
the EAG.
(4)Members of an expanded affiliated
group—(i)In general. Whether the mem-
bers of an EAG may use the simplified
deduction method is determined by refer-
ence to all the members of the EAG. If the
average annual gross receipts of the EAG
are less than or equal to $100,000,000 or
the total assets of the EAG are less than
or equal to $10,000,000, then each mem-
ber of the EAG may individually deter-
mine whether to use the simplified deduc-
tion method, regardless of the cost alloca-
tion method used by the other members.
(ii)Exception. Notwithstanding para-
graph (e)(4)(i) of this section, all members
of the same consolidated group must use
the same cost allocation method.
(iii)Examples. The following examples
illustrate the application of paragraph (e)
of this section:
Example 1. Corporations X, Y, and Z are the
o
nly three members of an EAG. Neither X, Y, nor Z
is a member of a consolidated group. X, Y, and Z
have average annual gross receipts of $20,000,000,
$
70,000,000, and $5,000,000, respectively. X, Y,
and Z each have total assetsat the end of the taxable
year of $5,000,000. Because the average annual
gross receipts of the EAG are less than or equal to
$100,000,000, each of X, Y, and Z may use either
the simplified deduction method or the section 861
method.
Example 2.ThefactsarethesameasinExample
1except that X and Y are members of the same con-
solidated group. X, Y, and Z may use either the sim-
plified deduction method or the section 861 method.
However, X and Y must use the same cost allocation
method.
Example 3.ThefactsarethesameasinExample
1except that Z’s average annual gross receipts are
$15,000,000. Because the average annual gross re-
ceipts of the EAG are greater than $100,000,000 and
the total assets of the EAG at the end of the taxable
year are greater than $10,000,000, X, Y, and Z must
each use the section 861 method.
(f)Small business simplified overall
method—(1)In general. A qualifying
June 19, 200611102006–25 I.R.B.

small taxpayer may use the small business
simplified overall method to apportion
CGS and deductions between DPGR and
non-DPGR. Under the small business
simplified overall method, a taxpayer’s
total costs for the current taxable year
(as defined in paragraph (f)(3) of this
section) are apportioned between DPGR
and non-DPGR based on relative gross
receipts. Accordingly, the amount of
total costs for the current taxable year
apportioned to DPGR is equal to the
same proportion of total costs for the
current taxable year that the amount of
DPGR bears to total gross receipts. To-
tal gross receipts for this purpose do
not include gross receipts that are allo-
cated to land under the land safe harbor
provided in §1.199–3(m)(6)(iv). See
§1.199–3(m)(6)(iv)(B).
(2)Qualifying small taxpayer. Except
as provided in paragraph (f)(5), for pur-
poses of this paragraph (f), aqualifying
small taxpayeris—
(i) A taxpayer that has average annual
gross receipts (as defined in paragraph (g)
of this section) of $5,000,000 or less;
(ii) A taxpayer that is engaged in the
trade or business of farming that is not re-
quired to use the accrual method of ac-
counting under section 447; or
(iii) A taxpayer that is eligible to use
the cash method as provided in Rev. Proc.
2002–28, 2002–1 C.B. 815 (that is, cer-
tain taxpayers with average annual gross
receipts of $10,000,000 or less that are
not prohibited from using the cash method
under section 448, including partnerships,
S corporations, C corporations, or individ-
uals). See §601.601(d)(2) of this chapter.
(3)Total costs for the current taxable
year—(i)In general. For purposes of the
small business simplified overall method,
total costs for the current taxable year
means the total CGS and deductions (ex-
cluding the net operating loss deduction
as provided in paragraph (c)(2) of this
section) for the current taxable year. Total
costs for the current taxable year are de-
termined under the methods of accounting
that the taxpayer uses to compute taxable
income.
(ii)Land safe harbor. A taxpayer
that uses the land safe harbor provided in
§1.199–3(m)(6)(iv) must reduce total costs
for the current taxable year by the costs of
land and any other costs capitalized to the
land (except costs for activities listed in
§1.199–3(m)(2)(iii)) prior to applying the
small business simplified overall method.
See §1.199–3(m)(6)(iv)(B). For example,
if a taxpayer has $1,000 of total costs
for the current taxable year and $600 of
such costs is attributable to land under
the land safe harbor, then only $400 of
such costs is apportioned between DPGR
and non-DPGR under the small business
simplified overall method.
(4)Members of an expanded affiliated
group—(i)In general. Whether the mem-
bers of an EAG may use the small business
simplified overall method is determined by
reference to all the members of the EAG.
If the average annual gross receipts of the
EAG are less than or equal to $5,000,000,
the EAG (viewed as a single corporation)
is engaged in the trade or business of farm-
ing that is not required to use the accrual
method of accounting under section 447,
or the EAG (viewed as a single corpora-
tion) is eligible to use the cash method as
provided in Rev. Proc. 2002–28, then
each member of the EAG may individually
determine whether to use the small busi-
ness simplified overall method, regardless
ofthecostallocationmethodusedbythe
other members.
(ii)Exception. Notwithstanding para-
graph (f)(4)(i) of this section, all members
of the same consolidated group must use
the same cost allocation method.
(iii)Examples. The following examples
illustrate the application of paragraph (f) of
this section:
Example 1. Corporations L, M, and N are the only
three members of an EAG. Neither L, M, nor N is a
member of a consolidated group. L, M, and N have
average annual gross receipts for the current taxable
year of $1,000,000, $1,500,000, and $2,000,000, re-
spectively. Because the average annual gross receipts
of the EAG are less than or equal to $5,000,000, each
of L, M, and N may use the small business simplified
overall method, the simplified deduction method, or
the section 861 method.
Example 2. The facts are the same as inExam-
ple 1except that M and N are members of the same
consolidated group. L, M, and N may use the small
business simplified overall method, the simplified de-
duction method, or the section 861 method. However,
M and N must use the same cost allocation method.
Example 3. The facts are the same as inExample
1except that N has average annual gross receipts of
$4,000,000. Unless the EAG, viewed as a single cor-
poration, is engaged in the trade or business of farm-
ing that is not required to use the accrual method of
accounting under section 447, or the EAG, viewed as
a single corporation, is eligible to use the cash method
as provided in Rev. Proc. 2002–28, because the aver-
age annual gross receipts of the EAG are greater than
$5,000,000, L, M, and N are all ineligible to use the
small business simplified overall method.
(5)Trusts and estates.Trustsandes-
tates under §1.199–9(e) may not use the
small business simplified overall method.
(g)Average annual gross receipts—(1)
In general. For purposes of the simplified
deduction method and the small busi-
ness simplified overall method, average
annual gross receipts means the average
annual gross receipts of the taxpayer (in-
cluding gross receipts attributable to the
sale, exchange, or other disposition of
land under the land safe harbor provided
in §1.199–3(m)(6)(iv)) for the 3 taxable
years (or, if fewer, the taxable years dur-
ing which the taxpayer was in existence)
preceding the current taxable year, even if
one or more of such taxable years began
before the effective date of section 199. In
the case of any taxable year of less than 12
months (a short taxable year), the gross re-
ceipts shall be annualized by multiplying
the gross receipts for the short period by
12 and dividing the result by the number
of months in the short period.
(2)Members of an expanded affiliated
group. To compute the average annual
gross receipts of an EAG, the gross re-
ceipts, for the entire taxable year, of each
corporation that is a member of the EAG
at the end of its taxable year that ends with
or within the taxable year of the comput-
ing member are aggregated. For purposes
of this paragraph, a consolidated group is
treated as one member of the EAG.
§1.199–5 Application of section 199
to pass-thru entities for taxable years
beginning after May 17, 2006, the
enactment date of the Tax Increase
Prevention and Reconciliation Act of
2005.[Reserved].
§1.199–6 Agricultural and horticultural
cooperatives.
(a)In general. A patron who receives
a qualified payment (as defined in para-
graph (e) of this section) from a speci-
fied agricultural or horticultural coopera-
tive (cooperative) (as defined in paragraph
(f) of this section) is allowed a deduc-
tion under §1.199–1(a) (section 199 de-
duction) for the taxable year the quali-
fied payment is received for the portion
of the cooperative’s section 199 deduction
passed through to the patron and identi-
fied by the cooperative in a written no-
2006–25 I.R.B.1111June 19, 2006

tice mailed to the person during the pay-
ment period described in section 1382(d).
The provisions of this section apply solely
for purposes of section 199 of the Internal
Revenue Code (Code).
(b)Cooperative denied section 1382
deduction for portion of qualified pay-
ments. A cooperative must reduce its sec-
tion 1382 deduction by an amount equal
to the portion of any qualified payment
that is attributable to the cooperative’s
section 199 deduction passed through to
the patron.
(c)Determining cooperative’s taxable
income. For purposes of determining its
section 199 deduction, the cooperative’s
taxable income is computed without taking
into account any deduction allowable un-
der section 1382(b) or (c) (relating to pa-
tronage dividends, per-unit retain alloca-
tions, and nonpatronage distributions).
(d)Special rule for marketing coopera-
tives. In the case of a cooperative engaged
in the marketing of agricultural and/or
horticultural products described in para-
graph (f) of this section, the cooperative is
treated as having manufactured, produced,
grown, or extracted (MPGE) (as defined
in §1.199–3(e)) in whole or in significant
part (as defined in §1.199–3(g)) within the
United States (as defined in §1.199–3(h))
any agricultural or horticultural products
marketed by the cooperative that its pa-
trons have MPGE.
(e)Qualified payment.Thetermquali-
fied paymentmeans any amount of a pa-
tronage dividend or per-unit retain allo-
cation, as described in section 1385(a)(1)
or (3) received by a patron from a co-
operative, that is attributable to the por-
tion of the cooperative’s qualified produc-
tion activities income (QPAI) (as defined
in §1.199–1(c)), for which the coopera-
tive is allowed a section 199 deduction.
For this purpose, patronage dividends and
per-unit retain allocations include any ad-
vances on patronage and per-unit retains
paid in money during the taxable year.
(f)Specified agricultural or horticul-
tural cooperative.Aspecified agricultural
or horticultural cooperativemeans a coop-
erative to which Part I of subchapter T of
the Code applies and the cooperative has
MPGE in whole or significant part within
the United States any agricultural or hor-
ticultural product, or has marketed agri-
cultural or horticultural products. For this
purpose, agricultural or horticultural prod-
ucts also include fertilizer, diesel fuel, and
other supplies used in agricultural or hor-
ticultural production.
(g)Written notice to patrons.Inorder
for a patron to qualify for the section 199
deduction, paragraph (a) of this section re-
quires that the cooperative identify in a
written notice the patron’s portion of the
section 199 deduction that is attributable
to the portion of the cooperative’s QPAI
for which the cooperative is allowed a sec-
tion 199 deduction. This written notice
must be mailed by the cooperative to its
patrons no later than the 15th day of the
ninth month following the close of the tax-
able year. The cooperative may use the
same written notice, if any, that it uses to
notify patrons of their respective alloca-
tions of patronage dividends, or may use a
separate timely written notice(s) to comply
with this section. The cooperative must
report the amount of the patron’s section
199 deduction on Form 1099-PATR, “Tax-
able Distributions Received From Cooper-
atives,” issued to the patron.
(h)Additional rules relating to
passthrough of section 199 deduction.
The cooperative may, at its discretion,
pass through all, some, or none of the
section 199 deduction to its patrons. How-
ever, the cooperative may not apply sec-
tion 199(d)(3) and this section to any
portion of the section 199 deduction that
is not passed through to its patrons. A
cooperative member of a federated coop-
erative may pass through the section 199
deduction it receives from the federated
cooperative to its member patrons. Pa-
trons may claim the section 199 deduction
for the taxable year in which they receive
the written notice from the cooperative
informing them of the section 199 amount
without regard to the taxable income limi-
tation under §1.199–1(a) and (b).
(i)W–2 wages. The W–2 wage limita-
tion described in §1.199–2 shall be applied
at the cooperative level whether or not the
cooperative chooses to pass through some
or all of the section 199 deduction. Any
section 199 deduction that has been passed
through by a cooperative to its patrons is
not subject to the W–2 wage limitation a
second time at the patron level.
(j)Recapture of section 199 deduction.
If the amount of the section 199 deduction
that was passed through to patrons exceeds
the amount allowable as a section 199 de-
duction as determined on audit or reported
on an amended return, then recapture of the
excess will occur at the cooperative level
in the taxable year the cooperative took the
excess section 199 deduction amount into
account.
(k)Section is exclusive. This section
is the exclusive method for cooperatives
and their patrons to compute the amount of
the section 199 deduction. Thus, a patron
may not deduct any amount with respect
to a patronage dividend or a per-unit retain
allocation unless the requirements of this
section are satisfied.
(l)No double counting. To the extent a
cooperative passes through the section 199
deduction to a patron, a qualified payment
received by the patron of the cooperative
is not taken in account for purposes of sec-
tion 199.
(m)Examples. The following examples
illustrate the application of this section:
Example 1. (i) Cooperative X markets corn
grown by its members within the United States for
sale to retail grocers. For its calendar year ended De-
cember 31, 2007, Cooperative X has gross receipts of
$1,500,000, all derived from the sale of corn grown
by its members within the United States. Cooper-
ative X pays $370,000 for its members’ corn and
its W–2 wages (as defined in §1.199–2(e)) for 2007
total $130,000. Cooperative X has no other costs.
Patron A is a member of Cooperative X. Patron A is
a cash basis taxpayer and files Federal income tax
returns on a calendar year basis. All corn grown by
Patron A in 2007 is sold through Cooperative X and
Patron A is eligible to share in patronage dividends
paid by Cooperative X for that year.
(ii) Cooperative X is a cooperative described in
paragraph (f) of this section. Accordingly, this sec-
tion applies to Cooperative X and its patrons and all
of Cooperative X’s gross receipts from the sale of its
patrons’ corn qualify as domestic production gross
receipts (as defined §1.199–3(a)). Cooperative X’s
QPAI is $1,000,000. Cooperative X’s section 199 de-
duction for its taxable year 2007 is $60,000 (.06 x
$1,000,000). Because thisamount is less than 50%
of Cooperative X’s W–2 wages, the entire amount is
allowed as a section 199 deduction subject to the rules
of section 199(d)(3) and this section.
Example 2. (i) The facts are the same as inEx-
ample 1except that Cooperative X decides to pass
its entire section 199 deduction through to its mem-
bers. Cooperative X declares a patronage dividend
for its 2007 taxable year of $1,000,000, which it pays
on March 15, 2008. Pursuant to paragraph (g) of this
section, Cooperative X notifies members in written
notices that accompany the patronage dividend noti-
fication that it is allocating to them the section 199 de-
duction it is entitled to claim in the taxable year 2007.
On March 15, 2008, PatronA receives a $10,000 pa-
tronage dividend that is a qualified payment under
paragraph (e) of this section from Cooperative X. In
the notice that accompanies the patronage dividend,
Patron A is designated a $600 section 199 deduction.
Under paragraph (a) of this section, Patron A must
claim a $600 section 199 deduction for the taxable
June 19, 200611122006–25 I.R.B.

year ending December 31, 2008, without regard to
the taxable income limitation under §1.199–1(a) and
(b). Cooperative X must report the amount of Patron
A’s section 199 deduction on Form 1099-PATR, “Tax-
able Distributions Received From Cooperatives,” is-
sued to Patron A for the calendar year 2008.
(ii) Under paragraph (b) of this section, Cooper-
ative X is required to reduce its patronage dividend
deduction of $1,000,000 by the $60,000 section 199
deduction passed through to members (whether or not
Cooperative X pays patronage on book or Federal in-
come tax net earnings). As a consequence, Cooper-
ative X is entitled to a patronage dividend deduction
for the taxable year ending December 31, 2007, in
the amount of $940,000 ($1,000,000 - $60,000) and
to a section 199 deduction in the amount of $60,000
($1,000,000 x .06). Its taxable income for 2007 is $0.
Example 3. (i)ThefactsarethesameasinEx-
ample 1except that Cooperative X paid out $500,000
to its patrons as advances on expected patronage net
earnings. In 2007, Cooperative X pays its patrons a
$500,000 ($1,000,000 - $500,000 already paid) pa-
tronage dividend in cash or a combination of cash and
qualified written notices of allocation. Under para-
graph (b) of this section and section 1382, Cooper-
ative X is allowed a patronage dividend deduction
of $440,000 ($500,000 - $60,000 section 199 deduc-
tion), whether patronage net earnings are distributed
on book or Federal income tax net earnings.
(ii) The patrons will have received a gross amount
of $1,000,000 in qualified payments under paragraph
(e) of this section from Cooperative X ($500,000 paid
during the taxable year as advances and the additional
$500,000 paid as patronage dividends). If Coopera-
tive X passes through its entire section 199 deduction
to its members by providing the notice required by
paragraph (g) of this section, then the patrons will be
allowed a $60,000 section 199 deduction, resulting
in a net $940,000 taxable distribution from Coopera-
tive X. Pursuant to paragraph (l) of this section, the
$1,000,000 received by the patrons from Cooperative
X is not taken into account for purposes of section 199
in the hands of the patrons.
§1.199–7 Expanded affiliated groups.
(a)In general. The provisions of this
section apply solely for purposes of sec-
tion 199 of the Internal Revenue Code
(Code). All members of an expanded affil-
iated group (EAG) are treated as a single
corporation for purposes of section 199.
Notwithstanding the preceding sentence,
except as otherwise provided in the Code
and regulations (see, for example, sections
199(c)(7) and 267, §1.199–3(b), paragraph
(a)(3) of this section, and the consolidated
return regulations), each member of an
EAG is a separate taxpayer that computes
its own taxable income or loss, qualified
production activities income (QPAI) (as
defined in §1.199–1(c)), and W–2 wages
(as defined in §1.199–2(e)). If members
of an EAG are also members of a consoli-
dated group, see paragraph (d) of this sec-
tion.
(1)Definition of expanded affiliated
group. An EAG is an affiliated group as
defined in section 1504(a), determined by
substitutingmore than 50 percentforat
least 80 percenteach place it appears and
without regard to section 1504(b)(2) and
(4).
(2)Identification of members of an ex-
panded affiliated group—(i)In general.A
corporation must determine if it is a mem-
ber of an EAG on a daily basis.
(ii)Becoming or ceasing to be a mem-
ber of an expanded affiliated group.If
a corporation becomes or ceases to be a
member of an EAG, the corporation is
treated as becoming or ceasing to be a
member of the EAG at the end of the day
on which its status as a member changes.
(3)Attribution of activities—(i)In
general. If a member of an EAG (the
disposing member) derives gross receipts
(as defined in §1.199–3(c)) from the lease,
rental, license, sale, exchange, or other
disposition (as defined in §1.199–3(i)) of
qualifying production property (QPP) (as
defined in §1.199–3(j)) that was manu-
factured, produced, grown or extracted
(MPGE) (as defined in §1.199–3(e)), in
whole or in significant part (as defined
in §1.199–3(g)) in the United States (as
defined in §1.199–3(h)), a qualified film
(as defined in §1.199–3(k)), or electricity,
natural gas, or potable water (as defined
in §1.199–3(l)) (collectively, utilities) that
was produced in the United States, such
property was MPGE or produced by an-
other corporation (or corporations), and
the disposing member is a member of the
same EAG as the other corporation (or
corporations) at the time that the disposing
member disposes of the QPP, qualified
film, or utilities, then the disposing mem-
ber is treated as conducting the previous
activities conducted by such other corpo-
ration (or corporations) with respect to the
QPP, qualified film, or utilities in deter-
mining whether its gross receipts are do-
mestic production gross receipts (DPGR)
(as defined in §1.199–3(a)). With respect
to a lease, rental, or license, the disposing
member is treated as having disposed of
the QPP, qualified film, or utilities on the
date or dates on which it takes into account
the gross receipts derived from the lease,
rental, or license under its methods of ac-
counting. With respect to a sale, exchange,
or other disposition, the disposing member
is treated as having disposed of the QPP,
qualified film, or utilities on the date on
which it ceases to own the QPP, qualified
film, or utilities for Federal income tax
purposes, even if no gain or loss is taken
into account.
(ii)Special rule. Attribution of ac-
tivities does not apply for purposes of
the construction of real property under
§1.199–3(m) or the performance of engi-
neering and architectural services under
§1.199–3(n). A member of an EAG must
engage in a construction activity under
§1.199–3(m)(2), provide engineering ser-
vices under §1.199–3(n)(2), or provide ar-
chitectural services under §1.199–3(n)(3)
in order for the member’s gross receipts to
be derived from construction, engineering,
or architectural services.
(4)Examples. The following exam-
ples illustrate the application of paragraph
(a)(3) of this section. Assume that all tax-
payers are calendar year taxpayers. The
examples are as follows:
Example 1. Corporations M and N are members
of the same EAG. M is engaged solely in the trade
or business of manufacturing furniture in the United
States that it sells to unrelated persons. N is engaged
solely in the trade or business of engraving compa-
nies’ names on pens and pencils purchased from un-
related persons and then selling the pens and pencils
to such companies. For purposes of this example, as-
sume that if N was not a member of an EAG, its ac-
tivities would not qualify as MPGE. Accordingly, al-
though M’s sales of the furniture qualify as DPGR
(assuming all the other requirements of §1.199–3 are
met), N’s sales of the engraved pens and pencils do
not qualify as DPGR because neither N nor another
member of the EAG MPGE the pens and pencils.
Example 2. For the entire 2007 year, Corpora-
tions A and B are members of the same EAG. A is
engaged solely in the trade or business of MPGE ma-
chinery in the United States. A and B each own 45%
of partnership C and unrelated persons own the re-
maining 10%. C is engaged solely in the trade or
business of MPGE the same type of machinery in the
UnitedStatesasA.In2007,Bpurchasesandthenre-
sells the machinery MPGE in 2007 by A and C. B also
resells machinery it purchases from unrelated per-
sons. If only B’s activities were considered, B would
not qualify for the deduction under §1.199–1(a) (sec-
tion 199 deduction). However, because at the time
B disposes of the machinery B is a member of the
EAG that includes A, B is treated as conducting A’s
previous MPGE activities in determining whether B’s
gross receipts from the sale of the machinery MPGE
by A are DPGR. C is not a member of the EAG and
thus C’s MPGE activities are not attributed to B in
determining whether B’s gross receipts from the sale
of the machinery MPGE by C are DPGR. Accord-
ingly, B’s gross receipts attributable to its sale of the
machinery it purchasesfrom A are DPGR (assuming
all the other requirements of §1.199–3 are met). B’s
2006–25 I.R.B.1113June 19, 2006

gross receipts attributable to its sale of the machin-
ery it purchases from C and from the unrelated per-
sons are non-DPGR because no member of the EAG
MPGE the machinery and because C does not qualify
as an EAG partnership.
Example 3. The facts are the same as inExample
2except that rather than reselling the machinery, B
rents the machinery to unrelated persons and B takes
the gross receipts attributable to the rental of the ma-
chinery into account under its methods of accounting
in 2007, 2008, and 2009. In addition, as of the close
of business on December 31, 2008, A and B cease to
be members of the same EAG. With respect to the ma-
chineryacquiredfromCandtheunrelatedpersons,
B’s gross receipts attributable to the rental of the ma-
chinery in 2007, 2008, and 2009 are non-DPGR be-
cause no member of the EAG MPGE the machinery
and because C does not qualify as an EAG partner-
ship. With respect to machinery acquired from A,
B’s gross receipts in 2007 and 2008 attributable to
the rental of the machinery are DPGR because at the
time B takes into account the gross receipts derived
from the rental of the machinery under its methods of
accounting, B is a member of the same EAG as A and
B is treated as conducting A’s previous MPGE activ-
ities. However, with respect to the rental receipts in
2009, because A and B are not members of the same
EAG in 2009, B’s rental receipts are non-DPGR.
Example 4. For the entire 2007 year, Corpora-
tion P owns over 50% of the stock of Corporation
S. In 2007, P MPGE QPP in the United States and
transfers the QPP to S. On February 28, 2008, P dis-
poses of stock of S, reducing P’s ownership of S be-
low 50% and P and S cease to be members of the same
EAG. On June 30, 2008, S sells the QPP to an unre-
lated person. Unless P’s transfer of the QPP to S took
place in a transaction to which section 381(a) applies
(see §1.199–8(e)(3)), because S is not a member of
the same EAG as P on June 30, 2008, S is not treated
as conducting the activities conducted by P in deter-
mining if S’s receipts are DPGR, notwithstanding that
P and S were members of the same EAG when P
MPGE the QPP and when P transferred the QPP to
S.
Example 5. For the entire 2007 year, Corpora-
tions X and Y are unrelatedcorporations. In 2007, X
MPGE QPP in the United States and sells the QPP to
Y. On August 31, 2008, X acquires over 50% of the
stock of Y, thus making X and Y members of the same
EAG. On November 30, 2008, Y sells the QPP to an
unrelated person. Because X and Y are members of
the same EAG on November 30, 2008, Y is treated as
conducting the activities conducted by X in 2007 in
determining if Y’s receipts are DPGR, notwithstand-
ing that X and Y were not members of the same EAG
when X MPGE the QPP nor when X sold the QPP to
Y.
(5)Anti-avoidance rule. If a transaction
between members of an EAG is engaged
in or structured with a principal purpose
of qualifying for, or increasing the amount
of, the section 199 deduction of the EAG
or the portion of the section 199 deduction
allocated to one or more members of the
EAG, adjustments must be made to elim-
inate the effect of the transaction on the
computation of the section 199 deduction.
(b)Computation of expanded affiliated
group’s section 199 deduction—(1)In
general. The section 199 deduction for an
EAG is determined by the EAG by aggre-
gating each member’s taxable income or
loss, QPAI, and W–2 wages, if any. For
purposes of this determination, a mem-
ber’s QPAI may be positive or negative.
A member’s taxable income or loss and
QPAI shall be determined by reference to
the member’s methods of accounting.
(2)Example. The following example
illustrates the application of paragraph
(b)(1) of this section:
Example. Corporations X, Y, and Z, calendar
year taxpayers, are the only members of an EAG
and are not members of a consolidated group. X
has taxable income of $50,000, QPAI of $15,000,
and W–2 wages of $1,000. Y has taxable income
of ($20,000), QPAI of ($1,000), and W–2 wages of
$750. Z has $0 taxable income and $0 QPAI, but has
W–2 wages of $2,000. In determining the EAG’s
section 199 deduction, the EAG aggregates each
member’s taxable income or loss, QPAI, and W–2
wages. Accordingly, the EAG has taxable income
of $30,000 ($50,000 + ($20,000) + $0), QPAI of
$14,000 ($15,000 + ($1,000) + $0), and W–2 wages
of $3,750 ($1,000 + $750 + $2,000).
(3)Net operating loss carrybacks and
carryovers. In determining the taxable in-
come of an EAG, if a member of an EAG
has a net operating loss (NOL) carryback
or carryover to the taxable year, then the
amount of the NOL used to offset taxable
income cannot exceed the taxable income
of that member.
(c)Allocation of an expanded af-
filiated group’s section 199 deduction
among members of the expanded affiliated
group—(1)In general. An EAG’s section
199 deduction as determined in paragraph
(b)(1) of this section is allocated among
the members of the EAG in proportion
to each member’s QPAI, regardless of
whether the EAG member has taxable in-
come or loss or W–2 wages for the taxable
year. For this purpose, if a member has
negative QPAI, the QPAI of the member
shall be treated as zero.
(2)Use of section 199 deduction to
create or increase a net operating loss.
Notwithstanding §1.199–1(b), if a mem-
ber of an EAG has some or all of the
EAG’s section 199 deduction allocated
to it under paragraph (c)(1) of this sec-
tion and the amount allocated exceeds the
member’s taxable income (determined
prior to allocation of the section 199 de-
duction), the section 199 deduction will
create an NOL for the member. Similarly,
if a member of an EAG, prior to the allo-
cation of some or all of the EAG’s section
199 deduction to the member, has an NOL
for the taxable year, the portion of the
EAG’s section 199 deduction allocated to
the member will increase the member’s
NOL.
(d)Special rules for members of the
same consolidated group—(1)Intercom-
pany transactions. In the case of an in-
tercompany transaction between consoli-
dated group members S and B (as the terms
intercompany transaction, S, and B are de-
fined in §1.1502–13(b)(1)), S takes the
intercompany transaction into account in
computing the section 199 deduction at the
same time and in the same proportion as S
takes into account the income, gain, deduc-
tion, or loss from the intercompany trans-
action under §1.1502–13.
(2)Attribution of activities in the con-
struction of real property and the perfor-
mance of engineering and architectural
services. Notwithstanding paragraph
(a)(3)(ii) of this section, a disposing mem-
ber (as described in paragraph (a)(3)(i)
of this section) is treated as conducting
the previous activities conducted by each
other member of its consolidated group
with respect to the construction of real
property under §1.199–3(m) and the per-
formance of engineering and architectural
services under §1.199–3(n), but only with
respect to activities performed during the
period of consolidation.
(3)Application of the simplified de-
duction method and the small business
simplified overall method. For purposes of
applying the simplified deduction method
under §1.199–4(e) and the small busi-
ness simplified overall method under
§1.199–4(f), a consolidated group deter-
mines its QPAI using its members’ DPGR,
non-DPGR, cost of goods sold (CGS), and
all other deductions, expenses, or losses
(deductions), determined after application
of §1.1502–13.
(4)Determining the section 199 deduc-
tion—(i)Expanded affiliated group con-
sists of consolidated group and non-con-
solidated group members. In determining
the section 199 deduction, if an EAG
includes corporations that are members
of the same consolidated group and cor-
porations that are not members of the
same consolidated group, the consoli-
dated taxable income or loss, QPAI, and
W–2 wages, if any, of the consolidated
June 19, 200611142006–25 I.R.B.

group (and not the separate taxable in-
come or loss, QPAI, and W–2 wages of
the members of the consolidated group),
are aggregated with the taxable income or
loss, QPAI, and W–2 wages, if any, of the
non-consolidated group members. For ex-
ample, if A, B, C, S1, and S2 are members
ofthesameEAG,andA,S1,andS2are
members of the same consolidated group
(the A consolidated group), then the A
consolidated group is treated as one mem-
ber of the EAG. Accordingly, the EAG is
considered to have three members, the A
consolidated group, B, and C. The consol-
idated taxable income or loss, QPAI, and
W–2 wages, if any, of the A consolidated
group are aggregated with the taxable in-
come or loss, QPAI, and W–2 wages, if
any, of B and C in determining the EAG’s
section 199 deduction.
(ii)Expanded affiliated group consists
only of members of a single consolidated
group. If all the members of an EAG are
members of the same consolidated group,
the consolidated group’s section 199 de-
duction is determined using the consoli-
dated group’s consolidated taxable income
or loss, QPAI, and W–2 wages, rather than
the separate taxable income or loss, QPAI,
and W–2 wages of its members.
(5)Allocation of the section 199 de-
duction of a consolidated group among its
members. The section 199 deduction of a
consolidated group (or the section 199 de-
duction allocated to a consolidated group
that is a member of an EAG) is allocated
to the members of the consolidated group
in proportion to each consolidated group
member’s QPAI, regardless of whether the
consolidated group member has separate
taxable income or loss or W–2 wages for
the taxable year. In allocating the sec-
tion 199 deduction of a consolidated group
among its members, any redetermination
of a corporation’s receipts, CGS, or other
deductions from an intercompany trans-
action under §1.1502–13(c)(1)(i) or (c)(4)
for purposes of section 199 is not taken
into account. Also, for purposes of this al-
location, if a consolidated group member
has negative QPAI, the QPAI of the mem-
ber shall be treated as zero.
(e)Examples. The following examples
illustrate the application of paragraphs (a)
through (d) of this section:
Example 1. Corporations X and Y are members
of the same EAG but are not members of a consoli-
dated group. All the activities described in this ex-
ample take place during the same taxable year. X
and Y each use the section 861 method described in
§1.199–4(d) for allocating and apportioning their de-
ductions. X incurs $5,000 in costs in manufacturing
a machine, all of which are capitalized. X is entitled
to a $1,000 depreciation deduction for the machine in
the current taxable year. X rents the machine to Y for
$1,500. Y uses the machine in manufacturing QPP
within the United States. Y incurs $1,400 of CGS in
manufacturing the QPP. Y sells the QPP to unrelated
persons for $7,500. Pursuant to section 199(c)(7) and
§1.199–3(b), X’s rental income is non-DPGR (and its
related costs are not attributable to DPGR). Accord-
ingly, Y has $4,600 of QPAI (Y’s $7,500 DPGR re-
ceived from unrelated persons - Y’s $1,400 CGS allo-
cable to such receipts - Y’s $1,500 of rental expense),
X has $0 of QPAI, and the EAG has $4,600 of QPAI.
Example 2. The facts are the same as inExample
1except that X and Y are members of the same con-
solidated group. Pursuant to section 199(c)(7) and
§1.199–3(b), X’s rental income ordinarily would not
be DPGR (and its related costs would not be allocable
to DPGR). However, because X and Y are members
of the same consolidated group, §1.1502–13(c)(1)(i)
provides that the separate entity attributes of X’s
intercompany items or Y’s corresponding items,
or both, may be redetermined in order to produce
the same effect as if X and Y were divisions of a
single corporation. If X and Y were divisions of
a single corporation, X and Y would have QPAI
of $5,100 ($7,500 DPGR received from unrelated
persons - $1,400 CGS allocable to such receipts
- $1,000 depreciation deduction). To obtain this
same result for the consolidated group, X’s rental
income is redetermined as DPGR, which results
in the consolidated group having $9,000 of DPGR
(the sum of Y’s DPGR of $7,500 + X’s DPGR of
$1,500) and $3,900 of costs allocable to DPGR
(the sum of Y’s $1,400 CGS + Y’s $1,500 rental
expense + X’s $1,000 depreciation expense). For
purposes of determining how much of the consoli-
dated group’s section 199 deduction is allocated to
X and Y, pursuant to paragraph (d)(5) of this section,
the redetermination of X’s rental income as DPGR
under §1.1502–13(c)(1)(i) is not taken into account
(X’s costs are considered to be allocable to DPGR
because they are allocable to the consolidated group
deriving DPGR). Accordingly, for this purpose, X
is deemed to have ($1,000) of QPAI (X’s $0 DPGR
- X’s $1,000 depreciation deduction). Because X
is deemed to have negative QPAI, also pursuant to
paragraph (d)(5) of this section, X’s QPAI is treated
as zero. Y has $4,600 of QPAI (Y’s $7,500 DPGR
- Y’s $1,400 CGS allocable to such receipts - Y’s
$1,500 of rental expense). Accordingly, X is allo-
cated $0/($0 + $4,600) of the consolidated group’s
section 199 deduction and Y is allocated $4,600/($0
+ $4,600) of the consolidated group’s section 199
deduction.
Example 3. Corporations P and S are members
of the same EAG but are not members of a consoli-
dated group. P and S each use the section 861 method
for allocating and apportioning their deductions and
are both calendar year taxpayers. In 2007, P incurs
$1,000 in research and development expenses in cre-
ating an intangible asset and deducts these expenses
in 2007. P anticipates that it will license the intan-
gible asset to S. On January 1, 2008, P licenses the
intangible asset to S for $2,500. S uses the intangible
asset in manufacturing QPP within the United States.
S incurs $2,000 of additional costs in manufacturing
the QPP. On December 31, 2008, S sells the QPP to
unrelated persons for $10,000. Because on December
31, 2007, P anticipates that it will license the intan-
gible asset to S, a related person, and also because
the intangible asset is not QPP, P’s license receipts
from S will be non-DPGR. Accordingly, P’s research
and development expenses in 2007 are not attribut-
able to DPGR. In 2008, S has $5,500 of QPAI (S’s
$10,000 DPGR received from unrelated persons - S’s
$2,000 additional costs in manufacturing the QPP -
S’s $2,500 of license expense), P has $0 of QPAI, and
the EAG has $5,500 of QPAI.
Example 4.(i)Determination of consolidated
group’s QPAI. The facts are the same as inExample
3except that P and S are members of the same con-
solidated group. Pursuant to section 199(c)(7) and
§1.199–3(b), and also because the intangible asset is
not QPP, P’s license income ordinarily would not be
DPGR (and its related costs would not be allocable
to DPGR). However, because P and S are members
of the same consolidated group, §1.1502–13(c)(1)(i)
provides that the separate entity attributes of P’s inter-
company items or S’s corresponding items, or both,
may be redetermined in order to produce the same ef-
fect as if P and S were divisions of a single corpora-
tion. If P and S were divisions of a single corporation,
in 2007 the single corporation would have $1,000 of
expenses allocable to the anticipated DPGR from the
sale of the QPP to unrelated persons, resulting in a
negative QPAI (from this individual item) of $1,000.
In 2008, the single corporation would have QPAI of
$8,000 ($10,000 DPGR received from unrelated per-
sons - $2,000 additional costs in manufacturing the
QPP). To obtain this same result for the consolidated
group, P’s license income from S is redetermined as
DPGR. P’s research and development expenses are
allocable to DPGR. This results in the consolidated
group having negative QPAI in 2007 (from the re-
search and development expense) of $1,000. In 2008,
the consolidated group has $12,500 of DPGR (the
sum of S’s DPGR of $10,000 + P’s DPGR of $2,500)
and $4,500 of costs allocable to DPGR (the sum of
S’s $2,000 additional costs + S’s $2,500 license ex-
pense), resulting in $8,000 of QPAI in 2008.
(ii)Allocation of deduction. Since the consoli-
dated group has no QPAI in 2007, there is no section
199 deduction to be allocated between P and S in
2007. In 2008, the consolidated group has $8,000
of QPAI and, assuming that the group has positive
taxable income and W–2 wages, the consolidated
group will have a section 199 deduction. For pur-
poses of determining how much of the consolidated
group’s section 199 deduction is allocated to P and
S, pursuant to paragraph (d)(5) of this section, the re-
determination of P’s license income as DPGR under
§1.1502–13(c)(1)(i) is not taken into account. Ac-
cordingly, for purposes of allocating the consolidated
group’s section 199 deduction between P and S, P is
deemed to have $0 DPGR and $0 QPAI in 2008. S
has $5,500 of QPAI (S’s $10,000 DPGR - S’s $2,000
in additional costs allocable to such receipts - S’s
$2,500 of license expense). Accordingly, P is allo-
cated $0/($0 + $5,500) of the consolidated group’s
section 199 deduction in 2008 and S is allocated
$5,500/($0 + $5,500) of the consolidated group’s
section 199 deduction.
2006–25 I.R.B.1115June 19, 2006

Example 5.(i)Facts. Corporations A and B
are the only two members of an EAG but are not
members of a consolidated group. A and B each file
Federal income tax returns on a calendar year basis.
The average annual gross receipts of the EAG are less
than or equal to $100,000,000 and A and B each use
the simplified deduction method under §1.199–4(e).
In 2007, A MPGE televisions within the United
States. A has $10,000,000 of DPGR from sales of
televisions to unrelated persons and $2,000,000 of
DPGR from sales of televisions to B. In addition,
A has gross receipts from computer consulting ser-
vices with unrelated persons of $3,000,000. A has
CGS of $6,000,000. A is able to determine from its
books and records that $4,500,000 of its CGS are
attributable to televisions sold to unrelated persons
and $1,500,000 are attributable to televisions sold to
B (see §1.199–4(b)(2)). A has other deductions of
$4,000,000. A has no other items of income, gain,
or deductions. In 2007, B sells the televisions it pur-
chased from A to unrelated persons for $4,100,000.
B also pays $100,000 for administrative services
performed in 2007. B has no other items of income,
gain, or deductions.
(ii)QPAI.(A)A’s QPAI. In order to determine
A’s QPAI, A subtracts its $6,000,000 CGS from its
$12,000,000 DPGR. Under the simplified deduction
method, A then apportions its remaining $4,000,000
of deductions to DPGR in proportion to the ratio
of its DPGR to total gross receipts. Thus, of A’s
$4,000,000 of deductions, $3,200,000 is apportioned
to DPGR ($4,000,000 x $12,000,000/$15,000,000).
Accordingly, A’s QPAI is $2,800,000 ($12,000,000
DPGR - $6,000,000 CGS - $3,200,000 deductions
apportioned to its DPGR).
(B)B’s QPAI. Although B did not MPGE the
televisions it sold, pursuant to paragraph (a)(3) of
this section, B is treated as conducting A’s MPGE of
the televisions in determining whether B’s gross re-
ceipts are DPGR. Thus, B has $4,100,000 of DPGR.
In order to determine B’sQPAI, B subtracts its
$2,000,000 CGS from its $4,100,000 DPGR. Under
the simplified deduction method, B then apportions
its remaining $100,000 of deductions to DPGR in
proportion to the ratio of its DPGR to total gross
receipts. Thus, because B has no other gross receipts,
all of B’s $100,000 of deductions is apportioned
to DPGR ($100,000 x $4,100,000/$4,100,000).
Accordingly, B’s QPAI is $2,000,000 ($4,100,000
DPGR - $2,000,000 CGS - $100,000 deductions
apportioned to its DPGR).
Example 6.(i)Facts. The facts are the same
as inExample 5except that A and B are members
of the same consolidated group, B does not sell the
televisions purchased from A until 2008, and B’s
$100,000 paid for administrative services are paid
in 2008 for services performed in 2008. In addition,
in 2008, A has $3,000,000 in gross receipts from
computer consulting services with unrelated persons
and $1,000,000 in related deductions.
(ii)Consolidated group’s 2007 QPAI.Thecon-
solidated group’s DPGR and total gross receipts
in 2007 are $10,000,000 and $13,000,000, respec-
tively, because, pursuant to paragraph (d)(1) of this
section and §1.1502–13, the sale of the televisions
from A to B is not taken into account in 2007. In
order to determine the consolidated group’s QPAI,
the consolidated group subtracts its $4,500,000
CGS from the televisions sold to unrelated persons
from its $10,000,000 DPGR. Under the simplified
deduction method, the consolidated group appor-
tions its remaining $4,000,000 of deductions to
DPGR in proportion to the ratio of its DPGR to
total gross receipts. Thus, $3,076,923 ($4,000,000 x
$10,000,000/$13,000,000) is allocated to DPGR. Ac-
cordingly, the consolidated group’s QPAI for 2007 is
$2,423,077 ($10,000,000 DPGR - $4,500,000 CGS -
$3,076,923 deductions apportioned to its DPGR).
(iii)Allocation of consolidated group’s 2007 sec-
tion 199 deduction to its members. Because B’s only
activity during 2007 is the purchase of televisions
from A, B has no DPGR or deductions and thus, no
QPAI, in 2007. Accordingly, the entire section 199
deduction in 2007 for the consolidated group will be
allocated to A.
(iv)Consolidated group’s 2008 QPAI.Pursuantto
paragraph (d)(1) of this section and §1.1502–13(c),
A’s sale of televisions to B in 2007 is taken into
account in 2008 when B sells the televisions to unre-
lated persons. However, because A and B are mem-
bers of a consolidated group, §1.1502–13(c)(1)(i)
provides that the separate entity attributes of A’s
intercompany items or B’s corresponding items, or
both, may be redetermined in order to produce the
same effect as if A and B were divisions of a single
corporation. Accordingly, A’s $2,000,000 of gross
receipts are redetermined to be non-DPGR and as not
being gross receipts for purposes of allocating costs
between DPGR and non-DPGR, and B’s $2,000,000
CGS are redetermined to be not allocable to DPGR.
Notwithstanding that A’s receipts are redetermined
to be non-DPGR and as not being gross receipts
for purposes of allocating costs between DPGR
and non-DPGR, A’s CGS are still considered to be
allocable to DPGR because they are allocable to
the consolidated group deriving DPGR. Accord-
ingly, the consolidated group’s DPGR in 2008 is
$4,100,000 from B’s sales of televisions, and its
total receipts are $7,100,000 ($4,100,000 DPGR
plus $3,000,000 non-DPGR from A’s computer
consulting services). To determine the consolidated
group’s QPAI, the consolidated group subtracts A’s
$1,500,000 CGS from the televisions sold to B from
its $4,100,000 DPGR. Under the simplified deduc-
tion method, the consolidated group apportions its
remaining $1,100,000 of deductions ($1,000,000
from A and $100,000 from B) to DPGR in propor-
tion to the consolidated group’s ratio of its DPGR to
total gross receipts. Thus, $635,211 ($1,100,000 x
$4,100,000/$7,100,000) is allocated to DPGR. Ac-
cordingly, the consolidated group’s QPAI for 2008
is $1,964,789 ($4,100,000 DPGR - $1,500,000 CGS
- $635,211 deductions apportioned to its DPGR),
the same QPAI that would result if A and B were
divisions of a single corporation.
(v)Allocation of consolidated group’s 2008 sec-
tion 199 deduction to its members.(A)A’s QPAI.
For purposes of allocating the consolidated group’s
section 199 deduction to its members, pursuant to
paragraph (d)(5) of this section, the redetermination
of A’s $2,000,000 in receipts is disregarded. Accord-
ingly, for this purpose, A’s DPGR are $2,000,000
(receipts from the sale of televisions to B taken into
account in 2008) and its total receipts are$5,000,000
($2,000,000 DPGR + $3,000,000 non-DPGR from
its computer consulting services). In determining A’s
QPAI, A subtracts its $1,500,000 CGS from the tele-
visions sold to B from its $2,000,000 DPGR. Under
the simplified deduction method, A apportions its
remaining $1,000,000 of deductions in proportion
to the ratio of its DPGR to total receipts. Thus,
$400,000 ($1,000,000 x $2,000,000/$5,000,000) is
allocated to DPGR. Thus, A’s QPAI is $100,000
($2,000,000 DPGR - $1,500,000 CGS - $400,000
deductions allocated to its DPGR).
(B)B’s QPAI. B’s DPGR and its total gross
receipts are each $4,100,000. For purposes of
allocating the consolidated group’s section 199 de-
duction to its members, pursuant to paragraph (d)(5)
of this section, the redetermination of B’s $2,000,000
CGS as not allocable to DPGR is disregarded. In
determining B’s QPAI, B subtracts its $2,000,000
CGS from the televisions purchased from A from
its $4,100,000 DPGR. Under the simplified deduc-
tion method, B apportions its remaining $100,000
deductions in proportion to the ratio of its DPGR
to total receipts. Thus, all $100,000 ($100,000
x $4,100,000/$4,100,000) is allocated to DPGR.
Thus, B’s QPAI is $2,000,000 ($4,100,000 DPGR -
$2,000,000 CGS - $100,000 deductions allocated to
its DPGR).
(C)Allocation to A and B.Pursuanttopara-
graph (d)(5) of this section, the consolidated
group’s section 199 deduction for 2008 is allo-
cated $100,000/($100,000 + $2,000,000) to A and
$2,000,000/($100,000 + $2,000,000) to B.
Example 7. Corporations S and B are members of
the same consolidated group that files its Federal in-
come tax returns on a calendar year basis. In 2007, S
manufactures office furniture for B to use in B’s cor-
porate headquarters and S sells the office furniture to
B. S and B have no other activities in the taxable year.
If S and B were not members of a consolidated group,
S’s gross receipts from the sale of the office furniture
to B would be DPGR (assuming all the other require-
ments of §1.199–3 are met) and S’s CGS or other de-
ductions, expenses, or losses from the sale to B would
be allocable to S’s DPGR. However, because S and
B are members of a consolidated group, the separate
entity attributes of S’s intercompany items or B’s cor-
responding items, or both, may be redetermined un-
der §1.1502–13(c)(1)(i) or (c)(4) in order to produce
the same effect as if S and B were divisions of a sin-
gle corporation. If S and B were divisions of a single
corporation, there would be no DPGR with respect to
theofficefurniturebecausetherewouldbenolease,
rental, license, sale, exchange, or other disposition of
the furniture by the single corporation (and no CGS or
other deductions allocable to DPGR). Thus, in order
to produce the same effect as if S and B were divisions
of a single corporation, S’s gross receipts are redeter-
mined as non-DPGR. Accordingly, the consolidated
group has no DPGR (and no CGS or other deductions
allocated or apportioned to DPGR) and receives no
section 199 deduction in 2007.
Example 8.(i)Facts. A and B are members of the
same consolidated group that files its Federal income
tax returns on a calendar year basis. On January 1,
2007, A MPGE QPP which is 10-year recovery prop-
erty for $100 and depreciates it under the straight-line
method. On January 1, 2009, A sells the property to
B for $130. Under section 168(i)(7), B is treated as
A for purposes of section 168 to the extent B’s $130
basis does not exceed A’s adjusted basis at the time of
the sale. B’s additional basis is treated as new 10-year
recovery property for which B elects the straight-line
June 19, 200611162006–25 I.R.B.

method of recovery. (To simplify the example, the
half-year convention is disregarded.)
(ii)Depreciation; intercompany gain. A claims
$10 of depreciation for each taxable year 2007 and
2008 and has an $80 basis at the time of the sale to
B. Thus, A has a $50 intercompany gain from its sale
to B. For each taxable year 2009 through 2016, B has
$10 of depreciation with respect to $80 of its basis
(the portion of its $130 basis not exceeding A’s ad-
justed basis) and $5 of depreciation with respect to
the $50 of its additional basis that exceeds A’s ad-
justed basis. For each taxable year 2017 and 2018, B
has $5 of depreciation with respect to the $50 of its
additional basis that exceeds A’s adjusted basis.
(iii)Timing. A’s $50 gain is taken into account
to reflect the difference for each consolidated return
year between B’s depreciation taken into account
with respect to the property and the depreciation that
would have been taken into account if A and B were
divisions of a single corporation. For each taxable
year 2009 through 2016, B takes into account $15
of depreciation rather than the $10 of depreciation
that would have been taken into account if A and
B were divisions of a single corporation. For each
taxable year 2017 and 2018, B takes into account
$5 of depreciation rather than the $0 of depreciation
that would have been taken into account if A and
B were divisions of a single corporation (the QPP
would have been fully depreciated after the 2016
taxable year if A and B were divisions of a single
corporation). Thus, A takes $5 of gain into account
in each of the 2009 through 2018 taxable years (10%
of its $50 gain). Pursuant to §1.199–7(d)(1), A takes
its sale to B into account in computing the section
199 deduction at the same time and in the same
proportion as A takes into account the income, gain,
deduction, or loss from the intercompany transaction
under §1.1502–13. Thus, in each taxable year 2009
through 2018, A takes into account $13 of gross
receipts (10% of its $130 gross receipts) from the
sale to B. The group’s income in each taxable year
2009 through 2016 is a $10 loss ($5 gain - $15 de-
preciation), the same net amount it would have been
if A and B were divisions of a single corporation.
The group’s income in each taxable year 2017 and
2018 is $0 ($5 gain - $5 depreciation), the same net
amount it would have been if A and B were divisions
of a single corporation.
(iv)Attributes. If A and B were not members
of a consolidated group,A’s gross receipts on the
sale of the QPP to B would be DPGR (assuming all
the other requirements of §1.199–3 are met). How-
ever, because A and B are members of a consolidated
group, the separate entity attributes of A’s DPGR may
be redetermined under §1.1502–13(c)(1)(i) or (c)(4)
in order to produce the same effect as if A and B
were divisions of a single corporation. If A and B
were divisions of a single corporation, there would
be no DPGR with respect to the QPP because there
would be no lease, rental, license, sale, exchange, or
other disposition of the QPP by the single corporation
(and no CGS or other deductions allocable to DPGR).
Thus, in order to produce the same effect as if A and
B were divisions of a single corporation, A’s $13 of
gross receipts taken into account in each year is re-
determined as non-DPGR. Accordingly, the consoli-
datedgrouphasnoDPGR(andnoCGSorotherde-
ductions allocable or apportioned to DPGR) and re-
ceives no section 199 deduction.
Example 9. Corporations X, Y, and Z are mem-
bers of the same EAG but are not members of a con-
solidated group. X, Y, and Z each files Federal in-
come tax returns on a calendar year basis. Assume
that the EAG has W–2 wages in excess of the sec-
tion 199(b) wage limitation. Prior to 2007, X had
no taxable income or loss. In 2007, X has $0 of
taxable income and $2,000 of QPAI, Y has $4,000
of taxable income and $3,000 of QPAI, and Z has
$4,000 of taxable income and $5,000 of QPAI. Ac-
cordingly, the EAG has taxable income of $8,000,
the sum of X’s taxable income of $0, Y’s taxable in-
come of $4,000, and Z’s taxable income of $4,000.
The EAG has QPAI of $10,000, the sum of X’s QPAI
of $2,000, Y’s QPAI of $3,000, and Z’s QPAI of
$5,000. Because X’s, Y’s, and Z’s taxable years all
began in 2007, the transition percentage under sec-
tion 199(a)(2) is 6%. Thus, the EAG’s section 199
deduction for 2007 is $480 (6% of the lesser of the
EAG’s taxable income of $8,000 or the EAG’s QPAI
of $10,000). Pursuant to paragraph (c)(1) of this sec-
tion, the $480 section 199 deduction is allocated to X,
Y, and Z in proportion to their respective amounts of
QPAI, that is $96 to X ($480 x $2,000/$10,000), $144
to Y ($480 x $3,000/$10,000), and $240 to Z ($480
x $5,000/$10,000). Although X’s taxable income for
2007 determined prior to allocation of a portion of the
EAG’s section 199 deduction to it was $0, pursuant to
paragraph (c)(2) of this section X will have an NOL
for 2007 equal to $96. Because X’s NOL for 2007
cannot be carried back to a previous taxable year, X’s
NOL carryover to 2008 will be $96.
Example 10.(i)Facts. Corporation P owns all
of the stock of Corporations S and T, and P, S, and
T file a consolidated Federal income tax return on a
calendar year basis. In 2007, P MPGE QPP in the
United States at a cost of $1,000. On November 30,
2007, P sells the QPP to S for $2,500. On February
28, 2008, P disposes of 60% of the stock of S. On
June 30, 2008, S sells the QPP to an unrelated person
for $3,000.
(ii)Analysis. Because P and S are members
of a consolidated group in 2007, pursuant to
§1.199–7(d)(1) and §1.1502–13, neither P’s $1,500
of gain on the sale of QPP to S nor P’s $2,500 gross
receipts from the sale are taken into account in 2007.
Under §1.1502–13(d), P takes the intercompany
transaction into account immediately before S be-
comes a non-member of the consolidated group. In
order to produce the same effect as if P and S were
divisions of a single corporation, P’s gross receipts
from the sale of the QPP to S are redetermined under
§1.1502–13(c)(1)(i) as non-DPGR. Further, because
P and S are not members of the same EAG when S
sells the QPP to the unrelated person, and because
P’s transfer of the QPP to S did not take place in a
transaction to which section 381(a) applies, S is not
treated as conducting the activities conducted by P in
determining if S’s receipts are DPGR, notwithstand-
ing that P and S were members of the same EAG
when P MPGE the QPP and when P sold the QPP to
S. Accordingly, neither the P consolidated group nor
S will have DPGR with respect to the QPP.
Example 11. Corporation X is the common parent
of a consolidated group, consisting of X and Y, which
has filed a consolidated Federal income tax return for
many years. Corporation Pis the common parent of
a consolidated group, consisting of P and S, which
has filed a consolidated Federal income tax return for
many years. The X and P consolidated groups each
file their consolidated Federal income tax returns on
a calendar year basis. X, Y, P and S are members
of the same EAG in 2008. In 2007, the X consoli-
dated group incurred a consolidated net operating loss
(CNOL) of $25,000, none of which was carried back
and used to offset taxableincome of prior taxable
years. Neither P nor S (nor the P consolidated group)
has ever incurred an NOL. In 2008, the X consoli-
dated group has (prior to the deduction under section
172) taxable income of $8,000 and the P consolidated
group has taxable income of $20,000. The X consol-
idated group uses $8,000 of its CNOL from 2007 to
offset the X consolidated group’s taxable income in
2008. None of the X consolidated group’s remaining
CNOL may be used to offset taxable income of the
P consolidated group under paragraph (b)(3) of this
section. Accordingly, for purposes of determining the
EAG’s section 199 deduction, the EAG has taxable
income of $20,000 (the X consolidated group’s tax-
able income (after the deduction under section 172)
of $0 plus the P consolidated group’s taxable income
of $20,000).
(f)Allocation of income and loss by a
corporation that is a member of the ex-
panded affiliated group for only a portion
of the year—(1)In general. A corporation
that becomes or ceases to be a member of
an EAG during its taxable year must allo-
cate its taxable income or loss, QPAI, and
W–2 wages between the portion of the tax-
able year that it is a member of the EAG
and the portion of the taxable year that it is
not a member of the EAG. In general, this
allocation of items is made by using thepro
rataallocation method described in para-
graph (f)(1)(i) of this section. However,
a corporation may elect to use the section
199 closing of the books method described
in paragraph (f)(1)(ii) of this section. Nei-
ther thepro rataallocation method nor the
section 199 closing of the books method is
a method of accounting.
(i)Pro rata allocation method. Under
thepro rataallocation method, an equal
portion of a corporation’s taxable income
or loss, QPAI, and W–2 wages for the tax-
able year is assigned to each day of the cor-
poration’s taxable year. Those items as-
signed to those days that the corporation
was a member of the EAG are then aggre-
gated.
(ii)Section 199 closing of the books
method. Under the section 199 closing
of the books method, a corporation’s tax-
able income or loss, QPAI, and W–2 wages
for the period during which the corpora-
tion was a member of an EAG are com-
putedbytreatingthecorporation’s taxable
year as two separate taxable years, the first
of which ends at the close of the day on
2006–25 I.R.B.1117June 19, 2006

whichthecorporation’sstatusasamem-
ber of the EAG changes and the second of
which begins at the beginning of the day
after the corporation’s status as a member
of the EAG changes.
(iii)Making the section 199 closing of
the books election. A corporation makes
the section 199 closing of the books elec-
tion by making the following statement:
“The section 199 closing of the books
election is hereby made with respect to
[insert name of corporation and its em-
ployer identification number] with respect
to the following periods [insert dates of
the two periods between which items are
allocated pursuant to the closing of the
books method].” The statement must be
filed with the corporation’s timely filed
(including extensions) Federal income tax
return for the taxable year that includes
the periods that are subject to the election.
Once made, a section 199 closing of the
books election is irrevocable.
(2)Coordination with rules relat-
ing to the allocation of income under
§1.1502–76(b). If §1.1502–76(b) (relating
to items included in a consolidated return)
applies to a corporation that is a member
of an EAG, then any allocation of items
required under this paragraph (f) is made
only after the allocation of the corpora-
tion’s items pursuant to §1.1502–76(b).
(g)Total section 199 deduction for a
corporation that is a member of an ex-
panded affiliated group for some or all of
its taxable year—(1)Member of the same
expanded affiliated group for the entire
taxable year. If a corporation is a mem-
ber of the same EAG for its entire taxable
year, the corporation’s section 199 deduc-
tion for the taxable year is the amount of
the section 199 deduction allocated to the
corporation by the EAG under paragraph
(c)(1) of this section.
(2)Member of the expanded affiliated
group for a portion of the taxable year.If
a corporation is a member of an EAG only
for a portion of its taxable year and is either
not a member of any EAG or is a member
of another EAG, or both, for another por-
tion of the taxable year, the corporation’s
section 199 deduction for the taxable year
is the sum of its section 199 deductions for
each portion of the taxable year.
(3)Example. The following example
illustrates the application of paragraphs (f)
and (g) of this section:
Example. Corporations X and Y, calendar year
corporations, are members of the same EAG for the
entire 2007 taxable year. Corporation Z, also a cal-
endar year corporation, is a member of the EAG of
which X and Y are members for the first half of 2007
and not a member of any EAG for the second half of
2007. During the 2007 taxable year, Z does not join
in the filing of a consolidated return. Z makes a sec-
tion 199 closing of the books election. As a result,
Z has $80 of taxable income and $100 of QPAI that
is allocated to the first half of 2007 and a $150 tax-
able loss and ($200) of QPAI that is allocated to the
second half of 2007. Taking into account Z’s taxable
income, QPAI, and W–2 wages allocated to the first
half of 2007 pursuant to the section 199 closing of
the books election, the EAG has positive taxable in-
come and QPAI for 2007 and W–2 wages in excess of
the section 199(b) wage limitation. Because the EAG
has both positive taxable income and QPAI and suf-
ficient W–2 wages, and because Z has positive QPAI
for the first half of 2007, a portion of the EAG’s sec-
tion 199 deduction is allocated to Z. Because Z has
negative QPAI for the second half of 2007, Z is al-
lowed no section 199 deduction for the second half of
2007. Thus, despite the fact that Z has a $70 taxable
loss and ($100) of QPAI for the entire 2007 taxable
year, Z is entitled to a section 199 deduction for 2007
equal to the section 199 deduction allocated to Z as a
member of the EAG.
(h)Computation of section 199 deduc-
tion for members of an expanded affiliated
group with different taxable years—(1)In
general. If members of an EAG have dif-
ferent taxable years, in determining the
section 199 deduction of a member (the
computing member), the computing mem-
ber is required to take into account the tax-
able income or loss, determined without
regard to the section 199 deduction, QPAI,
and W–2 wages of each other group mem-
ber that are both—
(i) Attributable to the period that each
other member of the EAG and the comput-
ing member are members of the EAG; and
(ii) Taken into account in a taxable year
that begins after the effective date of sec-
tion 199 and such taxable year ends with
or within the taxable year of the computing
member with respect to which the section
199 deduction is computed.
(2)Example. The following example
illustrates the application of this paragraph
(h):
Example. (i) Corporations X, Y, and Z are mem-
bers of the same EAG. Neither X, Y, nor Z is a mem-
ber of a consolidated group. X and Y are calendar
year taxpayers and Z is a June 30 fiscal year taxpayer.
Z came into existence on July 1, 2007. Each corpo-
ration has taxable income that exceeds its QPAI and
has sufficient W–2 wages to avoid the limitation un-
der section 199(b). For the taxable year ending De-
cember 31, 2007, X’s QPAI is $8,000 and Y’s QPAI
is ($6,000). For its taxable year ending June 30, 2008,
Z’s QPAI is $2,000.
(ii) In computing X’s and Y’s respective sec-
tion 199 deductions for their taxable years ending
December 31, 2007, X’s and Y’s taxable income,
QPAI, and W–2 wages from their respective taxable
years ending December 31, 2007, are aggregated.
The EAG’s QPAI for this purpose is $2,000 (X’s
QPAI of $8,000 + Y’s QPAI of ($6,000)). Because
the taxable years of the computing members, X and
Y, began in 2007, the transition percentage under
section 199(a)(2) is 6%. Accordingly, the EAG’s
section 199 deduction is $120 ($2,000 x .06). The
$120 deduction is allocated to each of X and Y in
proportion to their respective QPAI as a percentage
of the QPAI of each member of the EAG that was
taken into account in computing the EAG’s section
199 deduction. Pursuant to paragraph (c)(1) of
this section, in allocating the section 199 deduction
between X and Y, because Y’s QPAI is negative, Y’s
QPAI is treated as being $0.Accordingly, X’s section
199 deduction for its taxable year ending December
31, 2007, is $120 ($120 x $8,000/($8,000 + $0)).
Y’s section 199 deduction for its taxable year ending
December 31, 2007, is $0 ($120 x $0/($8,000 + $0)).
(iii) In computing Z’s section 199 deduction for
its taxable year ending June 30, 2008, X’s and Y’s
items from their respective taxable years ending De-
cember 31, 2007, are taken into account. Therefore,
X’s and Y’s taxable income or loss, determined with-
out regard to the section 199 deduction, QPAI, and
W–2 wages from their taxable years ending Decem-
ber 31, 2007, are aggregated with Z’s taxable in-
come or loss, QPAI, and W–2 wages from its tax-
able year ending June 30, 2008. The EAG’s QPAI is
$4,000 (X’s QPAI of $8,000 + Y’s QPAI of ($6,000)
+ Z’s QPAI of $2,000). Because the taxable year of
the computing member, Z, began in 2007, the transi-
tion percentage under section 199(a)(2) is 6%. Ac-
cordingly, the EAG’s section 199 deduction is $240
($4,000 x .06). A portion of the $240 deduction is
allocated to Z in proportion to its QPAI as a percent-
age of the QPAI of each member of the EAG that was
taken into account in computing the EAG’s section
199 deduction. Pursuant to paragraph (c)(1) of this
section, in allocating a portion of the $240 deduc-
tion to Z, because Y’s QPAI is negative, Y’s QPAI
is treated as being $0. Z’s section 199 deduction for
its taxable year ending June 30, 2008, is $48 ($240 x
$2,000/($8,000 + $0 + $2,000)).
§1.199–8 Other rules.
(a)In general. The provisions of this
section apply solely for purposes of sec-
tion 199 of the Internal Revenue Code
(Code). When calculating the deduction
under §1.199–1(a) (section 199 deduc-
tion), taxpayers are required to make
numerous allocations under §§1.199–1
through 1.199–9. In making these alloca-
tions, taxpayers may use any reasonable
method that is satisfactory to the Secretary
based on all of the facts and circumstances,
unless the regulations under §§1.199–1
through 1.199–9 specify a method. A
change in a taxpayer’s method of allocat-
ing or apportioning gross receipts, cost of
June 19, 200611182006–25 I.R.B.

goods sold (CGS), expenses, losses, or de-
ductions (deductions) does not constitute a
change in method of accounting to which
the provisions of sections 446 and 481 and
the regulations thereunder apply.
(b)Individuals. Inthecaseofanin-
dividual, the section 199 deduction is
equal to the applicable percentage of the
lesser of the taxpayer’s qualified produc-
tion activities income (QPAI) (as defined
in §1.199–1(c)) for the taxable year, or
adjusted gross income (AGI) for the tax-
able year determined after applying sec-
tions 86, 135, 137, 219, 221, 222, and 469,
and without regard to section 199.
(c)Trade or business requirement—(1)
In general. Sections 1.199–1 through
1.199–9 are applied by taking into account
only items that are attributable to the ac-
tual conduct of a trade or business.
(2)Individuals. An individual engaged
in the actual conduct of a trade or business
must apply §§1.199–1 through 1.199–9
by taking into account in computing QPAI
only items that are attributable to that
trade or business (or trades or businesses)
and any items allocated from a pass-thru
entity engaged in a trade or business.
Compensation received by an individual
employee for services performed as an
employee is not considered gross receipts
for purposes of computing QPAI under
§§1.199–1 through 1.199–9. Similarly,
any costs or expenses paid or incurred by
an individual employee with respect to
those services performed as an employee
are not considered CGS or deductions of
that employee for purposes of computing
QPAI under §§1.199–1 through 1.199–9.
(3)Trusts and estates. For purposes of
this paragraph (c), a trust or estate is treated
as an individual.
(d)Coordination with alternative min-
imum tax. For purposes of determin-
ing alternative minimum taxable income
(AMTI) under section 55, a taxpayer that
is not a corporation must deduct an amount
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 the taxpayer’s QPAI for the tax-
able year, or the taxpayer’s taxable income
for the taxable year, determined without
regard to the section 199 deduction (or in
the case of an individual, AGI). For pur-
poses of determining AMTI in the case of
a corporation (including a corporation sub-
ject to tax under section 511(a)), a taxpayer
must deduct an amount 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 the
taxpayer’s QPAI for the taxable year, or
the taxpayer’s AMTI for the taxable year,
determined without regard to the section
199 deduction. For purposes of comput-
ing AMTI, QPAI is determined without
regard to any adjustments under sections
56 through 59. In the case of an individ-
ual or a non-grantor trust or estate, AGI
and taxable income are also determined
without regard to any adjustments under
sections 56 through 59. The amount of the
deduction allowable under this paragraph
(d) for any taxable year cannot exceed 50
percent of the W–2 wages of the employer
for the taxable year (as determined under
§1.199–2). The section 199 deduction is
not taken into account in determining the
amount of the alternative tax net operating
loss deduction (ATNOL) allowed under
section 56(a)(4). For example, assume that
for the calendar year 2007, a corporation
has both AMTI (before the NOL deduction
and before the section 199 deduction) and
QPAI of $1,000,000, and has an ATNOL
carryover to 2007 of $5,000,000. Assume
that the taxpayer has W–2 wages in ex-
cess of the section 199(b) wage limitation.
Under section 56(d), the ATNOL deduc-
tion for 2007 is $900,000 (90 percent of
$1,000,000), reducing AMTI to $100,000.
The taxpayer must then further reduce
the AMTI by the section 199 deduction
of $6,000 (six percent of the lesser of
$1,000,000 or $100,000) to $94,000. The
ATNOL carryover to 2008 is $4,100,000.
(e)Nonrecognition transactions—(1)
In general—(i)Sections 351, 721, and
731. Except as provided for an EAG
partnership (as defined in §1.199–9(j))
andanexpandedaffiliatedgroup(EAG)
(as defined in §1.199–7), if property is
transferred by the taxpayer to an entity
in a transaction to which section 351 or
721 applies, then whether the gross re-
ceipts derived by the entity are domestic
production gross receipts (DPGR) (as de-
fined in §1.199–3) shall be determined
based solely on the activities performed
by the entity without regard to the ac-
tivities performed by the taxpayer prior
to the contribution of the property to the
entity. Except as provided for a quali-
fying in-kind partnership (as defined in
§1.199–9(i)) and an EAG partnership, if
property is transferred by a partnership to
a partner in a transaction to which section
731 applies, then whether gross receipts
derived by the partner are DPGR shall be
determined based on the activities per-
formed by the partner without regard to
the activities performed by the partnership
before the distribution of the property to
the partner.
(ii)Exceptions—(A)Section 708(b)
(1)(B). If property is deemed to be con-
tributed by a partnership (transferor part-
nership) to another partnership (transferee
partnership) as a result of a termina-
tion under section 708(b)(1)(B), then the
transferee partnership shall be treated as
performing those activities performed by
the transferor partnership with respect to
the transferred property of the transferor
partnership.
(B)Transfers by reason of death.If
property is transferred upon or by reason
of the death of an individual (decedent),
then the decedent’s successor(s) in interest
shall be treated as having performed those
activities performed by or deemed to have
been performed (pursuant to §1.199–9(i))
by the decedent with respect to the trans-
ferred property. For this purpose, a transfer
shall include without limitation the passing
of the property by bequest, contractual pro-
vision, beneficiary designation, or opera-
tion of law, and successor in interest shall
include without limitation the decedent’s
heirs or legatees, the decedent’s estate or
trust, or the beneficiary or beneficiaries of
the decedent’s estate or trust.
(2)Section 1031 exchanges.Ifatax-
payer exchanges property for replacement
property in a transaction to which section
1031 applies, then whether the gross re-
ceipts derived from the lease, rental, li-
cense, sale, exchange, or other disposi-
tion of the replacement property are DPGR
shall be determined based solely on the ac-
tivities performed by the taxpayer with re-
spect to the replacement property.
(3)Section 381 transactions.Ifa
corporation (the acquiring corporation)
acquires the assets of another corporation
(the target corporation) in a transaction
to which section 381(a) applies, then the
acquiring corporation shall be treated as
performing those activities of the target
corporation with respect to the acquired
assets of the target corporation. Therefore,
2006–25 I.R.B.1119June 19, 2006

to the extent that the acquired assets of
the target corporation would have given
rise to DPGR if leased, rented, licensed,
sold, exchanged, or otherwise disposed
of by the target corporation, such assets
will give rise to DPGR if leased, rented,
licensed, sold, exchanged, or otherwise
disposed of by the acquiring corporation
(assuming all the other requirements of
§1.199–3 are met).
(f)Taxpayers with a 52–53 week tax-
able year. For purposes of applying
§1.441–2(c)(1) in the case of a taxpayer
using a 52–53 week taxable year, any ref-
erence in section 199(a)(2) (the phase-in
rule), §§1.199–1 through 1.199–9 to a
taxable year beginning after a particular
calendar year means a taxable year be-
ginning after December 31st of that year.
Similarly, any reference to a taxable year
beginning in a particular calendar year
means a taxable year beginning after De-
cember 31st of the preceding calendar
year. For example, a 52–53 week taxable
year that begins on December 26, 2006, is
deemed to begin on January 1, 2007, and
the transition percentage for that taxable
year is 6 percent.
(g)Section 481(a) adjustments.For
purposes of determining QPAI, a section
481(a) adjustment, whether positive or
negative, taken into account by a taxpayer
during the taxable year that is solely at-
tributable to either the taxpayer’s gross
receipts, CGS, or deductions must be al-
located or apportioned between DPGR
and non-DPGR using the methods used by
a taxpayer to allocate or apportion gross
receipts, CGS, and deductions between
DPGR and non-DPGR for the current tax-
able year. See §§1.199–1 and 1.199–4
for rules related to the allocation and ap-
portionment of gross receipts, CGS, and
deductions, respectively. For example,
if a taxpayer changes its method of ac-
counting for inventories from the last-in,
first-out (LIFO) method to the first-in,
first-out (FIFO) method and the taxpayer
uses the small business simplified over-
all method to apportion CGS between
DPGR and non-DPGR, the taxpayer is
required to apportion the resulting section
481(a) adjustment, whether positive or
negative, between DPGR and non-DPGR
using the small business simplified overall
method. If a section 481(a) adjustment is
not solely attributable to either gross re-
ceipts, CGS, or deductions (for example,
the taxpayer changes its overall method
of accounting from an accrual method to
the cash method) and the section 481(a)
adjustment cannot be specifically identi-
fied with either gross receipts, CGS, or
deductions, then the section 481(a) ad-
justment, whether positive or negative,
must be attributed to, or among, gross
receipts, CGS, or deductions using any
reasonable method that is satisfactory to
the Secretary based onall of the facts and
circumstances, and then allocated or ap-
portioned between DPGR and non-DPGR
using the same methods the taxpayer uses
to allocate or apportion gross receipts,
CGS, or deductions between DPGR and
non-DPGR for the taxable year or taxable
years that the section 481(a) adjustment
is taken into account. Factors taken into
consideration in determining whether the
method is reasonable include whether the
taxpayer uses the most accurate informa-
tion available; the relationship between
the section 481(a) adjustment and the ap-
portionment base chosen; the accuracy of
themethodchosenascomparedwithother
possible methods; and the time, burden,
and cost of using alternative methods.
If a section 481(a) adjustment is spread
over more than one taxable year, then a
taxpayer must attribute the section 481(a)
adjustment among gross receipts, CGS,
or deductions, as applicable, in the same
amount for each taxable year within the
spread period. For example, if a taxpayer,
using a reasonable method that is satisfac-
tory to the Secretary based on all of the
facts and circumstances, determines that a
section 481(a) adjustment that is required
to be spread over four taxable years should
be attributed half to gross receipts and half
to deductions, then the taxpayer must at-
tribute the section 481(a) adjustment half
to gross receipts and half to deductions
in each of the four taxable years of the
spread period. Further, if such taxpayer
uses the simplified deduction method to
apportion deductions between DPGR and
non-DPGR in the first taxable year of the
spread period, then the taxpayer must use
the simplified deduction method to ap-
portion half the section 481(a) adjustment
for that taxable year between DPGR and
non-DPGR for that taxable year. Simi-
larly, if in the second taxable year of the
spread period the taxpayer uses the section
861 method to apportion and allocate costs
between DPGR and non-DPGR, then the
taxpayer must use the section 861 method
to allocate and apportion half the section
481(a) adjustment for that taxable year
between DPGR and non-DPGR for that
taxable year.
(h)Disallowed losses or deduc-
tions. Except as provided by publica-
tion in the Internal Revenue Bulletin (see
§601.601(d)(2)(ii)(b)ofthischapter),
losses or deductions of a taxpayer that
otherwise would be taken into account
in computing the taxpayer’s section 199
deduction are taken into account only if
and to the extent the deductions are not
disallowed by section 465 or 469, or any
other provision of the Code. If only a por-
tion of the taxpayer’s share of the losses or
deductions is allowed for a taxable year,
the proportionate share of those allowable
losses or deductions that are allocated to
the taxpayer’s qualified production activ-
ities, determined in a manner consistent
with sections 465 and 469, and any other
applicable provision of the Code, is taken
into account in computing QPAI for pur-
poses of the section 199 deduction for that
taxable year. To the extent that any of
the disallowed losses or deductions are al-
lowed in a later taxable year, the taxpayer
takes into account a proportionate share
of those losses or deductions in comput-
ing its QPAI for that later taxable year.
Losses or deductions of the taxpayer that
are disallowed for taxable years beginning
on or before December 31, 2004, are not
taken into account in a later taxable year
for purposes of computing the taxpayer’s
QPAI and the wage limitation of sec-
tion 199(d)(1)(A)(iii) under §1.199–9 for
that taxable year, regardless of whether the
losses or deductions are allowed for other
purposes. For taxpayers that are partners
in partnerships, see §1.199–9(b)(2). For
taxpayers that are shareholders in S corpo-
rations, see §1.199–9(c)(2).
(i)Effective dates—(1)In general. Sec-
tion 199 applies to taxable years begin-
ning after December 31, 2004. Sections
1.199–1 through 1.199–8 are applicable
for taxable years beginning on or after
June 1, 2006. For a taxable year be-
ginning on or before May 17, 2006, the
enactment date of the Tax Increase Pre-
vention and Reconciliation Act of 2005
(Public Law 109–222, 120 Stat. 345), a
taxpayer may apply §§1.199–1 through
1.199–9 provided that the taxpayer ap-
plies all provisions in §§1.199–1 through
June 19, 200611202006–25 I.R.B.

1.199–9 to the taxable year. For a taxable
year beginning after May 17, 2006, and
before June 1, 2006, a taxpayer may ap-
ply §§1.199–1 through 1.199–8 provided
that the taxpayer applies all provisions
in §§1.199–1 through 1.199–8 to the tax-
able year. For a taxpayer who chooses
not to rely on these final regulations for
a taxable year beginning before June 1,
2006, the guidance under section 199 that
applies to such taxable year is contained
in Notice 2005–14, 2005–1 C.B. 498 (see
§601.601(d)(2) of this chapter). In ad-
dition, a taxpayer also may rely on the
provisions of REG–105847–05, 2005–47
I.R.B. 987 (see §601.601(d)(2) of this
chapter), for a taxable year beginning
before June 1, 2006. If Notice 2005–14
and REG–105847–05 include different
rules for the same particular issue, then a
taxpayer may rely on either the rule set
forth in Notice 2005–14 or the rule set
forth in REG–105847–05. However, if
REG–105847–05 includes a rule that was
not included in Notice 2005–14, then a
taxpayer is not permitted to rely on the
absence of a rule in Notice 2005–14 to
apply a rule contrary to REG–105847–05.
For taxable years beginning after May
17, 2006, and before June 1, 2006, a tax-
payer may not apply Notice 2005–14,
REG–105847–05, or any other guidance
under section 199 in a manner inconsistent
with amendments made to section 199 by
section 514 of the Tax Increase Prevention
and Reconciliation Act of 2005.
(2)Pass-thru entities. In determining
the deduction under section 199, items
arising from a taxable year of a part-
nership, S corporation, estate, or trust
beginning before January 1, 2005, shall
not be taken into account for purposes of
section 199(d)(1).
(3)Non-consolidated EAG members.A
member of an EAG that is not a member
of a consolidated group may apply para-
graph (i)(1) of this section without regard
to how other members of the EAG apply
paragraph (i)(1) of this section.
(4)Computer software provided to cus-
tomers over the Internet.[Reserved].For
further guidance, see §1.199–8T(i)(4).
§1.199–9 Application of section 199
to pass-thru entities for taxable years
beginning on or before May 17, 2006,
the enactment date of the Tax Increase
Prevention and Reconciliation Act of
2005.
(a)In general. The provisions of this
section apply solely for purposes of section
199 of the Internal Revenue Code (Code).
(b)Partnerships—(1)In general—(i)
Determination at partner level.Thede-
duction with respect to the qualified pro-
duction activities of the partnership allow-
able under §1.199–1(a) (section 199 de-
duction) is determined at the partner level.
As a result, each partner must compute its
deduction separately. The section 199 de-
duction has no effect on the adjusted ba-
sis of the partner’s interest in the part-
nership. Except as provided by publi-
cation pursuant to paragraph (b)(1)(ii) of
this section, for purposes of this section,
each partner is allocated, in accordance
with sections 702 and 704, its share of
partnership items (including items of in-
come, gain, loss, and deduction), cost of
goods sold (CGS) allocated to such items
of income, and gross receipts that are in-
cluded in such items of income, even if the
partner’s share of CGS and other deduc-
tions and losses exceeds domestic produc-
tion gross receipts (DPGR) (as defined in
§1.199–3(a)) and regardless of the amount
of the partner’s share of W–2 wages (as
defined in §1.199–2(e)) of the partnership
for the taxable year. A partnership may
specially allocate items of income, gain,
loss, or deduction to its partners, subject
to the rules of section 704(b) and the sup-
porting regulations. Guaranteed payments
under section 707(c) are not considered al-
locations of partnership income for pur-
poses of this section. Guaranteed pay-
ments under section 707(c) are deductions
by the partnership that must be taken into
account under the rules of §1.199–4. See
§1.199–3(p) and paragraph (b)(6)Example
5of this section. Except as provided in
paragraph (b)(1)(ii) of this section, to de-
termine its section 199 deduction for the
taxable year, a partner aggregates its dis-
tributive share of such items, to the extent
they are not otherwise disallowed by the
Code, with those items it incurs outside the
partnership (whether directly or indirectly)
for purposes of allocating and apportion-
ing deductions to DPGR and computing
its qualified production activities income
(QPAI) (as defined in §1.199–1(c)).
(ii)Determination at entity level.
The Secretary may, by publication
in the Internal Revenue Bulletin (see
§601.601(d)(2)(ii)(b)ofthischapter),per-
mit a partnership to calculate a partner’s
share of QPAI at the entity level, instead
of allocating, in accordance with sections
702 and 704, the partner’s share of part-
nership items (including items of income,
gain, loss, and deduction). If a partnership
does calculate QPAI at the entity level—
(A) The partner is allocated its share
of QPAI and W–2 wages (as defined in
§1.199–2(e)), which (subject to the lim-
itations of paragraph (b)(2) of this sec-
tion and section 199(d)(1)(A)(iii), respec-
tively) are combined with the partner’s
QPAI and W–2 wages from other sources;
(B) For purposes of computing QPAI
under §§1.199–1 through 1.199–9, a part-
ner does not take into account the items
from such a partnership (for example, a
partner does not take into account items
from such a partnership in determining
whether a threshold orde minimisrule ap-
plies or when the partner allocates and ap-
portions deductions in calculating its QPAI
from other sources);
(C) A partner generally does not recom-
pute its share of QPAI from the partnership
using another method; however, the part-
ner might have to adjust its share of QPAI
from the partnership to take into account
certain disallowed losses or deductions, or
the allowance of suspended losses or de-
ductions; and
(D) A partner’s distributive share of
QPAI from a partnership may be less than
zero.
(2)Disallowed losses or deduc-
tions. Except as provided by publica-
tion in the Internal Revenue Bulletin (see
§601.601(d)(2)(ii)(b)ofthischapter),
losses or deductions of a partnership that
otherwise would be taken into account in
computing the partner’s section 199 de-
duction for a taxable year are taken into
account in that year only if and to the
extent the partner’s distributive share of
those losses or deductions from all of the
partnership’s activities is not disallowed
by section 465, 469, or 704(d), or any
other provision of the Code. If only a
portion of the partner’s distributive share
of the losses or deductions is allowed for
a taxable year, a proportionate share of
those allowable losses or deductions that
are allocated to the partnership’s quali-
fied production activities, determined in
a manner consistent with sections 465,
2006–25 I.R.B.1121June 19, 2006

469, and 704(d), and any other applicable
provision of the Code, is taken into ac-
count in computing QPAI and the wage
limitation of section 199(d)(1)(A)(iii) for
that taxable year. To the extent that any
of the disallowed losses or deductions are
allowed in a later taxable year, the partner
takes into account a proportionate share
of those losses or deductions in comput-
ing its QPAI for that later taxable year.
Losses or deductions of the partnership
that are disallowed for taxable years be-
ginning on or before December 31, 2004,
are not taken into account in a later tax-
able year for purposes of computing the
partner’s QPAI or the wage limitation of
section 199(d)(1)(A)(iii) for that taxable
year, regardless of whether the losses or
deductions are allowed for other purposes.
(3)Partner’s share of W–2 wages.
Under section 199(d)(1)(A)(iii), a part-
ner’s share of W–2 wages of a partnership
for purposes of determining the part-
ner’s section 199(b) wage limitation is
the lesser of the partner’s allocable share
of those wages (without regard to sec-
tion 199(d)(1)(A)(iii)), or 2 times 3 per-
cent of the QPAI computed by taking into
account only the items of the partnership
allocated to the partner for the taxable year
of the partnership. Except as provided by
publication in the Internal Revenue Bul-
letin (see §601.601(d)(2)(ii)(b)ofthis
chapter), this QPAI calculation is per-
formed by the partner using the same cost
allocation method that the partner uses
in calculating the partner’s section 199
deduction. The partnership must allocate
W–2 wages (prior to the application of
the wage limitation) among the partners
in the same manner as wage expense. The
partner must add the partner’s share of
the W–2 wages from the partnership, as
limited by section 199(d)(1)(A)(iii), to the
partner’s W–2 wages from other sources,
ifany. IfQPAI,computedbytakinginto
account only the items of the partnership
allocated to the partner for the taxable
year (as required by the wage limitation
of section 199(d)(1)(A)(iii)) is not greater
than zero, then the partner may not take
into account any W–2 wages of the part-
nership in applying the wage limitation
of §1.199–2 (but the partner will, never-
theless, aggregate itsdistributive share of
partnership items including wage expense
with those items not from the partnership
in computing its QPAI when determining
its section 199 deduction). See §1.199–2
for the computation of W–2 wages, and
paragraph (g) of this section for rules
regarding pass-thru entities in a tiered
structure.
(4)Transition percentage rule for W–2
wages. With regard to partnerships, for
purposes of section 199(d)(1)(A)(iii)(II)
the transition percentages determined un-
der section 199(a)(2) shall be determined
by reference to the partnership’s taxable
year. Thus, if a partner uses a calendar
year taxable year, and owns an interest
in a partnership that has a taxable year
ending on April 30, the partner’s section
199(d)(1)(A)(iii) wage limitation for the
partnership’s taxable year beginning on
May 1, 2006, would be calculated using 3
percent, even though the partner includes
the partner’s distributive share of partner-
ship items from that taxable year on the
partner’s 2007 Federal income tax return.
(5)Partnerships electing out of sub-
chapter K. For purposes of §§1.199–1
through 1.199–9, the rules of paragraph
(b) of this section shall apply to all partner-
ships, including thosepartnerships elect-
ing under section 761(a) to be excluded,
in whole or in part, from the application of
subchapter K of chapter 1 of the Code.
(6)Examples. The following examples
illustrate the application of this paragraph
(b). Assume that each partner has suf-
ficient adjusted gross income or taxable
income so that the section 199 deduction
is not limited under section 199(a)(1)(B);
that the partnership and each of its partners
(whether individual or corporate) are cal-
endar year taxpayers; and that the amount
of the partnership’s W–2 wages equals
wage expense for each taxable year. The
examples are as follows:
Example 1.Section 861 method with interest ex-
pense.(i)Partnership Federal income tax items.X
and Y, unrelated United States corporations, are each
50% partners in PRS, a partnership that engages in
production activities that generate both DPGR and
non-DPGR. X and Y share all items of income, gain,
loss, deduction, and credit 50% each. Both X and Y
are engaged in a trade or business. PRS is not able
to specifically identify CGS allocable to DPGR and
non-DPGR. In this case, because CGS is definitely re-
lated under the facts and circumstances to all of PRS’s
gross income, apportionment of CGS between DPGR
and non-DPGR based on gross receipts is appropriate.
For 2006, the adjusted basis of PRS’s business as-
sets is $5,000, $4,000 of which generate gross income
attributable to DPGR and $1,000 of which generate
gross income attributable to non-DPGR. For 2006,
PRS has the following Federal income tax items:
DPGR.........................................................................................
$3,000
Non-DPGR.....................................................................................
$3,000
CGS(includes$200ofW–2wages)................................................................. $3,240
Section162sellingexpenses(includes$300ofW–2wages).............................................. $1,200
Interestexpense(notincludedinCGS)...............................................................
$300
(ii)Allocation of PRS’s items of income, gain,
loss, deduction, or credit. X and Y each receive
the following distributive share of PRS’s items of in- come, gain, loss, deduction or credit, as determined
under the principles of §1.704–1(b)(1)(vii):
Gross income attributable to DPGR
($1,500 (DPGR) - $810 (allocable CGS,
includes$50ofW–2wages)) ..................................................................$690
Gross income attributable to non-DPGR
($1,500 (non-DPGR) - $810 (allocable CGS,
includes$50ofW–2wages)) ..................................................................$690
Section162sellingexpenses(includes$150ofW–2wages)..............................................$600
Interestexpense(notincludedinCGS)...............................................................
$150
June 19, 200611222006–25 I.R.B.

(iii)Determination of QPAI.(A)X’s QPAI.Be-
cause the section 199 deduction is determined at the
partner level, X determines its QPAI by aggregating,
to the extent necessary, its distributive share of PRS’s
Federal income tax items with all other such items
from all other, non-PRS-related activities. For 2006,
X does not have any other such items. For 2006, the
adjusted basis of X’s non-PRS assets, all of which
are investment assets, is $10,000. X’s only gross re-
ceipts for 2006 are those attributable to the allocation
of gross income from PRS. X allocates and apportions
its deductible items to gross income attributable to
DPGR under the section 861 method of §1.199–4(d).
In this case, the section 162 selling expenses (includ-
ing W–2 wages) are definitely related to all of PRS’s
gross receipts. Based on the facts and circumstances
of this specific case, apportionment of those expenses
between DPGR and non-DPGR on the basis of PRS’s
gross receipts is appropriate. X elects to apportion
its distributive share of interest expense under the tax
book value method of §1.861–9T(g). X’s QPAI for
2006 is $366, as shown below:
DPGR.........................................................................................
$1,500
CGSallocabletoDPGR(includes$50ofW–2wages) .................................................. ($810)
Section 162 selling expenses (includes $75 of W–2 wages)
($600x$1,500/$3,000)....................................................................... ($300)
Interest expense (not included in CGS)
($150 x $2,000 (X’s share of PRS’s DPGR assets)/
$12,500 (X’s non-PRS assets ($10,000) and X’s share
ofPRSassets($2,500))) ......................................................................($24)
X’sQPAI......................................................................................
$366
(B)Y’s QPAI.(1) For 2006, in addition to the ac-
tivities of PRS, Y engages in production activities
that generate both DPGR and non-DPGR. Y is able
to specifically identify CGS allocable to DPGR and
to non-DPGR. For 2006, the adjusted basis of Y’s
non-PRS assets attributable to its production activi-
ties that generate DPGR is $8,000 and to other pro-
duction activities that generate non-DPGR is $2,000.
Y has no other assets. Y has the following Federal
income tax items relating to its non-PRS activities:
Gross income attributable to DPGR
($1,500 (DPGR) - $900 (allocable CGS,
includes$70ofW–2wages)) ..................................................................$600
Gross income attributable to non-DPGR
($3,000 (other gross receipts) - $1,620
(allocableCGS,includes$150ofW–2wages)).................................................... $1,380
Section162sellingexpenses(includes$30ofW–2wages)...............................................$540
Interestexpense(notincludedinCGS)...............................................................
$90
(2) Y determines its QPAI in the same general
manner as X. However, because Y has other trade
or business activities outside of PRS, Y must aggre-
gate its distributive share of PRS’s Federal income
tax items with its own such items. Y allocates and
apportions its deductible items to gross income at-
tributable to DPGR under the section 861 method of
§1.199–4(d). In this case, Y’s distributive share of
PRS’s section 162 selling expenses (including W–2
wages), as well as those selling expenses from Y’s
non-PRS activities, are definitely related to all of its
gross income. Based on the facts and circumstances
of this specific case, apportionment of those expenses
between DPGR and non-DPGR on the basis of Y’s
gross receipts is appropriate. Y elects to apportion
its distributive share of interest expense under the tax
book value method of §1.861–9T(g). Y has $1,290
of gross income attributable to DPGR ($3,000 DPGR
($1,500 from PRS and $1,500 from non-PRS activi-
ties) - $1,710 CGS ($810 from PRS and $900 from
non-PRS activities)). Y’s QPAI for 2006 is $642, as
shown below:
DPGR ($1,500 from PRS and $1,500 from
non-PRSactivities) ..........................................................................
$3,000
CGS allocable to DPGR ($810 from PRS and $900 from
non-PRSactivities)(includes$120ofW–2wages) ................................................. ($1,710)
Section 162 selling expenses (includes $180 of W–2 wages)
($1,140 ($600 from PRS and $540 from non-PRS
activities) x ($1,500 PRS DPGR + $1,500 non-PRS
DPGR)/($3,000 PRS totalgross receipts + $4,500
non-PRS total gross receipts)) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
($456)
Interest expense (not included in CGS)
($240 ($150 from PRS and $90 from non-PRS
activities) x $10,000 (Y’s non-PRS DPGR assets
($8,000) and Y’s share of PRS DPGR assets
($2,000))/$12,500 (Y’s non-PRS assets ($10,000) and
Y’sshareofPRSassets($2,500))) .............................................................. ($192)
Y’sQPAI......................................................................................
$642
(iv)PRSW–2wagesallocatedtoXandYun-
der section 199(d)(1)(A)(iii). Solely for purposes of
calculating the PRS W–2 wages that are allocated to
them under section 199(d)(1)(A)(iii) for purposes of
the wage limitation of section 199(b), X and Y must
separately determine QPAI taking into account only
the items of PRS allocated to them. X and Y must use
the same methods of allocation and apportionment
that they use to determine their QPAI in paragraphs
2006–25 I.R.B.1123June 19, 2006

(iii)(A) and (B) of thisExample 1, respectively. Ac-
cordingly, X and Y must apportion deductible section
162 selling expenses that include W–2 wage expense
on the basis of gross receipts, and must apportion in-
terest expense according to the tax book value method
of §1.861–9T(g).
(A)QPAIofXandY,solelyforthispurpose,is
determined by allocating and apportioning each part-
ner’s share of PRS expenses to each partner’s share
of PRS gross income of $690 attributable to DPGR
($1,500 DPGR - $810 CGS, apportioned based on
gross receipts). Thus, QPAI of X and Y solely for
this purpose is $270, as shown below:
DPGR.........................................................................................
$1,500
CGSallocabletoDPGR ..........................................................................
($810)
Section 162 selling expenses (including W–2 wages)
($600x($1,500/$3,000))...................................................................... ($300)
Interest expense (not included in CGS)
($150 x $2,000 (partner’s share of adjusted basis of
PRS’s DPGR assets)/$2,500 (partner’s share of
adjustedbasisoftotalPRSassets))..............................................................
($120)
QPAI..........................................................................................
$270
(B) X’s and Y’s shares of PRS’s W–2 wages de-
termined under section 199(d)(1)(A)(iii) for purposes
of the wage limitation of section 199(b) are $16, the
lesser of $250 (partner’s allocable share of PRS’s
W–2 wages ($100 included in total CGS, and $150
included in selling expenses) and $16 (2 x ($270 x
.03)).
(v)Section 199 deduction determination. (A) X’s
tentative section 199 deduction is $11 (.03 x $366
(that is, QPAI determined at partner level)) subject to
the wage limitation of $8 (50% x $16). Accordingly,
X’s section 199 deduction for 2006 is $8.
(B) Y’s tentative section 199 deduction is $19 (.03
x $642 (that is, QPAI determined at the partner level)
subject to the wage limitation of $133 (50% x ($16
from PRS and $250 from non-PRS activities)). Ac-
cordingly, Y’s section 199 deduction for 2006 is $19.
Example 2.Section 861 method with R&E ex-
pense.(i)Partnership items of income, gain, loss,
deduction or credit. X and Y, unrelated United States
corporations each of which is engaged in a trade
or business, are partners in PRS, a partnership that
engages in production activities that generate both
DPGR and non-DPGR. Neither X nor Y is a member
of an affiliated group. X and Y share all items of in-
come, gain, loss, deduction, and credit 50% each. All
of PRS’s domestic production activities that generate
DPGR are within Standard Industrial Classification
(SIC) Industry Group AAA (SIC AAA). All of PRS’s
production activities that generate non-DPGR are
within SIC Industry Group BBB (SIC BBB). PRS
is not able to specifically identify CGS allocable to
DPGR and to non-DPGR and, therefore, apportions
CGS to DPGR and non-DPGR based on its gross
receipts. PRS incurs $900 of research and experi-
mentation expenses (R&E) that are deductible under
section 174, $300 of which are performed with re-
spect to SIC AAA and $600 of which are performed
with respect to SIC BBB. None of the R&E is legally
mandated R&E as described in §1.861–17(a)(4) and
none is included in CGS. PRS incurs section 162
selling expenses (that include W–2 wage expense)
that are not includible in CGS and are definitely
related to all of PRS’s gross income. For 2006, PRS
has the following Federal income tax items:
DPGR (all from sales of products within SIC AAA) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$3,000
Non-DP
GR(allfromsalesofproductswithinSICBBB).................................................
$3,000
CGS(includes$200ofW–2wages)................................................................. $2,400
Section162sellingexpenses(includes$100ofW–2wages)..............................................$840
Sectio
n174R&E-SICAAA.......................................................................
$300
Section174R&E-SICBBB........................................................................
$600
(ii)Allocation of PRS’s items of income, gain,
loss, deduction, or credit. X and Y each receive
the following distributive share of PRS’s items of in- come, gain, loss, deduction, or credit, as determined
under the principles of §1.704–1(b)(1)(vii):
Gross income attributable to DPGR
($1,500 (DPGR) - $600 (CGS, includes
$50ofW–2wages))..........................................................................$900
Gross income attributable to non-DPGR
($1,500 (other gross receipts) - $600 (CGS,
includes$50ofW–2wages)) ..................................................................$900
Section162sellingexpenses(includes$50ofW–2wages)...............................................$420
Section174R&E-SICAAA.......................................................................
$150
Section174R&E-SICBBB........................................................................
$300
(iii)Determination of QPAI.(A)X’s QPAI.Be-
cause the section 199 deduction is determined at the
p
artner level, X determines its QPAI by aggregat-
ing, to the extent necessary, its distributive shares of
PRS’s Federal income tax items with all other such
items from all other, non-PRS-related activities. For
2006, X does not have any other such tax items. X’s
only gross receipts for 2006 are those attributable to
the allocation of gross income from PRS. As stated,
all of PRS’s domestic production activities that gen-
erate DPGR are within SIC AAA. X allocates and
apportions its deductible items to gross income at-
t
ributable to DPGR under the section 861 method of
§1.199–4(d). In this case, the section 162 selling ex-
penses (including W–2 wages) are definitely related
to all of PRS’s gross income. Based on the facts and
circumstances of this specific case, apportionment of
those expenses between DPGR and non-DPGR on
the basis of PRS’s gross receipts is appropriate. For
purposes of apportioning R&E, X elects to use the
sales method as described in §1.861–17(c). Because
X has no direct sales of products, and because all
o
f PRS’s SIC AAA sales attributable to X’s share
of PRS’s gross income generate DPGR, all of X’s
share of PRS’s section 174 R&E attributable to SIC
AAA is taken into account for purposes of determin-
ingX’sQPAI.Thus,X’stotalQPAIfor2006is$540,
as shown below:
June 19, 200611242006–25 I.R.B.

DPGR (all from sales of products within SIC AAA) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$1,500
CGS(includes$50ofW–2wages).................................................................. ($600)
Section 162 selling expenses (including W–2 wages)
($420x($1,500DPGR/$3,000totalgrossreceipts)) ................................................ ($210)
Section174R&E-SICAAA.......................................................................
($150)
X’sQPAI......................................................................................
$540
(B)Y’s QPAI.(1) For 2006, in addition to the ac-
tivities of PRS, Y engages in domestic production
activities that generate both DPGR and non-DPGR.
With respect to those non-PRS activities, Y is not able
to specifically identify CGS allocable to DPGR and
to non-DPGR. In this case, because CGS is definitely
related under the facts and circumstances to all of Y’s
non-PRS gross receipts, apportionment of CGS be-
tween DPGR and non-DPGR based on Y’s non-PRS
gross receipts is appropriate. For 2006, Y has the fol-
lowing non-PRS Federal income tax items:
DPGR(fromsalesofproductswithinSICAAA).......................................................
$1,500
DPGR (from sales of products within SIC BBB) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$1,500
Non-DPGR (
from sales of products within SIC BBB) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$3,000
CGS (allocated to DPGR within SIC AAA)
(includes$56ofW–2wages) ..................................................................$750
CGS (allo
cated to DPGR within SIC BBB)
(includes$56ofW–2wages) ..................................................................$750
CGS (allocated to non-DPGR within SIC BBB)
(includ
es$113ofW–2wages)..................................................................
$1,500
Section162sellingexpenses(includes$30ofW–2wages)...............................................$540
Section174R&E-SICAAA.......................................................................
$300
Sectio
n174R&E-SICBBB........................................................................
$450
(2) Because Y has DPGR as a result of activi-
ties outside PRS, Y must aggregate its distributive
share of PRS’s Federal income tax items with such
items from all its other, non-PRS-related activities.
Y allocates and apportions its deductible items to
gross income attributable to DPGR under the section
861 method of §1.199–4(d). In this case, the section
162 selling expenses (including W–2 wages) are
definitely related to all of Y’s gross income. Based
on the facts and circumstances of the specific case,
apportionment of such expenses between DPGR
and non-DPGR on the basis of Y’s gross receipts
is appropriate. For purposes of apportioning R&E,
Y elects to use the sales method as described in
§1.861–17(c).
(3) With respect to sales that generate DPGR, Y
has gross income of $2,400 ($4,500 DPGR ($1,500
from PRS and $3,000 from non-PRS activities) -
$2,100 CGS ($600 from sales of products by PRS
and $1,500 from non-PRS activities)). Because all
of the sales in SIC AAA generate DPGR, all of Y’s
share of PRS’s section 174 R&E attributable to SIC
AAA and the section 174 R&E attributable to SIC
AAA that Y incurs in its non-PRS activities are taken
into account for purposes of determining Y’s QPAI.
Because only a portion of the sales within SIC BBB
generate DPGR, only a portion of the section 174
R&E attributable to SIC BBB is taken into account
in determining Y’s QPAI. Thus, Y’s QPAI for 2006
is $1,282, as shown below:
DPGR
($4,500 DPGR ($1,500 from PRS and $3,000
from non-PRS activities)) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$4,500
CGS ($600 from sales of products by PRS and $1,500
fro
m non-PRS activities) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
($2
,100)
Section 162 selling expenses (including W–2 wages)
($420 from PRS + $540 from non-PRS activities) x
($4
,500DPGR/$9,000totalgrossreceipts)........................................................
($4
80)
Section 174 R&E-SIC AAA ($150 from PRS and $300
from non-PRS activities) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
($450)
Se
ction 174 R&E-SIC BBB ($300 from PRS + $450
from non-PRS activities) x ($1,500 DPGR/$6,000
total gross receipts allocated to SIC BBB ($1,500
f
rom PRS and $4,500 from non-PRS activities)) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
(
$188)
Y’sQPAI......................................................................................
$1,282
(iv)PRSW–2wagesallocatedtoXandYunder
section 199(d)(1)(A)(iii). Solely for purposes of cal-
culating the PRS W–2 wages that are allocated to X
and Y under section 199(d)(1)(A)(iii) for purposes of
the wage limitation of section 199(b), X and Y must
separately determine QPAI taking into account only
the items of PRS allocated to them. X and Y must
use the same methods of allocation and apportion-
ment that they use to determine their QPAI in para-
graphs (iii)(A) and (B) of thisExample 2, respec-
tively. Accordingly, X and Y must apportion sec-
tion 162 selling expenses that include W–2 wage ex-
pense on the basis of gross receipts, and apportion
section 174 R&E expense under the sales method as
described in §1.861–17(c).
(A)QPAIofXandY,solelyforthispurpose,is
determined by allocating and apportioning each part-
ner’s share of PRS expenses to each partner’s share
of PRS gross income of $900 attributable to DPGR
($1,500 DPGR - $600 CGS, allocated based on PRS’s
gross receipts). Because all of PRS’s SIC AAA sales
generate DPGR, all of X’s and Y’s shares of PRS’s
section 174 R&E attributable to SIC AAA is taken
into account for purposes of determining X’s and Y’s
QPAI. None of PRS’s section 174 R&E attributable
to SIC BBB is taken into account because PRS has
no DPGR within SIC BBB. Thus, X and Y each has
QPAI, solely for this purpose, of $540, as shown be-
low:
2006–25 I.R.B.1125June 19, 2006

DPGR (all from sales of products within SIC AAA) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
$1,500
CGS(includes$50ofW–2wages).................................................................. ($600)
Section 162 selling expenses (including W–2 wages)
($420x$1,500/$3,000)....................................................................... ($210)
Section174R&E-SICAAA.......................................................................
($150)
QPAI..........................................................................................
$540
(B) X’s and Y’s shares of PRS’s W–2 wages de-
termined under section 199(d)(1)(A)(iii) for purposes
of the w
age limitation of section 199(b) are $32, the
lesser of $150 (partner’s allocable share of PRS’s
W–2 wages ($100 included in CGS, and $50 included
in sell
ing expenses)) and $32 (2 x ($540 x .03)).
(v)Section 199 deduction determination. (A) X’s
tentative section 199 deduction is $16 (.03 x $540
(QPAI d
etermined at partner level)) subject to the
wage limitation of $16 (50% x $32). Accordingly,
X’s section 199 deduction for 2006 is $16.
(B) Y’
s tentative section 199 deduction is $38 (.03
x $1,282 (QPAI determined at partner level) subject
to the wage limitation of $144 (50% x $287 ($32 from
PRS + $
255 from non-PRS activities)). Accordingly,
Y’s section 199 deduction for 2006 is $38.
Example 3.Partnership with special allocations.
(i)In
general. X and Y are unrelated corporate part-
ners in PRS and each is engaged in a trade or busi-
ness. PRS is a partnership that engages in a domestic
prod
uction activity and other activities. In general,
X and Y share all partnership items of income, gain,
loss, deduction, and credit equally, except that 80%
of th
e wage expense of PRS and 20% of PRS’s other
expenses are specially allocated to X (substantial eco-
nomic effect under section 704(b) is presumed). In
the
2006 taxable year, PRS’s only wage expense is
$2,000 for marketing, which is not included in CGS.
PRS has $8,000 of gross receipts ($6,000 of which
is D
PGR), $4,000 of CGS ($3,500 of which is al-
locable to DPGR), and $3,000 of deductions (com-
prised of $2,000 of wages for marketing and $1,000
of
other expenses). X qualifies for and uses the sim-
plified deduction method under §1.199–4(e). Y does
not qualify to use that method and, therefore, must
us
e the section 861 method under §1.199–4(d). In the
2006 taxable year, X has gross receipts attributable to
non-partnership trade or business activities of $1,000
a
nd wages of $200. None of X’s non-PRS gross re-
ceipts is DPGR.
(ii)Allocation and apportionment of costs.Un-
d
er the partnership agreement, X’s distributive share
of the items of PRS is $1,250 of gross income
attributable to DPGR ($3,000 DPGR - $1,750 al-
l
ocable CGS), $750 of gross income attributable
to non-DPGR ($1,000 non-DPGR - $250 alloca-
ble CGS), and $1,800 of deductions (comprised of
X’s special allocations of $1,600 of wage expense
($2,000 x 80%) for marketing and $200 of other
expenses ($1,000 x 20%)). Under the simplified
deduction method, X apportions $1,200 of other
deductions to DPGR ($2,000 ($1,800 from the part-
nership and $200 from non-partnership activities) x
($3,000 DPGR/$5,000 totalgross receipts)). Accord-
ingly, X’s QPAI is $50 ($3,000 DPGR - $1,750 CGS
- $1,200 of deductions). However, in determining
the section 199(d)(1)(A)(iii) wage limitation, QPAI
is computed taking into account only the items of
PRS allocated to X for the taxable year of PRS.
Thus, X apportions $1,350 of deductions to DPGR
($1,800 x ($3,000 DPGR/$4,000 total gross receipts
from PRS)). Accordingly, X’s QPAI for purposes
of the s
ection 199(d)(1)(A)(iii) wage limitation is
$0 ($3,000 DPGR - $1,750 CGS - $1,350 of deduc-
tions). X’s share of PRS’s W–2 wages is $0, the
lesser
of $1,600 (X’s 80% allocable share of $2,000
of wage expense for marketing) and $0 (2 x ($0 QPAI
x .03)). X’s tentative deduction is $2 ($50 QPAI x
.03),
subject to the section 199(b)(1) wage limitation
of $100 (50% x $200 ($0 of PRS-related W–2 wages
+ $200 of non-PRS W–2 wages)). Accordingly, X’s
secti
on 199 deduction for the 2006 taxable year is $2.
Example 4.Partnership with no W–2 wages.(i)
Facts. A,anindividual,andB,anindividual,are
partn
ers in PRS. PRS is a partnership that engages
in manufacturing activities that generate both DPGR
and non-DPGR. A and B share all items of income,
gain
, loss, deduction, and credit equally. In the 2006
taxable year, PRS has total gross receipts of $2,000
($1,000 of which is DPGR), CGS of $400 and deduc-
tion
s of $800. PRS has no W–2 wages. A and B each
use the small business simplified overall method un-
der §1.199–4(f). A has trade or business activities
out
side of PRS. With respect to those activities, A
has total gross receipts of $1,000 ($500 of which is
DPGR), CGS of $400 (including $50 of W–2 wages)
and
deductions of $200 for the 2006 taxable year. B
has no trade or business activities outside of PRS and
pays $0 of W–2 wages directly for the 2006 taxable
ye
ar. A’s distributive share of the items of the part-
nership is $500 DPGR, $500 non-DPGR, $200 CGS,
and $400 of deductions.
(i
i)Section 199(d)(1)(A)(iii) wage limitation.A’s
CGS and deductions apportioned to DPGR from PRS
equal $300 (($200 CGS + $400 of other deductions)
x(
$500 DPGR/$1,000 total gross receipts)). Accord-
ingly, for purposes of the wage limitation of section
199(d)(1)(A)(iii), A’s QPAI is $200 ($500 DPGR -
$
300 CGS and other deductions). A’s share of part-
nership W–2 wages after application of the section
199(d)(1)(A)(iii) limitation is $0, the lesser of $0 (A’s
5
0% allocable share of PRS’s $0 of W–2 wages) or
$12 (2 x ($200 QPAI x .03)). B’s share of PRS’s W–2
wages also is $0.
(
iii)Section 199 deduction computation.A’sto-
tal CGS and deductions apportioned to DPGR equal
$600 (($200 PRS CGS + $400 outside trade or busi-
ness CGS + $400 PRS deductions + $200 outside
trade or business deductions) x ($1,000 total DPGR
($500 from PRS + $500 from outside trade or busi-
ness)/$2,000 total gross receipts ($1,000 from PRS +
$1,000 from outside trade or business)). Accordingly,
A’s QPAI is $400 ($1,000 DPGR - $600 CGS and de-
ductions). A’s tentative deduction is $12 ($400 QPAI
x .03), subject to the section 199(b)(1) wage limita-
tion of $25 (50% x $50 total W–2 wages). A’s section
199 deduction for the 2006 taxable year is $12. B’s
total section 199 deduction for the 2006 taxable year
is $0 because B has no W–2 wages for the 2006 tax-
able year.
Example 5.Guaranteed payment.(i)Facts.The
facts are the same asExample 4except that in 2006
PRS als
o makes a guaranteed payment of $200 to A
for services, and PRS pays $200 of W–2 wages to
PRS employees, which is included within the $400
of CGS.
See section 707(c). This guaranteed pay-
ment is taxable to A as ordinary income and is prop-
erly deducted by PRS under section 162. Pursuant
to §1.
199–3(p), A may not treat any part of this pay-
ment as DPGR. Accordingly, PRS has total gross re-
ceipts of $2,000 ($1,000 of which is DPGR), CGS
of $40
0 (including $200 of W–2 wages) and deduc-
tions of $1,000 (including the $200 guaranteed pay-
ment) for the 2006 taxable year. A’s distributive share
of th
e items of the partnership is $500 DPGR, $500
non-DPGR, $200 CGS, and $500 of deductions.
(ii)Section 199(d)(1)(A)(iii) wage limitation.A’s
CGS a
nd deductions apportioned to DPGR from
PRS equal $350 (($200 CGS + $500 of other deduc-
tions) x ($500 DPGR/$1,000total gross receipts)).
Acco
rdingly, for purposes of the wage limitation of
section 199(d)(1)(A)(iii), A’s QPAI is $150 ($500
DPGR - $350 CGS and other deductions). A’s share
of p
artnership W–2 wages after application of the
section 199(d)(1)(A)(iii) limitation is $9, the lesser
of $100 (A’s 50% allocable share of PRS’s $200 of
W–2
wages) or $9 (2 x ($150 QPAI x .03)). B’s share
of PRS’s W–2 wages after application of section
199(d)(1)(A)(iii) also is $9.
(i
ii)A’s section 199 deduction computation.A’s
total CGS and deductions apportioned to DPGR equal
$591 (($200 PRS CGS + $400 outside trade or busi-
ne
ss CGS + $500 PRS deductions + $200 outside
trade or business deductions) x ($1,000 total DPGR
($500 from PRS + $500 from outside trade or busi-
ne
ss)/$2,200 total gross receipts ($1,000 from PRS
+ $200 guaranteed payment + $1,000 from outside
trade or business)). Accordingly, A’s QPAI is $409
(
$1,000 DPGR - $591 CGS and other deductions).
A’s tentative deduction is $12 ($409 QPAI x .03), sub-
ject to the section 199(b)(1) wage limitation of $30
(
50% x $59 ($9 PRS W–2 wages + $50 W–2 wages
from A’s trade or business activities outside of PRS)).
A’s section 199 deduction for the 2006 taxable year
is $12.
(iv)B’s section 199 deduction computation.B’s
QPAI is $150 ($500 DPGR - $350 CGS and other de-
ductions). B’s tentative deduction is $5 ($150 QPAI
x .03), subject to the section 199(b)(1) wage limita-
tion of $5 (50% x $9). Assuming that B engages in
no other activities generating DPGR, B’s section 199
deduction for the 2006 taxable year is $5.
(c)S corporations—(1)In gen-
eral—(i)Determination at shareholder
level. The section 199 deduction with
respect to the qualified production activ-
ities of an S corporation is determined at
the shareholder level. As a result, each
shareholder must compute its deduction
June 19, 200611262006–25 I.R.B.

separately. The section 199 deduction will
have no effect on the basis of a share-
holder’sstockinanScorporation. Ex-
cept as provided by publication pursuant
to paragraph (c)(1)(ii) of this section,
for purposes of this section, each share-
holder is allocated, in accordance with
section 1366, itspro ratashare of S corpo-
ration items (including items of income,
gain, loss, and deduction), CGS allocated
to such items of income, and gross re-
ceiptsincludedinsuchitemsofincome,
even if the shareholder’s share of CGS
and other deductions and losses exceeds
DPGR, and regardless of the amount of
the shareholder’s share of the W–2 wages
of the S corporation for the taxable year.
Except as provided by publication under
paragraph (c)(1)(ii) of this section, to de-
termine its section 199 deduction for the
taxable year, the shareholder aggregates
itspro ratashare of such items, to the ex-
tent they are not otherwise disallowed by
the Code, with those items it incurs out-
side the S corporation (whether directly
or indirectly) for purposes of allocating
and apportioning deductions to DPGR and
computing its QPAI.
(ii)Determination at entity level.
The Secretary may, by publication
in the Internal Revenue Bulletin (see
§601.601(d)(2)(ii)(b) of this chapter), per-
mit an S corporation to calculate a share-
holder’s share of QPAI at the entity level,
instead of allocating, in accordance with
section 1366, the shareholder’spro rata
share of S corporation items (including
items of income, gain, loss, and deduc-
tion). If an S corporation does calculate
QPAI at the entity level—
(A) Each shareholder is allocated its
share of QPAI and W–2 wages, which
(subject to the limitations under para-
graph (c)(2) of this section and section
199(d)(1)(A)(iii), respectively) are com-
bined with the shareholder’s QPAI and
W–2 wages from other sources;
(B) For purposes of computing QPAI
under §§1.199–1 through 1.199–9, a share-
holder does not take into account the items
from such an S corporation (for example,
a shareholder does not take into account
items from such an S corporation in deter-
mining whether a threshold orde minimis
rule applies or when the shareholder allo-
cates and apportions deductions in calcu-
lating its QPAI from other sources);
(C) A shareholder generally does not
recompute its share of QPAI from the
S corporation using another method; how-
ever, the shareholder might have to adjust
its share of QPAI from the S corporation
to take into account certain disallowed
losses or deductions, or the allowance of
suspended losses or deductions; and
(D) A shareholder’s share of QPAI from
an S corporation may be less than zero.
(2)Disallowed losses or deduc-
tions. Except as provided by publica-
tion in the Internal Revenue Bulletin (see
§601.601(d)(2)(ii)(b) of this chapter),
losses or deductions of the S corpora-
tion that otherwise would be taken into
account in computing the shareholder’s
section 199 deduction for a taxable year
are taken into account in that year only if
and to the extent the shareholder’spro rata
share of the losses or deductions from all
of the S corporation’s activities is not dis-
allowed by section 465, 469, or 1366(d),
or any other provision of the Code. If
only a portion of the shareholder’s share
of the losses or deductions is allowed for
a taxable year, a proportionate share of
those allowable losses or deductions that
are allocated to the S corporation’s quali-
fied production activities, determined in a
manner consistent with sections 465, 469,
and 1366(d), and any other applicable pro-
vision of the Code, is taken into account
in computing the QPAI and the wage lim-
itation of section 199(d)(1)(A)(iii) for that
taxable year. To the extent that any of
the disallowed losses or deductions are
allowed in a later taxable year, the share-
holder takes into account a proportionate
share of those losses or deductions in com-
puting its QPAI for that later taxable year.
Losses or deductions of the S corporation
that are disallowed for taxable years be-
ginning on or before December 31, 2004,
are not taken into account in a later taxable
year for purposes of computing the share-
holder’s QPAI or the wage limitation of
section 199(d)(1)(A)(iii) for that taxable
year, regardless of whether the losses or
deductions are allowed for other purposes.
(3)Shareholder’s share of W–2 wages.
Under section 199(d)(1)(A)(iii), an
S corporation shareholder’s share of
the W–2 wages of the S corporation
for purposes of determining the share-
holder’s section 199(b) limitation is the
lesser of the shareholder’s allocable share
of those wages (without regard to sec-
tion 199(d)(1)(A)(iii)), or 2 times 3 per-
cent of the QPAI computed by taking into
account only the items of the S corporation
allocated to the shareholder for the taxable
year of the S corporation. Except as pro-
vided by publication in the Internal Rev-
enue Bulletin (see §601.601(d)(2)(ii)(b)of
this chapter), this QPAI calculation is per-
formed by the shareholder using the same
cost allocation method that the shareholder
uses in calculating the shareholder’s sec-
tion 199 deduction. The S corporation
must allocate W–2 wages (prior to the
application of the wage limitation) among
the shareholders in the same manner as
wage expense. The shareholder must add
the shareholder’s share of W–2 wages
from the S corporation, as limited by sec-
tion 199(d)(1)(A)(iii), to the shareholder’s
W–2 wages from other sources, if any. If
QPAI,computedbytakingintoaccount
only the items of the S corporation allo-
cated to the shareholder for the taxable
year (as required by the wage limitation
of section 199(d)(1)(A)(iii)), is not greater
than zero, then the shareholder may not
take into account any W–2 wages of the
S corporation in applying the wage lim-
itation of §1.199–2 (but the shareholder
will, nevertheless, aggregate its distribu-
tive share of S corporation items including
wage expense with those items not from
the S corporation in computing its QPAI
when determining its section 199 deduc-
tion). See §1.199–2 for the computation
of W–2 wages, and paragraph (g) of this
section for rules regarding pass-thru enti-
ties in a tiered structure.
(4)Transition percentage rule for W–2
wages. With regard to S corporations, for
purposes of section 199(d)(1)(A)(iii)(II)
the transition percentages determined un-
der section 199(a)(2) shall be determined
by reference to the S corporation’s taxable
year. Thus, if an S corporation share-
holder uses a calendar year taxable year,
and owns stock in an S corporation that
has a taxable year ending on April 30,
the shareholder’s section 199(d)(1)(A)(iii)
wage limitation for the S corporation’s
taxable year beginning on May 1, 2006,
would be calculated using 3 percent, even
though the shareholder includes the share-
holder’spro ratashare of S corporation
items from that taxable year on the share-
holder’s 2007 Federal income tax return.
(d)Grantor trusts. To the extent that
the grantor or another person is treated as
2006–25 I.R.B.1127June 19, 2006

owning all or part (the owned portion) of a
trust under sections 671 through 679, such
person (owner) computes its QPAI with re-
spect to the owned portion of the trust as
if that QPAI had been generated by activi-
ties performed directly by the owner. Sim-
ilarly, for purposes of the section 199(b)
wage limitation, the owner of the trust
takes into account the owner’s share of the
W–2 wages of the trust that are attribut-
able to the owned portion of the trust. The
section 199(d)(1)(A)(iii) wage limitation
is not applicable to the owned portion of
the trust. The provisions of paragraph (e)
of this section do not apply to the owned
portion of a trust.
(e)Non-grantor trusts and estates—(1)
Allocation of costs.Thetrustorestate
calculates each beneficiary’s share (as
well as the trust’s or estate’s own share,
if any) of QPAI and W–2 wages from the
trust or estate at the trust or estate level.
The beneficiary of a trust or estate is not
permitted to use another cost allocation
method to recompute its share of QPAI
from the trust or estate or to reallocate
the costs of the trust or estate. Except as
provided in paragraph (d) of this section,
theQPAIofatrustorestatemustbecom-
puted by allocating expenses described
in section 199(d)(5) in one of two ways,
depending on the classification of those
expenses under §1.652(b)–3. Specifically,
directly attributable expenses within the
meaning of §1.652(b)–3 are allocated pur-
suant to §1.652(b)–3, and expenses not
directly attributable within the meaning of
§1.652(b)–3 (other expenses) are allocated
under the simplified deduction method of
§1.199–4(e) (unless the trust or estate does
not qualify to use the simplified deduc-
tion method, in which case it must use
the section 861 method of §1.199–4(d)
with respect to such other expenses). For
this purpose, depletion and depreciation
deductions described in section 642(e) and
amortization deductions described in sec-
tion 642(f) are treated as other expenses
describedinsection199(d)(5). Alsofor
this purpose, the trust’s or estate’s share of
other expenses from a lower-tier pass-thru
entity is not directlyattributable to any
class of income (whether or not those
other expenses are directly attributable to
the aggregate pass-thru gross income as a
class for purposes other than section 199).
A trust or estate may not use the small
business simplified overall method for
computing its QPAI. See §1.199–4(f)(5).
(2)Allocation among trust or estate and
beneficiaries—(i)In general. The QPAI
of a trust or estate (which will be less
than zero if the CGS and deductions allo-
cated and apportioned to DPGR exceed the
trust’s or estate’s DPGR) and W–2 wages
of the trust or estate are allocated to each
beneficiary and to the trust or estate based
on the relative proportion of the trust’s or
estate’s distributable net income (DNI), as
defined by section 643(a), for the taxable
year that is distributed or required to be
distributed to the beneficiary or is retained
by the trust or estate. To the extent that
the trust or estate has no DNI for the tax-
able year, any QPAI and W–2 wages are
allocated entirely to the trust or estate. A
trust or estate is allowed the section 199
deduction in computing its taxable income
to the extent that QPAI and W–2 wages
are allocated to the trust or estate. A ben-
eficiary of a trust or estate is allowed the
section 199 deduction in computing its tax-
able income based on its share of QPAI and
W–2 wages from the trust or estate, which
(subject to the wage limitation as described
in paragraph (e)(3) of this section) are ag-
gregated with the beneficiary’s QPAI and
W–2 wages from other sources.
(ii)Treatment of items from a trust or
estate reporting qualified production ac-
tivities income. When, pursuant to this
paragraph (e), a taxpayer must combine
QPAI and W–2 wages from a trust or es-
tate with the taxpayer’s total QPAI and
W–2 wages from other sources, the tax-
payer, when applying §§1.199–1 through
1.199–9 to determine the taxpayer’s to-
tal QPAI and W–2 wages from such other
sources, does not take into account the
items from such trust or estate. Thus, for
example, a beneficiary of an estate that re-
ceives QPAI from the estate does not take
into account the beneficiary’s distributive
share of the estate’s gross receipts, gross
income, or deductions when the benefi-
ciary determines whether a threshold orde
minimisrule applies or when the benefi-
ciary allocates and apportions deductions
in calculating its QPAI from other sources.
(3)Beneficiary’s share of W–2 wages.
The trust or estate must compute each
beneficiary’s share of W–2 wages from
the trust or estate in accordance with sec-
tion 199(d)(1)(A)(iii), as if the beneficiary
were a partner in a partnership. The ap-
plication of section 199(d)(1)(A)(iii) to
each trust and estate therefore means that
if QPAI, computed by taking into account
only the items of the trust or estate allo-
cated to the beneficiary for the taxable
year, is not greater than zero, then the
beneficiary may not take into account any
W–2 wages of the trust or estate in ap-
plying the wage limitation of §1.199–2
(but the beneficiary will, nevertheless,
aggregate its QPAI from the trust or estate
with its QPAI from other sources when
determining the beneficiary’s section 199
deduction). See paragraph (g) of this
section for rules applicable to pass-thru
entities in a tiered structure.
(4)Transition percentage rule for
W–2 wages. Withregardtotrusts
and estates, for purposes of section
199(d)(1)(A)(iii)(II), the transition per-
centages determined under section
199(a)(2) shall be determined by refer-
ence to the taxable year of the trust or
estate.
(5)Example. The following example
illustrates the application of this para-
graph (e) and paragraph (g) of this section.
Assume that the partnership, trust, and
trust beneficiary all are calendar year tax-
payers.
Example.(i)Computation of DNI and inclusion
and deduction amounts.(A)Trust’s distributive
share of partnership items. Trust, a complex trust,
is a partner in PRS, a partnership that engages in
activities that generate DPGR and non-DPGR. In
2006, PRS distributes $10,000 cash to Trust. Trust’s
distributive share of PRS items, which are properly
included in Trust’s DNI, is as follows:
June 19, 200611282006–25 I.R.B.

Gross income attributable to DPGR
($15,000 DPGR - $5,000 CGS
(includingW–2wagesof$1,000)) .............................................................. $10,000
Gross income attributable to non-DPGR
($5,000othergrossreceipts-$0CGS)........................................................... $5,000
Selling expenses (includes W–2 wages of $2,000) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .$3,000
Otherexpenses(includesW–2wagesof$1,000)....................................................... $2,000
(B)Trust’s direct activities. In addition to its cash
distribution in 2006 from PRS, Trust also directly has
the following items which are properly included in
Trust’s DNI:
Dividends......................................................................................
$10,000
Tax-exemptinterest..............................................................................
$10,000
Rents from commercial real property operated by Trust
asabusiness................................................................................
$10,000
Realestatetaxes.................................................................................
$1,000
Trusteecommissions.............................................................................
$3,000
Stateincomeandpersonalpropertytaxes.............................................................
$5,000
W–2wagesforrentalbusiness .....................................................................
$2,000
Otherbusinessexpenses ..........................................................................
$1,000
(C)A
llocation of deductions under §1.652(b)–3.
(1)Directly attributable expenses. In computing
Trust’s DNI for the taxable year, the distributive
sha
re of expenses of PRS are directly attributable
under §1.652(b)–3(a) to the distributive share of
income of PRS. Accordingly, the $5,000 of CGS,
$3,
000 of selling expenses, and $2,000 of other ex-
penses are subtracted from the gross receipts from
PRS ($20,000), resulting in net income from PRS of
$1
0,000. With respect to the Trust’s direct expenses,
$1,000 of the trustee commissions, the $1,000 of real
estate taxes, and the $2,000 of W–2 wages are di-
re
ctly attributable under §1.652(b)–3(a) to the rental
income.
(2)Non-directly attributable expenses. Under
§1
.652(b)–3(b), the trustee must allocate a portion
of the sum of the balance of the trustee commissions
($2,000), state income and personal property taxes
(
$5,000), and the other business expenses ($1,000) to
the $10,000 of tax-exempt interest. The portion to be
attributed to tax-exempt interest is $2,222 ($8,000 x
(
$10,000 tax-exempt interest/$36,000 gross receipts
net of direct expenses)), resulting in $7,778 ($10,000
- $2,222) of net tax-exempt interest. Pursuant to
its authority recognized under §1.652(b)–3(b), the
trustee allocates the entire amount of the remaining
$5,778 of trustee commissions, state income and
personal property taxes, and other business expenses
to the $6,000 of net rental income, resulting in $222
($6,000 - $5,778) of net rental income.
(D)Amounts included in taxable income.For
2006, Trust has DNI of $28,000 (net dividend in-
come of $10,000 + net PRS income of $10,000 + net
rental income of $222 + net tax-exempt income of
$7,778). Pursuant to Trust’s governing instrument,
Trustee distributes 50%, or $14,000, of that DNI to
B, an individual who is a discretionary beneficiary of
Trust. Assume that there are no separate shares under
Trust, and no distributions are made to any other ben-
eficiary that year. Consequently, with respect to the
$14,000 distribution B receives from Trust, B prop-
erly includes in B’s gross income $5,000 of income
from PRS, $111 of rents, and $5,000 of dividends,
and properly excludes from B’s gross income $3,889
of ta
x-exempt interest. Trust includes $20,222 in its
adjusted total income and deducts $10,111 under sec-
tion 661(a) in computing its taxable income.
(ii)
Section 199 deduction.(A)Simplified de-
duction method. For purposes of computing the
section 199 deduction for the taxable year, assume
Tru
st qualifies for the simplified deduction method
under §1.199–4(e). The determination of Trust’s
QPAI under the simplified deduction method re-
qui
res multiple steps to allocate costs. First, the
Trust’s expenses directly attributable to DPGR un-
der §1.652(b)–3(a) are subtracted from the Trust’s
DP
GR. In this step, the directly attributable $5,000
of CGS and selling expenses of $3,000 are subtracted
from the $15,000 of DPGR from PRS. Next, Trust
mu
st identify its other trade or business expenses
directly related to non-DPGR trade or business in-
come. In this example, the portion of the trustee
c
ommissions not directly attributable to the rental
operation ($2,000), as well as the portion of the
state income and personal property taxes not directly
a
ttributable to either the PRS interests or the rental
operation, are not trade or business expenses and,
thus, are ignored in computing QPAI. The portion
of the state income and personal property taxes
that is treated as other trade or business expenses
is $3,000 ($5,000 x $30,000 total trade or business
gross receipts/$50,000 total gross receipts). Trust
then allocates its other trade or business expenses on
the basis of its total gross receipts from the conduct
of a trade or business ($20,000 from PRS + $10,000
rental income). Trust then combines its non-di-
rectly attributable (other) business expenses ($2,000
from PRS + $4,000 ($1,000 of other expenses +
$3,000 of income and property taxes) from its own
activities) and then apportions this total between
DPGR and other receipts on the basis of Trust’s total
trade or business gross receipts ($6,000 x $15,000
DPGR/$30,000 total trade or business gross receipts
= $3,000). Thus, for purposes of computing Trust’s
and B’s section 199 deduction, Trust’s QPAI is
$4,000 ($7,000 - $3,000). Because the distribution
of Trust’s DNI to B equals one-half of Trust’s DNI,
Trus
t and B each has QPAI from PRS for purposes
of the section 199 deduction of $2,000.
(B)Section 199(d)(1)(A)(iii) wage limitation.
The w
age limitation under section 199(d)(1)(A)(iii)
must be applied both at the Trust level and at B’s
level. After applying this limitation to the Trust’s
sha
re of PRS’s W–2 wages, Trust is allocated $330
of W–2 wages from PRS (the lesser of Trust’s
allocable share of PRS’s W–2 wages ($4,000)
or 2
x 3% of Trust’s QPAI from PRS ($5,500)).
Trust’sQPAIfromPRSforpurposesofthesection
199(d)(1)(A)(iii) limitation is determined by taking
in
to account only the items of PRS allocated to Trust
($15,000 DPGR - ($5,000 of CGS + $3,000 selling
expenses + $1,500 of other expenses)). For this
pu
rpose, the $1,500 of other expenses is determined
by multiplying $2,000 of other expenses from PRS
by $15,000 of DPGR from PRS, divided by $20,000
o
f total gross receipts from PRS. Trust adds this $330
of W–2 wages to Trust’s own $2,000 of W–2 wages
(thus, $2,330). Because the $14,000 Trust distribu-
t
iontoBequalsone-halfofTrust’sDNI,Trustand
B each has W–2 wages of $1,165. After applying
the section 199(d)(1)(A)(iii) wage limitation to B’s
share of the W–2 wages allocated from Trust, B has
W–2 wages of $120 from Trust (lesser of $1,165
(allocable share of W–2 wages) or 2 x .03 x $2,000
(B’s share of Trust’s QPAI)). B has W–2 wages of
$100 from non-Trust activities for a total of $220 of
W–2 wages.
(C)Section 199 deduction computation.(1)B’s
computation. B is eligible to use the small business
simplified overall method. Assume that B has suf-
ficient adjusted gross income so that the section 199
deduction is not limited under section 199(a)(1)(B).
B has $1,000 of QPAI from non-Trust activities that
is added to the $2,000 QPAI from Trust for a total of
$3,000 of QPAI. B’s tentative deduction is $90 (.03 x
$3,000), but it is limited under section 199(b) to $110
(50% x $220 W–2 wages). Accordingly, B’s section
199 deduction for 2006 is $90.
(2)Trust’s computation. Trust has sufficient ad-
justed gross income so that the section 199 deduction
is not limited under section 199(a)(1)(B). Trust’s ten-
2006–25 I.R.B.1129June 19, 2006

tative deduction is $60 (.03 x $2,000 QPAI), but it is
limited under section 199(b) to $583 (50% x $1,165
W–2 wages). Accordingly, Trust’s section 199 de-
duction for 2006 is $60.
(f)Gain or loss from the disposition of
an interest in a pass-thru entity.DPGR
generally does not include gain or loss rec-
ognized on the sale, exchange, or other dis-
position of an interest in a pass-thru entity.
However, with respect to a partnership, if
section 751(a) or (b) applies, then gain or
loss attributable to assets of the partnership
giving rise to ordinary income under sec-
tion 751(a) or (b), the sale, exchange, or
other disposition of which would give rise
to DPGR, is taken into account in com-
puting the partner’s section 199 deduc-
tion. Accordingly, to the extent that cash
or property received by a partner in a sale
or exchange for all or part of its partner-
ship interest is attributable to unrealized
receivables or inventory items within the
meaning of section 751(c) or (d), respec-
tively, and the sale or exchange of the unre-
alized receivable or inventory items would
give rise to DPGR if sold, exchanged, or
otherwise disposed of by the partnership,
the cash or property received by the part-
ner is taken into account by the partner
in determining its DPGR for the taxable
year. Likewise, to the extent that a dis-
tribution of property to a partner is treated
under section 751(b) as a sale or exchange
of property between the partnership and
the distributee partner, and any property
deemed sold or exchanged would give rise
to DPGR if sold, exchanged, or otherwise
disposed of by the partnership, the deemed
sale or exchange of the property must be
taken into account in determining the part-
nership’s and distributee partner’s DPGR
to the extent not taken into account under
the qualifying in-kind partnership rules.
See §1.751–1(b) and paragraph (i) of this
section.
(g)Section 199(d)(1)(A)(iii) wage lim-
itation and tiered structures—(1)In gen-
eral. If a pass-thru entity owns an interest,
directly or indirectly, in one or more pass-
thru entities, then the wage limitation of
section 199(d)(1)(A)(iii) must be applied
at each tier (that is, separately for each
entity). For purposes of this wage limi-
tation, references to pass-thru entities in-
cludes partnerships, S corporations, trusts
(to the extent not described in paragraph
(d) of this section) and estates. Thus, at
each tier, the owner of a pass-thru en-
tity (or the entity on behalf of the owner)
calculates the amounts described in sec-
tions 199(d)(1)(A)(iii)(I) (owner’s alloca-
ble share) and 199(d)(1)(A)(iii)(II) (twice
the applicable percentage of the owner’s
QPAI from that entity) separately with re-
gard to its interest in that pass-thru entity.
(2)Share of W–2 wages. For purposes
of section 199(d)(1)(A)(iii) and section
199(b), the W–2 wages of the owner of
an interest in a pass-thru entity (upper-tier
entity) that owns an interest in one or
more pass-thru entities (lower-tier enti-
ties) are equal to the sum of the owner’s
allocable share of W–2 wages of the up-
per-tier entity, as limited in accordance
with section 199(d)(1)(A)(iii), and the
owner’s own W–2 wages. The upper-tier
entity’s W–2 wages are equal to the sum
of the upper-tier entity’s allocable share
of W–2 wages of the next lower-tier en-
tity, as limited in accordance with section
199(d)(1)(A)(iii), and the upper-tier en-
tity’s own W–2 wages. The W–2 wages of
each lower-tier entity in a tiered structure,
in turn, is computed as described in the
preceding sentence. Except as provided
by publication in the Internal Revenue
Bulletin (see §601.601(d)(2)(ii)(b)ofthis
chapter)—
(i) An upper-tier entity may compute its
share of QPAI attributable to items from
a lower-tier entity solely for purposes of
section 199(d)(1)(A)(iii)(II) by applying
either the section 861 method described
in §1.199–4(d) or the simplified deduc-
tion method described in §1.199–4(e), pro-
vided the upper tier entity would otherwise
qualifytousesuchmethod.
(ii) Alternatively, the upper-tier entity
(other than a trust or estate described in
paragraph (e) of this section) may com-
pute its share of QPAI attributable to items
from a lower-tier entity solely for pur-
poses of section 199(d)(1)(A)(iii)(II) by
applying the small business simplified
overall method described in §1.199–4(f),
regardless of whether such upper-tier en-
tity would otherwise qualify to use the
small business simplified overall method.
(3)Example. The following example
illustrates the application of this para-
graph (g). Assume that each partnership
and each partner (whether or not an indi-
vidual) is a calendar year taxpayer.
Example. (i) In 2006, A, an individual, owns a
50% interest in a partnership, UTP, which in turn
owns a 50% interest in another partnership, LTP.
All partnership items are allocated in proportion to
these ownership percentages. LTP has $900 DPGR,
$450 CGS (which includes W–2 wages of $100), and
$50 other deductions. Before taking into account its
share of items from LTP, UTP has $500 DPGR, $500
CGS (which includes W–2 wages of $200), and $500
other deductions. UTP chooses to compute its share
of QPAI attributable to items from LTP for purposes
of section 199(d)(1)(A)(iii)(II) by applying the small
business simplified overall method described in
§1.199–4(f). For purposes of the wage limitation of
section 199(d)(1)(A)(iii), UTP’s distributive share of
LTP’s QPAI is $200 ($450 DPGR - $250 CGS and
other deductions).
(ii) UTP’s share of LTP’s W–2 wages for pur-
poses of the section 199(d)(1)(A)(iii) limitation is
$12, the lesser of $50 (UTP’s 50% allocable share
of LTP’s $100 of W–2 wages) or $12 (2 x ($200
QPAI x .03)). After taking into account its share of
items from LTP, UTP has $950 DPGR, $725 CGS,
and $525 other deductions. A is eligible for and
uses the simplified deduction method described in
§1.199–4(e). For purposes of the wage limitation of
section 199(d)(1)(A)(iii), A’s distributive share of
UTP’s QPAI is ($151) ($475 DPGR - $363 CGS -
$263 other deductions). A’s wage limitation under
section 199(d)(1)(A)(iii) with respect to A’s interest
in UTP is $0, the lesser of $106 (A’s 50% allocable
share of UTP’s $212 of W–2 wages) or $0 (because
A’s share of UTP’s QPAI ($151), is less than zero).
(h)No attribution of qualified activ-
ities. Except as provided in paragraph
(i) of this section regarding qualifying
in-kind partnerships and paragraph (j)
of this section regarding EAG partner-
ships, an owner of a pass-thru entity is
not treated as conducting the qualified
production activities of the pass-thru en-
tity, and vice versa. For example, if a
partnership MPGE QPP within the United
States, or produces a qualified film or
produces utilities in the United States, and
distributes or leases, rents, licenses, sells,
exchanges, or otherwise disposes of such
property to a partner who then, without
performing its own qualifying MPGE or
other production, leases, rents, licenses,
sells, exchanges, or otherwise disposes
of such property, then the partner’s gross
receipts from this latter lease, rental, li-
cense, sale, exchange, or other disposition
are treated as non-DPGR. In addition, if
a partner MPGE QPP within the United
States, or produces a qualified film or
produces utilities in the United States, and
contributes or leases, rents, licenses, sells,
exchanges, or otherwise disposes of such
property to a partnership which then, with-
out performing its own qualifying MPGE
or other production, leases, rents, licenses,
sells, exchanges, or otherwise disposes of
such property, then the partnership’s gross
June 19, 200611302006–25 I.R.B.

receipts from this latter disposition are
treated as non-DPGR.
(i)Qualifying in-kind partnership—(1)
In general. If a partnership is a qualifying
in-kind partnership described in paragraph
(i)(2) of this section, then each partner is
treated as MPGE or producing the prop-
erty MPGE or produced by the partnership
that is distributed to that partner. If a part-
ner of a qualifying in-kind partnership de-
rives gross receipts from the lease, rental,
license, sale, exchange, or other disposi-
tion of the property that was MPGE or pro-
duced by the qualifying in-kind partner-
ship, then, provided such partner is a part-
ner of the qualifying in-kind partnership at
the time the partner disposes of the prop-
erty, the partner is treated as conducting
the MPGE or production activities previ-
ously conducted by the qualifying in-kind
partnership with respect to that property.
With respect to a lease, rental, or license,
the partner is treated as having disposed of
the property on the date or dates on which
it takes into account its gross receipts de-
rived from the lease, rental, or license un-
der its methods of accounting. With re-
spect to a sale, exchange, or other dispo-
sition, the partner is treated as having dis-
posed of the property on the date on which
it ceases to own the property for Federal in-
come tax purposes, even if no gain or loss
is taken into account.
(2)Definition of qualifying in-kind
partnership. For purposes of this para-
graph (i), a qualifying in-kind partnership
is a partnership engaged solely in—
(i) The extraction, refining, or process-
ing of oil, natural gas (as described in
§1.199–3(l)(2)), petrochemicals, or prod-
ucts derived from oil, natural gas, or petro-
chemicals in whole orin significant part
within the United States;
(ii) The production or generation of
electricity in the United States; or
(iii) An activity or industry desig-
nated by the Secretary by publication
in the Internal Revenue Bulletin (see
§601.601(d)(2)(ii)(b) of this chapter).
(3)Special rules for distributions.Ifa
qualifying in-kind partnership distributes
property to a partner, then, solely for pur-
poses of section 199(d)(1)(A)(iii)(II), the
partnership is treated as having gross re-
ceipts in the taxable year of the distribu-
tion equal to the fair market value of the
distributed property at the time of distribu-
tion to the partner and the deemed gross
receipts are allocated to that partner, pro-
vided that the partner derives gross re-
ceipts from the distributed property (and
takes into account such receipts under its
method of accounting) during the taxable
year of the partner with or within which
the partnership’s taxable year (in which
the distribution occurs) ends. For rules
for taking costs intoaccount (such as costs
included in the adjusted basis of the dis-
tributed property), see §1.199–4.
(4)Other rules. Except as provided
in this paragraph (i), a qualifying in-kind
partnership is treated the same as other
partnerships for purposes of section 199.
Accordingly, a qualifying in-kind partner-
ship is subject to the rules of this section
regarding the application of section 199
to pass-thru entities, including application
of the section 199(d)(1)(A)(iii) wage lim-
itation under paragraph (b)(3) of this sec-
tion. In determining whether a qualifying
in-kind partnership or its partners MPGE
QPP in whole or in significant part within
the United States, see §1.199–3(g)(2) and
(3).
(5)Example. The following example
illustrates the application of this paragraph
(i). Assume that PRS and X are calendar
year taxpayers.
Example.X,YandZarepartnersinPRS,aqual-
ifying in-kind partnership described in paragraph
(i)(2) of this section. X, Y, and Z are corporations. In
2006, PRS distributes oil to X that PRS derived from
its oil extraction. PRS incurred $600 of CGS, includ-
ing $500 of W–2 wages (as defined in §1.199–2(e)),
extracting the oil distributed to X, and X’s adjusted
basis in the distributed oil is $600. The fair market
value of the oil at the time of the distribution to X
is $1,000. X incurs $200 of CGS, including $100
of W–2 wages, in refining the oil within the United
States. In 2006, X, while it is a partner in PRS, sells
the oil to a customer for $1,500, taking the gross re-
ceipts into account under its method of accounting in
the same taxable year. Under paragraph (i)(1) of this
section, X is treated as having extracted the oil. The
extraction and refining of the oil qualify as an MPGE
activity under §1.199–3(e)(1). Therefore, X’s $1,500
of gross receipts qualify as DPGR. X subtracts from
the $1,500 of DPGR the $600 of CGS incurred
by PRS and the $200 of refining costs incurred by
X. Thus, X’s QPAI is $700 for 2006. In addition,
PRS is treated as having $1,000 of DPGR solely for
purposes of applying the wage limitation in section
199(d)(1)(A)(iii) based on the applicable percentage
of QPAI. Accordingly, X’s share of PRS’s W–2
wages determined under section 199(d)(1)(A)(iii) is
$24, the lesser of $500 (X’s allocable share of PRS’s
W–2 wages included in CGS) and $24 (2 x ($400
($1,000 deemed DPGR less $600 of CGS) x .03)).
X adds the $24 of PRS W–2 wages to its $100 of
W–2wagesincurredinrefiningtheoilforpurposes
of section 199(b).
(j)Partnerships owned by members of
a single expanded affiliated group—(1)In
general. For purposes of this section, if all
of the interests in the capital and profits of
a partnership are owned by members of a
single EAG at all times during the taxable
year of the partnership (EAG partnership),
then the EAG partnership and all members
of that EAG are treated as a single taxpayer
for purposes of section 199(c)(4) during
that taxable year.
(2)Attribution of activities—(i)In gen-
eral. If a member of an EAG (dispos-
ing member) derives gross receipts from
the lease, rental, license, sale, exchange,
or other disposition of property that was
MPGE or produced by an EAG partner-
ship, all the partners of which are mem-
bers of the same EAG to which the dis-
posing member belongs at the time that
the disposing member disposes of such
property, then the disposing member is
treated as conducting the MPGE or pro-
duction activities previously conducted by
the EAG partnership with respect to that
property. The previous sentence applies
only for those taxable years in which the
disposing member is a member of the EAG
of which all the partners of the EAG part-
nership are members for the entire taxable
year of the EAG partnership. With re-
spect to a lease, rental, or license, the dis-
posing member is treated as having dis-
posed of the property on the date or dates
on which it takes into account its gross re-
ceipts from the lease, rental, or license un-
der its methods of accounting. With re-
spect to a sale, exchange, or other dis-
position, the disposing member is treated
as having disposed of the property on the
date on which it ceases to own the prop-
erty for Federal income tax purposes, even
if no gain or loss is taken into account.
Likewise, if an EAG partnership derives
gross receipts from the lease, rental, li-
cense, sale, exchange, or other disposition
of property that was MPGE or produced by
a member (or members) of the same EAG
(the producing member) to which all the
partners of the EAG partnership belong at
the time that the EAG partnership disposes
of such property, then the EAG partner-
ship is treated as conducting the MPGE or
production activities previously conducted
by the producing member with respect to
that property. The previous sentence ap-
plies only for those taxable years in which
the producing member is a member of the
2006–25 I.R.B.1131June 19, 2006

EAG of which all the partners of the EAG
partnership are members for the entire tax-
able year of the EAG partnership. With re-
spect to a lease, rental, or license, the EAG
partnership is treated as having disposed of
the property on the date or dates on which
it takes into account its gross receipts de-
rived from the lease, rental, or license un-
der its methods of accounting. With re-
spect to a sale, exchange, or other dispo-
sition, the EAG partnership is treated as
having disposed of the property on the date
on which it ceases to own the property for
Federal income tax purposes, even if no
gain or loss is taken into account. See para-
graph (j)(5)Example 3of this section.
(ii)Attribution between EAG partner-
ships. If an EAG partnership (disposing
partnership) derives gross receipts from
the lease, rental, license, sale, exchange,
or other disposition of property that was
MPGE or produced by another EAG part-
nership (producing partnership), then the
disposing partnership is treated as con-
ducting the MPGE or production activities
previously conducted by the producing
partnership with respect to that property,
provided that the producing partnership
and the disposing partnership are owned
by members of the same EAG for the
entire taxable year of the respective part-
nership in which the disposing partnership
disposes of such property. With respect
to a lease, rental, or license, the disposing
partnership is treated as having disposed of
the property on the date or dates on which
it takes into account its gross receipts
from the lease, rental, or license under its
methods of accounting. With respect to a
sale, exchange, or other disposition, the
disposing partnership is treated as having
disposed of the property on the date on
which it ceases to own the property for
Federal income tax purposes, even if no
gain or loss is taken into account.
(iii)Exceptions to attribution.Attri-
bution of activities does not apply for
purposes of the construction of real prop-
erty under §1.199–3(m)(1) and the per-
formance of engineering and architectural
services under §1.199–3(n)(2) and (3),
respectively.
(3)Special rules for distributions.Ifan
EAG partnership distributes property to a
partner, then, solely for purposes of sec-
tion 199(d)(1)(A)(iii)(II), the EAG part-
nership is treated as having gross receipts
in the taxable year of the distribution equal
to the fair market value of the property
at the time of distribution to the partner
and the deemed gross receipts are allo-
cated to that partner, provided that the part-
ner derives gross receipts from the dis-
tributed property (and takes such receipts
into account under its methods of account-
ing) during the taxable year of the part-
ner with or within which the partnership’s
taxable year (in which the distribution oc-
curs) ends. For rules for taking costs into
account (such as costs included in the ad-
justed basis of the distributed property),
see §1.199–4.
(4)Other rules. Except as provided in
this paragraph (j), an EAG partnership is
treated the same as other partnerships for
purposes of section 199. Accordingly, an
EAG partnership is subject to the rules of
this section regarding the application of
section 199 to pass-thru entities, including
application of the section 199(d)(1)(A)(iii)
wage limitation under paragraph (b)(3) of
this section. In determining whether a
member of an EAG or an EAG partner-
ship MPGE QPP in whole or in significant
part within the United States or produced a
qualified film or produced utilities within
the United States, see §1.199–3(g)(2) and
(3) andExample 5of paragraph (j)(5) of
this section.
(5)Examples. The following examples
illustrate the rules of this paragraph (j).
Assume that PRS, X, Y, and Z all are cal-
endar year taxpayers.
Example 1.Contribution. X and Y are the only
partners in PRS, a partnership, for PRS’s entire 2006
taxable year. X and Y are both members of a single
EAG for the entire 2006 year. In 2006, X MPGE QPP
within the United States and contributes the property
to PRS. In 2006, PRS sells the QPP for $1,000. Un-
der this paragraph (j), PRS is treated as having MPGE
the QPP within the United States, and PRS’s $1,000
gross receipts constitute DPGR. PRS, X, and Y must
apply the rules of this section regarding the applica-
tion of section 199 to pass-thru entities with respect
to the activity of PRS, including application of the
section 199(d)(1)(A)(iii) wage limitation under para-
graph (b)(3) of this section.
Example 2.Sale.X,Y,andZaretheonlymem-
bers of a single EAG for the entire 2006 year. X and
Y each own 50% of the capital and profits interests
in PRS, a partnership, for PRS’s entire 2006 taxable
year. In 2006, PRS MPGE QPP within the United
States and then sells the property to X for $6,000, its
fair market value at the time of the sale. PRS’s gross
receipts of $6,000 qualify as DPGR. In 2006, X sells
the QPP to customers for $10,000, incurring selling
expenses of $2,000. Under this paragraph (j), X is
treated as having MPGE the QPP within the United
States, and X’s $10,000 of gross receipts qualify as
DPGR.PRS,XandYmustapplytherulesofthis
section regarding the application of section 199 to
pass-thru entities with respect to the activity of PRS,
including application of the section 199(d)(1)(A)(iii)
wage limitation under paragraph (b)(3) of this sec-
tion. The results would be the same if PRS sold the
property to Z rather than to X.
Example 3.Lease.X,Y,andZaretheonlymem-
bers of a single EAG for the entire 2005 year. X and
Y each own 50% of the capital and profits interests
in PRS, a partnership, for PRS’s entire 2005 taxable
year. In 2005, PRS MPGE QPP within the United
StatesandthensellsthepropertytoXfor$6,000,
its fair market value at the time of the sale. PRS’s
gross receipts of $6,000 qualify as DPGR. In 2005,
X rents the QPP it acquired from PRS to customers
unrelated to X. X takes thegross receipts attributable
to the rental of the QPP into account under its meth-
ods of accounting in 2005 and 2006. On July 1, 2006,
X ceases to be a member of the same EAG to which
Y, the other partner in PRS, belongs. For 2005, X is
treated as having MPGE the QPP in the United States,
and its gross receipts derived from the rental of the
QPP qualify as DPGR. For 2006, however, because
X and Y, partners in PRS, are no longer members of
the same EAG for the entire year, the gross rental re-
ceipts X takes into account in 2006 do not qualify as
DPGR.
Example 4.Distribution. X and Y are the only
partners in PRS, a partnership, for PRS’s entire 2006
taxable year. X and Y are both members of a sin-
gle EAG for the entire 2006 year. In 2006, PRS
MPGE QPP within the United States, incurring $600
of CGS, including $500 of W–2 wages (as defined
in §1.199–2(e)), and then distributes the QPP to X.
X’s adjusted basis in the QPP is $600. At the time
of the distribution, the fair market value of the QPP
is $1,000. X incurs $200 of directly allocable costs,
including $100 of W–2 wages, to further MPGE the
QPP within the United States. In 2006, X sells the
QPP for $1,500 to an unrelated customer and takes
the gross receipts into account under its method of
accounting in the same taxable year. Under para-
graph (j)(1) of this section, X is treated as having
MPGE the QPP within the United States, and X’s
$1,500 of gross receipts qualify as DPGR. In addition,
PRS is treated as having DPGR of $1,000 solely for
purposes of applying the wage limitation in section
199(d)(1)(A)(iii) based on the applicable percentage
of QPAI.
Example 5.Multiple sales.(i)Facts. X and Y are
the only partners in PRS, a partnership, for PRS’s en-
tire 2006 taxable year. X and Y are both non-consol-
idated members of a single EAG for the entire 2006
year. PRS produces in bulk form in the United States
the active ingredient for a pharmaceutical product.
Assume that PRS’s own MPGE activity with respect
to the active ingredient is not substantial in nature,
taking into account all of the facts and circumstances,
and PRS’s direct labor and overhead to MPGE the ac-
tive ingredient within the United States are $15 and
account for 15% of PRS’s $100 CGS of the active
ingredient. In 2006, PRS sells the active ingredient
in bulk form to X. X uses the active ingredient to
produce the finished dosage form drug. Assume that
X’s own MPGE activity with respect to the drug is
not substantial in nature, taking into account all of
the facts and circumstances, and X’s direct labor and
overhead to MPGE the drug within the United States
are $12 and account for 10% of X’s $120 CGS of the
June 19, 200611322006–25 I.R.B.

drug. In 2006, X sells the drug in finished dosage
to Y and Y sells the drug to customers. Assume that
Y’s own MPGE activity with respect to the drug is
not substantial in nature, taking into account all of
the facts and circumstances, and Y incurs $2 of direct
labor and overhead and Y’s CGS in selling the drug
to customers is $130.
(ii)Analysis. PRS’s gross receipts from the sale
of the active ingredient to X are non-DPGR because
PRS’s MPGE activity is not substantial in nature and
PRS does not satisfy the safe harbor described in
§1.199–3(g)(3) because PRS’s direct labor and over-
head account for less than 20% of PRS’s CGS of the
active ingredient. X’s gross receipts from the sale
of the drug to Y are DPGR because X is consid-
ered to have MPGE the drug in significant part in the
United States pursuant to the safe harbor described in
§1.199–3(g)(3) because the $27 ($15 + $12) of direct
labor and overhead incurred by PRS and X equals or
exceeds 20% of X’s total CGS ($120) of the drug at
the time X disposes of the drug to Y. Similarly, Y’s
gross receipts from the sale of the drug to customers
are DPGR because Y is considered to have MPGE
the drug in significant part in the United States pur-
suant to the safe harbor described in §1.199–3(g)(3)
because the $29 ($15 + $12 + $2) of direct labor and
overhead incurred by PRS, X, and Y equals or ex-
ceeds 20% of Y’s total CGS ($130) of the drug at the
time Y disposes of the drug to Y’s customers.
(k)Effective dates. Section 199 applies
to taxable years beginning after December
31, 2004. In determining the deduction
under section 199, items arising from a tax-
able 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
1.199–9 does not apply to taxable years be-
ginning after May 17, 2006, the enactment
date of the Tax Increase Prevention and
Reconciliation Act of 2005 (Public Law
109–222, 120 Stat. 345). For taxable years
beginning on or before May 17, 2006, a
taxpayer must apply §1.199–9 if the tax-
payer applies §§1.199–1 through 1.199–8
to that taxable year. Notwithstanding the
preceding sentence, a partnership or S cor-
poration that is a qualifying small taxpayer
under §1.199–4(f) of REG–105847–05,
2005–47 I.R.B. 987 (see §601.601(d)(2)
of this chapter) may use the small business
simplified overall method to apportion
CGS and deductions between DPGR
and non-DPGR at the entity level under
§1.199–4(f) of REG–105847–05 for tax-
able years beginning on or before May 17,
2006. If a taxpayer chooses not to rely on
§§1.199–1 through 1.199–9 (as provided
in §1.199–8(i)) for a taxable year begin-
ning before June 1, 2006, the guidance
under section 199 thatapplies to taxable
years beginning before June 1, 2006, is
contained in Notice 2005–14, 2005–1 C.B.
498 (see §601.601(d)(2) of this chapter).
In addition, a taxpayer also may rely on the
provisions of REG–105847–05 for taxable
years beginning before June 1, 2006. If
Notice 2005–14 and REG–105847–05 in-
clude different rules for the same particular
issue, then a taxpayer may rely on either
the rule set forth in Notice 2005–14 or the
rule set forth in REG–105847–05. How-
ever, if REG–105847–05 includes a rule
that was not included in Notice 2005–14,
then a taxpayer is not permitted to rely on
the absence of a rule in Notice 2005–14 to
apply a rule contrary to REG–105847–05.
For taxable years beginning after May
17, 2006, and before June 1, 2006, a tax-
payer may not apply Notice 2005–14,
REG–105847–05, or any other guidance
under section 199 in a manner inconsistent
with amendments made to section 199 by
section 514 of the Tax Increase Prevention
and Reconciliation Act of 2005.
PART 602—OMB CONTROL
NUMBERS UNDER THE PAPERWORK
REDUCTION ACT
Par. 3. The authority citation for part
602 continues to read as follows:
Authority: 26 U.S.C. 7805.
Par. 4. In §602.101, paragraph (b) is
amended by adding an entry to the table in
numerical order to read, in part, as follows:
§602.101 OMB Control numbers.
*****
(b) * * *
CFR part or section where
identified and described
Current OMB
control No.
*****
1.199–6........................................................... 1545–1966
*****
Mark E. Matthews,
Deputy Commissioner for
Services and Enforcement.
Approved May 2, 2006.
Eric Solomon,
Acting Deputy Assistant Secretary
of the Treasury.
(Filed by the Office of the Federal Register on May 24, 2006,
11:47 a.m., and published in the issue of the Federal Register
for June 1, 2006, 71 F.R. 31267)
Section 851.—Definition of
Regulated Investment
Company
26 CFR 1.851–2: Limitations.
(Also Sections 7704, 7805; 301.7805–1.)
Regulated investment company
(RIC).This ruling modifies Rev. Rul.
2006–1 to extend until September 30,
2006, the transition period provided by
that ruling, and clarifies that Rev. Rul.
2006–1 was not intended to preclude a
conclusion that income from certain in-
struments (such as structured notes) that
create a commodity exposure for the
holder is qualifying income under section
851(b)(2) of the Code. Rev. Rul. 2006–1
modified and clarified.
Rev. Rul. 2006–31
Rev. Rul. 2006–1, 2006–2 I.R.B. 261,
discusses derivative contracts with respect
to a commodity index (“Derivatives”) that
a regulated investment company (R)enters
into under Master Agreements with vari-
ous counterparties. Under the Derivatives,
Rwill pay an amount equal to the 3-month
U.S. Treasury bill rate plus a spread and
will receive (or pay) an amount based on
the total return gain (or loss) on a com-
modity index. The payment obligation on
each Derivative is settled monthly by the
2006–25 I.R.B.1133June 19, 2006

receipt (in the event of a gain) or pay-
ment (in the event of a loss) of cash, in
the net amount under the contract, and
each monthly measuring period constitutes
a separate derivative contract under the
Master Agreements.
Rev. Rul. 2006–1 holds that a deriva-
tive contract with respect to a commod-
ity index is not a security for purposes of
section 851(b)(2) of the Internal Revenue
Code and that, under the facts stated in
the ruling,R’s income from the contract is
not qualifying income for purposes of sec-
tion 851(b)(2), because the income from
the contract is not derived with respect to
R’s business of investing in stocks, secu-
rities, or currencies. Rev. Rul. 2006–1
further provides that under the authority of
section 7805(b)(8), the holding of the rev-
enue ruling will not be applied adversely
with respect to amounts of income that a
taxpayer recognizes on or before June 30,
2006.
It has come to the attention of the Ser-
vice that some taxpayers are questioning
whether the holding of the revenue rul-
ing applies to investments by regulated in-
vestment companies (RICs) in all deriva-
tive contracts with respect to a commod-
ity index, including for example structured
notes, rather than just to the Derivatives
described in the revenue ruling.
The ruling was not intended to preclude
a conclusion that the income from cer-
tain instruments (such as certain structured
notes) that create a commodity exposure
for the holder is qualifying income under
section 851(b)(2). Accordingly, to clar-
ify the holding of Rev. Rul. 2006–1, the
HOLDING section is revised to read:
A Derivative is not a security for pur-
poses of section 851(b)(2). Under the
facts above,R’s income from a Deriva-
tive is not qualifying income for pur-
poses of section 851(b)(2), because the
income from the contract is not derived
with respect toR’s business of invest-
ing in stocks, securities, or currencies.
In addition, some taxpayers have ques-
tioned whether the prospective application
of the ruling is limited to the Derivatives
described in the revenue ruling or includes
all derivative contracts with respect to a
commodity index or an individual com-
modity, including, for example, commod-
ity futures contracts.The Service has also
been informed that, due to temporary de-
mand/supply imbalances, some RICs that
had previously invested in derivative con-
tracts similar to the Derivatives described
in Rev. Rul. 2006–1 are having difficulty
in acquiring alternative commodity-linked
investments that result in qualifying in-
come for purposes of section 851(b)(2).
The prospective application of the rul-
ing was intended to apply to all derivative
contracts with respect to a commodity
index or an individual commodity. Ac-
cordingly, to alleviate temporary sup-
ply/demand pressure and to clarify the
scope of the PROSPECTIVE APPLICA-
TION section of Rev. Rul. 2006–1, that
section is revised to read:
Under the authority of section
7805(b)(8), the holding of this revenue
ruling will not be applied adversely
with respect to amounts of income
that a taxpayer recognizes on or before
September 30, 2006, from a Deriva-
tive. Neither will the Service apply the
principles set forth in this revenue rul-
ing adversely with respect to amounts
of income recognized on or before
September 30, 2006, by a taxpayer
from a derivative contract (including
an option, futures or forward contract)
on a commodity index or an individual
commodity.
EFFECT ON OTHER DOCUMENTS
Rev. Rul. 2006–1 is modified and clar-
ified.
DRAFTING INFORMATION
The principal author of this revenue
ruling is Dale S. Collinson of the Office
of the Associate Chief Counsel (Finan-
cial Institutions & Products). For further
information regarding this revenue rul-
ing, contact him at (202) 622–3900 or
Susan Thompson Baker at (202) 622–3930
(not toll-free calls).
Section 6621.—Determina-
tion of Rate of Interest
26 CFR 301.6621–1: Interest rate.
Interest rates; underpayments and
overpayments.The rate of interest de-
termined under section 6621 of the Code
for the calendar quarter beginning July 1,
2006, will be 8 percent for overpayments
(7 percent in the case of a corporation), 8
percent for underpayments, and 10 percent
for large corporate underpayments. The
rate of interest paid on the portion of a
corporate overpayment exceeding $10,000
will be 5.5 percent.
Rev. Rul. 2006–30
Section 6621 of the Internal Revenue
Code establishes the rates for interest
on tax overpayments and tax underpay-
ments. Under section 6621(a)(1), the
overpayment rate is the sum of the federal
short-term rate plus 3 percentage points (2
percentage points in the case of a corpo-
ration), except the rate for the portion of
a corporate overpayment of tax exceeding
$10,000 for a taxable period is the sum of
the federal short-term rate plus 0.5 of a
percentage point for interest computations
made after December 31, 1994. Under
section 6621(a)(2), the underpayment rate
is the sum of the federal short-term rate
plus 3 percentage points.
Section 6621(c) provides that for pur-
poses of interest payable under section
6601 on any large corporate underpay-
ment, the underpayment rate under section
6621(a)(2) is determined by substituting
“5 percentage points” for “3 percentage
points.” See section 6621(c) and section
301.6621–3 of the Regulations on Proce-
dure and Administration for the definition
of a large corporate underpayment and
for the rules for determining the appli-
cable date. Section 6621(c) and section
301.6621–3 are generally effective for
periods after December 31, 1990.
Section 6621(b)(1) provides that the
Secretary will determine the federal
short-term rate for the first month in each
calendar quarter.
Section 6621(b)(2)(A) provides that the
federal short-term rate determined under
section 6621(b)(1) for any month applies
during the first calendar quarter beginning
after such month.
Section 6621(b)(3) provides that the
federal short-term rate for any month is
the federal short-term rate determined
during such month by the Secretary in
accordance with § 1274(d), rounded to the
nearest full percent (or, if a multiple of
1
/2
of 1 percent, the rate is increased to the
next highest full percent).
June 19, 200611342006–25 I.R.B.

Notice 88–59, 1988–1 C.B. 546, an-
nounced that, in determining the quarterly
interest rates to be used for overpayments
and underpayments of tax under section
6621, the Internal Revenue Service will
use the federal short-term rate based on
daily compounding because that rate is
most consistent with section 6621 which,
pursuant to section 6622, is subject to daily
compounding.
Rounded to the nearest full percent, the
federal short-term rate based on daily com-
pounding determined during the month of
April 2006 is 5 percent. Accordingly, an
overpayment rate of 8 percent (7 percent
in the case of a corporation) and an under-
payment rate of 8 percent are established
for the calendar quarter beginning July 1,
2006. The overpayment rate for the por-
tion of a corporate overpayment exceeding
$10,000 for the calendar quarter beginning
July 1, 2006, is 5.5 percent. The under-
payment rate for large corporate underpay-
ments for the calendar quarter beginning
July 1, 2006, is 10 percent. These rates ap-
ply to amounts bearing interest during that
calendar quarter.
Interest factors for daily compound in-
terest for annual rates of 5.5 percent, 7 per-
cent, 8 percent, and 10 percent are pub-
lished in Tables 16, 19, 21, and 25 of Rev.
Proc. 95–17, 1995–1 C.B. 556, 570, 573,
575, and 579.
Annual interest rates to be compounded
daily pursuant to section 6622 that apply
for prior periods are set forth in the tables
accompanying this revenue ruling.
DRAFTING INFORMATION
The principal author of this revenue rul-
ing is Crystal Foster of the Office of Asso-
ciate Chief Counsel (Procedure & Admin-
istration). For further information regard-
ing this revenue ruling, contact Ms. Foster
at (202) 622–7198 (not a toll-free call).
TABLE OF INTEREST RATES
PERIODS BEFORE JUL. 1, 1975 — PERIODS ENDING DEC. 31, 1986
OVERPAYMENTS AND UNDERPAYMENTS
PERIODRATE
In 1995–1 C.B.
DAILY RATE TABLE
Before Jul. 1, 19756%Table 2, pg. 557
Jul. 1, 1975—Jan. 31, 19769%Table 4, pg. 559
Feb. 1, 1976—Jan. 31, 19787%Table 3, pg. 558
Feb. 1, 1978—Jan. 31, 19806%Table 2, pg. 557
Feb. 1, 1980—Jan. 31, 198212%Table 5, pg. 560
Feb. 1, 1982—Dec. 31, 198220%Table 6, pg. 560
Jan. 1, 1983—Jun. 30, 198316%Table 37, pg. 591
Jul. 1, 1983—Dec. 31, 198311%Table 27, pg. 581
Jan. 1, 1984—Jun. 30, 198411%Table 75, pg. 629
Jul. 1, 1984—Dec. 31, 198411%Table 75, pg. 629
Jan. 1, 1985—Jun. 30, 198513%Table 31, pg. 585
Jul. 1, 1985—Dec. 31, 198511%Table 27, pg. 581
Jan. 1, 1986—Jun. 30, 198610%Table 25, pg. 579
Jul. 1, 1986—Dec. 31, 19869%Table 23, pg. 577
TABLE OF INTEREST RATES
FROM JAN. 1, 1987 — DEC. 31, 1998
OVERPAYMENTSUNDERPAYMENTS
1995–1 C.B.1995–1 C.B.
RATE TABLEPGRATE TABLEPG
Jan
. 1, 1987—Mar. 31, 1987
8%215759%23577
Apr. 1, 1987—Jun. 30, 19878%215759%23577
Jul. 1, 1987—Sep. 30, 19878%215759%23577
Oc
t. 1, 1987—Dec. 31, 1987
9%2357
7
10%2557
9
Jan. 1, 1988—Mar. 31, 198810%7362711%75629
Apr. 1, 1988—Jun. 30, 19889%7162510%73627
J
ul. 1, 1988—Sep. 30, 1988
9%7
1
6
25
1
0
%7
3
6
27
Oct. 1, 1988—Dec. 31, 198810%7362711%75629
Jan. 1, 1989—Mar. 31, 198910%2557911%27581
Apr. 1, 1989—Jun. 30, 198911%2758112%29583
Jul. 1, 1989—Sep. 30, 198911%2758112%29583
Oct. 1, 1989—Dec. 31, 198910%2557911%27581
2006–25 I.R.B.1135June 19, 2006

TABLE OF INTEREST RATES
FROM JAN. 1, 1987 — DEC. 31, 1998 – Continued
OVERPAYMENTSUNDERPAYMENTS
1995–1 C.B.1995–1 C.B.
RATE TABLEPGRATE TABLEPG
Jan. 1, 1990—Mar. 31, 199010%2557911%27581
Apr. 1, 1990—
Jun. 30, 1990
10%2557911%27581
Jul. 1, 1990—Sep. 30, 199010%2557911%27581
Oct. 1, 1990—Dec. 31, 199010%2557911%27581
Jan. 1, 1991
—Mar. 31, 1991
10%2557911%27581
Apr. 1, 1991—Jun. 30, 19919%2357710%25579
Jul. 1, 1991—Sep. 30, 19919%2357710%25579
Oct. 1, 199
1—Dec. 31, 1991
9%2357710%25579
Jan. 1, 1992—Mar. 31, 19928%696239%71625
Apr. 1, 1992—Jun. 30, 19927%676218%69623
Jul. 1, 19
92—Sep. 30, 1992
7%676218%69623
Oct. 1, 1992—Dec. 31, 19926%656197%67621
Jan. 1, 1993—Mar. 31, 19936%175717%19573
Apr. 1, 1
993—Jun. 30, 1993
6%175717%19573
Jul. 1, 1993—Sep. 30, 19936%175717%19573
Oct. 1, 1993—Dec. 31, 19936%175717%19573
Jan. 1,
1994—Mar. 31, 1994
6%175717%19573
Apr. 1, 1994—Jun. 30, 19946%175717%19573
Jul. 1, 1994—Sep. 30, 19947%195738%21575
Oct. 1,
1994—Dec. 31, 1994
8%215759%23577
Jan. 1, 1995—Mar. 31, 19958%215759%23577
Apr. 1, 1995—Jun. 30, 19959%2357710%25579
Jul. 1
, 1995—Sep. 30, 1995
8%215759%23577
Oct. 1, 1995—Dec. 31, 19958%215759%23577
Jan. 1, 1996—Mar. 31, 19968%696239%71625
Apr.
1, 1996—Jun. 30, 1996
7%676218%69623
Jul. 1, 1996—Sep. 30, 19968%696239%71625
Oct. 1, 1996—Dec. 31, 19968%696239%71625
Jan
. 1, 1997—Mar. 31, 1997
8%215759%23577
Apr. 1, 1997—Jun. 30, 19978%215759%23577
Jul. 1, 1997—Sep. 30, 19978%215759%23577
Oc
t. 1, 1997—Dec. 31, 1997
8%2157
5
9%2357
7
Jan. 1, 1998—Mar. 31, 19988%215759%23577
Apr. 1, 1998—Jun. 30, 19987%195738%21575
Ju
l. 1, 1998—Sep. 30, 1998
7%1957
3
8%2157
5
Oct. 1, 1998—Dec. 31, 19987%195738%21575
TABLE OF INTEREST RATES
FROM JANUARY 1, 1999 — PRESENT
NONCORPORATE OVERPAYMENTS AND UNDERPAYMENTS
1995–1 C.B.
RATETABLEPG
Jan. 1, 1999—Mar. 31, 19997%19573
Apr. 1, 1999—Jun. 30, 19998%21575
Jul. 1, 1999—Sep. 30, 19998%21575
Oct. 1, 1999—Dec. 31, 19998%21575
Jan. 1, 2000—Mar. 31, 20008%69623
Apr. 1, 2000—Jun. 30, 20009%71625
Jul. 1, 2000—Sep. 30, 20009%71625
Oct. 1, 2000—Dec. 31, 20009%71625
Jan. 1, 2001—Mar. 31, 20019%23577
Apr. 1, 2001—Jun. 30, 20018%21575
June 19, 200611362006–25 I.R.B.

TABLE OF INTEREST RATES
FROM JANUARY 1, 1999 — PRESENT – Continued
NONCORPORATE OVERPAYMENTS AND UNDERPAYMENTS
1995–1 C.B.
RATETABLEPG
Jul. 1, 2001—Sep. 30, 20017%19573
Oct. 1, 2001—Dec. 31, 20017%19573
Jan. 1, 2002—Mar. 31, 20026%17571
Apr. 1, 2002—Jun. 30, 20026%17571
Jul. 1, 2002—Sep. 30, 20026%17571
Oct. 1, 2002—Dec. 31, 20026%17571
Jan. 1, 2003—Mar. 31, 20035%15569
Apr. 1, 2003—Jun. 30, 20035%15569
Jul. 1, 2003—Sep. 30, 20035%15569
Oct. 1, 2003—Dec. 31, 20034%13567
Jan. 1, 2004—Mar. 31, 20044%61615
Apr. 1, 2004—Jun. 30, 20045%63617
Jul. 1, 2004—Sep. 30, 20044%61615
Oct. 1, 2004—Dec. 31, 20045%63617
Jan. 1, 2005—Mar. 31, 20055%15569
Apr. 1, 2005—Jun. 30, 20056%17571
Jul. 1, 2005—Sep. 30, 20056%17571
Oct. 1, 2005—Dec. 31, 20057%19573
Jan. 1, 2006—Mar. 31, 20067%19573
Apr. 1, 2006—Jun. 30, 20067%19573
Jul. 1, 2006—Sep. 30, 20068%21575
TABLE OF INTEREST RATES
FROM JANUARY 1, 1999 — PRESENT
CORPORATE OVERPAYMENTS AND UNDERPAYMENTS
OVERPAYMENTSUNDERPAYMENTS
1995–1 C.B.1995–1 C.B.
RATE TABLEPGRATE TABLEPG
Jan
. 1, 1999—Mar. 31, 1999
6%175717%19573
Apr. 1, 1999—Jun. 30, 19997%195738%21575
Jul. 1, 1999—Sep. 30, 19997%195738%21575
Oc
t. 1, 1999—Dec. 31, 1999
7%1957
3
8%2157
5
Jan. 1, 2000—Mar. 31, 20007%676218%69623
Apr. 1, 2000—Jun. 30, 20008%696239%71625
J
ul. 1, 2000—Sep. 30, 2000
8
%
6
9
6
23
9
%
7
1
6
25
Oct. 1, 2000—Dec. 31, 20008%696239%71625
Jan. 1, 2001—Mar. 31, 20018%215759%23577
A
pr. 1, 2001—Jun. 30, 2001
7
%
1
9
5
73
8
%
2
1
5
75
Jul. 1, 2001—Sep. 30, 20016%175717%19573
Oct. 1, 2001—Dec. 31, 20016%175717%19573
Jan. 1, 2002—Mar. 31, 20025%155696%17571
Apr. 1, 2002—Jun. 30, 20025%155696%17571
Jul. 1, 2002—Sep. 30, 20025%155696%17571
Oct. 1, 2002—Dec. 31, 20025%155696%17571
Jan. 1, 2003—Mar. 31, 20034%135675%15569
Apr. 1, 2003—Jun. 30, 20034%135675%15569
Jul. 1, 2003—Sep. 30, 20034%135675%15569
Oct. 1, 2003—Dec. 31, 20033%115654%13567
Jan. 1, 2004—Mar. 31, 20043%596134%61615
Apr. 1, 2004—Jun. 30, 20044%616155%63617
Jul. 1, 2004—Sep. 30, 20043%596134%61615
2006–25 I.R.B.1137June 19, 2006

TABLE OF INTEREST RATES
FROM JANUARY 1, 1999 — PRESENT – Continued
CORPORATE OVERPAYMENTS AND UNDERPAYMENTS
OVERPAYMENTSUNDERPAYMENTS
1995–1 C.B.1995–1 C.B.
RATE TABLEPGRATE TABLEPG
Oct. 1, 2004—Dec. 31, 20044%616155%63617
Jan. 1, 2005—Mar. 31, 20054%135675%15569
Apr. 1, 2005
—Jun. 30, 2005
5%155696%17571
Jul. 1, 2005—Sep. 30, 20055%155696%17571
Oct. 1, 2005—Dec. 31, 20056%175717%19573
Jan. 1, 2006
—Mar. 31, 2006
6%175717%19573
Apr. 1, 2006—Jun. 30, 20066%175717%19573
Jul. 1, 2006—Sep. 30, 20067%195738%21575
TABLE OF INTEREST RATES FOR
LARGE COR
PORATE UNDERPAYMENTS
FROM JANUARY 1, 1991 — PRESENT
1995–1 C.B.
RATETABLEPG
Jan. 1, 1991—Mar. 31, 199113%31585
Apr. 1, 1991—Jun. 30, 199112%29583
Jul. 1,
1991—Sep. 30, 1991
12%29583
Oct. 1, 1991—Dec. 31, 199112%29583
Jan. 1, 1992—Mar. 31, 199211%75629
Apr. 1
, 1992—Jun. 30, 1992
10%73627
Jul. 1, 1992—Sep. 30, 199210%73627
Oct. 1, 1992—Dec. 31, 19929%71625
Jan.
1, 1993—Mar. 31, 1993
9%23577
Apr. 1, 1993—Jun. 30, 19939%23577
Jul. 1, 1993—Sep. 30, 19939%23577
Oct.
1, 1993—Dec. 31, 1993
9%23577
Jan. 1, 1994—Mar. 31, 19949%23577
Apr. 1, 1994—Jun. 30, 19949%23577
Jul
. 1, 1994—Sep. 30, 1994
10%25579
Oct. 1, 1994—Dec. 31, 199411%27581
Jan. 1, 1995—Mar. 31, 199511%27581
Ap
r. 1, 1995—Jun. 30, 1995
12%2958
3
Jul. 1, 1995—Sep. 30, 199511%27581
Oct. 1, 1995—Dec. 31, 199511%27581
J
an. 1, 1996—Mar. 31, 1996
1
1
%7
5
6
29
Apr. 1, 1996—Jun. 30, 199610%73627
Jul. 1, 1996—Sep. 30, 199611%75629
Oct. 1, 1996—Dec. 31, 199611%75629
Jan. 1, 1997—Mar. 31, 199711%27581
Apr. 1, 1997—Jun. 30, 199711%27581
Jul. 1, 1997—Sep. 30, 199711%27581
Oct. 1, 1997—Dec. 31, 199711%27581
Jan. 1, 1998—Mar. 31, 199811%27581
Apr. 1, 1998—Jun. 30, 199810%25579
Jul. 1, 1998—Sep. 30, 199810%25579
Oct. 1, 1998—Dec. 31, 199810%25579
Jan. 1, 1999—Mar. 31, 19999%23577
Apr. 1, 1999—Jun. 30, 199910%25579
Jul. 1, 1999—Sep. 30, 199910%25579
Oct. 1, 1999—Dec. 31, 199910%25579
Jan. 1, 2000—Mar. 31, 200010%73627
June 19, 200611382006–25 I.R.B.

TABLE OF INTEREST RATES FOR
LARGE CORPORATE UNDERPAYMENTS
FROM JANUARY 1, 1991 — PRESENT – Continued
1995–1 C.B.
RATETABLEPG
Apr. 1, 2000—Jun. 30, 200011%75629
Jul. 1, 2000—Sep. 30, 200011%75629
Oct. 1, 2000—Dec. 31, 200011%75629
Jan. 1, 2001—Mar. 31, 200111%27581
Apr. 1, 2001—Jun. 30, 200110%25579
Jul. 1, 2001—Sep. 30, 20019%23577
Oct. 1, 2001—Dec. 31, 20019%23577
Jan. 1, 2002—Mar. 31, 20028%21575
Apr. 1, 2002—Jun. 30, 20028%21575
Jul. 1, 2002—Sep. 30, 20028%21575
Oct. 1, 2002—Dec. 30, 20028%21575
Jan. 1, 2003—Mar. 31, 20037%19573
Apr. 1, 2003—Jun. 30, 20037%19573
Jul. 1, 2003—Sep. 30, 20037%19573
Oct. 1, 2003—Dec. 31, 20036%17571
Jan. 1, 2004—Mar. 31, 20046%65619
Apr. 1, 2004—Jun. 30, 20047%67621
Jul. 1, 2004—Sep. 30, 20046%65619
Oct. 1, 2004—Dec. 31, 20047%67621
Jan. 1, 2005—Mar. 31, 20057%19573
Apr. 1, 2005—Jun. 30, 20058%21575
Jul. 1, 2005—Sep. 30, 20058%21575
Oct. 1, 2005—Dec. 31, 20059%23577
Jan. 1, 2006—Mar. 31, 20069%23577
Apr. 1, 2006—Jun. 30, 20069%23577
Jul. 1, 2006—Sep. 30, 200610%25579
TABLE OF INTEREST RATES FOR CORPORATE
OVE
RPAYMENTS EXCEEDING $10,000
FROM JANUARY 1, 1995 — PRESENT
1995–1 C.B.
RATETABLEPG
Jan. 1, 1995—Mar. 31, 19956.5%18572
Apr. 1, 1995—Jun. 30, 19957.5%20574
Jul. 1, 1995—Sep. 30, 19956.5%18572
Oct. 1, 1995—Dec. 31, 19956.5%18572
Jan. 1, 1996—Mar. 31, 19966.5%66620
Apr. 1, 1996—Jun. 30, 19965.5%64618
Jul. 1, 1996—Sep. 30, 19966.5%66620
Oct. 1, 1996—Dec. 31, 19966.5%66620
Jan. 1, 1997—Mar. 31, 19976.5%18572
Apr. 1, 1997—Jun. 30, 19976.5%18572
Jul. 1, 1997—Sep. 30, 19976.5%18572
Oct. 1, 1997—Dec. 31, 19976.5%18572
Jan. 1, 1998—Mar. 31, 19986.5%18572
Apr. 1, 1998—Jun. 30, 19985.5%16570
Jul. 1, 1998—Sep. 30, 19985.5%16570
Oct. 1, 1998—Dec. 31, 19985.5%16570
Jan. 1, 1999—Mar. 31, 19994.5%14568
Apr. 1, 1999—Jun. 30, 19995.5%16570
Jul. 1, 1999—Sep. 30, 19995.5%16570
Oct. 1, 1999—Dec. 31, 19995.5%16570
2006–25 I.R.B.1139June 19, 2006

TABLE OF INTEREST RATES FOR CORPORATE
OVERPAYMENTS E
XCEEDING $10,000
FROM JANUARY 1, 1995 — PRESENT – Continued
1995–1 C.B.
RATETABLEPG
Jan. 1, 2000—Mar. 31, 20005.5%64618
Apr. 1, 2000—Jun. 30, 20006.5%66620
Jul. 1, 2000—Sep. 30, 20006.5%66620
Oct. 1, 2000—Dec. 31, 20006.5%66620
Jan. 1, 2001—Mar. 31, 20016.5%18572
Apr. 1, 2001—Jun. 30, 20015.5%16570
Jul. 1, 2001—Sep. 30, 20014.5%14568
Oct. 1, 2001—Dec. 31, 20014.5%14568
Jan. 1, 2002—Mar. 31, 20023.5%12566
Apr. 1, 2002—Jun. 30, 20023.5%12566
Jul. 1, 2002—Sep. 30, 20023.5%12566
Oct. 1, 2002—Dec. 31, 20023.5%12566
Jan. 1, 2003—Mar. 31, 20032.5%10564
Apr. 1, 2003—Jun. 30, 20032.5%10564
Jul. 1, 2003—Sep. 30, 20032.5%10564
Oct. 1, 2003—Dec. 31, 20031.5%8562
Jan. 1, 2004—Mar. 31, 20041.5%56610
Apr. 1, 2004—Jun. 30, 20042.5%58612
Jul. 1, 2004—Sep. 30, 20041.5%56610
Oct. 1, 2004—Dec. 31, 20042.5%58612
Jan. 1, 2005—Mar. 31, 20052.5%10564
Apr. 1, 2005—Jun. 30, 20053.5%12566
Jul. 1, 2005—Sep. 30, 20053.5%12566
Oct. 1, 2005—Dec. 31, 20054.5%14568
Jan. 1, 2006—Mar. 31, 20064.5%14568
Apr. 1, 2006—Jun. 30, 20064.5%14568
Jul. 1, 2006—Sep. 30, 20065.5%16570
June 19, 200611402006–25 I.R.B.

Part III. Administrative, Procedural, and Miscellaneous
Communications Excise Tax;
Toll Telephone Service
Notice 2006–50
SECTION 1. PURPOSE
(a)In general. As further described in
this notice, the Internal Revenue Service
will follow the holdings ofAm. Bankers
Ins. Group v. United States,408F.3d
1328 (11th Cir. 2005) (ABIG);OfficeMax,
Inc. v. United States, 428 F.3d 583 (6th
Cir. 2005);Nat’l R.R. Passenger Corp.
v. United States, 431 F.3d 374 (D.C. Cir.
2005) (Amtrak);Fortis v. United States,
2006 U.S. App. LEXIS 10749 (2d Cir.
Apr. 27, 2006); andReese Bros. v. United
States, 2006 U.S. App. LEXIS 11468 (3d
Cir. May 9, 2006). These cases hold that a
telephonic communication for which there
is a toll charge that varies with elapsed
transmission time and not distance (time-
only service) is not taxable toll telephone
service as defined in § 4252(b)(1) of the In-
ternal Revenue Code. As a result, amounts
paid for time-only service are not subject
to the tax imposed by § 4251. Accordingly,
the government will no longer litigate this
issue and Notice 2005–79, 2005–46 I.R.B.
952, which states otherwise, is revoked.
(b)Credits and refunds. Taxpayers may
be entitled to request credit or refund of
the excise taxes paid for the services cov-
ered by this notice. This notice provides
guidance regarding these requests. In ad-
dition, the Commissioner will authorize
the scheduling of an overassessment un-
der § 6407 to keep the period of limitations
open for these requests. This overassess-
ment will apply to all taxpayers and to all
taxes paid for the services covered by this
notice beginning with the tax paid on ser-
vices that were billed to customers after
February 28, 2003.
SECTION 2. BACKGROUND
(a)In general—(1)Tax imposed. Sec-
tion 4251(a)(1) imposes a tax on amounts
paid for communications services.
(2)Payment of tax. Section 4251(a)(2)
provides that the tax imposed shall be
paid by the person paying for the service
(taxpayer). Section 4251(b)(2) provides
that the applicable percentage is 3 percent
of amounts paid for communications ser-
vices.
(3)Collection of tax. Section 4291 pro-
vides that the tax is collected by the person
receiving the payment (collector). In most
cases, the collector, which is also respon-
sible for paying over the tax to the govern-
ment, is the telecommunications company
that provides the communications services
to the taxpayer.
(b)Definitions—(1)Communications
services. Section 4251(b)(1) provides
that the term communications services
means (A) local telephone service; (B) toll
telephone service; and (C) teletypewriter
exchange service. This notice does not
address teletypewriter exchange service.
(2)Local telephone service. Section
4252(a) provides that local telephone ser-
vice means (1) the access to a local tele-
phone system, and the privilege of tele-
phonic quality communication with sub-
stantially all persons having telephone or
radio telephone stations constituting a part
of such local telephone system; and (2)
any facility or serviceprovided in connec-
tion with such a service. Local telephone
service does not include any service that
is a toll telephone service as defined in
§ 4252(b) or a private communications ser-
vice as defined in § 4252(d). This notice
does not address private communications
service.
(3)Toll telephone service—(i)Time and
distance. Section 4252(b)(1) provides that
toll telephone service includes a telephonic
quality communication for which there is
atollchargethatvariesinamountwith
the distance and elapsed transmission time
of each individual communication and for
which the charge is paid within the United
States.
(ii)Periodic charge for a specified
area. Section 4252(b)(2) provides that
toll telephone service also includes a ser-
vice which entitles the subscriber, upon
payment of a periodic charge (determined
as a flat amount or upon the basis of total
elapsed transmission time), to the privilege
of an unlimited number of telephonic com-
munications to or from all or a substantial
portion of the persons having telephone
or radio telephone stations in a specified
area which is outside the local telephone
system area in which the station provided
with this service is located.
(c)Rev. Rul. 79–404.Rev.Rul.
79–404, 1979–2 C.B. 382, concludes that
a long distance telephone call for which
the charge varies with elapsed transmis-
sion time but not with distance is toll tele-
phone service described in § 4252(b)(1).
(d)Notice of proposed rulemaking.
In a notice of proposed rulemaking
(REG–141097–02, 2003–1 C.B. 807 [68
FR 15690]; April 1, 2003), the Service
proposed an amendment to the Facilities
and Services Excise Taxes Regulations
to provide that toll telephone service de-
scribed in section 4252(b)(1) may include
a communication service for which the
charge does not vary with the distance of
each individual communication.
(e)Recent litigation.ABIG,OfficeMax,
Amtrak,andReese Bros.hold time-only
service is not toll telephone service as
defined in § 4252(b)(1). Further,ABIG
,
OfficeMax,andReese Bros.hold that the
communications service provided was not
a service described in § 4252(b)(2) be-
cause the end result was not a “periodic
charge” based on total elapsed time but
rather a monthly bill based on a summation
of toll charges for individual communica-
tions. (InAmtrak, toll telephone service
described in § 4252(b)(2) would have been
exempt from tax under the common carrier
exception in § 4253(f).)ABIG,OfficeMax,
Amtrak,andReese Bros.also hold that the
communications services provided were
not local service, notwithstanding the ac-
cess the services provided to the local
telephone system. (Fortisaffirms, in aper
curiamopinion, a district court decision
reaching the same results.)
(f)Notice 2005–79. Notice 2005–79,
2005–46 I.R.B. 952, states that the Service
will continue to assess and collect the tax
imposed by § 4251 on all taxable commu-
nications services, including those similar
to the services inABIG.
SECTION 3. TERMS DEFINED
The following terms are defined solely
forpurposesofthisnotice:
(a)Bundled service. Bundled service
is local and long distance service pro-
vided under a plan that does not separately
state the charge for the local telephone
2006–25 I.R.B.1141June 19, 2006

service. Bundled service includes, for
example, Voice over Internet Protocol ser-
vice, prepaid telephone cards, and plans
that provide both local and long distance
service for either a flat monthly fee or a
charge that varies with the elapsed trans-
mission time for which the service is used.
Telecommunications companies provide
bundled service for both landline and
wireless (cellular) service.
(b)Local-only service. Local-only ser-
vice is local telephone service, as defined
in § 4252(a), provided under a plan that
does not include long distance telephone
service or that separately states the charge
for local service on its bill to customers.
The term also includes services and facil-
ities provided in connection with service
described in the preceding sentence even
though these services and facilities may
also be used with long distance service.
See, for example, Rev. Rul. 72–537,
1972–2 C.B. 574 (telephone amplifier);
Rev. Rul. 73–171, 1973–1 C.B. 445 (au-
tomatic call distributing equipment); and
Rev. Rul. 73–269, 1973–1 C.B. 444 (spe-
cial telephone).
(c)Long distance service.Longdis-
tance service is telephonic quality com-
munication with persons whose telephones
are outside the local telephone system of
the caller.
(d)Nontaxable service. Nontaxable
service means bundled service and long
distance service.
SECTION 4. EFFECT OFABIG,
OFFICEMAX,AMTRAK,FORTIS,AND
REESE BROS.
(a)Tax treatment of communications
service after ABIG, OfficeMax, Amtrak,
Fortis, and Reese Bros.TheServicewill
followABIG,OfficeMax,Amtrak,Fortis,
andReese Bros.Accordingly, taxpayers
are no longer required to pay tax under
§ 4251 for nontaxable service. In addition,
collectors or taxpayers may request a re-
fund of tax paid under § 4251 on nontax-
able service that was billed to the taxpayers
during the period after February 28, 2003,
and before August 1, 2006 (the relevant pe-
riod).
(b)Tax on local-only service. Collec-
tors should continue to collect and pay
over the § 4251 tax on amounts paid for
local-only service. As noted in section
3(b) of this notice, local-only service in-
cludes amounts paid for facilities or ser-
vices provided in connection with local
telephone service. Thus, for example, tax
will continue to be imposed on amounts
paid by a taxpayer for renting an ampli-
fier phone provided in connection with lo-
cal telephone service that is subject to tax.
(c)Effect on collectors. Collectors are
directed to cease collecting and paying
over tax under § 4251 on nontaxable ser-
vice that is billed after July 31, 2006, and
are not required to report to the IRS any
refusal by their customers to pay any tax
on nontaxable service that is billed after
May 25, 2006. Collectors should not pay
over to the IRS any tax on nontaxable
service that is billed after July 31, 2006.
The form will require collectors to cer-
tify that for the third quarter of 2006 the
§ 4251 tax reported on the Form 720 does
not include any tax on nontaxable service
that was billed after July 31, 2006. Con-
sequently, the IRS will deny all taxpayer
requests for refund of tax on nontaxable
service that was billed after July 31, 2006.
All such requests should be directed to
the collector. In addition, collectors may
repay to taxpayers the tax on nontaxable
service that was billed before August 1,
2006, but are not required to repay such
tax. Collectors may also request a refund
or make an adjustment to their separate
accounts, as appropriate, subject to the
provisions of § 6415 and section 5(d)(4)
of this notice. Collectors must continue to
collect and pay over tax under § 4251 on
amounts paid for local only service.
SECTION 5. REQUESTS FOR CREDIT
OR REFUND
(a)In general—(1)Requestmustfollow
this notice. The Commissioner agrees to
credit or refund the amounts paid for non-
taxable service if the taxpayer requests the
credit or refund in the manner prescribed
in this notice.
(2)Form of request. Taxpayers may re-
quest a credit or refund of tax on nontax-
able service that was billed after February
28, 2003, and before August 1, 2006, only
on their 2006 Federal income tax returns.
For this purpose, the 2006 income tax re-
turn is the income tax return for calendar
year 2006 or for the first taxable year in-
cluding December 31, 2006. Forms 1040
(series), 1041, 1065, 1120 (series), and
990–T will include a line for requesting the
overpayment amount. Persons that are not
otherwise required to file a federal income
tax return must nevertheless file a return
to obtain the credit or refund. Except as
provided in section 5(d)(4) of this notice,
a request for this credit or refund on any
other form (such as a Form 720, 843, or
8849) will not be processed by the Service.
Taxpayers will be permitted to request the
safe harbor amount under paragraph (c) of
this section only if they have paid all taxes
billed by their service provider after Febru-
ary 28, 2003, and before August 1, 2006.
(3)Guidance on the form.Theinstruc-
tions to the respective federal income tax
return forms will provide additional guid-
ance. The forms and instructions will re-
quire taxpayers to certify that (1) the tax-
payer has not received from the collector a
credit or refund of the tax paid on nontax-
able service billed during the relevant pe-
riod and (2) the taxpayer will not ask the
collector for a credit or refund of that tax
and has withdrawn any such request that
was previously submitted. The instruc-
tions will also require that taxpayers, ex-
cept for those individuals using the safe
harbor amount, retain records that substan-
tiate the request. These records should in-
clude bills from the collector that show the
amount of tax charged for nontaxable ser-
vice for each month during the relevant pe-
riod and receipts, canceled checks, or other
evidence that the amount requested was
actually paid.
(b)Period of request.TheCommis-
sioner will authorize the scheduling of an
overassessment under § 6407 to preserve
the period of limitations during which tax-
payers may request refunds of the tax on
nontaxable service that was billed to cus-
tomers after February 28, 2003, and before
August 1, 2006. Therefore, requests may
be made for credits or refunds of tax paid
for nontaxable servicebilled after Febru-
ary 28, 2003, and before August 1, 2006.
(c)Amount of the request—(1)Re-
quests by individual taxpayers—(i)Safe
harbor amount. Individual taxpayers may
request a safe harbor amount. No docu-
mentationwillberequiredtobesubmitted
or kept to support the safe harbor request.
However, taxpayers will be permitted to
request the safe harbor amount only if
they have paid all taxes billed by their
service provider after February 28, 2003,
and before August 1, 2006; have not re-
ceived a credit or refund of these taxes
June 19, 200611422006–25 I.R.B.

from the service provider, and either have
not requested such a credit or refund from
the service provider or have withdrawn
any such request. The amount of this safe
harbor is still under consideration and will
be announced in later guidance.
(ii)Actual amount. Taxpayers that do
not request the safe harbor amount may
request a credit or refund of the actual
amount of tax they paid.
(d)How to file—(1)Requests by in-
dividual taxpayers. Individual taxpayers
may request a credit or refund of federal
excise taxes paid on nontaxable service
only on their 2006 Form 1040, 1040A,
or 1040–EZ,U.S. Individual Income Tax
Return. Individuals who are not otherwise
required to file a federal income tax return
must nevertheless file Form 1040EZ–T
to request the credit or refund. Individual
taxpayers, including Schedule C filers,
may request either the safe harbor amount
or the actual amount of tax paid for non-
taxable service.
(2)Requests by taxpayers other than in-
dividual taxpayers. Taxpayers other than
individual taxpayers (entities) may request
only the actual amount of tax paid on non-
taxable service billedduring the relevant
period. No safe harbor amount is allowed
for entities.
(3)Requests by entities—(i)In general.
Entities may request a credit or refund of
federal excise taxes paid on nontaxable
service only on their 2006 income tax re-
turns. Any part of the credit or refund at-
tributable to tax payments that were de-
ducted as an ordinary and necessary busi-
ness expense (including in the determina-
tion of unrelated business taxable income)
must be included in income for the tax-
able year in which the refund is received
or accrued to the extent that the tax pay-
ments reduced the amount of federal in-
come tax (or unrelated business income
tax) imposed.
(ii)Partnerships. A partnership, as de-
fined in § 7701(a)(2), may request a credit
or refund of federal excise taxes paid on
nontaxable service only on its 2006 Form
1065,U.S. Return of Partnership Income.
Any amount of the credit or refund in-
cluded in partnership income and any in-
terest on the credit or refund must be re-
ported on the partnership’s return for the
taxable year in which received or accrued
and must be allocated to its partners on the
Schedule K–1,Partner’s Share of Income,
Deductions, Credits, etc., for that taxable
year.
(iii)S Corporations.AnSCorpora-
tion, as defined in § 1361, may request
a credit or refund of federal excise taxes
paid on nontaxable service only on its 2006
Form 1120S,U.S. Income Tax Return for
an S Corporation. Any amount of the
credit or refund included in S Corpora-
tion income and any interest on the credit
or refund must be reported on the S Cor-
poration’s return for the taxable year in
which received or accrued and must be al-
located to its shareholders on the Sched-
ule K–1,Shareholder’s Share of Income,
Deductions, Credits, etc., for that taxable
year.
(iv)Estates and trusts.Anestateor
a trust, as defined in § 301.7701–4(a) of
the Procedure and Administration Regula-
tions, may request a credit or refund of fed-
eral excise taxes paid on nontaxable ser-
vice only on its 2006 Form 1041,U.S. In-
come Tax Return for Estates and Trusts.
Any amount of the credit or refund in-
cluded in the estate’s or trust’s income and
any interest on the credit or refund must
be reported on the estate’s or trust’s Form
1041,U.S. Income Tax Return for Estates
and Trusts, for the taxable year in which
received or accrued. However, for a trust
that is treated as owned by the grantor or
other person under subpart E (§ 671 and
following), part I, subchapter J, chapter
1 of the Internal Revenue Code (grantor
trust), the owner of the trust may request
a credit or refund of federal excise taxes
treated as paid by the owner for nontaxable
service only on its applicable 2006 federal
tax return.
(v)Tax exempt organizations.Anor-
ganization that is described in § 501(a)
may request a credit or refund of federal
excise taxes paid on nontaxable service
only on its 2006 Form 990–T,Exempt Or-
ganization Business Income Tax Return.
Tax exempt organizations that are not oth-
erwise required to file a federal income
tax return must nevertheless file Form
990–T to request the credit or refund. Any
amount of the credit or refund included
in the organization’s unrelated business
taxable income must be reported on the
organization’s Form 990–T,Exempt Or-
ganization Business Income Tax Return,
for the taxable year in which received or
accrued. An organization that is subject to
tax on its interest income must also report
any interest on the credit or refund on its
Form 990–T,Exempt Organization Busi-
ness Income Tax Return, for the taxable
year in which received or accrued.
(vi)Corporations. A corporation, as
defined in § 7701(a)(3), that is not de-
scribed in section 5(d)(3)(iii) of this notice
may request a credit or refund of federal
excise taxes paid on nontaxable service
only on its 2006 Form 1120 (series) in-
come tax return (generally, Form 1120,
U.S. Corporation Income Tax Return).
Any amount of the credit or refund in-
cluded in the corporation’s income and
any interest on the credit or refund must
be reported on the corporation’s income
tax return for the taxable year in which
received or accrued. Corporations that
are not otherwise required to file a federal
income tax return must nevertheless file
Form 1120 (series) to request the credit or
refund.
(vii)Other nonfiling entities. Entities
that are not otherwise required to file a
federal income tax return must file Form
990–T to request the credit or refund.
(4)Requests and adjustments by col-
lectors—(i)Section 6415 conditions to al-
lowance
. The conditions to allowance de-
scribedin§6415applytoallrequestsand
adjustments by collectors, as defined by
section 2(a)(3) of this notice. Thus, a re-
quest by a collector isallowedonlyifthe
person that paid over the tax establishes
that it has repaid the amount of the tax to
the person from whom the tax was col-
lected, or obtains the written consent of
such person to the allowance of the credit
or refund.
(ii)Requests for regular method collec-
tors—(A)In general. A person that col-
lected the tax imposed by § 4251 on non-
taxable service and paid it over to the gov-
ernment based on amounts actually col-
lected under § 40.6302(c)–1(a)(2)(i) of the
Excise Tax Procedural Regulations (regu-
lar method collectors) may request a credit
or refund.
(B)Form of the request. Regular
method collectors may use Form 720X,
Amended Quarterly Federal Excise Tax
Return, line 1, IRS No. 22, for credit or
refund of amounts collected and repaid to
taxpayers.
(iii)Account adjustments for alter-
native method collectors.Apersonthat
collected the tax imposed by § 4251 on
nontaxable service and paid it over to the
2006–25 I.R.B.1143June 19, 2006

government based on amounts considered
as collected under § 40.6302(c)–1(a)(2)(ii)
(alternative method collectors) may adjust
the separate account for the amount of an
overpayment. The required adjustment
to the separate account is described in
§ 40.6302(c)–3(b)(2)(ii)(C). The adjust-
ment is reflected on Form 720, Schedule
A, line 2, but may not reduce tax liability
on Form 720 below zero.
(e)Interest on the credit or refund in-
cluded in income. If a taxpayer requests a
credit or refund of the actual amount of tax
paid, interest on the credit or refund of the
tax paid for nontaxable service must be in-
cluded as income on the taxpayer’s income
tax return for the taxable year in which the
interest is received or accrued. Thus, indi-
viduals are generally required to report the
interest on their 2007 income tax returns.
(f)Estimated tax effects. Although the
credit or refund allowed to a taxpayer un-
der this notice will be requested on the tax-
payer’s income tax return, it is not a credit
against tax for purposes of §§ 6654 and
6655. Accordingly, the taxpayer may not
take the credit or refund into account in de-
termining the amount of the required in-
stallments of estimated tax for 2006. In
determining the amount of the required in-
stallments of estimated tax for 2007, the in-
come attributable to the credit or refund is
taken into account on the date the income
is paid or credited in the case of a cash
method taxpayer and on the date the return
making the request is filed in the case of an
accrual method taxpayer.
(g)Requests that do not follow the pro-
visions of this notice. Requests that do
not follow the provisions of this notice
(whether filed before or after its publica-
tion)—
(1) Will not be processed to the extent
they relate to the tax paid on nontaxable
service that was billed after February 28,
2003; and
(2) Will be processed normally to the
extent they relate to the tax paid on nontax-
able service that was billed before March
1, 2003.
SECTION 6. EFFECT ON OTHER
DOCUMENTS
Notice 2005–79, 2005–46 I.R.B. 952,
is revoked. Rev. Rul. 79–404, 1979–2
C.B. 382, will be revoked in a later revenue
ruling.
SECTION 7. DRAFTING
INFORMATION
The principal author of this notice is
Taylor Cortright of the Office of the As-
sociate Chief Counsel (Passthroughs and
Special Industries). For further informa-
tion regarding this notice, contact (202)
622–3130 (not a toll-free call).
Renewable Electricity
Production Credit and
Refined Coal Production
Credit, Publication of Inflation
Adjustment Factor and
Reference Prices for Calendar
Year 2006
Notice 2006–51
This notice publishes the inflation ad-
justment factor and reference prices for
calendar year 2006 for the renewable elec-
tricity production credit and the refined
coal production credit under § 45 of the
Internal Revenue Code. The 2006 infla-
tion adjustment factor and reference prices
are used in determining the availability of
the credits. The 2006 inflation adjustment
factor and reference prices apply to calen-
dar year 2006 sales of kilowatt-hours of
electricity produced in the United States or
a possession thereof from qualified energy
resources and to calendar year 2006 sales
of refined coal produced in the United
States or a possession thereof.
BACKGROUND
Section 45(a) provides that the renew-
able electricity production credit for any
tax year is an amount equal to the prod-
uct of 1.5 cents multiplied by the kilowatt
hours of specified electricity produced by
the taxpayer and sold to an unrelated per-
son during the tax year. This electricity
must be produced from qualified energy
resources and at a qualified facility during
the 10-year period beginning on the date
the facility was originally placed in ser-
vice.
Section 45(b)(1) provides that the
amount of the credit determined under
§ 45(a) is reduced by an amount which
bears the same ratio to the amount of the
credit as (A) the amount by which the
reference price for the calendar year in
which the sale occurs exceeds 8 cents,
bears to (B) 3 cents. Under § 45(b)(2),
the 1.5 cent amount in § 45(a), the 8 cent
amount in § 45(b)(1), the $4.375 amount in
§ 45(e)(8)(A), and in § 45(e)(8)(B)(i) the
reference price of fuel used as feedstock
(within the meaning of § 45(c)(7)(A)) in
2002 are each adjusted by multiplying the
amount by the inflation adjustment factor
for the calendar year in which the sale
occurs. If any amount as increased under
the preceding sentence is not a multiple
of 0.1 cent, the amount is rounded to the
nearest multiple of 0.1 cent.
Section 45(c)(1) defines qualified
energy resources as wind, closed-loop
biomass, open-loop biomass, geother-
mal energy, solar energy, small irrigation
power, municipal solid waste, and quali-
fied hydropower production.
Section 45(d)(1) defines a qualified fa-
cility using wind to produce electricity as
any facility owned by the taxpayer that is
originally placed in service after Decem-
ber 31, 1993, and before January 1, 2008.
See § 45(e)(7) for rules relating to the in-
applicability of the credit to electricity sold
to utilities under certain contracts.
Section 45(d)(2)(A) defines a qualified
facility using closed-loop biomass to pro-
duce electricity as any facility (i) owned
by the taxpayer that is originally placed in
service after December 31, 1992, and be-
fore January 1, 2008, or (ii) owned by the
taxpayer which before January 1, 2008, is
originally placed in service and modified
to use closed-loop biomass to co-fire with
coal, with other biomass, or with both,
but only if the modification is approved
under the Biomass Power for Rural De-
velopment Programs or is part of a pilot
project of the Commodity Credit Corpora-
tion as described in 65 Fed. Reg. 63052.
Section 45(d)(2)(B)provides that in the
case of a qualified facility described in
§ 45(d)(2)(A)(ii), (i) the 10-year period re-
ferred to in § 45(a) is treated as begin-
ning no earlier than the date of enactment
of § 45(d)(2)(B)(i); (ii) the amount of the
credit determined under § 45(a) with re-
spect to the facility is an amount equal
to the amount determined without regard
to § 45(d)(2)(B)(ii) multiplied by the ratio
of the thermal content of the closed-loop
biomass used in the facility to the thermal
content of all fuels used in the facility; and
(iii)iftheownerofthefacilityisnotthe
June 19, 200611442006–25 I.R.B.

producer of the electricity, the person eli-
gible for the credit allowable under § 45(a)
is the lessee or the operator of the facility.
Section 45(d)(3)(A) defines a qualified
facility using open-loop biomass to pro-
duce electricity as any facility owned by
the taxpayer which (i) in the case of a facil-
ity using agricultural livestock waste nutri-
ents, (I) is originally placed in service after
the date of enactment of § 45(d)(3)(A)(i)(I)
and before January 1, 2008, and (II) the
nameplate capacity rating of which is not
less than 150 kilowatts; and (ii) in the case
of any other facility, is originally placed in
service before January 1, 2008. In the case
of any facility described in § 45(d)(3)(A),
if the owner of the facility is not the pro-
ducer of the electricity, § 45(d)(3)(B) pro-
vides that the person eligible for the credit
allowable under § 45(a) is the lessee or the
operator of the facility.
Section 45(d)(4) defines a qualified fa-
cility using geothermal or solar energy to
produce electricity as any facility owned
by the taxpayer which is originally placed
in service after the date of enactment of
§ 45(d)(4) and before January 1, 2008 (Jan-
uary 1, 2006, in the case of a facility us-
ing solar energy). A qualified facility us-
ing geothermal or solar energy does not in-
clude any property described in § 48(a)(3)
the basis of which is taken into account by
the taxpayer for purposes of determining
the energy credit under § 48.
Section 45(d)(5) defines a qualified
facility using small irrigation power to
produce electricity as any facility owned
by the taxpayer which is originally placed
in service after the date of enactment of
§ 45(d)(5) and before January 1, 2008.
Section 45(d)(6) defines a qualified fa-
cility using gas derived from the biodegra-
dation of municipal solid waste to produce
electricity as any facility owned by the tax-
payer which is originally placed in service
after the date of enactment of § 45(d)(6)
and before January 1, 2008.
Section 45(d)(7) defines a qualified fa-
cility that burns municipal solid waste to
produce electricity as any facility owned
by the taxpayer which is originally placed
in service after the date of enactment of
§ 45(d)(7) and before January 1, 2008. A
qualified facility burning municipal solid
waste includes a new unit placed in service
in connection with a facility placed in ser-
vice on or before the date of enactment of
§ 45(d)(7), but only to the extent of the in-
creased amount of electricity produced at
the facility by reason of such new unit.
Section 45(d)(8) provides in the case
of a facility that produces refined coal,
the term “refined coal production facility”
means a facility which is placed in service
after the date of enactment of § 45(d)(8)
and before January 1, 2009.
Section 45(d)(9) defines a qualified
facility producing qualified hydroelec-
tric production described in § 45(c)(8) as
(A) any facility producing incremental
hydropower production, but only to the
extent of its incremental hydropower pro-
duction attributable toefficiency improve-
ments or additions to capacity described
in § 45(c)(8)(B) placed in service after the
date of enactment of § 45(d)(9) and before
January 1, 2008, and (B) any other facility
placed in service after the date of enact-
ment of § 45(d)(9) and before January 1,
2008. Section 45(d)(9)(C) provides that in
the case of a qualified facility described in
§ 45(d)(9)(A), the 10-year period referred
to in § 45(a) is treated as beginning on
the date the efficiency improvements or
additions to capacity are placed in service.
Section 45(e)(8)(A) provides that the
refined coal production credit is an amount
equalto$4.375pertonofqualifiedre-
fined coal (i) produced by the taxpayer
at a refined coal production facility dur-
ing the 10-year period beginning on the
date the facility was originally placed in
service, and (ii) sold by the taxpayer (I)
to an unrelated person and (II) during the
10-year period and the tax year. Section
45(e)(8)(B) provides that the amount of
credit determined under § 45(e)(8)(A) is
reduced by an amount which bears the
same ratio to the amount of the increase
as (i) the amount by which the reference
price of fuel used as feedstock (within the
meaning of § 45(c)(7)(A)) for the calendar
year in which the sale occurs exceeds an
amount equal to 1.7 multiplied by the ref-
erence price for such fuel in 2002, bears to
(ii) $8.75.
Section 45(e)(2)(A) requires the Secre-
tary to determine and publish in the Fed-
eral Register each calendar year the infla-
tion adjustment factor and the reference
prices for the calendar year. The inflation
adjustment factor and the reference prices
for the 2006 calendar year were published
in the Federal Register on March 31, 2006
(71 Fed. Reg. 16420), and corrected on
May 9, 2006 (71 Fed. Reg. 27038).
Section 45(e)(2)(B) defines the infla-
tion adjustment factor for a calendar year
as the fraction the numerator of which is
the GDP implicit price deflator for the pre-
ceding calendar year and the denominator
of which is the GDP implicit price defla-
tor for the calendar year 1992. The term
“GDP implicit price deflator” means the
most recent revision of the implicit price
deflator for the gross domestic product as
computed and published by the Depart-
ment of Commerce before March 15 of the
calendar year.
Section 45(e)(2)(C) provides that the
reference price is the Secretary’s determi-
nation of the annual average contract price
per kilowatt hour of electricity generated
from the same qualified energy resource
and sold in the previous year in the United
States. Only contracts entered into af-
ter December 31, 1989, are taken into ac-
count.
Under § 45(e)(8)(C), the determination
of the reference price for fuel used as feed-
stock within the meaning of § 45(c)(7)(A)
is made according to rules similar to the
rules under § 45(e)(2)(C).
INFLATION ADJUSTMENT FACTOR
AND REFERENCE PRICES
The inflation adjustment factor for
calendar year 2006 is 1.2981. The ref-
erence price for calendar year 2006 for
facilities producing electricity from wind
based upon information provided by the
Department of Energy is 2.89 cents per
kilowatt hour. The reference prices for
fuel used as feedstock within the mean-
ing of § 45(c)(7)(A), relating to refined
coal production (based upon information
provided by the Department of Energy)
are $31.90 per ton for calendar year 2002
and $42.78 per ton for calendar year
2006. The reference prices for facilities
producing electricity from closed-loop
biomass, open-loop biomass, geother-
mal energy, solar energy, small irrigation
power, municipal solid waste, and quali-
fied hydropower production have not been
determined for calendar year 2006. The
IRS is exploring methods of determining
those reference prices for calendar year
2007.
PHASE-OUT CALCULATION
Because the 2006 reference price for
electricity producedfrom wind does not
2006–25 I.R.B.1145June 19, 2006

exceed 8 cents multiplied by the infla-
tion adjustment factor, the phaseout of
the credit provided in § 45(b)(1) does
not apply to such electricity sold during
calendar year 2006. Because the 2006 ref-
erence price of fuel used as feedstock for
refined coal does not exceed the $31.90
reference price of such fuel in 2002 mul-
tiplied by the inflation adjustment factor
and 1.7, the phaseout of credit provided
in § 45(e)(8)(B) does not apply to re-
fined coal sold during calendar year 2006.
Further, for electricity produced from
closed-loop biomass, open-loop biomass,
geothermal energy, solar energy, small
irrigation power, municipal solid waste,
and qualified hydropower production, the
phaseout of credit provided in § 45(b)(1)
does not apply to such electricity sold dur-
ing calendar year 2006.
CREDIT AMOUNT BY QUALIFIED
ENERGY RESOURCE AND FACILITY
AND REFINED COAL
As required by § 45(b)(2), the 1.5 cent
amount in § 45(a)(1), the 8 cent amount
in § 45(b)(1), and the $4.375 amount in
§ 45(e)(8)(A) are each adjusted by mul-
tiplying such amount by the inflation
adjustment factor for the calendar year
in which the sale occurs. If any amount
as increased under the preceding sen-
tence is not a multiple of 0.1 cent, such
amount is rounded to the nearest multi-
ple of 0.1 cent. In the case of electricity
produced in open-loopbiomass facilities,
small irrigation power facilities, landfill
gas facilities, trash combustion facili-
ties, and qualified hydropower facilities,
§ 45(b)(4)(A) requires the amount in ef-
fect under § 45(a)(1) (before rounding
to the nearest 0.1 cent) to be reduced by
one-half. Under the calculation required
by § 45(b)(2), the credit for renewable
electricity production for calendar year
2006 under § 45(a) is 1.9 cents per kilo-
watt hour on the sale of electricity pro-
duced from the qualified energy resources
of wind, closed-loop biomass, geothermal
energy, and solar energy, and 1.0 cent per
kilowatt hour on the sale of electricity
produced in open-loop biomass facilities,
small irrigation power facilities, landfill
gas facilities, trash combustion facilities,
and qualified hydropower facilities. Under
the calculation required by § 45(b)(2), the
credit for refined coal production for cal-
endar year 2006 under section 45(e)(8)(A)
is $5.679 per ton on the sale of qualified
refined coal.
DRAFTING AND CONTACT
INFORMATION
The principal author of this notice is
David A. Selig of the Office of Associate
Chief Counsel (Passthroughs and Special
Industries). For further information re-
garding this notice, contact Mr. Selig at
(202) 622–3040 (not a toll-free call).
Weighted Average Interest
Rate Update
Notice 2006–55
Sections 412(b)(5)(B) and 412(l)(7)
(C)(i) of the Internal Revenue Code gen-
erally provide that the interest rates used
to calculate current liability for purposes
of determining the full funding limitation
under § 412(c)(7) and the required con-
tribution under § 412(l) must be within
a permissible range around the weighted
average of the rates of interest on 30-year
Treasury securities during the four-year
period ending on the last day before the
beginning of the plan year.
Notice 88–73, 1988–2 C.B. 383, pro-
vides guidelines for determining the
weighted average interest rate and the
resulting permissible range of interest
rates used to calculate current liability for
the purpose of the full funding limitation
of § 412(c)(7) of the Code.
Section 417(e)(3)(A)(ii)(II) defines
the applicable interest rate, which must
be used for purposes of determining the
minimum present value of a participant’s
benefit under § 417(e)(1) and (2), as the
annual rate of interest on 30-year Treasury
securities for the month before the date
of distribution or such other time as the
Secretary may by regulations prescribe.
Section 1.417(e)–1(d)(3) of the Income
Tax Regulations provides that the applica-
ble interest rate for a month is the annual
interest rate on 30-year Treasury securi-
ties as specified by the Commissioner for
that month in revenuerulings, notices or
other guidance published in the Internal
Revenue Bulletin.
The rate of interest on 30-year Treasury
securities for May 2006 is 5.20 percent.
The Service has determined this rate as the
monthly average of the daily determina-
tion of yield on the 30-year Treasury bond
maturing in February 2036.
The following 30-year Treasury rates
were determined for the plan years begin-
ning in the month shown below.
For Plan Years
30-Year
Treasury90% to 105%90% to 110%
Beginning in:WeightedPermissiblePermissible
MonthYearAverageRangeRange
June20064.824.34 to 5.064.34 to 5.31
Drafting Information
The principal authors of this notice are
Paul Stern and Tony Montanaro of the Em-
ployee Plans, Tax Exempt and Govern-
ment Entities Division. For further infor-
mation regarding this notice, please con-
tact the Employee Plans’ taxpayer assis-
tance telephone service at 877–829–5500
(a toll-free number), between the hours of
8:30 a.m. and 4:30 p.m. Eastern time,
Monday through Friday. Mr. Stern may be
reached at 202–283–9703. Mr. Montanaro
may be reached at 202–283–9714. The
telephone numbers in the preceding sen-
tences are not toll-free.
June 19, 200611462006–25 I.R.B.

26 CFR 601.105: Examination of returns and claims
for refund, credit, or abatement; determination of
correct tax liability.
(Also: Part I, § 911, 1.911–1.)
Rev. Proc. 2006–28
SECTION 1. PURPOSE
.01 This revenue procedure provides
information to any individual who failed
to meet the eligibility requirements of
§ 911(d)(1) of the Internal Revenue Code
because adverse conditions in a foreign
country precluded the individual from
meeting those requirements for taxable
year 2005.
.02 This revenue procedure lists the
country, for which the eligibility require-
ments of § 911(d)(1) are waived for taxable
year 2005.
SECTION 2. BACKGROUND
.01 Section 911(a) of the Code allows
a “qualified individual,” as defined in
§ 911(d)(1), to exclude foreign earned
income and housing cost amounts from
gross income. Section 911(c)(3) of the
Code allows a qualified individual to
deduct housing cost amounts from gross
income.
.02 Section 911(d)(1) of the Code de-
fines the term “qualified individual” as an
individual whose tax home is in a foreign
country and who is (A) a citizen of the
United States and establishes to the satis-
faction of the Secretary of the Treasury that
the individual has been abona fideresident
of a foreign country or countries for an un-
interrupted period that includes an entire
taxable year, or (B) a citizen or resident of
the United States who, during any period
of 12 consecutive months, is present in a
foreign country or countries during at least
330 full days.
.03 Section 911(d)(4) of the Code pro-
vides an exception to the eligibility re-
quirements of § 911(d)(1). An individ-
ual will be treated as a qualified individ-
ual with respect to a period in which the
individual was abona fideresident of, or
was present in, a foreign country, if the in-
dividual left the country during a period
for which the Secretary of the Treasury, af-
ter consultation with the Secretary of State,
determines that individuals were required
to leave because of war, civil unrest, or
similar adverse conditions that precluded
the normal conduct of business. An in-
dividual must establish that but for those
conditions the individual could reasonably
have been expected to meet the eligibility
requirements.
.04 For 2005, the Secretary of the Trea-
sury, in consultation with the Secretary
of State, has determined that war, civil
unrest, or similar adverse conditions pre-
cluded the normal conduct of business in
the following country beginning on the
specified date:
Country
Date of Departure
On or after
HaitiMay 26, 2005
.05 Accordingly, for purposes of § 911
of the Code, an individual who left Haiti
on or after May 26, 2005, shall be treated
as a qualified individual with respect to the
period during which that individual was
present in, or was abona fideresident of,
Haiti, if the individual establishes a reason-
able expectation of meeting the require-
ments of § 911(d) but for those conditions.
.06 To qualify for relief under
§ 911(d)(4) of the Code, an individual
must have established residency, or have
been physically present, in the foreign
country on or prior to the date that the
Secretary of the Treasury determines that
individuals were required to leave the for-
eign country. Individuals who establish
residency, or are first physically present, in
the foreign country after the date that the
Secretary prescribes shall not be treated
as qualified individuals under § 911(d)(4)
of the Code. Therefore, individuals who
are first physically present or establish
residency in Haiti after May 26, 2005, are
not eligible to qualify for the exception
provided in § 911(d)(4) of the Code for
taxable year 2005.
SECTION 3. INQUIRIES
A taxpayer who needs assistance on
how to claim this exclusion, or on how to
file an amended return, should contact a lo-
cal IRS Office or, for a taxpayer residing
or traveling outside the United States, the
nearest overseas IRS office.
SECTION 4. DRAFTING
INFORMATION
The principal author of this revenue
procedureisKateY.HwaoftheOfficeof
Associate Chief Counsel (International).
For further information regarding this rev-
enue procedure, contact Kate Y. Hwa at
(202) 622–3840 (not a toll-free call).
2006–25 I.R.B.1147June 19, 2006

Definition of Terms
Revenue rulings and revenue procedures
(hereinafter referred to as “rulings”) that
have an effect on previous rulings use the
following defined terms to describe the ef-
fect:
Amplifieddescribes a situation where
no change is being made in a prior pub-
lished position, but the prior position is be-
ingextendedtoapplytoavariationofthe
fact situation set forth therein. Thus, if
an earlier ruling held that a principle ap-
plied to A, and the new ruling holds that the
same principle also applies to B, the earlier
ruling is amplified. (Compare withmodi-
fied,below).
Clarifiedis used in those instances
where the language in a prior ruling is be-
ing made clear because the language has
caused, or may cause, some confusion.
It is not used where a position in a prior
ruling is being changed.
Distinguisheddescribes a situation
where a ruling mentions a previously pub-
lished ruling and points out an essential
difference between them.
Modifiedis used where the substance
of a previously published position is being
changed. Thus, if a prior ruling held that a
principle applied to A but not to B, and the
new ruling holds that it applies to both A
and B, the prior ruling is modified because
it corrects a published position. (Compare
withamplifiedandclarified, above).
Obsoleteddescribes a previously pub-
lished ruling that is not considered deter-
minative with respect to future transac-
tions. This term is most commonly used in
a ruling that lists previously published rul-
ings that are obsoleted because of changes
in laws or regulations. A ruling may also
be obsoleted because the substance has
been included in regulations subsequently
adopted.
Revokeddescribes situations where the
position in the previously published ruling
is not correct and the correct position is
beingstatedinanewruling.
Supersededdescribes a situation where
the new ruling does nothing more than re-
state the substance and situation of a previ-
ously published ruling (or rulings). Thus,
the term is used to republish under the
1986 Code and regulations the same po-
sition published under the 1939 Code and
regulations. The term is also used when
it is desired to republish in a single rul-
ing a series of situations, names, etc., that
were previously published over a period of
time in separate rulings. If the new rul-
ing does more than restate the substance
of a prior ruling, a combination of terms
is used. For example,modifiedandsu-
persededdescribes a situation where the
substance of a previously published ruling
is being changed in part and is continued
without change in part and it is desired to
restate the valid portion of the previously
published ruling in a new ruling that is self
contained. In this case, the previously pub-
lished ruling is first modified and then, as
modified, is superseded.
Supplementedis used in situations in
which a list, such as a list of the names of
countries, is published in a ruling and that
list is expanded by adding further names in
subsequent rulings. After the original rul-
ing has been supplemented several times, a
new ruling may be published that includes
the list in the original ruling and the ad-
ditions, and supersedes all prior rulings in
the series.
Suspendedis used in rare situations
to show that the previous published rul-
ings will not be applied pending some
future action such as the issuance of new
or amended regulations, the outcome of
cases in litigation, or the outcome of a
Service study.
Abbreviations
The fol
lowing abbreviations in current use
and for
merly used will appear in material
publis
hedintheBulletin.
A—Individual.
Acq.—A
cquiescence.
B—Individual.
BE—Beneficiary.
BK—Bank
.
B.T.A.—Board of Tax Appeals.
C—Individual.
C.B.—Cu
mulative Bulletin.
CFR—Code of Federal Regulations.
CI—City.
COOP—Coo
perative.
Ct.D.—Court Decision.
CY—County.
D—Decede
nt.
DC—Dummy Corporation.
DE—Donee.
Del. Order
—Delegation Order.
DISC—Domestic International Sales Corporation.
DR—Donor.
E—Estate.
EE—Employee.
E.O.—Executive Order.
ER—Emp
loyer.
ERISA—Employee Retirement Income Security Act.
EX—Executor.
F—Fiduc
iary.
FC—Foreign Country.
FICA—Federal Insurance Contributions Act.
FISC—Fo
reign International Sales Company.
FPH—Foreign Personal Holding Company.
F.R.—Federal Register.
FUTA—Fed
eral Unemployment Tax Act.
FX—Foreign corporation.
G.C.M.—Chief Counsel’s Memorandum.
GE—Grante
e.
GP—General Partner.
GR—Grantor.
IC—Insura
nce Company.
I.R.B.—Internal Revenue Bulletin.
LE—Lessee.
LP—Limited
Partner.
LR—Lessor.
M—Minor.
Nonacq.—No
nacquiescence.
O—Organization.
P—Parent Corporation.
PHC—Persona
l Holding Company.
PO—Possession of the U.S.
PR—Partner.
PRS—Pa
rtnership.
PTE—Prohibited Transaction Exemption.
Pub. L.—Public Law.
REIT—Re
al Estate Investment Trust.
Rev. Proc.—Revenue Procedure.
Rev. Rul.—Revenue Ruling.
S—Subsi
diary.
S.P.R.—Statement of Procedural Rules.
Stat.—Statutes at Large.
T—Target
Corporation.
T.C.—Tax Court.
T.D.—Treasury Decision.
TFE—Trans
feree.
TFR—Transferor.
T.I.R.—Technical Information Release.
TP—Taxpay
er.
TR—Trust.
TT—Trustee.
U.S.C.—Uni
ted States Code.
X—Corporation.
Y—Corporation.
Z—Corporat
ion.
June 19, 2006i2006–25 I.R.B.

Numerical Finding List
1
Bulletin 2006–1 through 2006–25
Announcements:
2006-1, 2006-1 I.R.B.260
2006-2, 2006-2 I.R.B.300
2006-3, 2006-3 I.R.B.327
2006-4, 2006-3 I.R.B.328
2006-5, 2006-4 I.R.B.378
2006-6, 2006-4 I.R.B.340
2006-7, 2006-4 I.R.B.342
2006-8, 2006-4 I.R.B.344
2006-9, 2006-5 I.R.B.392
2006-10, 2006-5 I.R.B.393
2006-11, 2006-6 I.R.B.420
2006-12, 2006-6 I.R.B.421
2006-13, 2006-7 I.R.B.462
2006-14, 2006-8 I.R.B.516
2006-15, 2006-11 I.R.B.632
2006-16, 2006-12 I.R.B.653
2006-17, 2006-12 I.R.B.653
2006-18, 2006-12 I.R.B.654
2006-19, 2006-13 I.R.B.674
2006-20, 2006-13 I.R.B.675
2006-21, 2006-14 I.R.B.703
2006-22, 2006-16 I.R.B.779
2006-23, 2006-14 I.R.B.729
2006-24, 2006-16 I.R.B.820
2006-25, 2006-18 I.R.B.871
2006-26, 2006-18 I.R.B.871
2006-27, 2006-18 I.R.B.871
2006-28, 2006-18 I.R.B.873
2006-29, 2006-19 I.R.B.879
2006-30, 2006-19 I.R.B.879
2006-31, 2006-20 I.R.B.912
2006-32, 2006-20 I.R.B.913
2006-33, 2006-20 I.R.B.914
2006-34, 2006-21 I.R.B.937
2006-35, 2006-24 I.R.B.1061
2006-36, 2006-23 I.R.B.1038
2006-37, 2006-23 I.R.B.1039
2006-38, 2006-24 I.R.B.1062
Court Decisions:
2081, 2006-13 I.R.B.656
2082, 2006-14 I.R.B.697
Notices:
2006-1, 2006-4 I.R.B.347
2006-2, 2006-2 I.R.B.278
2006-3, 2006-3 I.R.B.306
2006-4, 2006-3 I.R.B.307
2006-5, 2006-4 I.R.B.348
2006-6, 2006-5 I.R.B.385
2006-7, 2006-10 I.R.B.559
Notices— Continued:
2006-8, 2006-5 I.R.B.386
2006-9, 2006-6 I.R.B.413
2006-10, 2006-5 I.R.B.386
2006-11, 2006-7 I.R.B.457
2006-12, 2006-7 I.R.B.458
2006-13, 2006-8 I.R.B.496
2006-14, 2006-8 I.R.B.498
2006-15, 2006-8 I.R.B.501
2006-16, 2006-9 I.R.B.538
2006-17, 2006-10 I.R.B.559
2006-18, 2006-8 I.R.B.502
2006-19, 2006-9 I.R.B.539
2006-20, 2006-10 I.R.B.560
2006-21, 2006-12 I.R.B.643
2006-22, 2006-11 I.R.B.593
2006-23, 2006-11 I.R.B.594
2006-24, 2006-11 I.R.B.595
2006-25, 2006-11 I.R.B.609
2006-26, 2006-11 I.R.B.622
2006-27, 2006-11 I.R.B.626
2006-28, 2006-11 I.R.B.628
2006-29, 2006-12 I.R.B.644
2006-30, 2006-24 I.R.B.1044
2006-31, 2006-15 I.R.B.751
2006-32, 2006-13 I.R.B.677
2006-33, 2006-15 I.R.B.754
2006-34, 2006-14 I.R.B.705
2006-35, 2006-14 I.R.B.708
2006-36, 2006-15 I.R.B.756
2006-37, 2006-18 I.R.B.855
2006-38, 2006-16 I.R.B.777
2006-39, 2006-17 I.R.B.841
2006-40, 2006-18 I.R.B.855
2006-41, 2006-18 I.R.B.857
2006-42, 2006-19 I.R.B.878
2006-43, 2006-21 I.R.B.921
2006-44, 2006-20 I.R.B.889
2006-45, 2006-20 I.R.B.891
2006-46, 2006-24 I.R.B.1044
2006-47, 2006-20 I.R.B.892
2006-48, 2006-21 I.R.B.922
2006-49, 2006-22 I.R.B.943
2006-50, 2006-25 I.R.B.1141
2006-51, 2006-25 I.R.B.1144
2006-55, 2006-25 I.R.B.1146
Proposed Regulations:
REG-107722-00, 2006-4 I.R.B.354
REG-104385-01, 2006-5 I.R.B.389
REG-122380-02, 2006-10 I.R.B.563
REG-137243-02, 2006-3 I.R.B.317
REG-139059-02, 2006-24 I.R.B.1052
REG-144784-02, 2006-23 I.R.B.1036
REG-133446-03, 2006-2 I.R.B.299
REG-113365-04, 2006-10 I.R.B.580
Proposed Regulations— Continued:
REG-148568-04, 2006-6 I.R.B.417
REG-106418-05, 2006-7 I.R.B.461
REG-133036-05, 2006-20 I.R.B.911
REG-138879-05, 2006-8 I.R.B.503
REG-143244-05, 2006-6 I.R.B.419
REG-146384-05, 2006-17 I.R.B.843
REG-146459-05, 2006-8 I.R.B.504
REG-157271-05, 2006-12 I.R.B.652
REG-164247-05, 2006-15 I.R.B.758
REG-111578-06, 2006-24 I.R.B.1060
Revenue Procedures:
2006-1, 2006-1 I.R.B.1
2006-2, 2006-1 I.R.B.89
2006-3, 2006-1 I.R.B.122
2006-4, 2006-1 I.R.B.132
2006-5, 2006-1 I.R.B.174
2006-6, 2006-1 I.R.B.204
2006-7, 2006-1 I.R.B.242
2006-8, 2006-1 I.R.B.245
2006-9, 2006-2 I.R.B.278
2006-10, 2006-2 I.R.B.293
2006-11, 2006-3 I.R.B.309
2006-12, 2006-3 I.R.B.310
2006-13, 2006-3 I.R.B.315
2006-14, 2006-4 I.R.B.350
2006-15, 2006-5 I.R.B.387
2006-16, 2006-9 I.R.B.539
2006-17, 2006-14 I.R.B.709
2006-18, 2006-12 I.R.B.645
2006-19, 2006-13 I.R.B.677
2006-20, 2006-17 I.R.B.841
2006-21, 2006-24 I.R.B.1050
2006-22, 2006-23 I.R.B.1033
2006-23, 2006-20 I.R.B.900
2006-24, 2006-22 I.R.B.943
2006-25, 2006-21 I.R.B.926
2006-26, 2006-21 I.R.B.936
2006-27, 2006-22 I.R.B.945
2006-28, 2006-25 I.R.B.1147
Revenue Rulings:
2006-1, 2006-2 I.R.B.261
2006-2, 2006-2 I.R.B.261
2006-3, 2006-2 I.R.B.276
2006-4, 2006-2 I.R.B.264
2006-5, 2006-3 I.R.B.302
2006-6, 2006-5 I.R.B.381
2006-7, 2006-6 I.R.B.399
2006-8, 2006-9 I.R.B.520
2006-9, 2006-9 I.R.B.519
2006-10, 2006-10 I.R.B.557
2006-11, 2006-12 I.R.B.635
2006-12, 2006-12 I.R.B.637
2006-13, 2006-13 I.R.B.656
1
A cumulative list of all revenue rulings, revenue procedures, Treasury decisions, etc., published in Internal Revenue Bulletins 2005–27 through 2005–52 is in Internal Revenue Bulletin
2005–52, dated December 27, 2005.
2006–25 I.R.B.iiJune 19, 2006

Revenue Rulings— Continued:
2006-14, 2006-15 I.R.B.740
2006-15, 2006-13 I.R.B.661
2006-16, 2006-14 I.R.B.694
2006-17, 2006-15 I.R.B.748
2006-18, 2006-15 I.R.B.743
2006-19, 2006-15 I.R.B.749
2006-20, 2006-15 I.R.B.746
2006-21, 2006-15 I.R.B.745
2006-22, 2006-14 I.R.B.687
2006-23, 2006-17 I.R.B.839
2006-24, 2006-19 I.R.B.875
2006-25, 2006-20 I.R.B.882
2006-26, 2006-22 I.R.B.939
2006-27, 2006-21 I.R.B.915
2006-28, 2006-22 I.R.B.938
2006-29, 2006-23 I.R.B.1031
2006-30, 2006-25 I.R.B.1134
2006-31, 2006-25 I.R.B.1133
Tax Conventions:
2006-6, 2006-4 I.R.B.340
2006-7, 2006-4 I.R.B.342
2006-8, 2006-4 I.R.B.344
2006-19, 2006-13 I.R.B.674
2006-20, 2006-13 I.R.B.675
2006-21, 2006-14 I.R.B.703
Treasury Decisions:
9231, 2006-2 I.R.B.272
9232, 2006-2 I.R.B.266
9233, 2006-3 I.R.B.303
9234, 2006-4 I.R.B.329
9235, 2006-4 I.R.B.338
9236, 2006-5 I.R.B.382
9237, 2006-6 I.R.B.394
9238, 2006-6 I.R.B.408
9239, 2006-6 I.R.B.401
9240, 2006-7 I.R.B.454
9241, 2006-7 I.R.B.427
9242, 2006-7 I.R.B.422
9243, 2006-8 I.R.B.475
9244, 2006-8 I.R.B.463
9245, 2006-14 I.R.B.696
9246, 2006-9 I.R.B.534
9247, 2006-9 I.R.B.521
9248, 2006-9 I.R.B.524
9249, 2006-10 I.R.B.546
9250, 2006-11 I.R.B.588
9251, 2006-11 I.R.B.590
9252, 2006-12 I.R.B.633
9253, 2006-14 I.R.B.689
9254, 2006-13 I.R.B.662
9255, 2006-15 I.R.B.741
9256, 2006-16 I.R.B.770
9257, 2006-17 I.R.B.821
9258, 2006-20 I.R.B.886
9259, 2006-19 I.R.B.874
Treasury Decisions— Continued:
9260, 2006-23 I.R.B.1001
9261, 2006-21 I.R.B.919
9262, 2006-24 I.R.B.1040
9263, 2006-25 I.R.B.1063
June 19, 2006iii2006–25 I.R.B.

Finding List of Current Actions on
Previously Published Items
1
Bulletin 2006–1 through 2006–25
Announcements:
2000-48
Modified by
Notice 2006-35, 2006-14 I.R.B.708
Notices:
89-85
Amplified by
Notice 2006-46, 2006-24 I.R.B.1044
2001-4
Sections (V)(C), (D), and (E) superseded by
T.D. 9253, 2006-14 I.R.B.689
2001-11
Superseded by
T.D. 9253, 2006-14 I.R.B.689
2001-43
Modified by
Notice 2006-35, 2006-14 I.R.B.708
Sections 2 and 3 superseded by
T.D. 9253, 2006-14 I.R.B.689
2002-35
Clarified and modified by
Notice 2006-16, 2006-9 I.R.B.538
2005-14
Obsoleted for taxable years beginning on or after
June 1, 2006, by
T.D. 9263, 2006-25 I.R.B.1063
2005-30
Modified and superseded by
Notice 2006-31, 2006-15 I.R.B.751
2005-44
Supplemented by
Notice 2006-1, 2006-4 I.R.B.347
2005-66
Supplemented by
Notice 2006-20, 2006-10 I.R.B.560
2005-73
Supplemented by
Notice 2006-20, 2006-10 I.R.B.560
2005-79
Revoked by
Notice 2006-50, 2006-25 I.R.B.1141
2005-81
Supplemented by
Notice 2006-20, 2006-10 I.R.B.560
Notices— Continued:
2005-98
Supplemented by
Notice 2006-7, 2006-10 I.R.B.559
Proposed Regulations:
REG-103829-99
Withdrawn by
Ann. 2006-16, 2006-12 I.R.B.653
REG-150313-01
Withdrawn by
Ann. 2006-30, 2006-19 I.R.B.879
REG-131739-03
Corrected by
Ann. 2006-10, 2006-5 I.R.B.393
REG-131264-04
Withdrawn by
Ann. 2006-34, 2006-21 I.R.B.937
REG-138647-04
Corrected by
Ann. 2006-4, 2006-3 I.R.B.328
REG-158080-04
Corrected by
Ann. 2006-11, 2006-6 I.R.B.420
Revenue Procedures:
81-17
Obsoleted by
Rev. Proc. 2006-24, 2006-22 I.R.B.943
89-8
Superseded by
Rev. Proc. 2006-23, 2006-20 I.R.B.900
89-56
Modified by
Rev. Proc. 2006-21, 2006-24 I.R.B.1050
90-39
Modified by
Rev. Proc. 2006-21, 2006-24 I.R.B.1050
96-52
Superseded by
Rev. Proc. 2006-10, 2006-2 I.R.B.293
97-27
Modified by
Rev. Proc. 2006-11, 2006-3 I.R.B.309
Modified and amplified by
Rev. Proc. 2006-12, 2006-3 I.R.B.310
Revenue Procedures— Continued:
2002-9
Modified by
Rev. Proc. 2006-11, 2006-3 I.R.B.309
Modified and amplified by
Notice 2006-47, 2006-20 I.R.B.892
Rev. Proc. 2006-12, 2006-3 I.R.B.310
Rev. Proc. 2006-14, 2006-4 I.R.B.350
Rev. Proc. 2006-16, 2006-9 I.R.B.539
2002-17
Modified by
Rev. Proc. 2006-14, 2006-4 I.R.B.350
2002-32
Modified by
Rev. Proc. 2006-21, 2006-24 I.R.B.1050
2002-52
Modified by
Rev. Proc. 2006-26, 2006-21 I.R.B.936
2003-31
Superseded by
Rev. Proc. 2006-19, 2006-13 I.R.B.677
2003-38
Modified by
Rev. Proc. 2006-16, 2006-9 I.R.B.539
2003-44
Modified and superseded by
Rev. Proc. 2006-27, 2006-22 I.R.B.945
2004-23
Superseded for certain taxable years by
Rev. Proc. 2006-12, 2006-3 I.R.B.310
2004-40
Superseded by
Rev. Proc. 2006-9, 2006-2 I.R.B.278
2005-1
Superseded by
Rev. Proc. 2006-1, 2006-1 I.R.B.1
2005-2
Superseded by
Rev. Proc. 2006-2, 2006-1 I.R.B.89
2005-3
Superseded by
Rev. Proc. 2006-3, 2006-1 I.R.B.122
2005-4
Superseded by
Rev. Proc. 2006-4, 2006-1 I.R.B.132
2005-5
Superseded by
Rev. Proc. 2006-5, 2006-1 I.R.B.174
2005-6
Superseded by
Rev. Proc. 2006-6, 2006-1 I.R.B.204
1
A cumulative list of current actions on previously published items in Internal Revenue Bulletins 2005–27 through 2005–52 is in Internal Revenue Bulletin 2005–52, dated December 27,
2005.
2006–25 I.R.B.ivJune 19, 2006

Revenue Procedures— Continued:
2005-7
Superseded by
Rev. Proc. 2006-7, 2006-1 I.R.B.242
2005-8
Superseded by
Rev. Proc. 2006-8, 2006-1 I.R.B.245
2005-9
Superseded for certain taxable years by
Rev. Proc. 2006-12, 2006-3 I.R.B.310
2005-12
Section 10 modified and superseded by
Rev. Proc. 2006-1, 2006-1 I.R.B.1
2005-15
Obsoleted in part by
Rev. Proc. 2006-17, 2006-14 I.R.B.709
2005-21
Superseded by
Rev. Proc. 2006-25, 2006-21 I.R.B.926
2005-22
Obsoleted by
Rev. Proc. 2006-20, 2006-17 I.R.B.841
2005-24
Modified by
Notice 2006-15, 2006-8 I.R.B.501
2005-61
Superseded by
Rev. Proc. 2006-3, 2006-1 I.R.B.122
2005-68
Superseded by
Rev. Proc. 2006-1, 2006-1 I.R.B.1
Rev. Proc. 2006-3, 2006-1 I.R.B.122
Revenue Rulings:
55-355
Obsoleted by
T.D. 9244, 2006-8 I.R.B.463
74-503
Revoked by
Rev. Rul. 2006-2, 2006-2 I.R.B.261
77-230
Obsoleted by
T.D. 9249, 2006-10 I.R.B.546
91-5
Modified by
T.D. 9250, 2006-11 I.R.B.588
92-19
Supplemented in part by
Rev. Rul. 2006-25, 2006-20 I.R.B.882
92-86
Modified by
T.D. 9250, 2006-11 I.R.B.588
Revenue Rulings— Continued:
2000-2
Modified and superseded by
Rev. Rul. 2006-26, 2006-22 I.R.B.939
2006-1
Modified and clarified by
Rev. Rul. 2006-31, 2006-25 I.R.B.1133
2006-25
Corrected by
Ann. 2006-35, 2006-24 I.R.B.1061
Treasury Decisions:
9191
Corrected by
Ann. 2006-26, 2006-18 I.R.B.871
9192
Corrected by
Ann. 2006-15, 2006-11 I.R.B.632
9203
Corrected by
Ann. 2006-12, 2006-6 I.R.B.421
9243
Corrected by
Ann. 2006-38, 2006-24 I.R.B.1062
9244
Corrected by
Ann. 2006-31, 2006-20 I.R.B.912
9248
Corrected by
Ann. 2006-32, 2006-20 I.R.B.913
June 19, 2006v2006–25 I.R.B.
U.S. GPO: 2006—320–797/20063