Today, President Bush signed the American Jobs Creation Act of 2004 (H.R. 4520) into law. The $145 billion corporate tax package contains a range of international tax reforms, corporate tax breaks and tax incentives that are intended to make United States manufacturing, service and high-technology businesses and workers more competitive and productive both in the United States and abroad. The Act provides the most significant reform of the corporate tax provisions of the Internal Revenue Code since 1986.

This Perkins Coie Update highlights the provisions of the Act that contain a new deduction relating to income attributable to certain production activities in the United States and a temporary deduction available for certain dividends received by domestic corporations from controlled foreign corporations.

Deduction Relating to Certain Manufacturing and Production Activities

Under pre-Act law, the Internal Revenue Code contained an "extraterritorial income" regime that provided tax relief to companies that manufactured goods in the United States but sold such goods overseas. The World Trade Organization has ruled that the regime is a prohibited export subsidy under relevant trade agreements and has been imposing billions of dollars in tariffs on goods exported by U.S. manufacturers into the European Union. While the Act was crafted to repeal the "extraterritorial income" regime under the Internal Revenue Code and bring the United States into compliance with its obligations under the Agreement on Subsidies and Countervailing Measures and other international trade agreements, Congress recognized the significant challenges that manufacturers have faced during our nation's recent economic slowdown and the adverse competitive impact that indirect tax systems of trading partners of the United States may have on U.S. manufacturers. Congress, therefore, replaced the benefits under the "extraterritorial income" regime with a provision in the Act that is specifically designed to provide tax relief to certain businesses engaged in U.S.-based production activities.

How Much Will Eligible Taxpayers Be Allowed to Deduct?

For taxable years beginning after 2004, the Act generally provides that a taxpayer will be allowed to deduct a specified percentage of the lesser of (1) its "qualified production activities income" for the taxable year or (2) its  taxable income for the taxable year (without regard to this deduction). The specified percentage is 3 percent for taxable years beginning in 2005 and 2006, 6 percent for taxable years beginning in 2007, 2008, and 2009, and 9 percent for taxable years beginning after 2009.

However, the amount of the deduction allowable for any taxable year cannot exceed 50 percent of the sum of the aggregate amounts of wages and elective deferrals (for example, Section 401(k) deferrals) that a taxpayer is required to include on its employees' Forms W-2 for the taxable year. Many capital-intensive, as opposed to labor-intensive, businesses may find that this limitation significantly reduces, or eliminates altogether, any potential deduction under the provision.

Who May Claim the Deduction?

The deduction generally is available to C corporations, S corporations, partnerships, sole proprietorships, cooperatives, estates and trusts. Special rules apply in the case of certain corporations that are members of an affiliated group and S corporations, partnerships, estates, trusts and other pass-through entities.

What is Qualified Production Activities Income?

In general, a taxpayer's "qualified production activities income" for any taxable year will consist of the taxpayer's "domestic production gross receipts" for the taxable year, reduced by allocable expenses. Under the Act, the Secretary of the Treasury is required to prescribe rules for the proper allocation of items of income, deduction, expense and loss for purposes of determining income attributable to U.S. production activities.

What are Domestic Production Gross Receipts?

"Domestic production gross receipts" generally include gross receipts of a taxpayer that are derived from:

• Any lease, rental, license, sale, exchange or other disposition of (1) "qualifying production property" (for example, tangible personal property, computer software or sound recordings) that was manufactured, produced, grown or extracted by the taxpayer in whole or in significant part within the United States or (2) certain motion picture films or video tapes;

• Any lease, rental, license, sale, exchange or other disposition of electricity, natural gas or potable water produced by the taxpayer in the United States;
• Construction performed in the United States (for example, activities that are directly related to the erection or substantial renovations of residential and commercial buildings and infrastructure); or
• Engineering or architectural services performed in the United States for construction projects in the United States.

However, "domestic production gross receipts" generally do not include any gross receipts of a taxpayer that are derived from:

• Property leased, licensed or rented by such taxpayer for use by any related person;

• The sale of food and beverages prepared by the taxpayer at a retail establishment; or
• The transmission or distribution of electricity, natural gas or potable water.

What Are Allocable Expenses?

Allocable expenses include the sum of the following amounts:

• The cost of goods sold that are allocable to such gross receipts;

• Other deductions, expenses or losses directly allocable to such receipts (for example, selling and marketing expenses); and
• A ratable portion of other deductions, expenses and losses that is not directly allocable to such receipts or another class of income (for example, general and administrative expenses allocable to selling and marketing expenses).

Tax Planning Considerations

While the provision is specifically designed to provide tax relief to certain businesses, it is expected that the provision will result in an increase in tax controversies between businesses and the Internal Revenue Service. Additionally, the multiple calculations and analyses required by the provision, as well as its overall complexity, will require taxpayers to devote significant additional resources to meet their substantiation obligations.

The provision raises a host of difficult issues to be analyzed and resolved by taxpayers and the Internal Revenue Service, including:

• What types of activities constitute production activities?

• What methodology should be used in allocating revenues and expenses between production and nonproduction activities?
• What is the scope of the terms "manufactured" and "produced"?
• When will a product be considered to be manufactured or produced "in whole or in significant part within the United States"?
• What types of property will qualify as "tangible personal property"? Also, how does the provision apply to traditional forms of tangible property that are sold in intangible formats (for example, sound recordings sold as downloads on the Internet)?
• What constitutes a "substantial renovation"?
• How does the provision apply when related and unrelated taxpayers perform parts of the production activity?
• How does the provision apply to companies that are involved in both sales and service?

The Internal Revenue Service has indicated that it expects to issue guidance before the end of the year on this new provision, which may address some or all of the foregoing issues. However, Internal Revenue Service Commissioner Mark W. Everson has warned that the distinction in the provision between production and other activities "places considerable tension on defining terms and designing anti-abuse rules," which will make it difficult to craft administrative guidance for taxpayers. Therefore, it is likely that the meaning and scope of key terms and concepts will develop over the years through case law resulting from increased litigation between businesses and the Internal Revenue Service.

Temporary Incentive to Reinvest Foreign Earnings in the United States

Income earned by a domestic parent corporation from foreign operations conducted by corporate foreign subsidiaries generally is subject to U.S. tax at graduated rates (currently at a maximum of 35 percent) when the income is actually distributed as a dividend to the domestic parent corporation. Thus, U.S. tax generally is deferred until an actual distribution of those earnings is made.

To encourage the reinvestment of foreign operating earnings in the United States, Congress included a temporary provision in the Act that generally allows an electing domestic corporation to claim an 85 percent dividends received deduction for cash dividends that it receives from controlled foreign corporations during a one-year period. Dividends eligible for the deduction will be taxed at an effective tax rate of 5.25 percent.

The deduction is subject to a number of limitations. For example, the amount of eligible dividends generally is capped at the greater of $500 million or the amount shown on the taxpayer's financial statements as earnings permanently reinvested outside the United States. Furthermore, only dividends received in excess of the taxpayer's average repatriation level over three of the five most recent taxable years ending on or before June 30, 2003 are eligible for the deduction. In addition, the deduction is not available unless the amount of the dividend is invested in the United States pursuant to a domestic reinvestment plan that (i) has been approved in accordance with certain prescribed procedures and (ii) provides for the reinvestment of such dividend in the United States (other than as payment for executive compensation), including, but not limited to, reinvestment as a source of funding for the hiring and training of workers, infrastructure, research and development capital investments or financial stabilization of the corporation for purposes of job retention or creation. The Internal Revenue Service expects to issue guidance addressing this provision before the end of the year.

The provision is effective, at the election of a domestic corporation, only for its last taxable year that begins before, or its first taxable year that begins on or after, October 22, 2004. Congress has warned that this provision is intended to be a temporary economic stimulus measure and that there is no intent to make this measure permanent, or to "extend" or enact it again in the future.

Additional Information

This update is only intended to provide a brief summary of the provisions of the Act that are discussed above. 

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