KPMG Comments on Wage Calculation Under Production Deduction Limitation

Dear Eric:

KPMG LLP is pleased to offer the following comments on the Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA),¹ on behalf of members of the power and utility industry.

Our comments concern the wages limitation under section 199² as modified by TIPRA. Specifically, we request that regulations issued under section 199 pursuant to TIPRA provide that W-2 wages are treated as "properly allocable" to domestic production gross receipts (DPGR) if the wages are paid to employees that are providing services in connection with a qualifying activity. Stated differently, as further discussed below, we believe that, under a proper interpretation of the TIPRA changes, it is not necessary for a pass-through entity to perform a qualifying activity in order for its wages to be treated as W-2 wages of an owner of the pass-through entity to the extent that the employees of the pass-through entity perform services that give rise to DPGR of another pass-through entity and the two entities have some common ownership. Further, in the case of an expanded affiliated group (EAG), we believe that, under TIPRA, it is not necessary for a member of an EAG to perform a qualifying activity in order for its wages to be treated as W-2 wages to the extent that the employees of the corporation perform services that give rise to DPGR of another member of the EAG.

Factual Overview

The following provides a description of a typical operating structure for members of the power and utility industry.

A group of related entities ("the enterprise") is engaged in the production, transmission and distribution of electricity. Some of the entities that are part of the enterprise are engaged exclusively in the production of electricity and not in the transmission and distribution of electricity. The entities engaged in power generation are pass-through entities for tax purposes. In some cases, these entities may be part of a joint venture with another, unrelated company.

Employees of the enterprise are typically engaged in providing either services related to the generation of electricity or services related to the transmission or distribution of electricity, but not both. Employees providing services relating to power generation typically do not receive wages from the entity engaged in power generation. These employees are paid by a related entity ("the employer entity"). The employer entity may be a C corporation or a pass-through entity. The employer entity may be part of an affiliated group that includes entities engaged in transmission and distribution.

The pass-through entities that are engaged in power generation enter into an operations and maintenance agreement with the employer entity. The pass-through entities establish an operations and maintenance account which is funded monthly by the power generation entity. The funds are allocable to, and reduce, domestic production gross receipts.

The wages, employment taxes and benefits of the employees may be funded in one of several ways. The payments may be made directly out of the operations and maintenance account (i.e., employees of the employer entity are paid directly out of an account owned and funded by the pass-through entity engaged in power generation). Alternatively, these amounts may be paid out of a bank account funded by the employer entity. In either case, the power generation entity is either, directly or indirectly, funding the cost of the workers engaged in power generation.

For purposes of employee benefits, employment taxes, and withholding taxes, the employees of the enterprise are treated as common-law employees of the employer entity.³

The legal structure described above is dictated by a number of practical considerations that are unrelated to taxation. Establishing a centralized employer entity serves a number of business purposes including:

• Reducing Liability -- The power generation entity may own tens of millions of dollars in hard assets. If the workers are the common law employees of the power generation entity, those employees could have a claim against the assets of the entity in the case of any employment-related lawsuits. Furthermore, there is a risk that the owners of the entity could be viewed as employers and face potential liability for employment issues. Finally, if an owner wanted to sell its interest in the entity, it would have to indemnify against potential employee liabilities and much effort would be spent on due diligence regarding employment issues.

• Facilitating Financing -- Lenders often require the enterprise to establish a separate employer entity in order to protect the assets of the power generation activity from employment-related lawsuits. In particular, lenders typically require the entity engaged in the power generation activity to represent and warrant that it does not sponsor, maintain, administer, contribute to, participate in, or have any obligation to contribute to or any liability under, any ERISA Plan.

• Centralizing Employee Benefit Plans -- A centralized employer entity permits the enterprise to maintain one set of health and welfare benefit plans. This provides significant business savings. In the absence of a centralized employer entity, the related entities of the enterprise might not be treated as a single employer under the employee benefit rules, and separate plans might need to be established for each entity.

• Reducing Costs -- Considerable business savings can be achieved by centralizing the payroll function. If payroll is not centralized, each entity, or related group of entities, would need to hire its own payroll staff, which would significantly increase costs.

• Centralizing Management -- The centralized corporate management of the employer entity allows the capturing of synergies of multiple and geographically dispersed operations, the establishment of best practice processes on a global basis and the coordination of continuous improvement programs.

Wages Paid by Employer to Employees engaged in the Production of Electricity are "Allocable" to DPGR

For tax years beginning on or before May 17, 2006, the section 199 deduction is limited to 50% of all W-2 wages paid by the taxpayer during the calendar year that ends in such tax year (the "W-2 wages limitation"). For this purpose, W-2 wages are wages that are paid to the common law employees of the taxpayer and that are reported on a Form W-2 filed with Social Security Administration.

TIPRA modifies the W-2 wages limitation so that taxpayers may only include amounts "properly allocable" to domestic production gross receipts (DPGR) in calculating their W-2 wages limitation.⁴ Thus, the W-2 wages limitation is 50% of W-2 wages that are incurred in qualifying production activities.

The statute provides in full as follows:

Under the fact pattern described above, we believe that the wages paid by the entity issuing W-2s are "properly allocable" to domestic production gross receipts. This is because: (i) the services are provided in connection with a qualifying activity -- namely, the production of electricity, and (ii) the entity engaged in the production of electricity reimburses the employer entity for the services provided, and the entity's payments are deducted in determining qualified production activities income.

We reach this conclusion based on a plain reading of the statute, and we further believe that this interpretation serves the policy objectives of the changes made by TIPRA.

Section 199 provides that, in the case of a pass-through entity, the amount of the deduction under section 199 is determined at the owner level. This provision provides authority to conclude that, in the case of a pass-through entity, wages are allocable to DPGR so long as the services giving rise to the wages generate DPGR to another pass-through entity in which the owner is a partner or shareholder.

The section 199 regulations provide that a partner or shareholder is required to aggregate its own DPGR with the DPGR of every pass-through entity in which it is a member to compute its own section 199 deduction. In other words, the owner must treat any distributed DPGR from a pass-through as its own DPGR. Further, a partner or shareholder must also treat its distributive share of wages from a pass-through entity as its own W-2 wages. If such wages are treated as the taxpayer's own wages, then it is equally clear that those wages are allocable to DPGR of the partner or shareholder, because the wages paid relate directly to the activity generating the distributed DPGR.

In the case of EAG members, the same reasoning applies. Section 199 provides that an EAG is treated as a single taxpayer for all purposes, including the wages limitation. Thus, there is authority to conclude that wages of an EAG member are allocable to DPGR so long as the services giving rise to the wages generate DPGR for any member of the EAG.

Applying this interpretation to the fact pattern described in the first section, it is not necessary for W-2 wages to be allocable to the DPGR of the power production entities in order for the W-2 wages to be properly allocable to DPGR. They simply must be W-2 wages of the taxpayer -- namely, the owner of the pass-through entity -- and allocable to the DPGR of that taxpayer. Further, since the power production entities are deducting payments for the very same services that give rise to the wages of the employer entity, they are clearly allocable to DPGR, even if the production entity itself is not the employer.

We believe that, in order to assist in enforcement efforts, the regulations should further provide rules requiring the employer entity to substantiate that the wages it pays are "properly allocable" to DPGR of another entity. This could be accomplished in a number of ways. Where wages and benefits are paid directly out of the power generation entity's O&M account, the power generation entity could certify the amount of W-2 wages paid out to the employer entity, and the percentage of those payments that were deducted in arriving at qualified production activities income (QPAI). Where the power generation entity makes intercompany payments to the employer entity, the employer entity could be required to obtain a certification from the power production entity that sets forth the amount of the inter-company payments made and the percentage of those payments that were deducted in arriving at QPAI. An allocable percentage of the wages paid by the employer entity would then be treated as properly allocable to DPGR.

In addition to being consistent with the language of the statute, this interpretation is entirely consistent with the policy objectives of TIPRA. Pre-TIPRA, the source of wages was not relevant, except that in the case of wages from a pass-through entity, the pass-through entity itself also had to have sufficient QPAI. In eliminating the requirement that the pass-through entity itself has to have sufficient QPAI, and considering that Congress decided to require the section 199 deduction to be applied at the owner level of a pass-through entity, wages should be allocable to DPGR as long as the owner includes in its taxable income DPGR (either generated itself or as a distributive share of another pass-through entity), and deducts from its taxable income wages paid to employees (either its own or those employed by a pass-through entity it owns) whose services created that DPGR.

Owners of Pass-through Entities may Include All Wages Allocated from a Pass-through Entity in Calculating QPAI

For tax years beginning on or before May 17, 2006, the amount of W-2 wages allocable to a partner or a shareholder of a pass-through entity, is limited to two times the QPAI that was allocated to that person for the tax year ("two times QPAI" limitation).

TIPRA repeals the two times QPAI limitation on W-2 wages allocable to partners or shareholders. For purposes of the W-2 wages limitation, a shareholder, partner, or similar person that is allocated components of qualified production activities income from a pass-through entity is treated as being allocated W-2 wages from the entity in an amount determined under regulations prescribed by the Secretary -- even if this amount is more than twice the applicable percentage of QPAI allocated to that person for the tax year.

The statute and associated legislative history are not entirely clear regarding whether a taxpayer, in determining whether wages are "allocable to DPGR" must allocate wages to the same DPGR that gave rise to the QPAI that is tested against the limit. We request that the regulations make clear that the statute provides no such limitation. Based on information statements from Treasury, we understand that there will be no such limitation on the use of wages. We ask that similar rules apply in the case of an EAG.

We look forward to discussing these issues with you further at a time of your convenience.

² Unless otherwise noted, all section references are to the Internal Revenue Code of 1986. as amended (the "Code").

³ We note that, although structured somewhat differently, the wind energy industry has a similar fact pattern. In the wind energy industry, workers who are engaged in operating and maintaining the wind energy facility typically are not paid by the entity that owns the wind energy facility. The entity that owns the wind energy facility typically enters into an operations and maintenance agreement with the employer entity, and the employer entity is the common law employer of the workers.

⁴ Pub. L. No. 109-222, at sec. 514.

⁵ H.R. Rep. No. 109-455, at 306-07.