Company Submits Recommendations on Manufacturing Deduction Guidance

VIA Electronic Mail: Notice.comments@irscounsel.treas.gov

CH2M HILL appreciates the opportunity to comment on Notice 2005-14 (the "Notice") pursuant to the invitation for comments under the Notice. We commend the Treasury Department (Treasury) and the Internal Revenue Service (the "Service") in expeditiously releasing interim guidance with respect to new section 199 of the Internal Revenue Code (the "Code").¹

Sections 199(c)(4)(A)(ii) and (iii) deal exclusively with construction and engineering and architectural services related to construction. It is our belief that the interim guidance with respect to sections 199(c)(4)(A)(ii) and (iii) is not consistent with the legislative intent and prior statutory language and decisions on the referenced subjects. The use and meaning of construction anti engineering and architectural services in the Code has existed for many years generating significant rulings, notices, and decisions which provide clear definitions and meaning for such terms. However, the interim guidance provides confusing definitional terms with respect to construction and seeks to include new restrictive language that is inconsistent with the statutory history of such terms and is without any such indication of legislative intent.

Finally, the guidance appears to be providing for a strict determination/substantiation requirement with respect to benefits available under sections 199(c)(4)(A)(ii) and (iii) which will render it nearly impossible for many taxpayers to realize the intended benefits without an undue record-keeping burden.

1. NOTICE INTERPRETATION OF IRC SECTION 199(c)(4)(A)(ii)

CH2M HILL believes that the proper resolution to clear guidance is to base such guidance on established regulations that is consistent with the legislative intent. The Code and regulations already provide for the definition of "real property" in the context of constructions projects under section 460 and interest capitalization rules under section 263A. In fact, the guidance does correctly reference the regulations under section 263A as noted above. We believe that reliance on the regulations under section 263A as well as the established rules under section 460 will provide the clear guidance and standard as required. Below is a discussion of established Code and regulation which we believe should be adopted as defining provisions for purposes of section 199(c)(4)(A)(ii).

On the subject of "construction activities" by way of additional background, the Conference Report states only, at footnote 26, "construction activities include activities that are directly related to the erection or substantial renovation of residential and commercial building and infrastructure. Substantial renovation would include structural improvements, but not mere cosmetic changes, such as painting.

Likewise, the language under the section 460 regulations is similar to the language used in the Conference Report when defining "construction activities". For example, footnote 26 of the Conference Report defines "construction activities" to include "activities that directly relate to the erection or substantial renovation of residential and commercial buildings and infrastructure." Again, this is similar to the requirements under the section 460 regulations.

Also, it is important to note that the section 460 regulation looks to the regulations under section 263A for definition as does the guidance under the Notice regarding the 95% de minimis test for construction projects as stated above.

Inherently permanent structures is further defined in Treas. Reg. section 1.263A-8(c)(3) to include

Additionally, Treas. Reg. Section 1.263A-8(c)(4) defines the term "machinery" in relation to "inherently permanent structure" as:

Thus, the statutory language and regulations thereunder in defining "real property" are similar to the Notice's and are consistent with the Conference Report and legislative intent.

2. NOTICE INTERPRETATION OF IRC SECTION 199(c)(4)(A)(iii)

CH2M HILL believes that the restriction to real property under the Notice is not warranted by section 199's legislative history and intent or by its history in statutory provision. Additionally, we believe leaving such language would be extremely burdensome to both taxpayers and the Service in conducting audits since the Service and taxpayers would now have to separate engineering and architectural services that relate to real property versus personal property.

Specifically, the Notice, section 4.04(12)(a), (emphasis added) defines "Engineering and Architectural services" as

Under section 924(a)(4), (emphasis added), FSC rules, the definition of the term "foreign trading gross receipts" means:

The Conference Report at footnote 26 in defining domestic production gross receipts relative to "construction activities" states "for this purpose, construction activities include activities that are directly related to the erection or substantial renovation of residential and commercial building and infrastructure."

Thus, none of the Committee Reports or the Conference Report restricts "construction projects" solely to real property in defining engineering or architectural services. Additionally, if there is any intention of borrowing the definition of "construction project" from the definition of "construction activities" under section 199(c)(4)(A)(ii) in determining DPGR from such activities, there is still no interjection of "real property" in legislative history or need for additional interjection.

Thus, we believe that Congress' intention was to continue and not to narrow the deduction for engineering and architectural services that it previously allowed for such services relating to foreign construction projects. The House Ways and Means Committee Report states:

Similarly the Senate Finance Committee states:

We believe that it is Congress' intention to keep the language already established under statute (i.e., sections 924, 993, and 942). If this were not true, then Congress would have put the public on notice.

The Notice does provide for a de minimis exception¹⁰ with respect to allowing total gross receipts to be derived from engineering and architectural services (i.e., treated as DPGR) if such receipts represent less than 5 percent for services performed outside the United States or relate to property "other than real property". However, this rule does not preclude a taxpayer from testing receipts associated with "real property" and "other than real property". Again, current systems would need to be developed to capture whether receipts relate to "real property" or "other than real property". In fact, the de minimis rule will only expand the burden for the Service and taxpayers inasmuch as additional records will need to analyzed and kept for substantiation purposes.

3. USE OF STATISTICAL SAMPLING

Additionally, the inclusion of "and the taxpayer providing these services must be able to substantiate that the services relate to a construction project within the United States" in Notice, section 4.04(12)(a) is not required; as the rules for such determination/substantiation are included in Notice, section 4.03(2). The inclusion of such statement suggest that there is an increased burden of substantiation with respect to the benefits available under section 199(c)(4)(A)(iii) only. The statement "and the taxpayer providing these services must be able to substantiate that the services relate to a construction project within the United States" should be removed and should not be included in regulations as finally promulgated.

Revenue Procedure 2004-34¹² allows taxpayers to use certain other methods, including a statistical basis (if adequate data is available to the taxpayer), when determining recognition of advance payments to the extent a payment is earned in the taxable year of receipt. This provision is similar to Revenue Procedure 2004-34's predecessor Revenue Procedure 71-21.¹³ Section 5.023(3)(b) was added to Revenue Procedure 2004-34 allowing the use of statistical sampling upon the Services' recognition that some taxpayers do not have an applicable financial statement and because some taxpayers are unable to trace the recognition of individual advance payments in their applicable financial statements.¹⁴

Revenue Procedure 81-70¹⁵ set forth guidelines for estimating the basis of stock acquired by an acquiring corporation in a B reorganization. Under the revenue procedure, the use of statistical sampling is permitted in estimating the basis of stock acquired. The revenue procedure recognized that in certain cases it may be time consuming, burdensome and costly for the acquiring corporation to contact each former shareholder of the acquired corporation.¹⁶

Thus, the Service has allowed the use of statistical sampling where the substantiation requirements prove to be rigorous, taxpayer financial records and systems are not suited towards tax compliance, and the efforts would be time consuming and burdensome to the taxpayer.

The application of the determination/substantiation requirements under the Notice "on an item-by-item basis" would require an enormous effort. Further, the determination of whether a particular activity qualifies as DPGR, for example, "on an item-by-item basis" will be an arbitrary determination. Under the rule in the Notice, it is unclear the meaning of "item" and whether the determination/substantiation requirements are to be focused on a project level, task level or sub-task level is also unclear. Thus, the determination/substantiation requirement coupled with the term "item" creates ambiguity on how taxpayers must and will comply with the Notice.

Additionally, the determination/substantiation requirements will in almost every case require CH2M HILL to create, retain, and reproduce for the Service documents that are not currently created in our business. CH2M HILL does not separately identify "on an item-by-item basis" revenues to the detail contemplated by the Notice. To do so would require the purchase (if available) or development of internal systems and processes necessary to gather and retain the information required in the Notice for each and every item generating a deduction under section 199.

Additionally, we believe the use of statistical sampling is a reasonable method for determination as discussed in Notice, section 4.03(2) and should be an acceptable method of determination /substantiation of deductions available under section 199. From a practical perspective, the efforts and costs to create, retain and reproduce for the Service documents that are not currently created in our business in order to determine/substantiate the deduction "on an item-by-item basis" will be enormous. Further, the cost of implementing such systems and process in complying with the determination/substantiation requirements may outweigh the benefit sought.

The Service has recognized the use of statistical sampling in the determination/substantiation of statutory deductions in other areas of tax law, and we respectfully request Treasury and the Service provide for the use of statistical sampling in determining the benefits under section 199 and provide guidance on such use.

CH2M HILL appreciates the opportunity to comment on Notice 2005-14 and commends the Service and Treasury on their efforts to and progress in promulgating regulations. We look forward to any opportunity to work with the Service and Treasury, and offer our assistance in the process.

²See Section 199(c)(4)(A)(ii).

³See Notice, section 4.04(11)(a).

⁴See Treas. Reg. section 1.460-3(a).

⁵ Treas. Reg. section 1.263A-8(c)(1).

⁶ Section 199(c)(4)(A)(iii).

⁷ Notice, section 3.12(a), (Emphasis added.).

⁸ As the FSC, DISC and ETI rules were setup to place disadvantage U.S. companies doing business overseas on even ground with foreign competitors, it is natural that the location requirement "for construction projects" be outside the United States; conversely, section 199 is to provide benefit for domestic activities, thus, the location reversal to "construction projects" within the United States.

⁹See footnote 8.

¹⁰See Notice, section 4.04(12)(d)

¹¹ 2004-20 I.R.B. 918.

¹² 2004-22 I.R.B. 991.

¹³ 1971-2 C.B. 549.

¹⁴See Announcement 2004-48, 2004-22 I.R.B. 998.

¹⁵ 1981-2 C.B. 729.

¹⁶See Notice 2004-44, 2004-28 I.R.B. 32.