KPMG Suggests Alternative for Wage Calculation Under Production Deduction Limitation

Dear Eric:

This letter follows up on our prior correspondence of September 29, 2006 (see September letter attached).

Our September letter concerned the wages limitation under section 199¹ as modified by the Tax Increase Prevention and Reconciliation Act of 2005 (TIPRA). Specifically, we requested 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 and the wages are properly taken as a deduction on the taxpayer's return (whether directly, or by reason of reporting qualified production activities income from a pass-through entity in which the taxpayer has an ownership interest). As we stated at the meeting, such an interpretation is supported by the explicit language of section 199(d)(1)(A), which provides that the application of the rules in section 199 is to be made at the partner or shareholder level in the case of a partnership or S corporation. There is no potential for abuse or overextended application of section 199 under this interpretation because the treatment of wages as allocable to qualifying activities would be conditioned on the wages and the qualifying income being reported on the same tax return of any owners.

Our prior letter was sent on behalf of members of the power and utility industry that operate outside the context of a consolidated or expanded affiliated group, mainly by employing a pass-through entity structure. The legal entities that are engaged in power generation typically enter into an operations and maintenance ("O&M") agreement with a related "employer entity" that provides O&M services. The "employer entity" is the common-law employer of the employees engaged in power production activities. The "employer entity" maintains employee benefit plans, pays employment taxes, and withholds income and employment taxes. Although the employees are employed by the "employer entity," these employees are, in fact, engaged in providing services in connection with a qualifying activity -- namely, the production of electricity. If the taxpayers in this situation are unable to apply the statute in the manner we recommend, they will be precluded from claiming a section 199 deduction, while other power and utility companies that operate in the corporate group form will enjoy the benefits of section 199.

In our prior letter we suggested that it is not necessary for W-2 wages to be paid by the power production entities in order for those wages to be properly allocable to DPGR. They simply must be W-2 wages allocated to the same taxpayer that is reporting qualified production activities income on the taxpayers tax return -- namely, the owner of the pass-through entity.

Since our September letter, we have been thinking about other alternatives that would solve the problem of the power and utility industry.

One alternative approach would be to extend the "activity attribution" rule to pass-through entities.

Currently, the "activity attribution" rule is available to: (i) members of an expanded affiliated group (EAG), (ii) EAG partnerships (as defined in the regulations), and (iii) certain in-kind partnerships (as defined in the regulations) (collectively, Eligible Groups). Broadly speaking, the "activity attribution" rule provides that the manufacturing or production activities of any member of the Eligible Group can be attributed to any other member of the Eligible Group whose revenue generating activities on a stand-alone basis would not qualify but would qualify if they were actually performed by the entity with qualifying activities. Therefore, even if an entity that is a member of an Eligible Group is not itself engaged in a qualifying production activity, it is treated as engaged in a qualifying production activity in determining whether the entity has realized DPGR and allocable deductions.

On behalf of our clients, and as an equally viable alternative to the interpretation we initially suggested, we recommend a limited extension of the "activity attribution" rule to pass-through entities with respect to revenue attributable to services performed by employees of an owner or pass-through entity if such revenue is taken into account as an item of income on a tax return in which the qualifying production activities income attributable to those services is also reported.

The limited expansion of the activity attribution rule described above would result in the recharacterization of non-DPGR to DPGR if the activities giving rise to the employee wages contribute to generating DPGR that is reported on the same tax return as the wage deduction. Thus, under our facts, the "employer entity" would be treated as engaged in a qualifying production activity to the extent of the eligible wages and gross receipts received by or attributed to the "employer entity." As a result of this recharacterization, the wages paid or attributed to the "employer entity" would be treated as "properly allocable" to DPGR at the employer entity level under the existing regulations.

The application of the proposed activity attribution rule is illustrated by the following example:

Power production partnership A, owned equally by C, D, E and F, pays or incurs $ 100 to partnership B, owned equally by C, D, G and H. B pays or incurs W-2 wages of $80 to its employees who provide services to A in the generation of power by A. B does not generate revenue from the sale of power. Because A is engaged in the sale of the power it produced, the $100 amount paid or incurred by A is a payment for services performed by employees of B whose services generate DPGR to A. The amount of the $100 that constitutes DPGR to A is determined in accordance with the direct proportion of common ownership between A and B. Accordingly, because only C and D will report DPGR from A as a component of their taxable income, and because they own at least the same percentage in A as they do in B, C and D may treat their 25% share of the $100 paid or incurred by A as derived from DPGR and the corresponding 25% share of the $80 wages paid or attributed to B as allocable to such DPGR.

The interpretation described above would permit members of the power and utility industry who are engaged in the production of electricity in partnership form to claim a section 199 deduction where wages are paid by an entity related to that which produces power.

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