Loss on purchased production equipment did not reduce QPAI

Plain-English summary

Chief Counsel considered a taxpayer that bought equipment, used it solely to produce qualifying production property, and later sold it for less than its adjusted basis. The equipment's depreciation had been capitalized into products whose sales generated domestic production gross receipts. The later equipment sale itself produced non-domestic production gross receipts because the taxpayer had not manufactured the equipment. Treasury Regulation § 1.199-4 treated the equipment's adjusted basis as cost of goods sold specifically allocable to those non-DPGR sale proceeds. As a result, the loss on the equipment sale did not reduce qualified production activities income for the former section 199 deduction.

Ruling snapshot

• Question: Did the loss on purchased production equipment reduce the taxpayer's qualified production activities income?
• Outcome: Advice given.
• Key authorities: IRC §§ 199 and 1221; Treas. Reg. §§ 1.199-3 and 1.199-4.

Full text (IRS public release)

       Office of Chief Counsel
       Internal Revenue Service
       Memorandum
       Number: 201642033
       Release Date: 10/14/2016
       CC:INTL:B03:RLChewning
       POSTN-126657-16

UILC: 199.04-01

date: September 14, 2016

 to:   Terri L. Onorato (CC:LB&I:CTM:SD)
       (Large Business & International)

from: Richard L. Chewning
Senior Counsel, Branch 3
Office of Associate Chief Counsel (International)

subject: Treatment under section 199 of loss on sale of purchased equipment used to produce
QPP

       This Chief Counsel Advice responds to your request for assistance. This advice may
       not be used or cited as precedent.

       ISSUE

       Whether a loss on the sale of Equipment A purchased by a taxpayer to produce
       qualifying production property (QPP) reduces the taxpayer’s qualified production
       activities income (QPAI)?

       CONCLUSION

       Under Treas. Reg. §1.199-4(b)(1), the adjusted basis of purchased equipment used to
       produce qualifying production property is considered cost of goods sold (CGS) when
       that equipment is sold. Under the facts and circumstances, that CGS will be allocated
       solely to the taxpayer’s non-domestic production gross receipts (non-DPGR) received
       on the sale of Equipment A and therefore the loss will not reduce the taxpayer’s QPAI.

       FACTS

       Taxpayer purchased Equipment A in Year 1 and solely used Equipment A for three
       years to produce QPP, the sales of which generated DPGR. Depreciation of the cost of
       Equipment A was properly capitalized to the QPP. In Year 3, taxpayer sold Equipment
       A for a sales price that was less than the adjusted basis of Equipment A at the time of

POSTN-126657-16 2

the sale. The gross receipts from the sale of Equipment A did not generate DPGR
because Equipment A was not manufactured, produced, grown, or extracted (MPGE) by
the taxpayer.

LAW AND ANALYSIS

The section 199 domestic production activities deduction (DPAD) is equal to the lesser
of a taxpayer's QPAI or taxable income (determined without regard to the section 199
deduction) multiplied by the applicable percentage. Section 199(a)(1). The applicable
percentage for current years is 9%.

Section 199(c)(1) defines QPAI as an amount equal to the excess, if any, of the
taxpayer’s DPGR for the taxable year over the sum of the CGS and the other expenses,
losses, or deductions (other than the deduction allowed under section 199) that are
properly allocable to such DPGR.

Section 199(c)(4)(A)(i)(I) defines DPGR, in part, as the gross receipts of the taxpayer
that are derived from any lease, rental, license, sale, exchange, or other disposition of
QPP which was MPGE by the taxpayer in whole or significant part within the United
States.

Section 1.199-3(c) provides the definition of gross receipts for purposes of determining
the gross receipts to characterize as DPGR or non-DPGR. In relevant part, Treas. Reg.
§1.199-3(c) provides that gross receipts for this purpose are not reduced by CGS or by
the cost of property sold if such property is described in section 1221(a)(1) (i.e.,
inventory property) or (a)(2) (i.e., depreciable property used in a trade or business).

In calculating QPAI, DPGR is reduced by CGS and the related other expenses, losses,
and deductions. In determining CGS allocable to DPGR for purposes of section
199(c)(1)(B)(i), Treas. Reg. §1.199-4(b)(2) provides that a taxpayer must use a
reasonable method based on all the facts and circumstances to allocate CGS between
DPGR and non-DPGR. In addition, that regulation section provides that “if a taxpayer
has information readily available 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….” Further, Treas. Reg. §1.199-4(b)(1) provides, in part, that “[i]n
the case of a sale, exchange, or other disposition … of non-inventory property, CGS for
purposes of this section includes the adjusted basis of the property.”

Prior to its sale, Equipment A was used exclusively to produce QPP, the sales of which
generated DPGR. Depreciation of the cost of Equipment A was properly capitalized to
the QPP. The taxpayer then allocated its CGS between DPGR and non-DPGR in
accordance with Treas. Reg. §1.199-4(b)(2) (e.g., if 100% of the gross receipts
recognized by taxpayer in a particular year qualified as DPGR, taxpayer should have
allocated all of its CGS to DPGR in that year). Taxpayer’s gross receipts from the sale
of Equipment A, however, are non-DPGR, because Equipment A is not QPP that was
POSTN-126657-16 3

MPGE by the taxpayer, even though it was used to produce QPP and the gross receipts
from sales of that QPP were DPGR.

Taxpayer should have information readily available to it to specifically identify
Equipment A’s adjusted basis, which under Treas. Reg. §1.199-4(b)(1) is treated as
CGS, allocable to non-DPGR received by taxpayer on the sale of Equipment A.
Accordingly, the adjusted basis of Equipment A will not reduce taxpayer’s DPGR and its
QPAI.1

Please call (202) 317-4912 if you have any further questions.

cc:
Tatiana Belenkaya (CC:LB&I)
Internal Revenue Service
K suite 2100
1111 Constitution Avenue NW
Washington, DC 20224-0002

1
Because Treas. Reg. §1.199-4(b)(1) applies in this case, paragraph (c) and (d) of Treas. Reg. §1.199-
4(c) regarding the allocation and apportionment of the taxpayer’s other expenses, losses, and deductions
to the taxpayer’s gross income attributable to its DPGR are not applicable.