Trump and Congress Have Two Tax Paths to Increase US Production

President-elect Donald Trump has pledged to reduce the corporate income tax rate from 21% to 15% for corporations that “produce” in the US. There are multiple ways that Congress can legislate this, but only two would increase domestic production—and neither one is an across-the-board reduction for all corporations.

The first is to restore Section 199 of the tax code, which allowed a tax deduction for income attributable to domestic production activities. It was enacted in 2004 in response to the repeal of another tax code provision that the World Trade Organization had struck down as an illegal export subsidy. But it was repealed in the 2017 Tax Cuts and Jobs Act.

Section 199 permitted companies to deduct up to 9% of the lesser taxable income from income capped at 50% of W-2 wages paid, or from qualified production activity income. The latter, known as QPAI, came from manufacturing, producing, growing, or extracting property in the US.

Qualifying production property included tangible personal property, any computer software, certain films, and sound recordings. Section 199 generally didn’t allow a tax deduction for services, although architectural and engineering services qualified, as did domestic construction.

The mechanics of allocating costs to calculate QPAI were complex. The IRS and taxpayers clashed over several issues, including contract manufacturing, what qualified as receipts from the disposition of computer software, whether an electronic book available online for download is computer software, and the scope and definition of qualified film.

If Congress and the Trump administration resurrect Section 199, it will require surgery before it can be plugged back into the federal tax code to avoid prior disputes. In addition to the disputes described above, Congress should review Section 199 cases and related Treasury regulations to reduce and resolve future disputes. For example, Congress should consider broadening and clarifying the definition of software in light of litigation and technological developments.

The wage limitation, for example, makes no sense in an increasingly digital and automated world. Also, Section 199 cherry-picks services that qualify for the deduction, so Congress should consider whether to expand section 199 beyond engineers and architects.

The second way to increase domestic production through a corporate income tax reduction is to overhaul the foreign derived intangible income rules to apply to routine returns, or the non-intangible property return.

In Section 250 of the tax code, FDII is the carrot to the global intangible low-taxed income system. It offers a lower tax rate on the deemed intangible return from the sale of goods for foreign use and for services provided to people or property outside the US.

It accomplishes this by allowing a deduction on eligible income exceeding 10% of a qualified business asset investment (effectively plant, property, and equipment). Through 2025, the deduction is 37.5%, which is designed to achieve a corporate income tax rate of 13.125% on qualifying income.

FDII rewards producers and service providers who have deemed intangibles, or qualifying foreign use revenue that exceeds 10% of qualified business asset investment. But not all tangible personal property has a high intellectual property component. If Congress uses FDII to reduce the corporate rate for producers, it will need to eliminate the qualified business asset investment requirement to expand the deduction to all producers.

Most of the FDII audit activity has yet to enter litigation, and the OECD Forum on Harmful Tax Practices hasn’t announced whether FDII is a harmful tax practice that needs to be withdrawn. However, in the latest update from the FHTP, the United States committed to withdraw FDII.

Section 199 and FDII are designed to achieve different results. The former is a domestic production subsidy that ignores the ultimate place of use of the property. By capping the benefit to 50% of W-2 wages paid, it’s ultimately a jobs creation provision.

In contrast, FDII supports the repatriation of intellectual property and export of goods and services. It has been an incredibly effective tool for onshoring and retaining intellectual property. If Congress pursues Section 199, it will need to reconcile its interaction with FDII and determine the best way to encourage US production.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Joshua D. Odintz is partner at Holland & Knight in Washington D.C. focusing on tax policy, tax controversy, and tax planning.

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