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June 2005 "Manufacturer" redefined by new tax law Unlike the ETI deduction, the new break for manufacturing companies is not limited to exporters, and it stands to benefit a broad variety of industries not normally associated with manufacturing Four years ago, the World Trade Organization banned the ETI – or “extraterritorial income” – tax deduction for U.S. exporters and began to levy high fines on the affected businesses. Coming to their rescue, Congress included in the American Jobs Creation Act of 2004 (AJCA) a repeal, over a four-year period, of the ETI (which itself replaced the repealed FSC benefit) and the creation of a phased-in deduction for manufacturers. The new deduction is not limited to exporters; it applies to all manufacturing that occurs in the United States. Further, it represents a special 3% deduction for years beginning in 2005. (The deduction is phased in as follows: 3% for 2005-2006, 6% for 2007-2009, and 9% for 2010.) “Manufacturing” is defined very broadly (explained below), and, during the phase-out of ETI, companies qualifying for both the ETI and manufacturers’ deduction will benefit from both items. Contrast with ETI. The manufacturers’ deduction differs from the ETI in two significant ways: the scope of the new deduction is not limited to exporters, and the definition of “manufacturer” has been broadened liberally. Not limited to exporters. Unlike the previous law, which provided up to a 30% tax break on foreign sale and lease income to U.S. companies, the manufacturers’ deduction applies to all gross receipts on qualified production – not just income from export sales. Enterprises with no foreign sales will still benefit from this provision. “Manufacturer” defined. The key difference is how broadly the new law defines eligible manufacturing activities. Industries that should take a closer look at how they might benefit from the tax break include:
The biggest winners during this transition period are companies that can take advantage of the new manufacturers’ deduction while still receiving partial ETI benefits. For example, a manufacturer that produces in the U.S. – but receives a significant share of its income from overseas sales – would most likely qualify for both benefits. Recent guidance. The Treasury Department has issued its first round of guidance on the manufacturers’ deduction. Key areas that received clarification include the following. Contract manufacturing. In a situation where one business contracts with another to manufacture its products, the deduction cannot apply to both parties. Instead, it can be used only by the business with the “benefits and burdens” of owning the property during the actual manufacturing process. The rules do, however, allow both general contractors and subcontractors to claim the deduction from the same activity and construction project. Qualified production. A safe harbor rule allows businesses to take the deduction if qualified domestic production costs – in labor and overhead – total more than 20% of the finished product’s cost. Computer software. Income from software sales, licensing, or leasing will qualify for the deduction, regardless of whether the product was sold in a store or downloaded from the Internet. Additionally, the sale of machine-readable coding for video games and other programs, regardless of whether the program was designed to operate on a computer, is eligible. Business interruption insurance. Proceeds from business interruption insurance can qualify for the deduction when the proceeds replace qualified gross receipts a business otherwise would have earned. Food and beverage production. If a business prepares food and beverages for both wholesale and retail sale, the wholesale gross receipts would qualify for the deduction. Based in Mesa, Arizona, and serving closely held businesses in the East Valley, the Phoenix area and throughout Arizona, Schmidt Westergard & Company, PLLC, is an independent full-service tax, audit, accounting and business advisory firm focusing on the middle market. |