by Keith Martin, in Washington

The Internal Revenue Service answered questions in late January about a new law that will let companies pay taxes at a lower rate on income from “manufacturing” in the United States.

US power companies would be well advised to pay close attention to how “tolling agreements” are drafted.

Generating electricity is considered “manufacturing,” but not if the power plant supplies electricity under a tolling agreement where a fuel supplier pays to have his gas converted into electricity. The IRS said it would look at the underlying substance of the arrangement. The issue is whether the power plant is selling electricity or merely providing services. Only income from electricity sales qualifies potentially for the reduced income tax rate. The provision of services is not considered “manufacturing.”

Income from manufacturing in the United States will be taxed starting this year at a lower rate. The rate reduction is as much as 3.15%, but it phases in. Even a reduction of 1% can be worth millions of dollars to US utilities and other energy companies.

Background

Congress reduced US income taxes on domestic manufacturing income in a so-called JOBS bill that President Bush signed into law on October 22.

The United States was under orders from the World Trade Organization to repeal a tax break for companies that export US-made products. The export tax relief was worth $50 billion to US industry. Congress decided to give an equivalent amount of tax relief to US manufacturers. Defining what qualifies as US manufacturing is a challenge. The IRS made an initial stab at it in late January in “interim guidance,” but asked for comments on its approach by the end of March. The guidance is in Notice 2005-14.

Congress did not actually prescribe a lower tax rate, but rather let companies deduct — or avoid paying tax on — as much as 9% of their domestic manufacturing income. With the corporate tax rate at 35%, this equates to a 3.15% reduction in tax rate.

The deduction is phased in. Only 3% of domestic manufacturing income may be deducted in tax years beginning in 2005 or 2006. The figure is 6% in 2007, 2008 and 2009. The full 9% deduction takes effect in 2010. Thus, any company with a November 30 tax year would not get any benefit from the deduction until its tax year that starts December 1, 2005.

The amount of deduction a company is allowed each year is capped. The limit is 50% of wages reported on Form W-2 for the year for its employees. The IRS said there is no single box on the W-2 form that will tell a company its wages for this purpose and suggested three ways it can derive the information. Companies taking on more employees during the year through acquisitions of new business divisions will not be able to count the wages paid during the year by the company that sold it the division.

“Manufacturing”

Domestic manufacturing income is broadly defined. The Senate floor manager of the JOBS bill, Senator Charles Grassley (R.-Iowa), grumbled at one point that every industry with a Republican lobbyist managed to have its activities defined as “manufacturing.”

Qualifying income includes gross receipts from the “lease, rental, license, sale, exchange, or other disposition” of “tangible personal property,” computer software, sound recordings and films (but not those with explicit sex scenes) “manufactured, produced, grown, or extracted by the taxpayer in whole or in significant part within the United States.”

Companies producing electricity, natural gas or potable water in the United States are considered engaged in manufacturing.

In cases where a company owns a power plant, but hires a contract operator to run it, the power plant owner is ordinarily entitled to deduct part of its receipts from electricity sales on grounds that they are domestic manufacturing income. The contract operator cannot do so with his fees because he is providing services. However, the IRS said it would look at who has the “burdens and benefits of ownership” of the electricity, and only one party on “contract manufacturing” arrangements is entitled to the deduction. It is possible that some contracts might unwittingly shift the deduction to the operator.

Tolling agreements are a bigger issue. The classic tolling agreement is where a farmer pays a mill a fee to grind his wheat into flour. Tolling agreements in the power industry have a fuel supplier paying a power plant owner — at least in form — a fee to convert the fuel into electricity. However, many such contracts are power sales agreements rather than tolling agreements in substance. The distinction in particular deals will determine which party — the power plant owner or the fuel supplier — can claim the deduction. The IRS will not let both do so.

Companies that produce natural gas are engaged in manufacturing. Manufacturing continues through the point of processing to put the gas in a pipeline. However, the IRS said that landfill gas is not “natural” gas because it is not gas from a natural deposit. Therefore, landfill gas companies will not get the benefit of the lower tax rate.

Gas pipeline companies, local gas distribution companies and electric utilities with transmission or distribution lines are not engaged manufacturing, unless they also produce gas or generate electricity. Companies that do both must allocate not only their receipts, but also their expenses between the activities that qualify as manufacturing and those that do not. The IRS declined to specify how companies should allocate receipts. It said it has “not identified a single method that would be appropriate for all taxpayers,” and simply directed that the method used should be “reasonable.” The method is more likely to be reasonable if it is used for other business purposes and not strictly for taxes and the company uses it consistently from year to year. Receipts must be allocated item by item, meaning, for example, for each electricity or gas sale. In general, the IRS wants accuracy, but suggested companies — particularly smaller companies — could take into account the cost of tracking data and use another method where item-by-item accounting is prohibitively expensive.

If more than 95% of the gross receipts in a year come from domestic manufacturing, then the company does not have to bother with an allocation. Its entire income qualifies.

Construction contractors also qualify as “manufacturers.” However, engineering and architectural services qualify as manufacturing only if they relate to “real property, inherently permanent structures other than tangible property in the nature of machinery, inherently permanent land improvements, and infrastructure.” Since most power plants are considered almost entirely machinery, work done on the “E” portion of an EPC contract — an engineering, procurement and construction contract — for a power plant would not qualify. “Infrastructure” is defined as “roads, power lines, water systems, railroad spurs, communications facilities, sewers, sidewalks, cable, and wiring” and “inherently permanent oil and gas platforms.”

The actual construction work should qualify whether or not the project is real property.

To get to manufacturing income that is taxed at the lower rate, a company must reduce its gross receipts from domestic manufacturing by related expenses, including depreciation on the assets used in manufacturing. Thus, for example, power plant depreciation will offset income that is taxed at a lower rate in the future. Companies running pro formas on power deals should take this into account in their projections.

A company that is carrying forward net operating losses does not have to reduce its domestic manufacturing income by them when it eventually uses the NOL deductions.

Many project finance deals are conducted through partnerships (or limited liability companies treated as partnerships). The IRS said that each partner should calculate separately its domestic manufacturing income that is taxed at the lower rate. The Form K-1 that partnerships give partners to tell them their shares of partnership items will get longer in the future as partnerships will have to let each partner know his share of W-2 wages paid by the partnership so that the partner can calculate his wage cap. Each partner will also be allocated a share of gross receipts from domestic manufacturing and related expenses so that he can do his own calculations.

Sale of a partnership interest does not produce domestic manufacturing income, even if the partnership is engaged solely in that activity, with one exception. The exception is US tax laws treat the partner as having sold a share of any “hot assets” in the partnership directly. Gain from the sale of hot assets is potentially domestic manufacturing income. Examples of hot assets are receivables or gain that is attributable to tax depreciation claimed earlier on the partnership assets.

Expanded Groups

One potentially significant new rule — and potentially a source of enormous complication from a business perspective — is all corporations that are part of an “expanded affiliated group” — must compute the total domestic manufacturing income of the expanded group and then allocate it among the group members. Expanded group means not only companies that join in filing a consolidated US income tax return, but also other companies that are owned at least 50% by vote and value by a common parent company.

Once the domestic manufacturing income of the expanded group is calculated, it is then allocated among the group members in the same ratio as they contributed domestic manufacturing income to the group calculation. Suppose a group has three corporations in it. Two have domestic manufacturing income for the year and the third has a domestic manufacturing loss. The loss reduces the group’s total domestic manufacturing income. That total is then allocated to the two group members who contributed positive income in the ratio of their positive incomes. At the end of the day, less of their income will qualify for the lower tax rate than if they did the calculations separately.

Whether a company is part of an expanded affiliated group must be checked on a daily basis and the calculations must take into account its income or loss for the portion of the year it was part of the group.

Only manufacturing done in the United States is rewarded. “United States” in this context means just the 50 states and the 200 miles out to sea that the US considers territorial waters. Activity in Puerto Rico or other US territories and possessions does not qualify for the tax break.

The tax deductions can be claimed by companies that pay “alternative minimum taxes.” The United States has essentially two corporate income tax systems. A company must compute its taxes at a 35% rate and then compute what the taxes would be at a 20% rate but on a broader income base and pay essentially whichever amount is greater.

Keith Martin