On December 20, 2018, the Joint Committee on Taxation (JCT) issued its general explanation or "Bluebook" of the Tax Cuts and Jobs Act (the Act), P.L. 115-97. The Bluebook provides a comprehensive technical description of the Act and identifies several technical corrections needed to the law. While the Bluebook is not intended to serve as reliance guidance, it does shed light on congressional intent and offers clarifying descriptions of provisions that may have been ambiguous in the Act and congressional reports. Specifically, the Bluebook clarifies or otherwise addresses certain provisions under the Act related to Section 451, bonus depreciation, Section 199A, research and development incentives, and other provisions discussed herein.

This Alert provides a detailed overview of significant implications relevant to the provisions addressed; however, the Bluebook should be referenced for comprehensive and precise language offering further insights.

Special rules for tax year of income inclusion

The Act revises the rules associated with the timing of income recognition under the all-events test of Section 451. The new Section 451 statutory provisions substantially modified long-standing revenue recognition rules.

New Section 451(b) requires accrual-basis taxpayers to recognize income at the earlier of when recognized for tax purposes under the historic "all-events test" or when taken into account in applicable financial statements (AFS). This effectively requires tax revenue recognition at the earliest of earned, due, received or recognized for financial statement purposes. Furthermore, new Section 451(c) codifies and modifies the deferral method for advance payments permitted under Revenue Procedure 2004-34 and eliminates multiple-year deferral under Treas. Reg. Section 1.451-5.

For a contract containing multiple performance obligations, Section 451(b)(4) provides that the allocation of the transaction price to each performance obligation equals the amount allocated to each performance obligation for purposes of including such item in revenue in the taxpayer's AFS. The footnotes in the Bluebook indicate that Congress expects that Treasury will provide guidance on whether and how to allocate the transaction price: (1) to performance obligations that are not contractually based (e.g., the provision of free goods or services to a customer or the provision of a customary amount of training or support); (2) for arrangements that include both income subject to Section 451 and long-term contracts subject to Section 460; and (3) when the income-realization event for income tax purposes differs from the income-realization event for financial statement purposes.

Additionally, the Bluebook clarifies several issues related to income recognition under Section 451, which are discussed next in more detail.

Interplay between Section 451(b) and new book revenue recognition rules

During 2018, significant changes were made to the rules governing the recognition of revenue for book and tax purposes. Similarly, ASC 606 and IFRS 15 (the New Standards) significantly changed the way in which revenue is recognized on GAAP and IFRS financial statements. The Financial Accounting Standards Board and the International Accounting Standards Board issued the New Standards, which supersede nearly all existing revenue recognition guidance. The core principle is that a taxpayer must recognize revenue when (or as) it satisfies performance obligations to customers at an amount that reflects the consideration to which the taxpayer expects to be entitled to receive in exchange for such performance obligations. In doing so, taxpayers will likely use more judgment and make more estimates than under former guidance.

The interplay between: (1) Section 451(b)'s requirement to recognize revenue no later than when such revenue is recorded in an AFS and (2) the New Standards' changes in the way revenue is recognized in an AFS creates some uncertainty for taxpayers when computing taxable income.

Cost of goods sold

The New Standards, in the context of manufacturing customized goods, may require an acceleration of revenue as goods are produced, accompanied by an acceleration of the related cost of goods sold (COGS). For example, a transaction involving the manufacture and sale of a customized product may have triggered revenue and COGS recognition simultaneously, under the former book rules, when title passed from the manufacturer to the purchaser using a units-of-delivery method. Under the New Standards, however, it is possible to accelerate the revenue and the COGS to the period over which the goods are produced. While it seems clear that Section 451(b) requires acceleration of the revenue portion in this example transaction, uncertainty exists regarding the proper timing of the COGS deduction (i.e., prior to title transfer).

The Bluebook clarifies this issue by indicating that there is no change in law pertaining to COGS. Accordingly, an amount may not be taken into account in the computation of COGS and, thus reduce total sales, any earlier than the tax year in which economic performance occurs with respect to that amount. Once economic performance occurs, amounts may be taken into account in the computation of COGS when ownership transfers to the customer (if they are not required to be capitalized and are not subject to any other provision of the Internal Revenue Code requiring the deduction to be taken in a tax year later than the year in which economic performance occurs). Thus, it is unlikely that taxpayers will be able to accelerate a COGS deduction to better match revenue with expense or to follow the book reporting of COGS if there has not been a transfer of ownership.

Realization event

Section 61 provides that gross income generally includes all income from whatever source derived (with certain exceptions). Gross income generally includes all items that are clearly realized accessions to wealth. Gross income is clearly realized when an item is sufficiently fixed and definite to be treated as taxable income. Once there is a realization event, Section 451 provides the general timing rule (subject to certain special rules) for the year of inclusion of gross income in taxable income.

Section 451(b)'s requirement to recognize revenue no later than when the revenue is recorded in an AFS caused many taxpayers to question whether this provision requires tax revenue recognition when a realization event did not occur. The Bluebook provides that Section 451(b) does not revise the rules regarding when an item of income is realized for tax purposes and, accordingly, does not require recognition of income when a realization event has not yet occurred. This concept is illustrated in several Bluebook examples.

Performance bonuses — Taxpayers may enter into contracts providing for the receipt of a performance bonus upon the occurrence of certain events. Before the New Standards, such performance bonus revenue may not have been recognized for book purposes until the triggering event (i.e., satisfaction of the material conditions and requirements) occurred. Under the New Standards, however, all or a portion of performance bonus revenue may be recognized before the occurrence of the triggering event.

The Bluebook clarifies the proper application of Section 451(b) to performance bonuses and indicates that the performance bonus is not realized until the year in which the necessary material conditions and requirements for receipt of the performance bonus have been met and the taxpayer has a fixed and definite right to receive the income. Future independent events cannot be assumed to occur for federal income tax purposes even though book treats the events as likely to occur and recognizes income. Accordingly, a performance bonus may not be included in taxable income in accordance with the provisions of the all-events test even though all or a portion of such bonus may be reflected in the taxpayer's AFS before such time.

Contingent commissions — Taxpayers may enter into contracts that entitle the taxpayer to receive a commission upon the occurrence of specified events (e.g., $X upon the initial placement/signing of an insurance policy and $Y upon each subsequent renewal of the policy). Before the New Standards, book revenue may have been recognized upon the occurrence of each specified and subsequent event. Under the New Standards, however, an estimate of total anticipated contract revenue (e.g., the initial placement commission and anticipated subsequent renewal commissions) may be accelerated and recorded for book purposes.

The Bluebook clarifies the application of Section 451(b) in this situation and indicates that the commission revenue is not required to be included in taxable income until a realization event occurs (e.g., upon the signing of the initial policy and thereafter upon the renewal of such policy). Future independent transactions cannot be assumed to occur for federal income tax purposes, even though book treats the events as likely to occur and recognizes income. Accordingly, contingent commission revenue may be included in taxable income in accordance with the provisions of the all-events test, even though estimated future commissions may be reflected in the taxpayer's AFS before such time.

Cost recovery

Bonus depreciation for qualified property

The Act extends the additional first-year depreciation deduction through 2026 (2027 for longer production period property and certain aircraft). The Act allows taxpayers to claim 100% bonus depreciation for qualified property acquired and placed in service after September 27, 2017, and before January 1, 2023 (January 1, 2024, for certain qualified property with a longer production period, as well as certain aircraft). The Act phases down bonus depreciation to 80% for qualified property placed in service before January 1, 2024; 60% for qualified property placed in service before January 1, 2025; 40% for qualified property placed in service before January 1, 2026; and 20% for qualified property placed in service before January 1, 2027 (with an additional year to place in service available for long-production period property and certain aircraft associated with each phase-down percentage). The provision also applies to certain plants planted or grafted after September 27, 2017, and before January 1, 2027, with similar bonus percentages in place.

The Act also expands the definition of qualified property to include certain used property (previously only property that satisfied the original-use requirement qualified for bonus depreciation). Under the used-property rules, property is generally eligible for bonus depreciation if it is the taxpayer's first use of such property (provided that such "used" property is not acquired from a related party or in certain specified transactions — generally those resulting in the acquirer receiving a carryover basis in the used property). Additionally, the Act expands the definition of qualified property to include certain qualified film and television productions, as well as certain qualified theatrical productions.

While the Act generally expands the definition of qualified property (as previously noted), it also specifies that certain property that previously qualified for bonus depreciation under prior law is now excluded from the definition of qualified property. Specifically, qualified property does not include property used by a regulated public utility in the trade or business of the furnishing or sale of: (1) electrical energy, water or sewage disposal services; (2) gas or steam through a local distribution system; or (3) transportation of gas or steam pipeline, if the rates for the furnishing or sale of such services have been established or approved by a state or political subdivision thereof, by an agency or instrumentality of the United States, or by a public service or utility commission or other similar body of any state or political subdivision thereof. Additionally, the Act excludes from the definition of qualified property any property used in a trade or business that has had floor plan financing indebtedness (as defined in paragraph (9) of Section 163(j)), if the floor plan financing interest related to such indebtedness was taken into account in computing the interest limitation under Section 163(j).

These amendments to Section 168(k) apply to property that is both acquired and placed in service after September 27, 2017 (or, for specified plants, those planted or grafted after September 27, 2017). For purposes of the preceding sentence, property shall not be treated as acquired after the date on which a written binding contract is entered for such acquisition.

The Act also repealed the election to accelerate AMT credits in lieu of bonus depreciation under Section 168(k)(4).

The Bluebook provides the following clarifications on bonus depreciation under the Act:

• Utilities that are on a fiscal year and place bonus-eligible property into service in 2018 (but as part of the taxpayer's 2017 fiscal year) may utilize bonus depreciation if the property is otherwise bonus-eligible, but a technical correction may be needed to reflect this intent; this is consistent with the provisions of Prop. Reg. Section 1.168(k)-2.
• A lessor of property to certain utilities that may not utilize bonus depreciation per Section 168(k)(9) may itself utilize bonus depreciation on such property if the property is otherwise bonus-eligible, unless the lessor is in a trade or business that is not eligible to utilize bonus depreciation under Section 168(k)(9).
• A trade or business with floor plan financing indebtedness is not necessarily unable to claim bonus depreciation on otherwise bonus-eligible property under Section 168(k)(9); rather, such trade or business is only ineligible to claim bonus depreciation in years in which floor plan financing interest related to such indebtedness is factored into the deductible interest expense under Section 163(j), and may elect whether to utilize floor plan financing interest as part of its deductible interest expense for a tax year.
• Once floor plan financing interest is included as part of the interest to be deducted by such trade or business, then the trade or business may not utilize bonus depreciation for assets placed in service in such tax year or any proceeding tax years.
• Property constructed by a third party for the taxpayer under a written binding contract is acquired on the date into which a written binding contract to acquire that property is entered (i.e., such property is not considered "self-constructed" property).

Implications

While, as previously noted, the Bluebook is not reliance guidance, it does provide taxpayers with additional items of consideration within the bonus depreciation space pending the release of the final regulations for Section 168(k) and Section 163(j), respectively. Of particular note is the suggestion that: (1) lessors may utilize bonus depreciation on property leased to certain utilities; and (2) trades or businesses with interest related to floor plan financing indebtedness may be able to take bonus depreciation on bonus-eligible property placed in service by such trade or business in certain instances. It is anticipated that both these items, as well as additional items of note described previously, will be addressed within the final regulations issued under Section 168(k) and/or Section 163(j).

Applicable recovery period for real property

The Act eliminates the separate definitions of qualified leasehold improvement property, qualified restaurant property and qualified retail improvement property. Instead, the Act retains a single definition for qualified improvement property, although no recovery period is specified for such property under the Act. The Act also shortens the recovery period for residential rental property under the alternative depreciation system from 40 years to 30 years.

In addition, the Act requires a real property trade or business that elects out of the limitation on the interest deduction under Section 163(j) to use the alternative depreciation system to depreciate any of its nonresidential real property, residential rental property and qualified improvement property.

The Bluebook provides the following additional clarifications:

• The intent of the Act was to give qualified improvement property a 15-year recovery period under the general depreciation system and a 20-year recovery period under the alternative depreciation system, but a technical correction may be needed to give effect to this intent.
• An electing real property trade or business (i.e., a real property trade or business that is electing not to be subject to the interest expense limitations of Section 163(j)) must use the alternative depreciation system for not only non-residential real property, residential rental property and qualified improvement property, but also for qualified leasehold improvement property, qualified retail improvement property and qualified restaurant property, but a technical correction may be needed to reflect this intent
• A change to use of the alternative depreciation system for certain property of an electing real property trade or business (as described in the preceding bullet) is a change in use governed by Treas. Reg. Section 1.168(i)-4.

Implications

The Bluebook provides taxpayers with additional items of consideration for certain real property and certain real property trades or businesses, pending the release of the final regulations for Section 168(k) and Section 163(j). Specifically, the Bluebook suggests, as have congressional leaders and several tax practitioners and working groups, that qualified improvement property is intended to have a 15-year recovery period for general depreciation system purposes; the Bluebook, however, indicates that a technical correction to the Act may be needed to give effect to this intent. In public comments, IRS and Treasury officials have suggested that the Bluebook authors do not believe they may unilaterally provide for such recovery period, absent a technical correction. In addition, the Bluebook suggests that a real property trade or business electing not to be subject to the interest expense limitations of Section 163(j) must use the alternative depreciation system not only for nonresidential real property, residential rental property, and qualified improvement property, but also for qualified leasehold improvement property, qualified retail improvement property, and qualified restaurant property. As currently drafted, however, Section 168(g)(8) does not reference qualified leasehold improvement property, qualified retail improvement property, or qualified restaurant property. In public comments, IRS officials have stated that they do not believe that the alternative depreciation system must be utilized for such property held by an electing real property trade or business.

Section 199A qualified business income deduction

For eligible taxpayers, the Act establishes a new statutory provision, Section 199A, that allows a 20% deduction on certain trade or business income and allows a 20% deduction for certain dividends received from REITs and certain publicly traded partnership income. Section 199A limits the deductible trade or business income based on W-2 wages/depreciable assets used in the trade or business and limits the taxpayer's overall deduction under Section 199A to 20% of the taxpayer's taxable income (excluding net capital gain).

The Bluebook clarifies that the intent of Section 199A was to distinguish labor income from capital income for non-corporate businesses, such that a reduced tax rate could apply to capital income, consistent with the reduction in the corporate tax rate. The Bluebook explains that Section 199A identifies some service businesses that generally give rise to income from labor services (labor income) and generally excludes those business by defining them as "specified service trades or businesses." The Bluebook specifically refers to a trade or business in which the taxpayer works as an independent contractor as being within the category of specified service trades or businesses in which the taxpayer/independent contractor works for various unrelated businesses, holds minimal property, and the principal asset of the independent contractor is the reputation or skill of its owner. For trades or businesses defined by Section 199A as specified service trades or businesses, the Bluebook refers to a "similar list" in Section 448(d)(2(A), and describes the definitions used in the Section 448 regulations. The Bluebook does not indicate, however, that the Section 448 definitions were intended to be adopted for purposes of Section 199A.

For determining whether activities rise to the level of constituting a trade or business (and therefore eligible to generate qualified business income under Section 199A), the judicial standard articulated in Commissioner v. Groetzinger, 480 U.S. 23 (1987) (regular and continuous conduct of the activity and a primary purpose to earn a profit) should be applied for purposes of Section 199A. Additionally, the Bluebook referred to the factors used under Section 446 for determining whether a taxpayer has multiple separate trades of business for purposes of applying Section 199A. The Bluebook states that Section 469 principles are not determinative of a separate and distinct trade or business for purposes of Section 199A.

In an example illustrating when an activity will be treated as a trade or business under Section 199A, the Bluebook concludes that a rental real estate activity constitutes a single trade or business for purposes of Section 199A based on the following facts: the commercial and residential rental activities were accounted for using a single set of books and records, there was "material participation" by the taxpayer, and cost recovery and expense deductions were allowed under Sections 168 and 162.

The Bluebook clarifies that current-year and carryover losses from qualified business income from trades or businesses could not reduce the aggregate qualified business income from trades or businesses below zero, for purposes of determining the combined qualified business income amount. The Bluebook indicated, however, that a technical correction to the statute may be needed to reflect this intent.

The Bluebook clarifies that a taxpayer who is the shareholder of a RIC that holds a REIT or publicly traded partnership (PTP) should be treated as if it received qualified REIT dividends and qualified PTP income directly to the extent the RIC dividends are attributable to such qualifying amounts. The Bluebook does not indicate that a technical or clerical correction was needed for this result. The Bluebook also indicated that Congress intended holding period rules for REIT stock, to avoid manipulation, which may require a technical correction.

Regarding the effective date of Section 199A, the Bluebook indicates that a taxpayer that has a calendar year 2018 tax year can include qualified Section 199A items from a fiscal year pass-through entity that has a tax year beginning in 2017 and ending in 2018.

Implications

Proposed regulations (REG-107892-18; Proposed Regulations) would limit the "reputation or skill" category of specified service trades or business to trades or business in which a person receives income from endorsements, the use of an individual's identity, or personal appearances. The Bluebook's comments related to independent contractors suggest a significantly broader definition.

The Bluebook provides some additional clarity regarding how Congress intended taxpayers to evaluate whether activities constitute a trade or business or how to determine whether activities are separate trades or businesses. The rental real estate example included in the Bluebook states facts making it evident that the activity is a trade or business (primarily, that the taxpayer may deduct cost recovery and expenses under Sections 168 and 162). The Bluebook and the Proposed Regulations are consistent in referring to existing case law and a facts-and-circumstances inquiry into the fundamental questions of whether activities constitute a trade or business under Section 199A and whether a single or multiple separate trades or businesses exist.

The Bluebook confirms expectations that current-year and carryover losses with respect to trade or business qualified business income do not reduce qualified REIT dividends or qualified PTP income for purposes of determining combined qualified business income. Therefore, if a taxpayer has negative trade or business qualified business income, but positive qualified REIT dividends or qualified PTP income, the taxpayer may take a deduction based only on the qualified REIT dividends or qualified PTP income (further, the negative trade or business qualified business income that reduces the positive trade or business qualified business income below zero is carried over to offset any positive trade or business qualified business income generated in the next year). The Bluebook differs from the Proposed Regulations, however, in that the Bluebook notes that negative trade or business qualified business income may not be netted against positive trade or business qualified business income from other qualified trades or businesses before applying the W-2 wage limit or W-2 wage and depreciable assets limit. See Example (9) in Prop. Reg. Section 1.199A-1(d)(4) and Example 6 on page 36 of the Bluebook.

Regarding an individual's treatment of RIC dividends attributable to qualified REIT or qualified PTP income, the Bluebook provides clarity to an area of uncertain congressional intent, providing that qualified income from REITs and PTPs owned indirectly by taxpayers through RICs will be includable in combined qualified business income under Section 199A. The result indicated in the Bluebook is not reflected in the Proposed Regulations; regulations specifically related to RICs and REITs under Section 199A, however, are currently under review (RIN 1545-BP12) at the Office of Management and Budget's Office of Information and Regulatory Affairs (OIRA). To the extent that the regulations under review at OIRA reflect the Bluebook's interpretation, the result will be taxpayer-favorable.

The Bluebook supports the inclusion of a fiscal-year (2017–2018) pass-through entities' Section 199A items in a taxpayer's calendar year (2018) return, which is taxpayer-favorable. The Bluebook's discussion of the interaction between Section 199A and former Section 199 conforms to the statutory effective dates for Section 199A and the repeal of Section 199 (both applicable to tax years beginning after December 31, 2017).

Research and development incentives

Amortization of research or experimental expenditures

The Act requires taxpayers to treat research or experimental expenditures as chargeable to a capital account and amortized over five years (15 years for foreign research). The Act also modifies Section 174 to require all software development costs to be treated as research or experimental expenditures. Any capitalized research or experimental expenditures relating to property that is disposed of, retired or abandoned during the amortization period must continue to be amortized throughout the remainder of the period.

The Bluebook restates the rules provided under the Act, specifically relating to amortization of research or experimental expenditures over five years (15 years in the case of foreign research), the inclusion of software development expenditures in the definition of research or experimental expenditures and the amortization rules for research or experimental expenditures relating to disposed of, retired or abandoned property, effective for amounts paid or incurred in tax years beginning after December 31, 2021.

The Bluebook also references the conforming changes to Sections 41 and 280C, and provides under footnote 686 a brief explanation of how to compute a taxpayer's full or reduced research credit under Sections 41 and 280C. Specifically, the Bluebook provides that, if a taxpayer's research credit under Section 41 for a tax year beginning after 2021 exceeds the amount allowed as an amortization deduction under the provision for such tax year, the amount chargeable to the capital account under the provision for such tax year must be reduced by that excess amount. A taxpayer may alternatively elect to claim a reduced credit amount under Section 41 in lieu of reducing its Section 174 expenditures for the tax year. If such an election is made, the research credit is reduced by an amount equal to that credit multiplied by the highest corporate tax rate.

In addition, the Bluebook explicitly states that the application of Section 174 as provided in the Act is treated as a change in the taxpayer's method of accounting for purposes of Section 481 initiated by the taxpayer and made with the consent of the Secretary. The Bluebook also states that the change applies on a cutoff basis to research or experimental expenditures paid or incurred in tax years beginning after December 31, 2021, so there is no adjustment under Section 481(a) for research or experimental expenditures paid or incurred in tax years beginning before January 1, 2022.

Implications

Taxpayers should prepare to file an automatic accounting method change for their current Section 174 costs, in addition to all software development costs, regardless of whether such Section 174 costs or software development costs are currently being expensed or capitalized under Section 162, 174 or Revenue Procedure 2000-50. Taxpayers should also analyze their current Section 174 costs and future potential Section 174 costs (whether related to software development or not) to determine whether those costs meet the definition of research or experimental expenditures under the Section 174 requirements. Costs not meeting those requirements will not be subject to the new amortization rules under Section 174.

Research credit — Base erosion and anti-abuse tax (BEAT)

The Act did not make substantive changes to Section 41 and the Bluebook does not contain any explanation specifically regarding the research credit.

The Bluebook does contain, however, various examples illustrating the different effects that the research credit has on the calculation of the base erosion minimum tax amount for purposes of computing an applicable taxpayer's BEAT liability. Under BEAT, applicable taxpayers must pay a tax equal to the base erosion minimum tax amount for the tax year, in addition to any other regular tax liability they may have. The base erosion minimum tax amount equals the excess, if any, of 10% of modified taxable income (12.5% for tax years beginning after December 31, 2025) over the amount of regular tax liability reduced (but not below zero) by the sum of a certain amount of Chapter 1 credits, but not the research credit. Under the examples section of Part II.A, the Bluebook provides four examples (specifically, Examples 3-6) of the computation of a base erosion minimum tax amount that involve a research credit.

Implications

The examples demonstrate that a larger research credit will not increase a taxpayer's BEAT liability for tax years beginning before 2026 because it is excluded from the calculation of the base erosion minimum tax amount (unlike certain other Section 38 credits). For tax years beginning after December 31, 2025, however, the amount of regular tax liability is reduced by all Section 38 credits, including the Section 41 credit. A taxpayer's research credit cannot offset its BEAT liability.

Accounting for inventories

In general

The Act exempts businesses from the requirement to maintain inventories if they meet the $25 million average gross receipts test (i.e., annual average gross receipts that do not exceed $25 million for the three prior tax-year periods). The $25 million amount is indexed for inflation for tax years beginning after 2018. The Act allows these businesses to: (1) treat inventories as non-incidental materials and supplies; or (2) follow their financial accounting treatment of inventories.

The Bluebook reiterates that taxpayers meeting the $25 million gross receipts test are not required to account for inventories under Section 471, and rather may use one of the two methods of accounting for inventories identified in the previous paragraph. A taxpayer that fails the $25 million gross receipts test for a tax year is not eligible for the exception from keeping inventories for that tax year.

Additionally, the Bluebook reiterates that the application of this provision is a change in the taxpayer's method of accounting for purposes of Section 481, which is treated as initiated by the taxpayer and made with the consent of the Secretary.

Implications

The Bluebook's explanations are consistent with previous interpretation of the new small-business rules, which allow more taxpayers to be exempt from accounting for inventories under Section 471. Taxpayers that meet the gross receipts test and wish to apply the new small-business rules generally will need to file an accounting method change request to either: (1) account for inventories as non-incidental materials and supplies; or (2) follow their financial accounting treatment of inventories. Generally, such a change is automatic under the procedures issued in Revenue Procedure 2018-40.

Uniform capitalization - Capitalization and inclusion of certain expenses in inventory costs

The Act expands the exception from the uniform capitalization rules for small-businesstaxpayers. Under the Act, any producer or reseller meeting the $25 million gross receipts test is exempt from the application of Section 263A. The Act also retains the exemptions from the UNICAP rules that are not based on gross receipts.

The Bluebook reiterates the expanded exception for small-business taxpayers from the uniform capitalization rules and does not provide further clarification.

In addition, the Bluebook clarifies the interaction between Section 263A and Section 163(j). The Bluebook provides that, "as with prior-law Section 163(j), the provision applies after Section 263A is applied to capitalize interest," in accordance with Treas. Reg. Section 1.263A-9(g)(1)(i).

Implications

The Bluebook's explanations are consistent with previous interpretation of the new small-business rules, which allow more taxpayers to be exempt from applying the rules under Section 263A. Taxpayers that meet the gross receipts test and wish to apply the new small-business rules generally will need to file an accounting method change request to no longer capitalize costs under Section 263A. Generally, such a change is automatic under the procedures issued in Revenue Procedure 2018-40.

In addition, the clarification that Section 263A applies before Section 163(j) is consistent with recently issued proposed regulations under Section 163(j). Therefore, interest capitalized to designated property under Section 263A is not "interest" for purposes of applying the Section 163(j) limitation. Taxpayers (in particular, those that will be limited under Section 163(j)) should revisit present interest capitalization methodologies and assess whether such methods are permissible under the Section 263A rules. Interest capitalized to designated property is recovered through depreciation/COGS, and such recovery may occur earlier than if the interest was first limited under Section 163(j) and carried forward. Further, to the extent interest was capitalized under Section 263A(f) to depreciable assets benefiting inventory production or resale activities, the interest recovered as depreciation would be capitalized to inventory under Section 263A and recovered as COGS. To the extent such interest was incurred for debt with a foreign related party, such interest would appear to escape the BEAT under Section 59A.

Other inventory/Section 263A considerations

The Bluebook explanations do not affect inventory/Section 263A BEAT planning (based on previous interpretation). Therefore, taxpayers subject to the BEAT could benefit from Section 263A inventory planning, as amounts paid to foreign related parties, which are allocable to inventory and reduce income through COGS, are not subject to BEAT. Taxpayers should identify amounts paid to foreign related parties and determine whether such amounts are capitalized under present Section 263A inventory methodologies, and if not, whether they should be. An accounting method change would likely be needed to change any Section 263A inventory methodology (e.g., to begin to capitalize costs not previously capitalized). Further, it is imperative that any costs capitalized to inventory under Section 263A are presented in COGS on the tax return (when such goods are sold). Accounting method changes may be required to change from treating costs "below the line" as a deduction to "above the line" as COGS, or vice versa.

Taxpayers intending to file accounting method changes in conjunction with GILTI/foreign-derived intangible income (FDII) planning should be aware that several automatic changes require Section 263A compliance for the item being changed. For CFCs, a change to the US ratio method (if eligible) could lessen the administrative burden of satisfying such requirement (or to otherwise comply with Section 263A). Additionally, taxpayers should consider whether Section 263A planning for self-constructed assets (e.g. capitalizing required costs to self-constructed asset basis or removing costs not required to be capitalized) should be employed in conjunction with GILTI/FDII planning.

Production period for beer, wine, and distilled spirits

The Act temporarily excludes the aging periods for beer, wine and distilled spirits from the production period for purposes of the UNICAP interest capitalization rules. Thus, under the Act, producers of beer, wine and distilled spirits may deduct interest expenses (subject to any other applicable limitation) attributable to a shorter production period. This provision does not apply to interest costs paid or accrued after December 31, 2019.

The Bluebook clarifies that application of the provision is not a change in method of accounting subject to Section 481, as a taxpayer's method of accounting for capitalizable interest costs is unchanged. If a taxpayer capitalizes aging period interest costs paid or accrued after December 31, 2017, and before January 1, 2020, and wants to no longer capitalize such costs, however, such a change is a change in method of accounting subject to Section 481.

Implications

The Bluebook's explanations are consistent with previous interpretations of the provision. Producers of beer, wine and distilled spirits may deduct interest expenses (subject to any other applicable limitation) attributable to a shorter production period and application of the rules may or may not require the filing of an accounting method change request (depending on the fact pattern).

Meal and entertainment expenses

The Act made significant changes to the business provisions affecting a company's ability to deduct meals and entertainment (M&E) expenses incurred on or after January 1, 2018.

For employer-provided meals and entertainment, the Act modified Section 274 by making all entertainment expenses, including entertainment event tickets and taxpayer-operated facilities, non-deductible. The Act did not modify the exceptions to either the entertainment disallowance or the 50% limitation contained in prior law; accordingly, nondiscriminatory employee recreation expenses are still 100% deductible.

In the context of de minimis fringe benefits involving food or beverages, Section 274(n) was modified to reflect that the business deduction for food and beverage expenses is now limited to 50% for:

• De minimis meal benefits provided to employees under Section 132(e)(1)
• Meals provided in an employer-operated eating facility under Section 132(e)(2) (including meals provided for the convenience of the employer under Section 119 at the facility)

Furthermore, effective January 1, 2026, new Section 274(o) prohibits business deductions for any expense for:

• Meals provided in an employer-operated eating facility
• Meals provided for the convenience of the employer

For more information on employer-provided meals, see Tax Alert 2018-0143.

The Bluebook clarifies that the Act does not affect exceptions to the 50% limitation that existed under prior law. As an example, the Bluebook notes that restaurant or catering businesses may continue to deduct 100% of costs for food or beverage items, purchased in connection with preparing and providing meals to paying customers, even though employees who work for the restaurant or catering business may consume those meals at the worksite.

The Bluebook also clarifies that taxpayers may continue to deduct 50% of certain business-related food and beverage expenses. Accordingly, a taxpayer may deduct 50% of:

• Food or beverage expenses associated with operating its trade or business (e.g., meals employees consume while travelling for work)
• Properly substantiated food or beverage expenses associated with a meal that is considered a business meal with a client

In addition, the Bluebook states that a technical correction may be needed to clarify that entertainment expenses incurred either at: (1) employee, stockholder, etc., business meetings (Section 274(n)(2)(A) and Sections 274(e)(5)), or (2) meetings of business leagues, (Section 274(n)(2)(A) and Section (274(e)(6)), are not 100% deductible.

Foreign derived intangible income

The Act allows a domestic C corporation a deduction generally equal to 37.5% (21.875% for tax years beginning after 2025) of foreign derived intangible income (FDII). A domestic corporation's FDII is a computed income amount — a portion of gross income is deemed a return on intangible property (deemed intangible income (DII)), when a subset of the DII, which is attributable to qualifying foreign sales of property and services, is eligible for the FDII deduction.

The Bluebook is generally consistent with EY's interpretation of the rules related to FDII, pending further clarification in forthcoming Treasury regulations. For example, footnote 1727 clarifies that "the [S]ection 250 deduction is computed after applying the limitation on the deduction for business interest ([Section] 163(j)) and the limitation on the deduction for NOLs ([Section] 172)." In addition, the Bluebook provides references to certain areas for which a clerical or technical correction may be needed to reflect a particular intent. The Bluebook provides three notable clarifications:

• Deduction-eligible income (DEI) — In addition to the six exclusions from DEI provided in the Act, the Bluebook identified a seventh: "any income received or accrued that is of a kind that would be foreign personal holding company income (as defined in [S]ection 954(c))."
• Taxable income limitation — Contrary to the language in the Act, the Bluebook notes that the Section 78 gross-up amount is included when determining the applicability of the taxable income limitation. The Bluebook provides that, "[i]f the sum of a domestic corporation's FDII, GILTI, and GILTI-attributable [S]ection 78 gross-up amounts exceeds its taxable income determined without regard to this provision, then the amount of FDII, GILTI, and GILTI-attributable [S]ection 78 gross-up for which a deduction is allowed is reduced (but not below zero) by an amount determined by such excess"; footnote 1751 notes that a technical correction may be needed to reflect this intent.
• Federal government as facilitator — Footnote 1740 provides that, "[i]f property is sold by the taxpayer to a person who is not a [US] person, but the Federal government facilitates the transaction purely as an intermediary (e.g., for certain foreign military sales), income derived from the sale of such property may be treated as foreign-derived deduction eligible income if the other requirements are met. A technical correction may be needed to reflect this intent."

Implications

Potential implications of the previously mentioned items on the FDII deduction computation are as follows:

Foreign personal holding income

For taxpayers that have foreign personal holding company income, the exclusion of this additional item of income from DEI may result in the reduction of the FDII amount.

Section 78 gross-up amount

The inclusion of the Section 78 gross-up amount may trigger a reduction to FDII, GILTI and the Section 78 gross-up amount for purposes of computing their respective deductions. Under the Act, taxable income was compared to the sum of FDII and GILTI amounts to determine if a reduction was required. The Bluebook, however, provides that taxable income is to be compared to the sum of FDII, GILTI, and the Section 78 gross-up amount. With the inclusion of the Section 78 gross-up amount in this determination, certain taxpayers may be more likely affected by the taxable income limitation, resulting in lower deductions.

Qualified sales

For taxpayers that have otherwise qualifying sales in which transactions are facilitated by the Federal government as an intermediary, footnote 1740 provides a welcome clarification, providing that income derived from such transactions may be treated as foreign-derived deduction eligible income. Under the Act, it was unclear whether such transactions would be excluded from FDII because the federal government acted as a domestic intermediary. Like the guidance provided under repealed Section 199, the Bluebook clarifies that such transactions are not excluded from FDII.

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