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The driving force behind the American Jobs Creation Act of 2004 (the Act) was the need to repeal the exclusion for extraterritorial income (ETI) that the World Trade Organization found to be an illegal export subsidy. The violations provoked the European Union to impose tariffs on U.S. companies. However, the Act goes far beyond simply repealing the ETI and ushers in a breathtakingly large variety of tax incentives and revenue offsets that apply both widely and to specialized industries and taxpayers. The centerpiece of the legislation is a new deduction for production activities conducted in the U.S.

Here are more details regarding these important provisions.

ETI Repeal

The Act repeals the ETI exclusion effective for transactions occurring after Dec. 31, 2004, except for transition relief. Under the transition rules:

1. the ETI exclusion continues to apply to transactions in the ordinary course of business that are pursuant to a binding contract that was in effect on Sept.17, 2003, and at all times thereafter; and
2. taxpayers are provided with 80% of their otherwise-applicable ETI benefits during 2005 and 60% of their otherwise-applicable ETI benefits during 2006.

New deduction for U.S. production activities

The Act replaces ETI with a new tax deduction for domestic production activities. The deduction is the lesser of (i) a percentage of the net income from those activities-3% in 2005-2006, 6% for 2007-2009, 9% after 2009; or (ii) taxable income. When fully phased in, the deduction is designed to be economically equivalent to a 3-percentage point reduction in the federal income tax rate on U.S.-based production activities. The amount of the deduction for any tax year may not exceed 50% of the employer's W-2 wages for that tax year. The deduction is available to all taxpayers with qualified production activities income and is allowable in computing alternative minimum taxable income.

The U.S. production activities deduction is allowed with respect to a taxpayer's qualified production activities income. This is defined as the amount of the taxpayer's domestic production gross receipts for the taxable year in excess of the sum of (i) cost of goods sold allocable to such receipts, (ii) other deductions, expenses, or losses directly allocable to such receipts; and (iii) a ratable portion of other deductions, expenses, and losses that are not directly allocable such receipts or another class of income.

Domestic production gross receipts are gross receipts derived from:

• Any lease, rental, license, sale, exchange, or other disposition of-
  • qualifying production property (i.e., tangible personal property, any computer software, and certain sound recordings) that was manufactured, produced, grown, or extracted in whole or in significant part by the taxpayer within the U.S.
  • any qualified film produced by the taxpayer; or
  • electricity, natural gas, and potable water produced by the taxpayer in the U.S.
• Construction performed in the U.S.
• Engineering and architectural services performed in the U.S. for construction projects in the U.S.

For pass-through entities such as S corporations, partnerships, and estates and trusts, the deduction generally is determined at the shareholder, partner, or similar level by taking into account at that level the proportional share of the qualified production activities income of the entity.