The House of Representatives' recent advancement of the "One Big Beautiful Bill" contained several long-expected changes and extensions to the Tax Code. It also contained a couple of surprise provisions that have drawn attention, such as the proposed increase in the applicable percentage under § 199A from 20% to 23% and new tax-advantaged savings accounts. However, not widely noted is an increase to the accrual method threshold for manufacturers from $25 million of average annual gross receipts for the preceding three years to $80 million.
This increase means that manufacturers will more than triple the gross income threshold above which they are required to adopt an accrual method of accounting. It also means that the UNICAP rules of § 263A should not apply to any manufacturer with gross receipts averaging $80 million or less for the preceding three-year period. Finally, the inventory accounting rules under §§ 471 and 472 do not become mandatory until the § 448(c) threshold is exceeded, allowing the use of inventory account methods that conform to the taxpayer's applicable financial statement or books and records.
Who Benefits From the Increased § 448(c) Threshold?
The proposed legislation benefits manufacturers with gross receipts in excess of $25 million and up to $80 million. For purposes of new § 448(c)(4), a manufacturing taxpayer includes a corporation or partnership where substantially all of the income during the three-year testing period comes from lease, rental, license, sale, exchange, or other disposition of "qualified products." Qualified product, in turn, is defined as tangible personal property (excluding food sold at retail on site for consumption) that is produced or manufactured by the taxpayer in a manner that results in a substantial transformation under new § 168(n)(2)(D).
Considerations and Open Questions
Although one might expect the proposed legislation to explain what a substantial transformation is, it does not clearly state where the term is defined. The legislative language under new § 168(n)(2)(D) defines "qualified production activity" and merely states that for purposes of § 168(n)(2)(D) the activities of a taxpayer do not constitute manufacturing, production or refining unless the activities result in a substantial transformation of the property comprising the product, leaving open the question of what constitutes a substantial transformation.
The foreign base company income rules of Subpart F feature a substantial transformation test that, pending specific guidance from the IRS and Treasury, could guide taxpayers in evaluating whether they qualify for the increased § 448(c) threshold. The applicable § 954 Treasury regulations offer examples meant to illustrate what constitutes a substantial transformation and include rules that address circumstances where the use of purchased components or a substantial contribution will constitute manufacturing for purposes of Subpart F. The IRS has issued numerous rulings addressing the substantial transformation test in the Subpart F context. In addition, there is caselaw interpreting the term substantial transformation, primarily in relation to non-tax international trade and country-of-origin disputes. These decisions may also help guide the analysis of whether a manufacturer meets the requirements of § 448(c)(4). However, the language of proposed § 168(n)(2)(D) does not reference any existing body of law or suggest that the term should be interpreted in light of any other rule or statute. In the absence of guidance from the IRS and Treasury, taxpayers may consider adopting a "plain language" interpretation of the statutory language. Although reasonable on its face, such an interpretation is just that – an interpretation – and could be subject to scrutiny from the IRS in close calls.
Next Steps
If the increased threshold passes, Taft expects the IRS to develop guidance addressing how to make the method change, including automatic change guidance. As part of that guidance, Taft would also expect the IRS to adopt certain safe harbors around what constitutes "substantially all" gross receipts under the statute, with the caution that the proposed manufacturing threshold applies the § 448(c) aggregation rules for the additional purpose of determining whether the taxpayer is a manufacturer.
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