What Was PL 108-357, the American Jobs Creation Act?

Public Law 108-357, the American Jobs Creation Act of 2004, was a piece of tax legislation enacted in the United States. Its primary catalyst was a World Trade Organization (WTO) ruling against a U.S. tax provision that benefited exporters, which prompted a legislative response to avoid retaliatory tariffs from the European Union.

The Act was designed to bring U.S. tax law into compliance with international trade rules and stimulate the domestic economy. It accomplished this by repealing the offending tax rule and introducing a wide array of new measures. These changes affected corporate, international, and individual taxation and were intended to encourage business investment and job creation within the United States.

Repeal of the Extraterritorial Income Exclusion

The main driver behind the American Jobs Creation Act was the need to repeal the Extraterritorial Income (ETI) exclusion. The ETI regime was a tax benefit for U.S. companies that exported goods, allowing them to exclude a portion of their income from foreign sales from U.S. taxation. This provision was designed to make American products more competitive in global markets and had replaced a similar rule, the Foreign Sales Corporation (FSC) rule, which was also found to violate trade agreements.

The World Trade Organization ruled that the ETI exclusion constituted an illegal trade subsidy, giving U.S. exporters an unfair advantage. This ruling put the U.S. at risk of significant retaliatory tariffs from the European Union on a wide range of American-made goods. To comply with the WTO and avert a trade war, Congress used the Act to phase out the ETI benefit.

The repeal was structured as a gradual elimination. Under the Act, companies could claim 80% of their otherwise allowable ETI benefits in 2005, which was reduced to 60% in 2006. After 2006, the ETI exclusion was fully repealed, which required Congress to create a new, WTO-compliant incentive to support domestic companies.

The Domestic Production Activities Deduction

As a replacement for the ETI exclusion, the Act introduced the Domestic Production Activities Deduction (DPAD). This deduction was designed to encourage manufacturing and other production activities within the United States. Unlike the ETI, the DPAD was available for goods produced domestically, regardless of where they were sold, making it compliant with WTO rules while still providing a tax benefit to U.S. businesses.

The core of the DPAD was Qualified Production Activities Income (QPAI). This was income derived from the lease, license, sale, or other disposition of qualifying production property that was manufactured, produced, grown, or extracted by the taxpayer in the United States. Qualifying activities were broad and included:

• Traditional manufacturing
• Construction
• Engineering and architectural services
• Energy production
• Production of computer software
• Production of sound recordings and qualified films

The deduction was calculated as a percentage, initially 3% in 2005 and rising to 9% by 2010, of the lesser of the taxpayer’s QPAI or their taxable income. A limitation was also included: the deduction could not exceed 50% of the W-2 wages paid by the taxpayer. This wage limitation was added to ensure the tax benefit was linked to the creation and maintenance of U.S. jobs.

A wide range of business entities were eligible to claim the DPAD, including C corporations, S corporations, partnerships, and sole proprietorships. The DPAD was a valuable deduction for many U.S. producers until it was repealed by the Tax Cuts and Jobs Act of 2017.

One-Time Repatriation of Foreign Earnings

A provision of the Act was a temporary tax incentive for U.S. multinational corporations to bring foreign earnings back to the United States. This measure, established under Internal Revenue Code Section 965, offered a one-time, reduced tax rate on dividends repatriated from controlled foreign corporations (CFCs). The goal was to encourage companies to reinvest their accumulated offshore profits in the domestic economy.

Corporations could elect to claim an 85% dividends-received deduction on qualifying repatriated earnings for a single taxable year. This deduction effectively lowered the tax rate on these profits to 5.25%, a substantial reduction from the standard 35% corporate tax rate at the time. To qualify, the amount of the repatriated dividend had to be extraordinary, meaning it exceeded the company’s average repatriation level over a preceding base period.

A requirement for this provision was the establishment of a “domestic reinvestment plan.” The legislation mandated that repatriated funds be used for specific purposes within the United States, such as hiring and training workers, funding research and development, and making capital investments. The law prohibited using the funds for executive compensation, paying dividends, or conducting stock buybacks.

This section of the tax code was fundamentally altered by the Tax Cuts and Jobs Act of 2017 (TCJA). The TCJA amended Section 965 to create a mandatory one-time tax on the untaxed foreign earnings of certain foreign corporations. Known as the “transition tax,” this required U.S. shareholders to pay the tax on their share of post-1986 deferred foreign income, regardless of whether the funds were repatriated.

Key Changes for S Corporations

The American Jobs Creation Act of 2004 also introduced several changes affecting S corporations. These modifications were designed to provide greater flexibility and simplify certain rules for these pass-through entities, making it easier for businesses to qualify for and maintain S corporation status.

One of the changes was an increase in the maximum number of permissible shareholders for an S corporation, raising the limit from 75 to 100. This expansion allowed S corporations to attract capital from a larger pool of investors without risking the termination of their S status.

The law also simplified shareholder counting rules for families by allowing all members of a family to be treated as a single shareholder for the 100-shareholder limit. The definition of “family” was broad, encompassing up to six generations of lineal descendants from a common ancestor, as well as their spouses. This was beneficial for family-owned businesses that might otherwise have exceeded the shareholder limit.

Another change related to the treatment of suspended losses. If an S corporation shareholder’s interest was terminated, any losses that had been suspended due to basis limitations were previously lost. The Act amended this rule to allow for the transfer of these suspended losses when stock was transferred to a spouse or former spouse incident to a divorce.

Provisions Targeting Tax Shelters

The American Jobs Creation Act contained provisions aimed at curbing the use of abusive tax shelters and other tax avoidance transactions. A portion of the legislation was dedicated to increasing transparency and imposing stricter penalties on taxpayers and promoters who engaged in transactions that lacked economic substance.

The Act strengthened the disclosure requirements for “reportable transactions,” which are those identified by the IRS as having the potential for tax avoidance. The law imposed monetary penalties on taxpayers who failed to properly disclose their participation in such transactions. To further deter this activity, the legislation increased the accuracy-related penalty for tax understatements attributable to undisclosed transactions and introduced new penalties for promoters of tax shelters.

The Act also laid the groundwork for the future codification of the “economic substance doctrine.” This judicial principle holds that a transaction must have a real economic purpose apart from reducing taxes to be respected for tax purposes. The 2004 Act’s focus on transactions lacking economic purpose was a precursor to later legislation that formally incorporated this standard into the Internal Revenue Code.