The IRS has released an internal legal memorandum (ILM 2012-26-015) outlining how it approaches questions regarding whether receipts for licensing or selling "cloud"-based software qualify as domestic production gross receipts (DPGRs) for purposes of the Section 199 domestic production activities deduction (DPAD).

Receipts attributable to the license or other disposition of computer software are considered DPGRs for purposes of DPAD only if certain conditions are met. Generally, software must be affixed to a physical medium such as a CD or available for download to a customer's computer in order for the revenues from its disposition to qualify as a DPGR. Payments received for customers using software that exists only on a server and is accessible through the cloud is generally ineligible to qualify as DPGRs. If, however, the taxpayer or another person derives, on a regular, ongoing basis, gross receipts from the licensing or disposition of substantially identical software that is affixed to a physical medium or available for download, revenues from the online use of the software will qualify as DPGRs.

The taxpayer addressed in ILM 2012-26-015 offered access to its online software to customers through a downloadable application. The application consisted of an executable file that allowed the customer to communicate with the taxpayer's server over the Internet. The taxpayer identified unrelated parties that in the aggregate had similar downloadable computer software products, but the taxpayer's online software was not replicated by a single competitor's downloadable software.

The IRS reasoned that for the online software to qualify as substantially identical software, it must:

  • be provided by another person in a tangible medium such as a DVD or a download from the Internet,
  • have the same functional result as the taxpayer's online software from a customer's perspective, and
  • significantly overlap with the online software's features or purpose.

Multiple third-party software programs may not be aggregated to produce a comparable to the online software. Thus, the IRS held that the taxpayer's online software did not meet the third-party comparable exception, because it was not substantially identical to the offline software of another person. The IRS stated that the taxpayer could apply the third-party comparable exception to individual components of its online software to determine if any of the components qualify.

IRS field agents have embraced this guidance and are asking taxpayers to be prepared to:

  • indicate the principle features of software they seek to qualify,
  • indicate the features available through CD or downloadable software, and
  • segregate and treat as non-DPGR those revenues that can be attributed to the features that do not duplicate the CD or downloadable software.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.