The IRS has issued a general legal advice memorandum (GLAM 2014-008), rejecting a taxpayer's attempt to treat revenue attributable to a downloadable computer software application that allowed access to the taxpayer's online banking system as qualifying domestic production gross receipts (DPGR) under Section 199.
The IRS memo takes the positions that the application was not qualifying personal property (QPP), since it was "online software," and that none of the taxpayer's gross receipts were derived directly from the disposition of the software. The memo, released Dec. 5, rejected the attribution of any DPGR to the online banking software itself, because no third party provided substantially identical software to similar customers.
Treasury regulations specifically state that "gross receipts derived from online services (such as Internet access services, online banking services, providing access to online electronic books, newspapers, and journals) and other similar services" do not constitute DPGR (Treas. Reg. Sec. 1.199-3(i)(6)(ii)). The IRS's positions that the application in question was merely an alternative way of connecting through the Internet to the taxpayer's online banking software and that all revenues were attributable to the provision of online services are consistent with an IRS effort to defend the effect of that regulation.
In determining that the software in question was online software, the GLAM notes as a fact that the application was useful to customers only while connected to the Internet and provided no benefits outside of offering another platform to receive the taxpayer's online banking services. The memo stated that to be QPP, downloaded software must have independent functionality after customers have downloaded it and are no longer connected to the Internet. If strictly followed, this could disallow downloaded software that requires an Internet connection to complete its intended function, that includes significant downloaded code allowing for user manipulation on the customer's machine. Similarly, it could disallow downloaded software that provides an alternative, but highly superior, platform for accessing services on the taxpayer's machine. It's unknown whether the IRS could factually distinguish these situations.
Although nothing else would be necessary to disallow the claimed Section 199 deduction, the IRS memo states that even if the application was considered qualifying software and thus QPP, none of the revenue attributable to its use by customers would be considered DPGR, because none of the online banking receipts were derived directly from the disposition of the application. This approach would seem to limit the use of the "shrinkback" concept to the definition of the item and not allow it to be used to separate intertwined streams of revenue — some of which might qualify and some not.
The taxpayer in question also attempted to qualify a portion of the revenue from online banking services based on the theory that online banking software on the taxpayer's machines could be QPP, since a third-party provider licensed similar software to other banks for installation on their machines. The IRS memo rejected this, noting that the software provided a different functional result to the taxpayer's customers than was provided to the bank customers of the third-party provider. The IRS has previously stated that similarity must be tested from the customer's perspective, and this result is consistent with that position.
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