United States: The IRS Attacks Taxpayers' Section 199 (Computer Software) Deductions

Taxpayers' section 199 computer software deductions are under attack! The issue is being coordinated within the IRS, and at Exam and Appeals taxpayers are running into a brick wall. A resource-starved IRS is trying to treat all similarly (and not so similarly) situated taxpayers uniformly. Accordingly, there is an effort to resolve all cases on the same basis, despite factual differences.

The IRS's hardline approach has spurred substantial controversy. Indeed, there are presently three docketed court cases relating to the section 199 computer software deduction. See Vesta Corp. v. Comm'r, Tax Court docket No. 26847-16; BATS Global Mrkts Hldgs, Inc. v. Comm'r, Tax Court docket No. 1068-17; and Bloomberg LP v. Comm'r, Tax Court docket No. 375-17. Moreover, we are aware of numerous other cases under audit and at IRS Appeals in which taxpayers are pushing back against the IRS's unreasonable position. Until a court decides this issue, we can expect a continuing increase in controversy in this area.

In 2004, Congress enacted section 199 to encourage taxpayers to manufacture products domestically, with an aim of improving US employment opportunities. The deduction, however, is not available if the taxpayer is merely providing services. The line between what is considered a service as opposed to "production" is sometimes unclear. Section 199 by its terms applies to the production of "any computer software." The regulations, however, provide a narrow interpretation of the statute that acts to restrict the availability of the deduction.

Background

Section 199(a) provides a deduction equal to 9 percent of the lesser of: (1) "qualified production activities income" (QPAI) of the taxpayer for the year; or (2) taxable income. (Section 199(b) limits the deduction to 50 percent of the wages that are attributable to the domestic production activities.) Section 199(c) defines QPAI as the taxpayer's "domestic production gross receipts" (DPGR) for the year less the costs of goods sold and expenses allocable to DPGR. DPGR is further defined as gross receipts of a taxpayer that are derived from the lease, rental, license, sale, exchange or other disposition (collectively "disposition") of "qualifying production property" (QPP), which was "manufactured, produced, grown, or extracted" (MPGE) by the taxpayer in whole or in significant part within the United States. QPP includes "any computer software."

Section 1.199-3(i)(6)(i) of the US Department of Treasury regulations provides that DPGR includes gross receipts of the taxpayer that are derived from the disposition of computer software produced by the taxpayer in whole or in significant part within the United States. Section 1.199-3(i)(6)(ii) provides, however, that gross receipts derived from customer and technical support, telephone and other telecommunication services, online services (such as internet access and online banking services), and other similar services do not constitute gross receipts derived from a disposition of computer software. Recognizing that a taxpayer can make a disposition of software by placing it on a tangible medium (a disc) or by providing the customer with access to the software while connected to the internet or private communications network, the regulations include an exception to this rule in instances where, under specified conditions, a taxpayer derives gross receipts from providing customers access to computer software produced in whole or significant part by the taxpayer within the United States for the customers' direct use while connected to the internet or any other public or private communications network (online software). Such gross receipts will be treated as derived from the disposition of computer software provided the requirements of either the "self-comparable test" or the "third-party comparable test" are met.

The self-comparable test is satisfied if a taxpayer derives, on a regular and ongoing basis in the taxpayer's business, gross receipts from the disposition of computer software to customers that are unrelated persons which computer software: (1) has only minor or immaterial differences from the online software; (2) was MPGE by the taxpayer in whole or in significant part within the United States; and (3) has been provided to such customers affixed to a tangible medium or by allowing the customers to download the computer software from the internet.

The third-party comparable test is satisfied if another person derives, on a regular and ongoing basis in its business, gross receipts from the disposition of substantially identical software (as compared to the taxpayer's online software) to its customers pursuant to a tangible medium or via a download from the internet. "Substantially identical software" is defined as software that: (1) from a customer's perspective, provides the same functional result as the online software; and (2) has a significant overlap of features or purpose with the online software.

The line between what constitutes a non-deductible service and a deductible disposition of computer software is becoming increasingly blurred given the pace of technological advances affecting the development, application and use of computer software since section 199 was enacted in 2004. What was traditionally considered a "computer" is no longer the sole province of software. Today we find sophisticated software in phones, cars, television cable boxes and even our refrigerators. Moreover, the way in which we interact with the world has changed dramatically. Go to any restaurant and count the number of people that are staring at their phones, texting and looking up reviews of the restaurant on Google.

One of the areas that has seen substantial change is online access to computer software. Unlike in 2004, today we spend most of our time shopping, paying bills and banking online through our computers, smart phones and tablets. The amount invested each year by US businesses to develop online software that keeps them connected with consumers, employees and suppliers is in the billions of dollars.

The relevant regulations, however, deny a deduction for this investment unless the taxpayer satisfies one of the two aforementioned "comparables" conditions—provisions that do not reflect technological advances. For example, the current trend in software development is focused on a closed-system with access only through the "cloud." Because there is no equivalent computer software available on a disc or by download, under the IRS's formulation, all cloud-based computer software, despite being produced in the United States, might be denied the section 199 benefit.

Moreover, the IRS has interpreted the regulations quite restrictively. It is clear that the IRS does not like section 199, and will interpret the provision as narrowly as possible to deny deductions to taxpayers.

The Banking App GLAM

A good example of the disconnect between Congress's purpose in enacting the section 199 software deduction and the IRS's implementation is the so-called "Banking App GLAM." In 2014, the IRS published AM 2014-008, in which it concluded that a bank did not derive DPGR when the taxpayer permitted its customers to download a free "app" that allows its customers to interact and access its online banking services.

The taxpayer provided customer banking services, and interacted in various ways, including online through its website and an app it developed. Through its app, customers could access their bank accounts, transfer and wire funds and deposit checks. From the bank's perspective, all of the actions were the same regardless of whether executed in person or virtually—the bank's internal computers would process the transactions. Accordingly, for the app to have its intended functionality, it had to be connected to the bank's network via the internet; the app had very little, independent functionality.

Customers who used the app were required to accept the terms and conditions of use under the bank's nonexclusive, limited license. The app was free to download and to use, and the bank earned revenue from activities that customers performed with the app, for example, wire transfer transactions. For financial reporting purposes, the taxpayer recognized the revenue generated through the app as banking services revenue, and ascribed no portion of the revenue to the licensing of the app. Other banks have similar apps that allow similar banking functions to be performed.

The IRS determined that the app fit squarely within the definition of online software described in section 1.199-3(i)(6)(iii), pointing out that the app did not operate unless it was connected to the internet. The IRS interpreted the regulations as implying that the mere downloading of the app by a customer of the taxpayer is not a "disposition" for section 199 purposes. In the GLAM, the IRS also determined that the bank did not derive any gross receipts from the deployment of the app. Lastly, the IRS determined that the bank satisfied neither the self-comparable test nor the third-party comparable test.

The IRS's conclusions are incorrect for at least three reasons:

  1. A disposition occurs when an app is downloaded to a customer's device: The IRS's position is too broad, and not supported by the statute or legislative history. Downloading an app onto a customer's device should be considered a "disposition." In addition, there is no authority to require that downloaded computer software have free-standing functionality.
  2. Taxpayers earn revenue from the deployment of apps: Whether a taxpayer directly or indirectly charges for the software customer's use should not matter. The key question should be whether the taxpayer can reasonably and rationally allocate revenue to the downloaded computer software. Requiring a direct exchange (money for software) is very formalistic and does not comport with the evolving nature of e-commerce. Indeed, commercial enterprises give items away all of the time to entice customers and support their businesses.
  3. The banking app satisfies the third-party comparables test: The IRS concluded in the Banking App GLAM that the taxpayer failed to satisfy the third-party comparable test, finding that from the customer's perspective the app provided a different functional result, and did not have substantial overlap in purpose with the third-party comparables. For example, the IRS determined that the taxpayer's customers used the online software to order individual banking services, whereas the third-party comparable used the software to provide banking services to multiple customers. The IRS's position is untenable. The taxpayer's app was substantially the same product (a software portal) and provided the same functionality (access to banking services) as the third-party comparable.

The Banking App GLAM underscores the IRS's narrow and antiquated approach to the section 199 deduction for computer software.

Defend Your Deduction!

To defend your section 199 computer software deduction, make strategic decisions. First, argue the facts to distinguish your situation from the published guidance and the examples in the regulations. Focus on the technology, and get into the details. Second, argue the law. Published guidance such as the Banking App GLAM is not binding authority and is merely a position taken by the IRS in that specific case. It should not be afforded any deference. Lastly, argue tax policy. Congressional intent should drive the result. The regulations go far beyond what Congress intended. By providing the narrowest of interpretations of the statute, the IRS is thwarting the objectives of the law and taxpayers are being left caught short.

The IRS has substantial hazards of litigation in advancing the extreme positions we are seeing. Depending upon the size of the benefit from claiming the section 199 deduction, strategically it may make sense to claim the benefit and battle with the IRS on Exam and at Appeals pending a favorable court decision.

The IRS Attacks Taxpayers' Section 199 (Computer Software) Deductions

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