Sec. 199 generally provides a deduction for qualifying domestic production activities equal to 9% (3% for tax years beginning in 2005 or 2006 and 6% for tax years beginning 2007–2009) of the lesser of the taxpayer’s (1) qualified production activities income for the tax year or (2) taxable income, determined without regard to Sec. 199.
On March 19, 2007, Treasury issued final regulations under Sec. 199 (TD 9317) regarding online software and the treatment of advertising income. The final regulations, which differ slightly from the temporary and proposed regulations under Sec. 199 issued 10 months earlier, generally are effective for tax years beginning after March 19, 2007, but taxpayers may elect to apply them retroactively to tax years beginning after 2004 (Sec. 199’s effective date) and before March 20, 2007.
The final regulations affect taxpayers that produce computer software and provide access to it for a customer’s direct use while connected to the Internet or any other public or private communications network.
Online Software Safe-Harbor Exceptions
Shortly after Sec. 199’s enactment, the IRS and Treasury issued Notice 2005-14 to provide taxpayers with interim guidance in computing the new deduction. (For a discussion, see Gibbs and Rathnau, Tax Clinic, “Notice 2005-14 Offers Sec. 199 Guidance,” TTA, June 2005, p. 339.) That guidance set forth the general position that the use of computer software online by customers is a service, and not a lease, rental, license, sale, exchange or other disposition of the software. Accordingly, gross receipts derived from such customers do not constitute domestic production gross receipts (DPGR), because they are not attributable to a qualifying disposition of the software.
In subsequent guidance (i.e., the temporary regulations and, most recently, the final regulations) regarding the treatment of computer software under Sec. 199, Treasury and the IRS have continued to maintain the position that the use of computer software online by customers is a service. However, such guidance also has included two safe-harbor exceptions that, if met, treat gross receipts derived from the use of computer software online by customers as being derived from a qualifying disposition of the software (and, thus, treat such receipts as DPGR).
Safe harbor #1: Under the first safe-harbor exception, Regs. Sec. 1.199-3(i)(6)(iii)(A), gross receipts derived from providing computer software for customer use online will be treated as DPGR if (1) the taxpayer sells the software both online and affixed to a tangible medium (e.g., a CD) or via an Internet download, (2) the software has only minor or immaterial differences from the online software and (3) the software has been manufactured, produced, grown or extracted by the taxpayer in whole or in significant part in the U.S.
Safe harbor #2: Under the second safe-harbor exception, Regs. Sec. 1.199-3(i)(6)(iii)(B), gross receipts derived from providing computer software that has been manufactured, produced, grown or extracted by the taxpayer in whole or in significant part in the U.S. for customer use online will be treated as DPGR if “another person” sells “substantially identical” software to its customers affixed to a tangible medium or via an Internet download. Regs. Sec. 1.199-3(i)(6)(iv)(A) defines substantially identical software as software that (1) from a customer’s perspective, has the same functional result as the online software and (2) has a significant overlap of features or purposes with the online software.
The final regulations do not define “significant” overlap of features; unfortunately, the two examples in the final regulations do not offer substantive guidance.
While the two safe-harbor exceptions are largely the same in the final regulations as in the temporary ones, the final regulations made certain noteworthy changes. First, in response to comments, Regs. Sec. 1.199-3(i)(6)(iii) clarifies that both exceptions extend to computer software for which access is provided over any public or private communications network, not just the Internet. Second, Regs. Sec. 1.199-3(i)(6)(iii)(B) contains a potentially significant word change for the second safe-harbor exception. Under the final regulations, the taxpayer’s software comparison is made with respect to “another person.” Under the temporary regulations, the comparison was made with respect to “an unrelated person.” Treasury officials have stated informally that the language was changed to ensure that the second safe-harbor exception applies when a taxpayer provides online software through one entity and a related party to the taxpayer provides the same software to customers affixed to a tangible medium or by an Internet download.
Treasury and the Service specifically rejected comments to expand the safe-harbor exceptions to cover all use of computer software online. Taxpayers noted that the computer software industry is continually evolving; in the future, more software may be available only online, thus limiting the potential applicability of the two safe-harbor exceptions (i.e., over time, fewer taxpayers will be able to meet either safe harbor). Treasury and the IRS clearly recognized this point, but felt constrained by the Sec. 199 statutory language requiring a lease, rental, license, sale, exchange or other disposition of the computer software. In their view, the two safe-harbor exceptions were narrowly tailored to satisfy that language. Accordingly, Treasury and the Service thought it inappropriate to expand the exceptions further as part of the final regulations; see the preamble to TD 9317.
Online Software Advertising
Prior to issuance of the final regulations, advertising income derived from (1) advertisements placed in newspapers, magazines, telephone directories, periodicals and other similar printed publications (collectively, “newspapers”) and (2) advertisements and products placed or integrated into a qualified film qualified as DPGR if the gross receipts from the disposition of the underlying qualifying property (i.e., newspaper or qualified film) were (or would be) DPGR.
The final regulations extend the favorable advertising rules to certain computer software. Specifically, DPGR now includes advertising income derived from advertisements and products placed or integrated into computer software that is either affixed to a tangible medium or provided through an Internet download; see Regs. Sec. 1.199-3(i)(5)(ii)(B).
Significantly, the favorable advertising rule does not extend to advertisements and products placed or integrated into online software; see Regs. Sec. 1.199-3(i)(6)(iv)(F). Commentators had requested such an extension, but it was rejected. As noted above, Treasury and the IRS felt constrained by the Sec. 199 statutory language and the need for a qualifying disposition of computer software.
While the final regulations made only slight changes to the online software rules, many taxpayers nonetheless will be affected by them. For example, taxpayers that produce computer software and provide access to it for a customer’s direct use while connected to any public or private communications network (not just the Internet) may qualify gross receipts derived from these activities as DPGR. Moreover, taxpayers that derive gross receipts from advertising or product placements integrated in the software may qualify such receipts as DPGR. Thus, the changes made in the final regulations provide additional taxpayers with the opportunity to take advantage of the Sec. 199 deduction.
Sec. 199 is not a method of accounting but, rather, a permanent deduction. Because of the final regulations’ retroactive applicability, affected taxpayers can amend previously filed tax returns to avail themselves of the favorable rules (e.g., the advertising rule applicable to certain computer software) contained therein.
Annette B. Smith, CPA, Washington National Tax Services PricewaterhouseCoopers LLP, Washington, DC.
Unless otherwise noted, contributors are members of or associated with PricewaterhouseCoopers, LLP.
If you would like additional information about these items, contact Ms. Smith at (202) 414–1048 or firstname.lastname@example.org.