Among the first wave of examination "campaigns" announced by the IRS's Large Business & International division (LB&I) is the application of the Sec. 199 domestic production activities deduction to "multi-channel video programming distributors" (such as cable and satellite TV providers) and TV broadcasters. In a related technical advice memorandum (TAM), the IRS National Office has adopted a previously rejected LB&I interpretation of "qualified films," raising potential red flags for some members of the media industry.
Sec. 199 provides a current deduction equal to (roughly) 9% of the taxpayer's net income from certain domestic production activities during the year (subject to numerous exceptions and special rules). Domestic production gross receipts (DPGR) eligible for this benefit include (among many other things) receipts derived from licensing any "qualified film." Sec. 199(c)(6) defines "qualified film" to include "any property described in section 168(f)(3)" that is produced in the United States (i.e., "if not less than 50 percent of the total compensation relating to the production of such property is compensation for services performed in the United States by actors, production personnel, directors, and producers," subject to certain exceptions). Sec. 168(f)(3) is equally expansive, defining films and videotape as "any motion picture film or video tape."
The Sec. 199 regulations require the taxpayer to determine whether gross receipts are eligible for Sec. 199 by identifying the "item" giving rise to those gross receipts. For this purpose, the relevant item is "the property offered by the taxpayer in the normal course of the taxpayer's business" (Regs. Sec. 1.199-3(d)(1)(i)).
A qualifying item may include a finished product that the taxpayer produces using components acquired in whole or in part from third parties. So long as the taxpayer's domestic activities in combining the acquired components into a finished product are "substantial in nature," the aggregation of self-produced and purchased components into a new item falls squarely within the scope of Sec. 199 (Regs. Sec. 1.199-3(g)(2)).
Therefore, reading these provisions together, Sec. 199 permits a taxpayer to treat as DPGR any gross receipts that it derives from the licensing to customers of any "item" of motion picture film or videotape that the taxpayer produces in the United States. In addition, for this purpose, an item of qualified film can be interpreted to include a finished product resulting from the taxpayer's own efforts in aggregating film, video, or broadcast elements, either self-produced or acquired from third parties. As such, the essential inquiry is the nature of what the taxpayer is offering to its customers, how that specific item (rather than its component parts) was produced, and by whom.
This interpretation of Sec. 199 and the regulations was adopted by the IRS in TAM 201049029, in which the IRS National Office analyzed the application of Sec. 199 to gross receipts derived by a media conglomerate from licensing programming packages to multiple systems operators (MSOs) such as cable and satellite TV providers. In the TAM, cable networks the taxpayer owned licensed to MSOs programming packages that the MSOs agreed to provide to subscribers in an unaltered manner. The programming packages consisted of programs produced either by the network itself or by another member of its consolidated group, programs produced by third parties that the taxpayer had acquired the rights to broadcast, commercials, and interstitials.
In treating the license fees as DPGR, the taxpayer took the position that the composite package of media content offered to cable and satellite TV providers in an as-is condition (i.e., the package must be distributed to subscribers without alteration) was the relevant item, and that it had undertaken significant efforts to produce that composite item from various components of film and video programming.
LB&I, however, took the position that gross receipts derived from the licensing of programming packages cannot be DPGR, because, in LB&I's view, the definition of "qualified film" under Sec. 199(c)(6) is limited to "individual films" and, therefore, the gross receipts attributable to programming packages are not derived from a qualified film.
The IRS National Office rejected LB&I's assertion that a qualified film for purposes of Sec. 199 is limited to individual films, concluding instead that a taxpayer may derive DPGR from the licensing of a programming package it compiles. The National Office noted that Sec. 199 applies to other types of property consisting of multiple self-produced and purchased components if that composite is the property offered by the taxpayer to its customers in the ordinary course of business.
A change of course
In 2016, the IRS National Office reached a contrary conclusion on similar but distinguishable facts. In TAM 201646004, the National Office considered the application of Sec. 199 to subscriber fees received by a multichannel video programming distributor (MVPD) regulated by the Federal Communications Commission as a telecommunications service provider. The facts are roughly the same as those in TAM 201049029, except from the perspective of the cable or satellite TV provider's transactions with its subscribers.
The National Office concluded in TAM 201646004 that a "subscription package" offered by an MVPD is not a qualified film for purposes of Sec. 199. The ruling appears to rest on two principal rationales. First, the National Office seemed troubled by its perception that the taxpayer was functioning as a distributor of content rather than as a producer of a qualified film. Second, the National Office agreed with LB&I that for purposes of Sec. 199, a qualified film is limited to "individual films" and therefore cannot include subscription packages offered by MVPDs.
While the facts of the two TAMs are distinguishable (and TAMs are nonprecedential documents and may not be relied on as authority), the breadth and tone of the language used by the National Office in accepting LB&I's definition of "qualified film" as applied to MVPDs raise questions regarding how the National Office intends to administer Sec. 199 within the media industry. Although the 2010 TAM rests upon a sound analysis grounded in the plain language of the relevant law, the 2016 TAM takes the opposite position, asserting that "even the most liberal reading" of the applicable law does not support applying Sec. 199 to more than an "individual film."
The 2016 TAM acknowledges but makes no effort to distinguish or reconcile the National Office's prior determination. Thus, it is difficult to assess the extent to which the taxpayers' differing roles within the industry (cable television network versus cable or satellite TV provider) may have influenced the National Office's views on their respective facts. In any event, neither TAM has precedential effect for any other taxpayer.
New look at Sec. 199
LB&I's initial list of examination "campaigns" includes "Domestic Production Activities Deduction, Multi-Channel Video Program Distributors (MVPDs) and TV Broadcasters" (available at www.irs.gov. LB&I has indicated it will focus on the application of Sec. 199 to MVPDs both in terms of the issue discussed in TAM 201646004 and how Sec. 199 applies to software produced by those companies in providing customers with online access to media content. The IRS announcement states that the "treatment streams" for this campaign will include developing an externally published practice unit; potentially, published guidance; and issue-based exams, when warranted. The campaign by its terms is limited to MVPDs and TV broadcasters.
The National Office's reasoning in TAM 201646004 and LB&I's announcement of the new Sec. 199 campaign for MVPDs and broadcasters likely will concern those members of the media industry that had accepted the reasoning of TAM 201049029 as the National Office's considered view. Nonetheless, the long-term impact of the 2016 TAM and of the LB&I campaign may be mitigated by the potential repeal of Sec. 199 as part of comprehensive tax reform. (As of this writing, no actual tax reform legislation has been introduced, and there can be no guarantee whether or when tax reform will occur or what form it would take.) Otherwise, the National Office's revised position may open another area of controversy between taxpayers and the IRS in applying Sec. 199.
Mary Van Leuven is a director, Washington National Tax, at KPMG LLP in Washington.
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