Guidance on Characterizing Gross Receipts from Telecommunications Services

Editor: Michael Dell, CPA

Expenses & Deductions

In Rev. Rul. 2011-24, the IRS provided guidance for determining whether a taxpayer that provides telecommunications services derives gross receipts from services, leasing or renting property, or a combination of the two, for purposes of the domestic production activities deduction under Sec. 199.

Facts

The revenue ruling presents three hypothetical situations.

Situation 1: Z corporation provides telecommunications services, including the transmission of voice, data, and video communications. Z contracts with A corporation, which has multiple business locations and is not in the telecommunications industry, to transmit A’s telecommunications. Under the contract, Z must transmit A’s telecommunications at A’s desired times to A’s desired destinations and at a certain speed. A must pay Z for transmitting the telecommunications. If Z cannot transmit A’s telecommunications according to the terms of the contract, then Z must give A a service credit.

Z’s optical and digital transmission equipment, usually a synchronous optical network (SONET) ring, and the associated public switched telephone network (PSTN) are used to transmit A’s telecommunications. The SONET ring interconnects multiple business locations designated by A to transmit telecommunications among A’s business locations without transmitting them to Z’s PSTN. Additionally, the SONET ring connects to Z’s central office, switching center, or remote terminal to transmit telecommunications to and from Z’s PSTN.

The PSTN consists primarily of fiber optic cable and copper cable that connects switching centers with each other and to remote terminals. The PSTN is owned by Z and is not dedicated to A or to any of Z’s other customers. The PSTN provides different pathways to transmit telecommunications to and from A’s business locations. The SONET ring and PSTN assets used to transmit A’s telecommunications include: (1) network electronics, such as multiplexers, switches, routers, digital cross-connects, and optical and digital transmission equipment; (2) fiber optic cable and/or copper cable; (3) network facilities such as a central office; and (4) software.

A owns telecommunications equipment that connects with the SONET ring to allow transmission of the telecommunications among A’s business locations or to the PSTN and transmission of others’ telecommunications to A from the PSTN. A’s equipment includes a router, channel service or data service unit, and a diagnostics modem (customer-premises equipment). Z is not required to provide services related to A’s customer-premises equipment.

Z owns, installs, operates, and maintains the SONET ring and PSTN. Z will replace any SONET ring and PSTN assets when required. Under the contract, A must grant Z reasonable access to A’s premises to install, inspect, test, rearrange, maintain, repair, or remove any SONET ring assets located on A’s property. Z repairs and maintains the SONET ring and PSTN at no additional charge to A. A cannot install, inspect, test, rearrange, maintain, repair, or remove any component of the SONET ring or PSTN.

Situation 2: The facts are the same as in Situation 1, except that A does not have multiple business locations, and Z uses a dedicated circuit, instead of a SONET ring, to transmit A’s telecommunications to the PSTN and others’ telecommunications from the PSTN. Z transmits all telecommunications to or from A through the PSTN. Z’s dedicated circuit comprises Z’s equipment, including fiber optic or copper cable and point-of-presence equipment, and dedicated or shared equipment. Z generally does not notify A if Z repairs the dedicated circuit or PSTN. Z may notify A if Z upgrades the dedicated circuit or PSTN. A cannot stop Z from making any necessary repairs or upgrades to the dedicated circuit or PSTN.

Situation 3: The facts are the same as in Situation 2, except that A does not own the customer-premises equipment required to connect with the dedicated circuit to allow transmission of A’s telecommunications. As part of the contract, Z must provide the customer-premises equipment and support services in relation to that equipment. The contract states that Z is leasing the customer-premises equipment to A, but does not state the lease amount. Z delivers and installs the customer-premises equipment on A’s premises. If necessary, Z provides telephone support services to A’s designated employees related to diagnosing problems and repairing and replacing the customer-premises equipment. Z also may remotely perform maintenance or diagnostic tasks.

A’s designated employees complete any required repair or replacement, and A is liable for any repair charges or the replacement cost of the equipment if it is damaged or lost. A can relocate or modify the customer-premises equipment and may attach it to non-Z equipment with Z’s authorization, which Z may not unreasonably withhold. At the end of the contract term, A must return the customer-premises equipment or make it available to Z for removal. If A fails to return the equipment, A will be liable to Z for the customer-premises equipment’s then-current market value. A is liable for any costs of restoring the customer-premises equipment, beyond those of ordinary wear and tear.

Law and Analysis

Sec. 199(a)(1) allows a deduction equal to 9% (3% for tax years beginning in 2005 or 2006, and 6% for tax years beginning in 2007, 2008, or 2009) of the lesser of (1) the taxpayer’s qualified production activities income (QPAI) for the tax year, or (2) taxable income (determined without regard to Sec. 199) for the tax year, subject to the limitation that the deduction may not exceed 50% of the taxpayer’s W-2 wages for the tax year that are allocable to domestic production gross receipts (DPGR). Sec. 199(c)(1) defines QPAI as an amount equal to the excess (if any) of (1) the taxpayer’s DPGR for the tax year over (2) the sum of the cost of goods sold that are allocable to DPGR and other expenses, losses, or deductions that are properly allocable to DPGR.

Sec. 199(c)(4)(A)(i)(I) defines DPGR as the taxpayer’s gross receipts that are derived from any lease, rental, license, sale, exchange, or other disposition of qualifying production property that was manufactured, produced, grown, or extracted by the taxpayer in whole or in significant part within the United States. Under Regs. Sec. 1.199-3(i)(1), applicable federal income tax principles apply in determining whether a transaction is in substance a lease, rental, license, sale, exchange, or other disposition, a service, or a combination of any of these. Regs. Sec. 1.199-3(i)(4)(i)(A) prohibits gross receipts derived from the performance of services generally from qualifying as DPGR.

Under Regs. Sec. 1.199-3(i)(6)(ii), gross receipts derived from customer and technical support, telephone and other telecommunications services, online services (e.g., internet access services or online banking services), and other similar services are not gross receipts derived from a lease, rental, license, sale, exchange, or other disposition of computer software.

In determining whether the contract in each of the three hypothetical situations outlined above is a lease or rental, or a service contract, the IRS considered Rev. Rul. 68-109; Rev. Rul. 72-407; Xerox Corp., 656 F.2d 659 (Ct. Cl. 1981); Smith, T.C. Memo. 1989-318; and Sec. 7701(e)(1). Each of these authorities distinguished lease or rental arrangements from service contracts, focusing on factors including the property’s ownership, possession, use, control, and risk of loss, and whether the property is part of a broader, integrated system of equipment and services. Sec. 7701(e)(1) provides that, for purposes of chapter 1 (which includes Sec. 199), a purported service contract is treated as a lease of property if the contract is properly treated as a lease of property, taking into account all relevant factors, including whether:

• The service recipient is in physical possession of the property;
• The service recipient controls the property;
• The service recipient has a significant economic or possessory interest in the property;
• The service provider does not bear any risk of substantially diminished receipts or substantially increased expenditures if there is nonperformance under the contract;
• The service provider does not use the property concurrently to provide significant services to entities unrelated to the service recipient; and
• The total contract price does not substantially exceed the rental value of the property for the contract period.

The IRS noted that authorities such as those cited above generally apply federal income tax principles to determine a single character for a given transaction. However, Regs. Sec. 1.199-3(i)(1) states that, for Sec. 199 purposes, a single transaction may have both a service and a lease element. Therefore, the application of federal income tax principles described in Regs. Sec. 1.199-3(i)(1) requires an analysis of relevant factors taken from federal income tax principles but does not require a determination of a single character. An analysis of the relevant factors may nonetheless lead to a determination that the transaction has only a single character element for purposes of Sec. 199.

Applying federal income tax principles to Situation 1, the IRS concluded that Z is using its SONET ring and PSTN to provide telecommunications services to A, not providing a combination of telecommunications services with a lease or rental of Z’s SONET ring or PSTN to A. Essentially, in Situation 1, A contracts with Z for reliable telecommunications services, and Z provides those services using its SONET ring and PSTN, subject to the contract terms governing the quantity and quality of services that Z must provide A.

The IRS emphasized that Z maintains control of the SONET ring and PSTN. In particular, A does not control how Z uses the SONET ring and PSTN to provide the services. Further, Z, and not A, has a possessory interest in the SONET ring and PSTN that Z uses to complete the transmissions. Z, and not A, operates, maintains, repairs, and upgrades the SONET ring and PSTN. Indeed, A is prohibited from installing, inspecting, testing, rearranging, maintaining, repairing, or removing any component of the SONET ring or PSTN. In the event that Z cannot transmit A’s telecommunications according to the terms of the contract, then Z is required to provide a service credit. The SONET ring and PSTN are also part of Z’s broader integrated operation of transmitting telecommunications. The PSTN is owned by Z and not dedicated to A (or any other of Z’s customers). Accordingly, the IRS concluded that Z derives its gross receipts from the performance of telecommunications services without the lease or rental of Z’s SONET ring and PSTN to A for purposes of Sec. 199, and the gross receipts are not DPGR.

In Situation 2, the IRS concluded that Z is using its dedicated circuit and PSTN to provide telecommunications services to A, not providing a combination of telecommunications services with a lease or rental of Z’s dedicated circuit or PSTN to A. Essentially, in Situation 2, A contracts with Z for reliable telecommunications services, and Z provides those services using its dedicated circuit and PSTN, subject to the contract terms governing the quantity and quality of services that Z must provide. The IRS noted that A does not control the dedicated circuit or PSTN because Z maintains the same control it has over the SONET ring and PSTN in Situation 1. Additionally, A does not have a possessory interest in the dedicated circuit and PSTN that Z uses to complete the transmissions. In fact, Z has broader access to a dedicated circuit than a SONET ring. The dedicated circuit is also part of Z’s broader integrated operation. The dedicated circuit must connect with Z’s PSTN to transmit telecommunications to and from A’s business location. Therefore, Z derives its gross receipts from the performance of telecommunications services without the lease or rental of Z’s dedicated circuit and PSTN to A for Sec. 199 purposes, and the gross receipts are not DPGR.

In Situation 3, the IRS ruled that Z is providing a combination of telecommunications services using its dedicated circuit and PSTN and a lease or rental of Z’s customer-premises equipment to A. Essentially, in Situation 3, A contracts with Z for reliable telecommunications services, and Z provides those services using its dedicated circuit and PSTN, subject to the contract terms governing the quantity and quality of services that Z must provide. However, A also contracts for the lease or rental of customer-premises equipment. With respect to the dedicated circuit and PSTN, the same analysis applies to Situation 3 as in Situation 2. The IRS pointed out that, under the contract, Z provides customer-premises equipment to A to allow A to connect with the dedicated circuit so that Z can transmit telecommunications to and from A’s business location. A controls this equipment, generally, in the same manner as in Situation 2, where A owns the customer equipment; however, in Situation 3, Z owns, and provides necessary telephone support services for, the customer-premises equipment and can perform certain remote maintenance and diagnostic tasks on it.

The IRS noted that A has a possessory interest in and operates the customer-premises equipment. For example, A can relocate or modify the customer-premises equipment and may attach it to non-Z equipment with Z’s written authorization, which Z may not unreasonably withhold. A is liable for any repair charges or the replacement cost of the equipment if it is damaged or lost. A must return the customer-premises equipment or make it available for removal by Z at the end of the contract term, or A will be liable to Z for the customer-premises equipment’s then-current market value. A is also liable for restoration costs beyond ordinary wear and tear. Since A is ultimately the party responsible for ensuring that the customer-premises equipment is available to connect with the dedicated circuit to allow Z to transmit telecommunications to and from A’s business location using Z’s dedicated circuit and PSTN, the customer-premises equipment should not be considered part of Z’s broader integrated network. Therefore, the IRS concluded that Z’s gross receipts derived from the performance of services are not DPGR. However, Z’s gross receipts derived from the lease or rental of the customer-premises equipment qualify as DPGR only if Z meets the other Sec. 199 requirements for the customer-premises equipment.

Implications

Rev. Rul. 2011-24 provides taxpayers in the telecommunications industry with insight into the IRS’s interpretation of whether certain gross receipts constitute DPGR for purposes of Sec. 199. Specifically, the revenue ruling summarizes the applicable federal income tax principles that the IRS believes are instrumental in determining whether agreements are service contracts or leases.

The three hypothetical situations presented in the revenue ruling offer taxpayers an additional framework for determining whether gross receipts are derived from the provision of services and/or the lease of qualified production property by indicating which fact patterns the IRS believes will result in qualifying activity under Sec. 199. Taxpayers that have taken the dedicated-circuit approach (i.e., the approach under the second two fact patterns) will not welcome the IRS’s conclusions. Going forward, taxpayers should carefully review the terms and conditions of their existing contracts to determine which factors described in the revenue ruling, if any, are satisfied. Taxpayers should also be very specific with these factors when drafting new contracts.

It is important to note that the revenue ruling recognizes that a single transaction, depending on applicable federal income tax principles, may consist of both a services element and a lease element. As such, taxpayers with facts similar to those discussed in Situation 3 may need to allocate gross receipts between DPGR and non-DPGR under Regs. Sec. 1.199-3(i)(4).

Furthermore, the revenue ruling may also help taxpayers in other industries distinguish between services and lease rentals. However, it should be noted that each inquiry is fact-specific.

EditorNotes

Michael Dell is a partner at Ernst & Young LLP in Washington, DC.

For additional information about these items, contact Mr. Dell at (202) 327-8788 or michael.dell@ey.com.

Unless otherwise noted, contributors are members of or associated with Ernst & Young LLP.