Expenses & Deductions
Subject to a W-2 wage limitation, the Sec. 199 deduction is computed as a percentage (generally, 9% for 2010 and thereafter) of the lesser of a taxpayer's qualified production activities income (QPAI) or taxable income.
In general, a taxpayer's QPAI equals the excess of its domestic production gross receipts (DPGR) over (1) the sum of the cost of goods sold allocable to such receipts and (2) other expenses, losses, or deductions that are properly allocable to such receipts. DPGR are the gross receipts of the taxpayer derived from any lease, rental, license, sale, exchange, or other disposition (qualified disposition) of qualifying production property (QPP) that was manufactured, produced, grown, or extracted (MPGE) by the taxpayer in whole or in significant part within the United States. QPP includes tangible personal property, any computer software, and sound recordings.
Computer software provided to customers for their direct use while connected to the internet or other public or private communications network, collectively known as online software, is classified as a service provided to customers. Accordingly, because providing access to online software is classified as the provision of services, gross receipts attributable to the use of online software generally are not considered to be derived from a qualified disposition of software.
However, the Sec. 199 regulations provide two exceptions that, if satisfied, recharacterize the provision of online software as a qualified disposition of the software for Sec. 199 purposes.
Under the first exception (the self-comparable exception), gross receipts derived by a taxpayer from providing customers with access for their direct use of online software are treated as being derived from a qualified disposition of computer software—assuming all other Sec. 199 qualification requirements are met—if the taxpayer also derives on a regular and ongoing basis in its business gross receipts from a qualified disposition to customers (that are not related persons) of computer software that has (1) only "minor or immaterial differences" from the online software and (2) has been provided to such customers affixed to a tangible medium or by download from the internet (Regs. Sec. 1.199-3(i)(6)(iii)(A)).
Under the second exception (the third-party comparable exception), gross receipts derived by the taxpayer from providing access to online software for customers' direct use are treated as being derived from a qualified disposition of computer software—assuming all other Sec. 199 qualification requirements are met—if "another person" derives on a regular and ongoing basis in its business gross receipts from a qualified disposition to its customers of "substantially identical" software affixed to a tangible medium or by download from the internet (Regs. Sec. 1.199-3(i)(6)(iii)(B)). Substantially identical software is defined as computer software that (1) from a customer's perspective has the same functional result as the online software and (2) has a significant overlap of feature or purpose with the online software (Regs. Sec. 1.199-3(i)(6)(iv)(A)).
Banking apps: According to the facts set forth in generic legal advice memorandum (GLAM) 2014-008, the taxpayer is a bank that offers banking services to its customers through a variety of means, including through the taxpayer's mobile banking application (the App). The taxpayer's online platforms (including the App) allow customers to perform various banking activities, such as accessing bank accounts, making deposits, and wiring funds.
The taxpayer's customers can download the App free. The taxpayer grants customers a nonexclusive, nonsublicensable, nontransferable, personal, limited license to install and use the App on mobile devices that are owned and controlled by the taxpayer's customers. Customers may incur fees for receiving certain banking services, such as wire transfers or check deposits, initiated through the App.
Z, an unrelated third party, produces a mobile banking software application (App Z) that it offers to its customers—the taxpayer's competitor banks—by download over the internet. Z licenses App Z to the taxpayer's competitor banks and derives gross receipts from those licenses on a regular and ongoing basis. The taxpayer's competitor banks use App Z to provide banking services to their account holders. The competitor banks' customers use App Z in the same manner as the taxpayer's account holders use the App.
IRS analysis: The IRS first analyzed whether the taxpayer makes a qualifying disposition of computer software when customers download the App. The IRS determined that the App fits within the definition of online software because the App does not fully function unless the taxpayer's customers are connected to the internet. Therefore, the IRS found that the taxpayer does not dispose of computer software in a qualifying disposition. This determination, however, would not necessarily apply with respect to apps that have usable software functionality while not connected to the internet or any other public or private communications network.
The IRS further concluded that because the taxpayer does not meet either of the two online software exceptions in the regulations, no portion of the taxpayer's gross receipts could be treated as derived from a qualified disposition of computer software.
According to the IRS, the taxpayer does not meet the self-comparable exception with respect to any of its online software, which includes both its website and the App. The IRS found that the taxpayer does not dispose of any computer software that would satisfy the requirements to serve as a self-comparable to the online software for purposes of the exception.
The IRS also concluded that the taxpayer does not meet the third-party comparable exception because the third-party disposition of App Z to the taxpayer's competitor banks is not a disposition of substantially identical computer software. The IRS found that the computer software provided by Z provides a different functional result than, and does not have a significant overlap of purpose with, the taxpayer's computer software. In its view, the taxpayer's customers, who are account holders, use its online software to order individual banking services, while Z's customers, the taxpayer's competitor banks, use App Z to provide banking services to multiple account holders. The fact that the competitor banks' account holders use App Z in the same manner as the taxpayer's account holders use the App does not affect the IRS's analysis because the competitor banks' account holders are not relevant customers for purposes of the third-party comparable exception.
The IRS concluded that "a customer's perspective" under the third-party comparable exception refers to the direct customers of Z—that is, the taxpayer's competitor banks. However, the third-party comparable exception in Regs. Sec. 1.199-3(i)(6)(iii)(B) explicitly states that App Z must have the same functional result as the taxpayer's App from a customer's perspective—this regulatory language seems to reflect a perspective tied to any customer (in this case, end users of the apps), rather than only the direct customers of the unrelated third party.
The relevant test would seem to be whether the downloaded software maintains the same functionality in its downloaded form as that of the online version. Under such an analysis, one could question whether the regulatory language of the third-party comparable exception supports the IRS's conclusion in the GLAM that only the direct licensees of App Z, the taxpayer's competitor banks, are the relevant customers for purposes of the third-party exception.
Annette Smith is a partner with PricewaterhouseCoopers LLP, Washington National Tax Services, in Washington.
For additional information about these items, contact Ms. Smith at 202-414-1048 202-414-1048 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with PricewaterhouseCoopers LLP.