Section 199 and Online Software — Correct Conclusion but Questionable Rationale

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By Gary D. Sprague, Esq.

Baker & McKenzie LLP, Palo Alto, CA

The IRS Chief Counsel's Office recently issued guidance on the §199 eligibility of a computer software application used to access online banking services. While the guidance reached the correct conclusion for the case at hand, the technical analysis included a couple of questionable interpretations of the §199 regulations as applicable to online software which do not seem necessary to determine the proper outcome in this case. As there has been little interpretation to date of the online software regulations, hopefully these interpretations will be reconsidered in the future as other cases arise.

In AM 2014-008 (Nov. 21, 2014), the taxpayer, a bank, provided its customers with a software application ("App") to enable online banking. Customers downloaded the App, but the App could only be used when the user was connected to the internet. No functions were available solely through functionality contained in the App. The taxpayer did not charge customers to download or access the App. Instead, the bank earned fees for providing certain banking services (e.g., wire transfers).

In general, §199 allows a deduction for a certain percentage of income from certain domestic production activities.  Section 199(c)(4)(A) defines "domestic production gross receipts" (DPGR) as including a taxpayer's gross receipts that are derived from any lease, rental, license, sale, exchange, or other 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. Section 199(c)(5) defines QPP to include "any computer software."

Reg. §1.199-3(i)(6)(ii) provides that gross receipts derived from certain online services, expressly including "online banking services," do not constitute gross receipts from the disposition of computer software. Reg. §1.199-3(i)(6)(iii) further provides that gross receipts from providing customers access to software MPGE within the United States "for the customers' direct use while connected to the Internet or any other public or private communications network (online software)" nevertheless will be treated as a qualifying disposition of computer software as long as one of two exceptions is satisfied.

The first exception that qualifies the payment for the provision of access to online software as DPGR applies if the taxpayer itself regularly derives income from the lease, rental, license, sale, exchange, or other disposition to unrelated customers of computer software that: (1) has only "minor or immaterial differences" from the taxpayer's online software; (2) has been MPGE in whole or in significant part within the United States; and (3) is provided to customers either on tangible media or via download. Reg. §1.199-3(i)(6)(iii)(A). The second exception applies if another person derives income from the lease, rental, license, sale, exchange, or other disposition of "substantially identical software" as compared to the taxpayer's online software. Reg. §1.199-3(i)(6)(iii)(B). This second qualifying circumstance is satisfied only if the third-party's software has the same functional result and has a significant overlap of features or purpose as the taxpayer's online software. Reg. §1.199-3(i)(6)(iv)(A).

The regulations provide several examples of qualifying and nonqualifying online software. Reg. §1.199-3(i)(6)(v) Ex. 1 describes a bank that produces computer software that enables its customers to receive online banking services for a fee. The facts do not state whether customers access the online banking services solely through a web browser, or through an app provided by the bank.  Referring to Reg. §1.199-3(i)(6)(ii) (quoted above), the example concludes that the bank's gross receipts are attributable to a nonqualifying service and not to the disposition of computer software.

The AM concluded that the provision of a free software application to enable online banking was not a qualifying disposition of computer software for purposes of §199 on the basis of three arguments. First, despite the fact that the App was downloaded, the AM concluded that the App should be analyzed as "online software" and not regarded as a separately "disposed" item of QPP. Second, the AM concluded that even if the bank were treated as disposing of the App, the bank derived its gross receipts from the provision of banking services and not from the provision of the App. Finally, assuming that the bank was regarded as providing access to online software, the GLAM concluded that neither of the two exceptions for online software otherwise delivered to customers via tangible medium or download applied. On that point, the taxpayer apparently had offered a very interesting argument to qualify under the second exception for software delivered by third-party providers by referring to a developer of online banking apps which apparently licensed its app to other banks, which banks then delivered copies of the app to their own users to allow online banking activity.

The IRS's arguments on the first and third points are questionable. The second point should have been sufficient, by itself, to dispose of the case.

The IRS first concluded that delivering the App via download was not a disposition on the basis that "[w]hile the §199 regulations contain references to computer software downloads as dispositions, the intent is to include downloaded software that has independent functionality after customers have downloaded it and are no longer connected to the Internet. See, e.g., Reg. §1.199-3(i)(6)(iii) and §1.199-3(i)(6)(v) Ex. 4.  This makes sense because if customers can only use downloaded computer software while connected to the Internet, the software cannot be materially distinguished from other software that customers access and directly use while connected to the Internet that is not downloaded (i.e., it is equivalent to online software)."

This interpretation, if applied more expansively to include software other than apps whose sole function is to allow communication with online functionality, could inappropriately call into question the eligibility for §199 benefits of a wide variety of applications that clearly should qualify under the statutory mandate that computer software can be QPP. It is common for software applications to be developed including features that rely on internet connectivity to operate. In some cases, some functions may be available solely through execution of the application as it resides on the user's device, although many features of the application may be degraded or unavailable due to the lack of internet connectivity. The AM interpretation apparently would still regard deliveries of these programs as not online software, as they provide at least some functionality based solely on executing the files that reside on the user's device. In some cases, however, the core functionality of the application may simply be unavailable if access to data or other applications hosted in the cloud are not available during the user session. In these cases, where a software program is in fact transferred to the user, it would seem that such transactions should be analyzed as a disposition of QPP that is not online software. The consequence of falling outside the online software classification is that the taxpayer then does not need to establish analogous offline transactions under one of the two exceptions described above to qualify its receipts as DPGR.

On the third point, the IRS addressed the applicability of the third-party exception, on the assumption that the App did constitute online software. The taxpayer apparently offered as a relevant third party a mobile app developer that licensed its app to other banks.  The AM referred to a third party, Z, which produced mobile banking software and licensed it to its customers, the taxpayer's competitor banks. The banks apparently then provided copies of the app to their own account holders. The account holders used Z's software in the same manner as the taxpayer's account holders used the App.

The IRS applied the third-party software test by focusing very narrowly on the use made by the immediate customer of the provider as opposed to the functionality of the software.  From that perspective, the Service concluded that Z's software did not produce the same functional result or serve the same purpose as the App because Z's software was used by Z's customers (i.e., banks) to provide banking services, while the App was used by the taxpayer's customers (i.e., account holders) to receive banking services.

This distinction essentially is focused on the place of the third-party transaction in the distribution chain as opposed to the functionality of the software. If this theory were extended to other cases, a showing that functionally identical software was licensed to a distribution intermediary for reproduction and distribution to users might not be regarded as sufficiently similar to the provision of online software direct to users that provides the same functionality.  There would seem to be no policy reason to make that distinction.

As interesting as these analytical issues may be, there was no need for the Service to push the boundaries of the regulations on these points when the second argument was perfectly sufficient to address the case. In that second argument, the IRS stated that even if the download of the App was a disposition of computer software, the taxpayer only earned revenue from providing online banking services, not from the disposition of the App. Therefore, the disposition still failed to qualify under §199 because the term "derived from the disposition" of QPP "is limited to gross receipts directly derived from the disposition." The App was provided free of charge, and the taxpayer charged fees only for completed banking transactions.

This point would seem to be entirely sufficient to determine the result in this case. After all, Example 1, described above, states expressly that online banking activities do not qualify for the online software rule. The fact that the bank provides a mobile app whose only function is to allow access to those online banking services should not change the result.

Based on the observations above, it would seem that the more appropriate analytical framework would be to conclude that providing the App to users could qualify as a disposition of computer software. The next question is whether some part of the taxpayer's gross receipts should be allocated to the App. In this case, the bank gave away the App for free, and the nature of the App clearly is ancillary to the bank's main activity of providing banking services, justifying no allocation of any banking fees to the provision of the App.

The result potentially could be different in other cases of free apps. There may be cases where a software company would document the delivery of a software program as for no charge, when it formed an important part of the company's provision of online software services to the user. In that case, it might be appropriate to allocate some portion of the fees for the services to the app.  In that context, a reasonable allocation would be made between the portion of gross receipts attributable to the app and the portion attributable to the rest of the services

This commentary also will appear in the May 2015 issue of the Tax Management International Journal.  For more information, in the Tax Management Portfolios, see Benko, 510 T.M., Section 199: Deduction Relating to Income Attributable to Domestic Production Activities,  and in Tax Practice Series, see ¶2220, Deduction for Domestic Production Activities.

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