IRS discusses Section 199 online software regulations and application to service revenue

In a recent emailed chief counsel advice memorandum (ECC 201603028) (Jan. 15, 2016), the IRS addressed the appropriateness of applying the “self-comparable exception” and the “third party comparable exception” to determine if the gross receipts derived from the disposition of computer software qualified for purposes of Section 199. The emailed advice states that these exceptions apply only if a taxpayer derives gross receipts from providing customers access to computing capabilities they can unilaterally execute; the exceptions are irrelevant when the gross receipts are derived from providing a service through software.

In the memorandum, the IRS analyzed the evolution of the regulations in an effort to provide a better understanding of Treas. Reg. Sec. 1.199-3(i)(6), which deals with computer software. Through Notice 2005-14 and the first set of proposed regulations, the government took the position that the disposition requirement for computer software is met only when the software is provided to customers on a tangible medium or downloaded through the Internet and that all software accessed over the Internet should be treated as a service. However, some members of Congress asked the IRS and Treasury to reconsider the treatment of this software.

Later, the IRS and Treasury issued temporary regulations that provided exceptions under which gross receipts derived from software accessed online may be treated as derived from the disposition of software. Under the temporary regulations, the taxpayer (or another person) must provide the software (with only minor or immaterial differences) as a download or on a tangible medium. The temporary regulations didn’t modify the rule that gross receipts from the provision of online services don’t qualify. Subsequent final regulations adopted the temporary regulations and added nine examples.

In the memorandum, the IRS compared the various examples in the regulations to the fact pattern at issue and determined the facts most closely resembled those outlined under Example 1 of Treas. Reg. Sec. 1.199-3(i)(6). In that example, a taxpayer provided online banking services through its software, and thus any fees were attributable to services, and such gross receipts did not constitute domestic production gross receipts.

Tax professional standards statement
This content supports Grant Thornton LLP’s marketing of professional services and is not written tax advice directed at the particular facts and circumstances of any person. If you are interested in the topics presented herein, we encourage you to contact us or an independent tax professional to discuss their potential application to your particular situation. Nothing herein shall be construed as imposing a limitation on any person from disclosing the tax treatment or tax structure of any matter addressed herein. To the extent this content may be considered to contain written tax advice, any written advice contained in, forwarded with or attached to this content is not intended by Grant Thornton LLP to be used, and cannot be used, by any person for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.

The information contained herein is general in nature and is based on authorities that are subject to change. It is not, and should not be construed as, accounting, legal or tax advice provided by Grant Thornton LLP to the reader. This material may not be applicable to, or suitable for, the reader’s specific circumstances or needs and may require consideration of tax and nontax factors not described herein. Contact Grant Thornton LLP or other tax professionals prior to taking any action based upon this information. Changes in tax laws or other factors could affect, on a prospective or retroactive basis, the information contained herein; Grant Thornton LLP assumes no obligation to inform the reader of any such changes. All references to “Section,” “Sec.,” or “§” refer to the Internal Revenue Code of 1986, as amended.