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

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Tax Hot Topics: Section 199 online software regulationsIn 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.

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