Section 199 and Cloud Software: Clearing the Fog

The domestic production activity deduction under Section 199 of the Internal Revenue Code of 1986, as amended (hereinafter “Section 199”), provides a deduction equal to nine percent of the lesser of taxable income or income attributable to certain qualified production activities. For the 2016 fiscal year, this deduction was estimated as a $15.8 billion tax expenditure, the third largest corporate tax expenditure behind only the deferral of income on certain foreign earnings and accelerated depreciation.¹ Not surprisingly, with the large tax expenditure comes significant scrutiny from the Internal Revenue Service (IRS), particularly with respect to deductions claimed for making software available to customers.

The IRS has taken a very restrictive view of the type of software and software-related transactions that qualify for the Section 199 deduction, a view that is unwarranted by, and inconsistent with, the language of the statute and the well-established purpose of Section 199. This article begins with a brief discussion of the history of Section 199. The second section describes the IRS’ current position on the eligibility of software-related revenues to qualify as domestic production gross receipts, a key input in computing the amount of the Section 199 deduction. This section also includes a discussion of the IRS’ most recent articulation of its position, a heavily redacted IRS Chief Counsel Advice (CCA 201724026 (June 6, 2017)). The third section discusses potential paths forward for taxpayers that have claimed a Section 199 deduction with respect to their software activities but are concerned that the deduction may be disallowed on audit, or at Appeals, based on the current IRS position.

History of Section 199

Congress has long recognized that many production activities are significantly more expensive in the United States than in foreign jurisdictions. A combination of higher labor costs and more expensive materials has made it difficult for U.S.-based operations to compete against foreign enterprises. Congress has enacted numerous provisions to attempt to stimulate domestic production, including various tax credits, accelerated depreciation, and bonus depreciation.

Much of Congress’s past effort also focused on leveling the playing field with foreign competition. Over the years, Congress attempted a variety of approaches to make U.S. industry more competitive globally. Those efforts included the Domestic International Sales Corporation (DISC) regime, the Foreign Sales Corporation (FSC) regime, and the Extraterritorial Income (ETI) regime. Each was designed to give domestic producers tax incentives that would allow them to compete more effectively with their offshore counterparts. However, none was viable in the long term, as each was successfully challenged by the European Union (or its predecessor).

Faced with the threat of $4 billion of retaliatory tariffs after the United States’ most recent defeat before the World Trade Organization, Congress repealed the ETI regime and replaced it with what is now Section 199. The Senate Finance Committee, in reporting on its version of the ETI repeal, stated:

The Committee understands that simply repealing the ETI regime will diminish the prospects for recovery from the recent economic downturn by the manufacturing sector. Consequently, the Committee believes that it is necessary and appropriate to replace the ETI regime with new provisions that reduce the tax burden on domestic manufacturers, including small businesses engaged in manufacturing.²

Statements by the relevant Congressional committees on the proposed legislation that would become Section 199 are evidence that Congress’s intent in enacting the provision was to stimulate job creation through lowering the overall tax burden on domestic manufacturing activities. For example, in its Report on the JOBS Act, the Senate Finance Committee stated: “The Committee believes that creating new jobs is an essential element of economic recovery and expansion, and that tax policies designed to foster job creation also must reverse the recent declines in manufacturing sector employment levels.”³ The House Ways and Means Committee similarly stated in its report:

The Committee also believes that it is important to use the opportunity afforded by the repeal of the ETI regime to reform the U.S. tax system in a manner that makes U.S. businesses and workers more productive and competitive than they are today. To this end, the Committee believes that it is important to provide tax cuts to U.S. domestic manufacturers and to update the U.S. international tax rules, which are over 40 years old and make U.S. companies uncompetitive in the United States and abroad. . . . The Committee believes that creating new jobs is an essential element of economic recovery and expansion, and that tax policies designed to foster economic strength also will contribute to the continuation of the recent increases in employment levels. To accomplish this objective, the Committee believes that Congress should enact tax laws that enhance the ability of domestic businesses, and domestic manufacturing firms in particular, to compete in the global marketplace. The Committee believes that a reduced tax burden on domestic manufacturers will improve the cash flow of domestic manufacturers and make investments in domestic manufacturing facilities more attractive. Such investment will create and preserve U.S. manufacturing jobs.⁴

Finally, the Conference Report, which reported on Congress’s final version of Section 199, stated:

The conferees recognize that manufacturers are a segment of the economy that has faced significant challenges during the nation’s recent economic slowdown. The conferees recognize that trading partners of the United States retain subsidies for domestic manufacturers and exports through their indirect tax systems. The conferees are concerned about the adverse competitive impact of these subsidies on U.S. manufacturers.⁵

In short, Section 199 was designed to provide incentives to keep jobs at home and encourage expansion of domestic employment and at the same time to remain compliant with the U.S.’s existing trade and treaty obligations. To do so, Congress had to eliminate the international component of the earlier attempts, as those types of regimes had repeatedly failed in international courts. Instead, Congress enacted a broad-based, effective tax rate reduction for all domestic production activities that result in a qualifying disposition of a product manufactured, produced, grown, or extracted (MPGE) in the United States. Any effort to interpret Section 199 should do so with its fundamental purpose in mind.

A Primer on Section 199 Calculation

Determining whether a taxpayer qualifies for the Section 199 deduction and, if so, the amount of the deduction is a complicated endeavor. At its most basic level, the Section 199 deduction is nine percent of the lesser of the taxpayer’s taxable income or qualified production activities income (QPAI).⁶ For this purpose, taxable income is determined pursuant to Section 63 and without regard to Section 199. This means that the Section 199 deduction is capped at nine percent of the QPAI amount (i.e., the income from the manufacturing activities that Congress intended to incentivize), unless the QPAI amount exceeds the taxable income of the taxpayer, in which case the lower taxable income amount is used to calculate the deduction. As a simple example, assume a taxpayer operates two divisions, one of which generates one hundred dollars of QPAI and the other of which generates forty dollars of service income. In this example, the Section 199 deduction would be limited to nine percent of the one hundred dollars of QPAI. On the other hand, if the service division were to lose forty dollars instead, the Section 199 deduction would be limited to nine percent of the sixty dollars of the net taxable income generated by the taxpayer, even though the QPAI was significantly larger than the taxable income.

QPAI often determines the amount of the Section 199 deduction, particularly for single-line-of-business taxpayers that do not have a significant amount of non-QPAI-generating activity. QPAI is the excess of the taxpayer’s domestic production gross receipts (DPGR) over the sum of (i) the cost of goods sold (CGS) that are allocable to such DPGR; and (ii) other expenses, losses or deductions, which are properly allocable to such DPGR.⁷ DPGR is the gross receipts of the taxpayer derived from certain qualifying activities, the most important of which includes the rental, license, sale, exchange, or other disposition of qualifying production property that was MPGE by the taxpayer in whole or in significant part within the United States.⁸

There is another important limitation on the amount of the Section 199 deduction: the deduction cannot exceed fifty percent of the taxpayer’s W-2 wages for the year. For purposes of calculating the fifty percent wage limitation, the term “W-2 wages” refers to the sum of the aggregate amount the taxpayer is required to include pursuant to Sections 6501(a)(3) and (8) on the W-2s for its employees that are allocable to DPGR.⁹ This wage limitation produces disparate impact depending upon the industry of the taxpayer. For example, a taxpayer in a capital-intensive industry may generate significant QPAI, without incurring any material labor expenses. In other labor-intensive industries, the W-2 limitation will have no impact on the amount of the deduction. This computation confirms that the Section 199 deduction should be viewed as a broad-based incentive for labor, which is fitting for a provision enacted in the JOBS Act.

Putting this all together, for a corporate taxpayer solely engaged in the MPGE of a widget, the Section 199 deduction would be nine percent of the revenues from selling widgets, less the cost of goods sold for such sales (assuming, for these purposes, that the wage limitation does not apply). In this highly simplified example, the revenues from selling widgets, less the cost of goods sold, would approximate the taxpayer’s net taxable income for the year. The Section 199 deduction of nine percent of net taxable income would then have the effect of decreasing the taxpayer’s tax rate from thirty-five percent to thirty-two percent as a means to incentive manufacturing and production within the United States.

Computer Software Is Within Scope of Section 199

Although software development is not typically thought of as manufacturing, Congress specifically made the Section 199 deduction applicable to software that is developed or produced in the United States and made available to customers in a qualifying disposition. From a policy perspective, it was no surprise that Congress applied the Section 199 deduction to software production. The United States has long sought to be at the forefront of technological advancements. Moreover, software development jobs are particularly prone to being lost offshore. Software development does not require extensive property, plant, or equipment and thus can easily be moved without sacrificing infrastructure investment. As Linda Levine observed in a report for the Congressional Research Service:

The now widespread dissemination of technologies that enable relatively low cost, good quality, and high-speed transmission of voice and data communications has allowed U.S. firms to extend offshoring beyond the jobs of workers that produce goods to the jobs of workers that provide services (e.g., writers of software code. . .).¹⁰

Levine also observed that, “[t]he occupational groups identified as being vulnerable to offshoring include . . . computer programmers and software engineers . . . .” The Bureau of Labor Statistics concurred, reporting that “virtually all computer and mathematical science occupations [are] to some degree susceptible to offshoring.”¹¹

Moreover, numerous developing countries, most notably India, have ever-increasing capacity to perform software development and production activities. India has numerous exceptional computer science educational institutions and an ever-larger workforce of highly trained specialists. Other countries, including China and Russia, are following suit. As a result, the supply of capable foreign software development and production personnel is growing rapidly, exacerbating the risk of losing skilled technical jobs domestically. Any domestic job loss is problematic, but losing technical jobs in the information age is particularly troubling.

Of course, the availability of jobs is a function of the demand for services. When production costs are higher in one jurisdiction, demand for employees in that jurisdiction can be expected to decline as production activities migrate to lower-cost locations. To the extent that costs are higher in the United States than in other countries where there is capacity to perform similar production activities, such as software development, there will be less production in the United States. Congress designed the domestic production activity deduction to offset that effect with respect to the activities to which it applies, including technology-related jobs, by reducing the cost to produce in the United States, thereby stimulating U.S. production and the demand for U.S. workers.

Even though Congress contemplated that software production could qualify for the Section 199 deduction, Congress provided very little guidance as to what would constitute a qualifying disposition of software. The statute itself refers to “any lease, rental, license, sale, exchange or other disposition” of the software.¹² Each of the first five conveyances described in the statute is a well-worn concept in the tax law, with the sixth catchall bringing in other undefined types of transactions. Congress did not condition its granting of this important incentive to software producers on the particular medium used to make the software available to customers. Nor does the statute support denying a deduction for the domestic production of software when the customer pays for online access to the taxpayer’s software for the customer’s own use. Any disposition of software, including by making it available for a fee while the user is connected to the internet, should be sufficient to qualify under Section 199, if the other requirements of the section are met.

Despite the broad qualification for dispositions, Congress did not intend to extend the Section 199 deduction to taxpayers that provide services to their customers, including services provided by software.¹³ But in attempting to distinguish between software and services in the context of certain types of internet software, the applicable Treasury regulations (which we describe in more detail below) take a ham-handed approach that purports to lump a significant portion of internet software into the “services” category unless certain extra-statutory exceptions apply. To make matters worse, for reasons we describe below, the IRS has interpreted those exceptions in an unduly narrow manner. This approach has generated significant controversy between the IRS and the taxpayer community. This controversy is unnecessary and runs counter to the policy objectives of Section 199.

The Evolution of Computer Software

When Section 199 was enacted, the common delivery models for software differed from what they are today. At that time, users purchased PCs with preloaded operating systems. Thus, to purchase a PC was to buy at least two things: the hardware and the embedded software essential to make the computer operate. Computers were also generally preloaded with other types of software (e.g., word-processing programs). Often, users purchased additional software with their computers, such as security programs, games, and educational tools. Many users also purchased disks containing software from their local software stores to install on their machines. Others downloaded software over the internet. Once installed, the software they purchased resided on their own computers and did not depend on internet access to function. In the remainder of this article, we refer to this type of software as “traditional software.”

The internet’s evolution from obscurity to ubiquity has had considerable impact on the development and functionality of computer software. Much traditional software was developed without the functionality of the internet in mind. Today, almost all modern computer software depends on the internet in some way, and a significant amount of computer software is designed exclusively for use on, or while connected to, the internet. Although much of this software still resides in whole or in part on the end user’s device (which we refer to as “connected software”), more and more computing capacity and software resides in the “cloud” on remote computers (which we refer to as “cloud software”) rather than on the end user’s device.

In lay terms, cloud computing involves making computing capability and cloud software (which may include operating system software, networking software, and software providing specific end-user functionality) available to customers. When using cloud software, customers use their computers or other devices to gain access to remote computers operated by a cloud service provider (CSP). In doing so, customers at a minimum use the networking software, operating systems, and computing capacity made available by the CSP. In certain cases, the end user may also use other software made available by the CSP.¹⁴ The operating system software, the networking software, and the end-use software reside on the CSP’s server, and the end users generally do not download any of those to their own computers. In some circumstances, customers may also use the computing capacity, operating systems, and networking software made available by the CSP to run their own software or third-party software.

In the process of using cloud computing, a customer effectively uses (and, in the case of paid software, pays to use) computing capacity and one or more pieces of cloud software. The CSP may also provide support services to users. It is therefore impossible to lump all CSPs into the category of service providers, or to assign inflexible labels (such as “banking services”) to all aspects of a particular instance of cloud software. Much cloud software is far more complicated than traditional software, and necessarily involves multiple layers of software and hardware, all of which must work harmoniously for the offering to function as desired.

It should be noted that due in part to the fact that cloud software is not physically transferred to the end user’s device, cloud computing capacity and cloud software (in all its forms) are often referred to by the industry as “services” and are properly treated as not involving property dispositions for state tax law purposes. The software functionality and user experience, however, are essentially the same as in the case of traditional software or connected software. But while the distribution of tax preparation software via disk is generally regarded as a sale or license of property, granting access to cloud software that provides the same tax preparation functionality is generally referred to by the industry as a service, even though both transactions have the same effect for customers: they can use computer software for a fee to prepare a tax return.

The industry’s categorization of software as a service is not the proper basis upon which to distinguish between software that should or should not qualify for the Section 199 deduction. How, then, can one distinguish between software that belongs in the “service” category and software that belongs in the “software” category for Section 199 purposes? The answer lies in the substance of the functionality performed or offered by the software. Software can be divided broadly into two baskets. In one basket is software that allows end users to undertake tasks they wish to perform, using that software and either its own computing capacity (in the case of connected software) or the capacity of a CSP (in the case of cloud software). We refer to this type of software as “tool software.” In all cases, the software provides the end user with functionality to be used as the customer sees fit. Such software is a tool employed by end users for use in their business or personal activities and not solely to allow them to communicate with the provider or to facilitate the provider’s provision of services. Thus, for example, networking software that allows computers used by the end users to perform the tasks sought by those end users and end-use software, e.g., accounting and tax preparation software, fall within the tool software category. Tool software ought not to be viewed as the type of “service” that is outside the scope of Section 199, even if the industry labels such cloud software as a service.

The second basket contains software that a business makes available, at least in part, to allow its customers to do business with it, such as software that a bank makes available to allow its customers to perform a traditional banking service that a teller might otherwise perform, like depositing checks and transferring funds from one account to another. We refer to this type of software as “mixed software.”

It would be simplistic to classify all revenues associated with mixed software as services revenue. For example, a bank may offer software that permits customers to perform the traditional banking services described above.¹⁵ This sort of functionality may be viewed as a service, because the software substitutes for a bank teller that would have performed the same services in the pre-internet era. But the software offered by a bank may do much more than that. It may, for example, permit a banking customer to analyze income or spending trends, categorize debits and credits according to spending or income categories, and generate financial reports. This sort of functionality goes beyond traditional banking services and may well replace traditional software that one would previously have had to purchase to perform the same tasks. In other words, some aspect of mixed software may have the functionality of tool software.

In short, one cannot and should not take an overly narrow view of the function and purpose of modern software—particularly cloud software—in an attempt to make judgments about applying Section 199. Few, if any, examples of cloud software only provide services; many types do not replace services at all, whereas others both provide a tool and replace certain services. Yet the IRS’ position regarding the treatment of connected software and cloud software takes exactly this sort of narrow view. This approach cannot be justified in the context of Section 199’s language and purpose and is arguably inconsistent with the operative provisions of the applicable Treasury regulations.

IRS Position on Computer Software

Current Treasury Regulations

The current version of the Section 199 Treasury regulations starts with the general provision that DPGR includes, among other things, gross receipts “derived from the lease, rental, license, sale, exchange, or other disposition of computer software” that is produced by the taxpayer in whole or in significant part within the United States.¹⁶ This general rule is largely uncontroversial because it is consistent with the legislative history and the purpose of Section 199, as described above.

But the IRS was concerned that the provision of software can, in certain circumstances, become the provision of a service—an activity that Congress did not intend to incentivize through the Section 199 deduction. As a result, in the next paragraph, the regulations pull back from that general rule by providing that gross receipts from online services (such as internet access services, online banking services, providing access to online electronic books, newspapers and journals), and other similar services do not constitute gross receipts derived from a lease, rental license, sale, exchange, or other disposition of computer software and thus are not included as DPGR.¹⁷ Again, this rule in and of itself is largely uncontroversial, as Section 199 was not intended to incentivize the provision of services, and the IRS, through regulations, was not authorized to expand the scope of the Section 199–qualifying activities to include gross receipts from the provision of services. However, it should not be the case that all software used while connected to the internet is converted into a service described in that second paragraph.

The IRS, apparently concerned that it would be difficult to distinguish between software and services in the context of software that is hosted at least in part in the cloud, enacted further regulations to deal with such software. The current attempt to distinguish between software disposition and services provided by software is found in Treasury regulation § 1.199-3(i)(6)(iii). This regulation provides that, “Notwithstanding paragraph (i)(6)(ii),” if a taxpayer derives gross receipts from providing customers access to computer software for the customers’ direct use while connected to the internet or any other public or private communications network (online software), then such gross receipts will be treated as being derived from the lease, rental, license, sale, exchange, or other disposition of computer software only if:

The taxpayer also derives, on a regular and ongoing basis in the taxpayer’s business, gross receipts from the lease, rental, license, sale, exchange, or other disposition to customers that are not related persons (as defined in paragraph (b)(1) of this section) of computer software that—
1. Has only minor or immaterial differences from the online software;
2. Has been MPGE by the taxpayer in whole or in significant part within the United States; and
3. Has been provided to such customers either affixed to a tangible medium (for example, a disk or DVD) or by allowing them to download the computer software from the Internet; or
Another person derives, on a regular and ongoing basis in its business, gross receipts from the lease, rental, license, sale, exchange, or other disposition of substantially identical software (as described in paragraph (i)(6)(iv)(A) of this section) (as compared to the taxpayer’s online software) to its customers pursuant to an activity described in paragraph (i)(6)(iii)(A)(3) of this section.

In an internal memorandum, the IRS has provided a detailed explanation of its view of the genesis of these regulatory distinctions. This explanation can aid in understanding the distinction that was attempted in the drafting.

First, [in] [sic] Notice 2005-14 and the first proposed regulations, the Treasury took a position that the disposition requirement for computer software is met only when computer software is provided to customers on a tangible medium (disk or CD) or by download over the Internet. See T.D. 9262 at 3 and T.D. 9262 [at] [sic] 4. All software accessed over the Internet only was treated as a service (non-qualifying for 199). This different treatment of computer software based on the method of its delivery was criticized in the public comments and in a letter to Treasury some members of Congress asked the Treasury to reconsider the different treatment of computer software that is solely accessed on the Internet v. downloaded or sold in a box. “[O]n July 21, 2005, the Chairman and Ranking Member of the Senate Finance Committee and the Chairman of the House Ways and means Committee sent a letter to the Treasury Department suggesting that the Treasury Department consider further the treatment of online access to computer software and, in particular, whether such treatment should be similar to the treatment of computer software distributed by other means, such as by physical delivery or delivery via internet download. The letter notes that gross receipts from the provision of services are not treated as DPGR, regardless of the fact that computer software may be used to facilitate such service transactions.” See T.D. 9262.

Next, the Treasury issued temporary regulations (T.D. 9262) providing for the first time “two exceptions under which gross receipts derived by a taxpayer from providing computer software to customers for the customers’ direct use while connected to the internet will be treated as being derived from the [disposition] of such computer software.” The published preamble explains that the exceptions were made “as a matter of administrative convenience.” At the same time, the temporary regulations did not modify the rule that the gross receipts from the provision of online services do not qualify. This rule was retained in Treasury regulation § 1.199-3(i)(6)(ii), and it provides that gross receipts derived from customer and technical support, telephone and other telecommunication services, online services (such as internet access services, online banking services, providing access to online electronic books, newspapers, and journals), and other similar services do not constitute gross receipts derived from the disposition of computer software.

The final regulations adopted the temporary regulations and added nine examples illustrating the rules. T.D. 9317. The preamble to the final regulations provides: [t]o give meaning to the statutory language requiring [disposition], the online software exceptions have been narrowly tailored and are intended to apply only to gross receipts derived from providing customers access to computer software for the customers’ direct use while connected to the internet and only when the taxpayer (or another person) also derives gross receipts from the [disposition] of the computer software (or substantially identical software) affixed to a tangible medium or by download.” The “narrowly tailored” exceptions are now known as the “self-comparable exception” (in A) and the “third party comparable exception” (in B) of Treas. Reg. § 1.199-3(i)(6)(iii) (collectively, Exceptions).¹⁸

Regrettably, the IRS takes very restrictive views of the software-related gross receipts that are eligible for computing the Section 199 deduction.

A real-world fact pattern can be used to illustrate how the IRS views the interplay of the three regulatory provisions. In AM 2014-008 (November 21, 2014), the IRS considered whether a taxpayer derives domestic production gross receipts from the disposition of computer software when the taxpayer allows its customers to download computer software (the “app”) free of charge, and the app allows customers to access the taxpayer’s online fee-based services (online banking services, under the facts of the memorandum). The IRS organized its analysis in three parts: (i) whether the download of the app is a qualifying disposition; (ii) whether the taxpayer derives gross receipts from the app; and (iii) whether the exception to Treasury regulation § 1.199-3(i)(6)(iii) applies.

In rejecting the taxpayer’s claim of domestic production gross receipts with respect to the app, the IRS concluded that downloading the app was not a qualifying disposition.

While 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., Treas. Reg. §§1.199-3(i)(6)(iii) and (v), Example 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).

Thus, even where computer software is downloaded and accessed locally by the end user, the IRS distinguished between connected software (i.e., software that depends on internet access to function) and traditional software (i.e., software that does not depend on internet access) and took the view that all connected software must satisfy the self-comparable or third-party comparable exceptions.

The second part of the IRS’ analysis in AM 2014-008 was whether the taxpayer derived gross receipts attributable to the app.¹⁹ Treasury regulation § 1.199-3(i)(1)(i) provides that the Section 199 deduction calculation is limited to gross receipts directly derived from the qualifying disposition. The fact pattern posited in AM 2014-008 involved a situation where the app itself was downloaded for free, even though the taxpayer might earn fees in connection with the customer’s use of the app’s functionality. In concluding that the taxpayer did not derive any gross receipts from the app, the IRS appeared to place significant weight on the fact that the app could initially be downloaded for free.

The final part of the IRS’ analysis in AM 2014-008 was whether downloading the app satisfied either the self-comparable exception or third-party comparable exception described above. The IRS quickly dismissed the self-comparable exception because, according to the IRS, the taxpayer did not dispose of any software (the taxpayer’s website was likewise not treated as a disposition), so there would be nothing to compare to the app. The IRS also drew factual distinctions between the app’s functionality (which was limited to accessing banking services provided by the taxpayer) and that of a third-party comparable (which was used by the taxpayer’s competitors and their customers to provide competing banking services).

The IRS’ position has been frequently criticized.²⁰ The test that was applied in the first issue in the memorandum appears to have been devised from whole cloth. For example, the statute itself provides that a qualifying disposition includes the “lease, rental, license, sale, exchange, or other disposition” of the computer software, and the self-comparable and third-party exceptions can both be invoked if the comparable software is disposed of via “download . . . from the Internet.”²¹ The IRS’ analysis notes that the app was downloaded, and that in the process the taxpayer’s customers were given a limited license to install and use the app. Nevertheless, the IRS concludes that there was no disposition, because the app was connected software (because its functionality depended on a continuous connection to the internet). But the fact that the taxpayer’s app was connected software is logically unrelated to whether the transfer of the app to its customers constituted, for tax purposes, a lease, rental, license, sale, or other disposition.²²

As to the second issue in this memorandum, the IRS applies an overly simplistic analysis in determining whether the taxpayer’s use of the app should be treated as generating gross receipts that are attributable to the disposition of the app. According to the IRS, the taxpayer did not derive gross receipts “from allowing its customers to download its [a]pp.” This analysis seems to make no effort to determine whether any of the ongoing fees earned by the taxpayer in connection with its customers’ use of the app should be attributed to the customers’ license to use the app, regardless of whether a fee was assessed for the right to download the app. The computation of the Section 199 deduction requires precisely this type allocation. It should not be enough merely to state that no separate consideration was specified for the right to download computer software initially. The question should be what receipts the taxpayer earned as consideration for granting the right to use the software.

In short, the IRS’ position in AM 2014-008 effectively lumped connected software and cloud software together and then narrowly applied the comparables exception. Such an approach is unjustified and, if sustained, would gut the self-comparable and third-party comparable exceptions.²³

Outdated Delivery Requirements

The IRS’ analysis in AM 2014-008 aptly illustrates how and why the Section 199 regulations (and the IRS’ interpretation of those regulations) have not kept pace with the software market. The means of delivering software have changed over time and are bound to continue changing. Modern software is either connected software or cloud software. Traditional software is becoming a relic of the past. In addition, even in the case of connected software, the means to transmit that software have evolved. Long gone are the days when Netscape and AOL filled our mailboxes with CDs.²⁴ Most connected software is now delivered via online download. As a result, the existing self-comparable and third-party comparable exceptions will be increasingly difficult to qualify for as taxpayers and their competitors shift toward developing cloud software, particularly if, as the IRS argues, connected software cannot be relied upon as a comparable to satisfy either of the clause (iii) exceptions. And the IRS’ narrow construction of these exceptions, if sustained, would mean that more and more computer software will become ineligible for the Section 199 deduction. There is no evidence to suggest that Congress envisioned or intended this result.

On the contrary, Congress recognized the risk that Treasury’s initial strained interpretation of the provisions governing software would fail to keep pace with technological developments. As noted in CCA 201603028 (quoted above), in a letter to Treasury in 2005, the chairman of the House Committee on Ways and Means and the chairman and ranking member of the Senate Finance Committee directed Treasury to “consider further, the treatment of online access to computer software and, in particular, whether such treatment should be similar to the treatment of computer software distributed by other means, such as by physical delivery or delivery via internet download.”²⁵ This language sent a strong signal that the method of giving customers access to software should not affect eligibility for the deduction. Nevertheless, the IRS and the Treasury Department apparently felt that their options were limited in promulgating the current version of the regulations in order to give meaning to the statutory language that requires a disposition. They drafted the online software exceptions narrowly and retained the self-comparable and third-party comparable tests that were included in the temporary regulations.²⁶

Notwithstanding Treasury’s concerns at the time that it promulgated the regulations, in order to give effect to Congress’s intention, the applicable rules should not be interpreted to restrict qualification to certain ways of delivering software at the expense of others, especially when the favored means of distribution in the existing regulations are becoming outdated; in fact, the statute provides no support for drawing such distinctions. The purpose of Section 199 as applied to software demands that the regulations be interpreted in a manner that is compatible with the growing, some might say paramount, importance of the delivery of software over the internet.

CCA 201724026

On June 16, 2017, the IRS released a highly redacted CCA expounding upon its analysis of the computer software regulations under Section 199. The IRS described a taxpayer that offered its customers access to a platform that included websites, interfacing software applications, servers, hardware, etc. The taxpayer charged a variety of fees for the features and functions offered to customers on each platform. Some features were required for customers’ use of a platform and were subject to mandatory fees. Other features were offered on an optional basis and were subject to various fees that customers could choose to pay. However, the taxpayer did not separately or directly charge for computer software on the platforms or the enabling infrastructure.

In the CCA, the IRS stated that the “Taxpayer’s computer software allows customers to [redacted text] which is similar to the Internet auctions described in Example 2.” The referenced example states:

M is an Internet auction company that produces computer software within the United States that enables its customers to participate in Internet auctions for a fee. Under paragraph (i)(6)(ii) of this section, gross receipts derived from online auction services are attributable to a service and do not constitute gross receipts derived from a lease, rental, license, sale, exchange, or other disposition of computer software. M’s activities constitute the provision of online services. Therefore, M’s gross receipts derived from the Internet auction services are non-DPGR.²⁷

In analyzing whether the taxpayer’s software qualified for the Section 199 deduction, the IRS depicted the line drawing problem as one in distinguishing between receipts from services enabled in part by computer software and receipts from providing customers access to computer software. In doing so, the IRS placed significant weight on the examples in the regulations. A blunt view of the IRS reasoning is that the taxpayer was only providing a service to its customers because the regulatory examples indicate that superficially similar online auction software is a service. By concluding that the taxpayer was providing a service, the conclusion that the taxpayer’s gross receipts were not eligible for use in computing the Section 199 deduction was not surprising. The IRS explained its conclusion as follows:

After considering the substance of the transactions between taxpayer and its customers (including the language in relevant customer user agreements and schedule of fees) and the rules described in § 1.199-3(i)(6), we conclude that Taxpayer’s gross receipts from online [redacted]. . . and fees in connection with online [redacted] are for services enabled in part by computer software, rather than from providing customers access to computer software for their direct use. Taxpayer cannot treat any of these fees as from the disposition of computer software under § 1.199-3(i)(6)(iii). They remain gross receipts from online services under § 1.199-3(i)(6)(ii).

This explanation suggests that the taxpayer in the CCA was offering a single, monolithic piece of cloud software, all of which served as a means of providing services, and no aspect of which permitted the end user to use the software to perform desired functions beyond the receipt of services. While the heavily redacted nature of the CCA makes it impossible to determine whether or not the IRS’ treatment of the taxpayer’s software was fair, the IRS’ justification for its position at the very least hints at the use of an unjustified oversimplification. Simply pointing out that a taxpayer’s software permits functionality that is “similar” to the services in the highly simplified examples in the regulations does not demonstrate a degree of analytical vigor that one would expect to be necessary in order to analyze the functionality of most modern cloud software.

Another thread running through the heavily redacted CCA is that the IRS, in analyzing the substance of the transactions, reached its conclusion, in part, because the taxpayer did not separately identify its fees, and that identifiable software fees are an implicit prerequisite to distinguish between the provision of services and the disposition of software. Consistent with that approach, the IRS’ position might be that unless there is a stand-alone charge for the software disposition, a bundled transaction that includes any services will be treated as the provision of services and not the disposition of software. Of course, there is no legal basis in the statute, legislative history, or the regulations themselves for making the Section 199 deduction dependent upon the existence of a separately charged fee. Example 6 of the applicable Section 199 regulations makes clear that a separately stated fee is not necessary.28 Moreover, such a condition would make no sense given that taxpayers could separately identify a software fee without changing the ultimate economics of the relationship between the parties.

Rather than setting out its detailed legal analysis for why the taxpayer is ineligible for the Section 199 deduction, the CCA devoted significant efforts to refuting what may, for the reasons set out below, amount to a straw man argument. The CCA suggests that the taxpayer’s position was that because the taxpayer’s platform satisfied the third-party comparable standard in the regulations, Treasury regulation § 1.199-3(i)(6)(iii) converted all of its gross receipts from providing access to the platform into gross receipts from a disposition of computer software. The IRS rejected this argument. The IRS argued that Treasury regulation § 1.199-3(i)(6)(iii) is a limited exception that only applies to gross receipts from providing customers access to computer software for their direct use. The inference is that the IRS believes this software was not directly used by the customer, but the CCA does not explain how it reached that conclusion where the customer was in fact using the software. According to the IRS, largely based on its reading of the regulatory examples, the online platform provided by the taxpayer was providing a service, not access to computer software, and thus, the Treasury regulation § 1.199-3(i)(6)(iii) exception would not apply even if the third-party comparable requirement was otherwise met. In advancing this position, the CCA did not offer a cogent reading of Treasury regulation § 1.199-3(i)(6)(iii). Moreover, the CCA never came to grips with whether a portion of the taxpayer’s revenues were attributable to the disposition of computer software, and not the provision of services, and thus, were eligible for the Section 199 deduction as illustrated by Treasury regulation § 1.199-3(i)(6)(v) (Example 6). The CCA included an additional page of “CASE DEVELOPMENT, HAZARDS AND OTHER CONSIDERATIONS,” which may recognize the weakness of this legal position.

Potential Paths Forward

The good news, perhaps, is that the IRS is considering how to eliminate the focus on the delivery method. Speaking at the September 18, 2015 American Bar Association Section of Taxation Meeting, Christopher Call, attorney-advisor, Treasury Office of Tax Legislative Counsel acknowledged that “We think there is a general shift toward a model where there is no downloadable version and no disks being sold and we really may end up in a world where everything is online and all software is really just a license.” Given the shift in technology, the government is looking for a new rule that is more easily administered than the third-party comparable rule and is consistent with the current model.29 While this is an outcome that even the IRS foresaw at the time the current Treasury regulations were issued, the IRS is still working through these issues and currently it is unclear whether any new regulations will make the Section 199 deduction more accessible.

In the meantime, it is unfortunate for taxpayers that the IRS has chosen to apply an unduly narrow interpretation of what are already muddled regulations. Under the IRS’ view, some taxpayers who receive a fee for making software they produced available to customers do not qualify. If upheld, the IRS’ interpretation of the current regulations will mean that many taxpayers whose software development activities are exactly the type that Congress intended to incentivize will be denied a Section 199 deduction.

Nevertheless, we believe that taxpayers whose Section 199 deductions are challenged based on the IRS’ unduly narrow interpretation may have at least three arguments at their disposal. First, taxpayers who develop software may argue that a strict and literal interpretation of the operative provisions of the regulations is required in light of the purpose of Section 199, and that under such an interpretation, it is not necessary that their software qualify for the self-comparable or third-party comparable exceptions. Second, taxpayers may be able to argue for a more reasonable interpretation of what constitutes direct use. Then, even if the IRS were to prevail in arguing that the software must meet the requirements of either the self-comparable or third-party comparable exception, taxpayers may be able to argue that their customers used the entire software offering and that it has a comparable, or that what the IRS views as a single, monolithic piece of software is really an amalgamation of software that must be tested under the self-comparable and third-party comparable exceptions by applying the shrink-back rule where necessary.30 As a last resort, taxpayers may be able to establish that the regulations, as currently drafted, are invalid in light of the statutory text and the purpose for which Section 199 was adopted.

Must Software Meet the Self-Comparable or Third-Party Exception?

One argument potentially available to taxpayers is that certain connected software and cloud software need not meet the self-comparable or third-party exceptions at all. The IRS, relying in large part upon the examples in the Section 199 regulations and the use of the word “only” before the recitation of exceptions, seems to disagree with this interpretation. The structure of the operative provisions in the Treasury regulations, however, casts doubt on whether the IRS’ position is correct.

The heading for all of Treasury regulation section 1.199-3(i)(6) is “Computer software.” Clause (i), which is introduced with the subheading “In general,” provides that DPGR includes gross receipts from the disposition of computer software. This is a general rule that largely sweeps software into the Section 199 eligibility without regard to whether there is a service element to the software. Thus, the default under the structure of the regulations is that all software qualifies for the Section 199 deduction if there is a lease, rental, license, sale, exchange, or other disposition. This default rule should apply in all cases except those for which there is an explicit exception.

Clause (ii), which is introduced with the subheading “Gross receipts derived from services,” includes such an exception. The exception disallows the deduction for software made available online that is in the nature of a service. The regulations do not define what is meant by providing services, but instead provide examples of the types of services for which a Section 199 deduction is not permitted with respect to software revenues. These services include customer and technical support, telephone and other telecommunication services, online services, and similar services. From a drafting perspective, it would have been far easier to include “gross receipts from software used while connected to the internet” in that list if such broad coverage was what was meant by “online services.” Instead, clause (ii) contains further specific examples of the types of online services contemplated by this exception to the general rule in clause (i) “such as Internet access services, online banking services, providing access to online electronic books, newspapers, and journals.” We believe that clause (ii) is thus better read as implementing the Congressional intent not to extend the Section 199 deduction to services rather than as a provision that automatically redefines all online software as a service.

Turning to clause (iii), with the subheading “Exceptions,” and introduced by the phrase “Notwithstanding paragraph (i)(6)(ii),” if a taxpayer derives gross receipts from providing customers access to computers software for the customer’s direct use while connected to the internet, then the gross receipts are eligible for the Section 199 deduction “only if” either the self-comparable or third-party comparable exception is satisfied.31 By its express terms, clause (iii) may be read as an exception to the exception in clause (ii), not as an additional requirement applicable to software described in clause (i). Structurally, this means that, for gross receipts to qualify for the Section 199 deduction, they must relate to software that is either (1) described in clause (i) but not clause (ii) or (2) described in clause (ii), but meeting either the self-comparable or third-party comparable exceptions in clause (iii).

Applying this interpretation to tool software and mixed software produces results that are both logical and consistent with the intended purpose of Section 199. Tool software is an example of a type of software that does not provide services to the user of the type described in clause (ii), and, because clause (iii) should be read as an exception to clause (ii), satisfaction of the self-comparable and third-party comparable exceptions in clause (iii) should not be required of tool software. Applying these tests to mixed software requires additional analysis. For example, as noted above, mixed software often consists of some combination of operating system software and networking software and may also consist of end-use software. Those components that perform a tool function, like tool software, do not provide a service function and should qualify for the Section 199 deduction without the need also to satisfy the clause (iii) comparability exceptions. For the rest of the software, the comparable exceptions provide the answers in close questions—where something may or may not be a service, the fact that someone sells software that performs that same function can be seen as proof that the cloud software does not simply facilitate a service, and hence is eligible for the Section 199 deduction.

Conversely, the IRS, as reiterated in CCA 201724026, argues that the clause (iii) exception is a narrow one that must be satisfied by any software that requires connection to the internet.32 The IRS bases its position, in part, on Treasury’s statements in a preamble to the prior, temporary Section 199 regulations to the effect that any use of online software does not rise to the level of lease, rental, license, sale, exchange or other disposition, “but is instead a service,” and must meet the clause (iii) exception.33 We are not convinced that such software is transformed into a service merely because the Treasury at one point unilaterally labeled it as such in a regulatory preamble. This reading of clause (iii) has the effect of imposing an additional comparability requirement on all cloud software. Neither the statute nor legislative history includes a comparability standard for software, so there is no basis for the regulation to include this extra-statutory requirement. Moreover, there is no reason to believe that Congress intended to treat cloud software (or, for that matter, connected software) as a service that is ineligible for the incentive. Indeed, the July 21, 2005, letter from the chairman and ranking member of the Senate Finance Committee and the Chairman of the House Ways and Means Committee is strong evidence that Congress had no such intent.34

The examples in the regulations can, for the most part, be read as supporting this reading of clauses (i) through (iii). The first five regulatory examples all posit simplified facts that reach a binary conclusion as to whether the taxpayer provides a service. Example 2, referred to in the discussion of CCA 201724026, provides that:

The key portion of that example is the third and fourth sentences. The example concludes that the online auction software is the provision of an online service to M’s customers. In general, gross receipts from online services are excluded from DPGR under Treasury regulation § 1.199-3(i)(6)(ii). In this regard, if one assumes that the software in question is extremely simple software whose sole function is to provide a service, then the example correctly illustrates the application of clause (ii) to the software. The example then reaches an uncontroversial overall conclusion that M’s gross receipts are non-DPGR, because gross receipts from the provision of services are ineligible for the Section 199 deduction. It would be inappropriate, however, for one to read this simple example as illustrating the application of clause (iii) in a situation in which such application was not required under the posited facts.

Examples 6 through 8 are less clear-cut. Examples 6 and 7 deal with “payroll management computer software.” There is, in our mind, some question as to whether payroll management computer software should be viewed as mixed software at all, but the analysis in those examples turns on whether the third-party comparable exception is satisfied. Thus, if “payroll management computer software” were viewed, for example, as providing a tool function, but no service function, Examples 6 and 7 would imply that such software still needs to meet either the self-comparable or third-party comparable exceptions because the software is cloud software. However, Examples 6 and 7 are so factually sparse that it would be inappropriate to read them as confirmation of the IRS’ position that all cloud software must meet either the self-comparable or third-party comparable exception. An equally plausible interpretation of the examples is that Treasury was envisioning an instance of payroll management computer software that contained a significant enough element of service, thereby requiring the satisfaction of clause (iii).

Example 8 is even less clear. That example involves computer software games. Once again, the example analyzes whether or not the software meets one of the two clause (iii) exceptions (in this case, the self-comparable exception). But, once again, it is difficult from this example alone to draw a conclusion that Treasury intended for all cloud software to have to meet one of the two exceptions in clause (iii). Under the regulations, there is a safe harbor for computer software games that treats “all computer software games [as] … substantially identical software.”35 As a practical matter, this safe harbor means that computer software games will always meet the third-party exception, making internet connectivity irrelevant to the Section 199 analysis. Thus, again, it arguably would be inappropriate for the IRS to rely on Example 8 as evidence that all cloud software has to qualify under the self-comparable or third-party exception.

In short, although the IRS’ informal guidance indicates that it interprets clause (iii) to apply broadly to all cloud software, regardless of whether it is mixed software, there are flaws in this interpretation. In particular, the structure of the operative provisions in the Treasury regulations casts doubt on whether the IRS’ position is the better reading of the Treasury regulations, particularly since the IRS’ position runs counter to the legislative intent behind Section 199.36

Satisfying the Comparability Exceptions

Even if one concedes that cloud software must meet either the self-comparable or third-party comparable exception, those exceptions should be read broadly to account for the purposes of Section 199 (i.e., incentivizing nonservice employment). To do so, clause (iii) should be interpreted as a means to help determine whether something that is, at least in part, a service still has enough of an element of software disposition to be eligible for the Section 199 deduction. If the software passes (in whole or in part) the comparability tests under clause (iii), the deduction should be allowed at least to some extent, even though the software may have a service element, because by satisfying clause (iii), one has shown proof that at least some portion of the software in question did not merely facilitate a service.

In practice, taxpayers have sometimes found it difficult to convince the IRS to make those sorts of distinctions. Indeed, IRS Exam teams have tried to prevent taxpayers from even getting to the question of whether either the self-comparable or third-party comparable exceptions are satisfied by giving a very narrow construction to the introductory language of clause (iii), which provides that the clause applies to situations where software access is provided to customers for “direct use while connected” to the internet or other network. Indeed, as noted above and in the 2017 CCA, the IRS has argued that the reference to “direct use” means only software that customers interact with directly can qualify and then only if they use it independently of interacting with the taxpayer. According to this theory, software that customers depend for access to cloud software, even though the customer may not interface with the software directly, does not generate DPGR.

The first part of that argument does not convincingly interpret Treasury regulations. The statute draws no such distinction, nor do the operative provisions of the Section 199 Treasury regulations. Any software necessary to allow the customer to use the offering should qualify. The second part of the argument finds no support in the statute. If a customer pays a fee for software and uses it, the fact that it facilitates communication with the taxpayer does not make the use less “direct.”37 A far more appropriate interpretation of the purpose of the words “direct use” is to distinguish between software that is intended to provide functionality directly to the customer from software that may benefit a customer indirectly as a result of the taxpayer’s use of the software’s functionality in the course of its dealings with the customer.

IRS Exam teams have also attempted to throw up other barriers to qualifying software under clause (iii). For example, IRS Exam teams have argued that in order to generate DPGR, the revenue from software must be separately stated. As discussed above, there is no legal basis in the statute, legislative history, or the regulations themselves for making the Section 199 deduction depend on the existence of a separate fee. Example 6 of the applicable Section 199 regulations makes clear that a separately stated fee is unnecessary.

Perhaps the IRS has taken these approaches in an effort to avoid fact-intensive inquiries into whether the comparable exceptions in clause (iii) have been satisfied. But such an approach cannot be justified. Even if one concedes that clause (iii) applies to all cloud software, the analysis should not turn on technicalities such as whether a customer interfaces directly with every aspect of the cloud software package or whether the taxpayer charges a separate fee for use of the cloud software. Rather, if a good comparable exists for the entire cloud software package, then the entire software package should be treated as satisfying the comparability exceptions of clause (iii) and therefore should be eligible for the Section 199 deduction (provided, of course, that all other relevant requirements are satisfied). Even in the more difficult case where no good comparable exists for the entire cloud software package, that should not end the inquiry. Rather, the question should be whether any subset of the cloud software package can independently satisfy the comparables exception.³⁸ If so, revenues generated by the cloud software package should be allocated to those portions of the cloud software package that qualify, and those portions should be treated as generating DPGR.

The analysis of whether or not clause (iii) exceptions are satisfied also should not turn on whether the IRS can find some superficial similarity between the software in question and one of the examples in the regulations. Take, for example, banking software. Treasury regulation § 1.199-3(i)(6)(ii) tells us that gross receipts derived from “online services . . . such as . . . banking services” do not constitute gross receipts derived from the disposition of computer software. Example 1 in Treasury regulation § 1.199-3(i)(6)(v) illustrates this by positing the existence of a bank that “produces computer software . . . that enables its customers to receive online banking services.” The regulation concludes that, under clause (ii), the software in question is a service, and that the taxpayer’s gross receipts from the software are non-DPGR.

But what if a bank produces cloud software that, in addition to permitting its customers to perform traditional banking functions (such as depositing checks and transferring funds), permits customers to analyze income or spending trends, sort, categorize, and filter various debits and credits according to amount, date, or category, and generate financial reports? The functions in the former category could perhaps be viewed as mixed software that does not produce DPGR. But what about the functions in the latter category? If such functions were offered on a standalone basis, one could easily find comparable software with the same features and purpose (e.g., calculator software, spreadsheet software, database software). There is no reason to think that this granular analysis is inappropriate under existing regulations, or that the latter set of software should be ineligible for the Section 199 deduction merely because the software happens to be offered by a bank as part of a broader offering that includes traditional banking services.

Of course, breaking down a complicated cloud software offering into component parts suggests the need for more fact-intensive inquiries and more complicated allocations of gross receipts. But the examples in the current regulations illustrate that such an allocation is not only possible, but specifically contemplated. In Example 6, the taxpayer produces payroll management computer software and provides storage of its customer’s data and telephone support for the customer. The example provides that the payroll management software satisfies the comparability test of Treasury regulation § 1.199-3(i)(6)(iii), and then bifurcates the taxpayer’s gross receipts between those allocable to the computer software (treated as DPGR) and those allocable to a service (not eligible for the deduction). Thus, these regulations support the proposition that in the situation in which the taxpayer provides both software and a service, the gross receipts allocable to qualifying software are eligible for the Section 199 deduction. There is no reason to conclude that a similar allocation should not be performed with regard to the various aspects of a single cloud software package, some of which may, when viewed individually, satisfy the clause (iii) exceptions.

Validity of Current Treasury Regulations

If a taxpayer’s computer software receipts do not qualify as DPGR under either of the preceding arguments (i.e., that the exceptions in clause (iii) need not be satisfied, or that some aspect of the cloud software in fact meets the exceptions), the taxpayer may be left to argue that there are at least two arguments for why Treasury regulation § 1.199-3(i)(6) is invalid. Successfully sustaining an argument that Treasury regulations are invalid is always difficult, and in this case such an argument would need to overcome Section 199(d)(10), which requires the Treasury to prescribe “such regulations as are necessary to carry out the purposes of this section.” Whether the current Section 199 regulations are a permissible exercise of this delegation of authority is beyond the scope of this article.³⁹ However, we note that there are at least two arguments for why the current regulations are invalid. The first argument is that the Treasury regulations restrict the Section 199 deduction beyond that which is required by the statute. This is especially true if one adopts the IRS’ interpretation of the Treasury regulations—in particular, the view that all software depending on internet access must satisfy either the self-comparable or third-party exception. If interpreted as the IRS reads them, the regulations deny a Section 199 deduction for software made available for a fee to customers over the internet—a denial inconsistent with the express words of the statute.

Another potential argument can be gleaned from the recent Tax Court decision in Altera Corp. v. Comm’r, 145 T.C. 91 (2015). In Altera, the taxpayer prevailed, at least in part, because it was able to convince the court that the Treasury regulations at issue were inconsistent with the market facts that were provided to the government during the notice and comment period.40 Similarly, in this instance, it appears that the government ignored generally understood facts about the online software market. Treasury regulation § 1.199-3(i)(6)(iii) focuses solely on the means of disposition based on where the software code resides and ignores the fact that there is no meaningful distinction, from a software development or even jobs perspective, between software written to be downloaded to the user’s computer and software written to be used while the user is connected to the internet. A deep dive through every comment filed during the notice and comment period may yield additional market evidence that the government ignored in promulgating these regulations. Moreover, the arguments under Altera are bolstered because the purposes of the Section 199 deduction are furthered by incentivizing both types of software development, but the IRS has narrowed the scope to one type for mere administrative convenience.⁴¹

As with any strategy that relies upon asserting the invalidity of Treasury regulations, any optimism about the success of arguing the invalidity of Treasury regulation § 1.199-3(i)(6)(iii) should be tempered with the knowledge that settling any tax controversy short of litigation will be almost impossible if the taxpayer proffers only an invalid Treasury regulations argument. Moreover, success in convincing a court to invalidate Treasury regulations, while becoming more common in recent years, is still extremely rare.

Conclusion

Section 199 was enacted to stem the flow of jobs offshore. Software development jobs are particularly vulnerable to offshoring, and Section 199 should be interpreted in a way that is consistent with incentivizing jobs to stay in the United States. The applicable Treasury regulations, in this regard, have not kept pace with the evolution of the software market. Regrettably, the IRS takes very restrictive views of the software-related gross receipts that are eligible for computing the Section 199 deduction—views that are not based on the language of the statute and that run counter to its purposes. Taxpayers have numerous strong arguments to counter this unjustifiably narrow approach, but litigation may be required to establish their validity.

Matthew Lerner, Kevin Pryor, and Scott Pollock are attorneys with the law firm Sidley Austin LLP.

Endnotes

1. Department of the Treasury, Office of Tax Analysis, Tax Expenditures in the Income Tax (September 28, 2016).
2. Senate Committee on Finance, Jumpstart Our Business Strength (JOBS) Act, S. Rep. 108-192, at 11 (2003). JOBS Act was the Senate version of the American Jobs Creation Act (AJCA), the House’s version of the legislation. Senate version available at www.finance.senate.gov/imo/media/doc/11-7FSC%20Cmte%20Rpt%20s1.pdf.
3. Id. at 11.
4. House Committee on Ways and Means, American Jobs Creation Act of 2004, H. Rep. 108-548, at 114, 115 (2004) (emphases added).
5. H.R. Rep. No. 108-755 at 275 (2004) (Conf. Report).
6. For taxable years beginning after 2004 and before 2010, a lower deduction rate applied. For taxable years beginning in 2005 or 2006, the rate was three percent. For taxable years beginning in 2007, 2008, or 2009, the rate was six percent. See Internal Revenue Code of 1986, as amended (“I.R.C.”) § 199(a)(2) (as in effect prior to amendment by P.L. 113-295 (2014)).
7. I.R.C. § 199(c)(1).
8. I.R.C. § 199(c)(4).
9. An “employee” of the taxpayer for purposes of the limitation is determined according to the common law definition. Treas. Reg. § 1.199-2(a)(1).
10. Linda Levine, “Offshoring (or Offshore Outsourcing) and Job Loss Among U.S. Workers,” Congressional Research Service (2012), at 3, https://fas.org/sgp/crs/misc/RL32292.pdf.
11. Id. at 6.; see also Blinder, “How Many U.S. Jobs Might Be Offshorable?,” World Economics, 10, no. 2, at 59 (April-June 2009) (labeling computer programming as “highly offshorable” and computer software engineering as “offshorable”).
12. I.R.C. § 199(c)(4)(i).
13. See I.R.C. § 199(c)(4)(A)(i) (defining DPGR as including, among other things, gross receipts derived from the “lease, rental, license, sale, exchange, or other disposition of … qualifying production property which was manufactured, produced, grown, or extracted by the taxpayer in whole or in significant part within the United States”); cf. I.R.C § 199(c)(4)(A)(iii) (providing that certain engineering or architectural services may give rise to DPGR).
14. Some of that software may facilitate the CSP’s rendering of services.
15. It is not clear under the language of the statute why certain types of software that perform an activity previously performed by a human should not qualify if one pays a fee to use them.
16. Treas. Reg. § 1.199-3(i)(6)(i).
17. Treas. Reg. § 1.199-3(i)(6)(ii).
18. CCA 201603028 (Jan. 15, 2016).
19. This analysis would only be relevant if the IRS’ first position on the disposition were incorrect.
20. See, e.g., Elliott, “IRS Defends Line Drawn in Section 199 Deduction Banking App Memo,” Tax Notes Today (February 23, 2015).
21. I.R.C. § 199(c)(4)(A)(i).
22. Treasury regulation § 1.199-3(i)(1) provides that applicable federal income tax principles apply to determine whether a transaction is a lease, rental, license, sale, exchange, or other disposition, whether it is a service, or some combination. For an example of these general principles, see Treas. Reg. § 1.861-18.
23. This approach is also incompatible with the purposes of Section 199. There is no principled reason to favor U.S. employment of software developers who develop traditional software over the U.S. employment of software developers who develop connected software and cloud software. The already ubiquitous nature of the internet means that substantially all modern computer software will shift towards functionality that depends upon internet access in some form. Software development jobs are highly susceptible to offshoring, regardless of the nature of the computer software and its dependence on the internet for functionality. Section 199 was intended to encourage employment in both circumstances.
24. Indeed, this delivery mechanism is so arcane that the AOL CD-ROM has become a collector’s item. See Erin Blakemore, “Remember These Free AOL CDs? They’re Collectibles Now” (October 13, 2015), www.smithsonianmag.com/smart-news/aol-cd-rom-collecting-thing-180956902/.
25. Letter dated July 21, 2005, to John W. Snow from William M. Thomas, Charles E. Grassley, Jr., and Max Baucus.
26. Even when the regulations were promulgated, the IRS and Treasury Department recognized that in the future some software would only be made available over the internet and that the final rules would result in a more limited application of the deduction to such activities. T.D. 9317 (March 20, 2007). Left unclear from the preamble is why the IRS did not consider the click-through license, a common if not universally prevalent aspect of commercial software, to be sufficient to satisfy the qualifying disposition requirement that was causing such statutory concern. Licensed software satisfies the literal statutory requirement and may be treated as a disposition under other current regulations, such as Treasury regulation § 1.861-18. If the IRS had been willing to accept this broader market-based concept of disposition, then for mixed software the line-drawing exercise would move to the allocation of the gross receipts between the software and the service, an inquiry more appropriate and consistent with the purposes of Section 199.
27. Treas. Reg. § 1.199-3(i)(6)(v), Example 2. Examples in regulations qualify as at least persuasive authority. See, e.g., Cook v. Comm’r, 269 F.3d 854, 858 (7th Cir. 2001).
28. Treas. Reg. § 1.199-3(i)(6)(v), Example 6.
29. N. Richman, “ABA Section of Taxation Meeting: Natural Gas and Retail Safe Harbor Resolutions Coming Soon,” Tax Notes Today (Sep. 28, 2015).
30. See Treas. Reg. § 1.199-3(d)(1)(ii).
31. “Although helpful, labels or headings cannot change the express language of the Internal Revenue Code or regulations.” Cinelli v. Comm’r, T.C. Memo. 1991-29.
32. The preamble to the final Treasury regulations states that the clause (iii) exception has been “narrowly tailored” so as to apply “only to gross receipts derived from providing customers access to computer software … while connected to the Internet.” See T.D. 9317 (March 20, 2007). This is not necessarily incompatible with treating clause (iii) as an exception to software that falls within clause (ii). But cf. T.D. 9262 (May 24, 2006) (noting that the comparable exceptions were created as a matter of “administrative convenience” in response to comments suggesting “that the provision of computer software for online use should qualify under Section 199”).
33. T.D. 9262 (May 24, 2006). In reading the preamble to the temporary regulations, one could be left with the impression that Treasury intended for all online software to have to satisfy the comparables exceptions in clause (iii). But reading the Treasury regulations in this manner would put them at odds with the statute and the legislative intent in enacting Section 199. Convincing a court to accept our reading may be difficult. However, a court might well be tempted to disregard the statements in the preamble in favor of an interpretation of the Treasury regulations that is consistent with the statute.
34. Courts, when faced with two interpretations of an ambiguous regulation, generally will adopt the interpretation that is consistent with the statute. See, e.g., Wasco Real Properties I, LLC v. Comm’r., TC Memo 2016-224. Reading clause (iii) as an exception to clause (ii) is the better one because reading clause (iii) as applying to all online software makes the Treasury regulations inconsistent with the statute.
35. Treas. Reg. § 1.199-3(i)(6)(iv)(B).
36. Although the IRS’ position has weaknesses, one should keep in mind that courts generally defer to the IRS’ interpretation of ambiguous Treasury regulations provided that the IRS’ interpretation is reasonable and not plainly erroneous or inconsistent with the Treasury regulations, or unless there is another reason to suspect that the interpretation does not reflect the IRS’ fair and considered judgment on the matter in question. See, e.g., Mitchell v. Comm’r, 775 F.3d 1243 (10th Cir. 2015).
37. See T.D. 9262 (May 24, 2006) (“If a taxpayer’s provision of computer software for online use meets the requirements set forth in the temporary regulations, then an allocation of gross receipts between DPGR and non-DPGR will be necessary if, as part of the same transaction, the taxpayer derives gross receipts other than from providing computer software to a customer for the customer’s direct use while connected to the Internet. For example, if in connection with providing computer software to a customer for the customer’s direct use while connected to the Internet, a taxpayer also provides a service such as storing its customers’ data … then the taxpayer must allocate its gross receipts between DPGR and non-DPGR using any reasonable method”).
38. See Treas. Reg. § 1.199-3(d)(1)(ii).
39. Strong support for such an argument may arise from the fact that if a taxpayer produces software and earns a fee for making it available, the taxpayer has satisfied the statutory requirements. The Treasury regulations cannot impose an additional requirement (comparability) that is not in the statute. The Treasury regulations can use comparability only to determine if something is “software.”
40. Lerner and Pryor, “Altera Deconstructed: A Nuanced Alteration in Tax Law,” Tax Executive, 68, no. 1 (January 2016), http://taxexecutive.org/altera-deconstructed-a-nuanced-alteration-in-tax-law/.
41. Indeed, Treasury and the IRS foresaw that the regulations would become outdated, making an administrative convenience argument all the more improper. In the preamble to the final online software regulations, Treasury stated:
  
  Commentators noted that, in the future, some computer software will only be available over the Internet. In addition, newly developed computer software provided over the Internet may not have a substantially identical counterpart. The IRS and Treasury Department recognize that the computer software industry is evolving and current industry trends may result in a more limited applicability of the online software exceptions provided in the final regulation.
  
  T.D. 9317 (March 20, 2007).

Section 199 and Cloud Software: Clearing the Fog
Are you up-to-date on current Treasury regs?