United States

App to access online service does not generate section 199 DPGR

TAX ALERT  | 

In a recent general legal memorandum, AM 2014-008 (the GLAM),1 the IRS determined that a taxpayer's provision of a free, downloadable computer software application (the App) to its customers did not meet the requirements for treatment as a qualifying disposition under section 199. Furthermore, the IRS determined that, even if provision of the App was a qualifying disposition under section 199, the gross receipts derived from its use would not be includable in the taxpayer's domestic production gross receipts (DPGR) since the receipts relate to online banking services.

AM 2014-008: An overview

AM 2014-008 analyzed whether a bank (Taxpayer) derived DPGR from its customers' download of the App. In its analysis, the IRS focused on three factors: (1) whether a customer's download of the App constituted a qualifying disposition under Reg. section 1.199-3(i)(6)(i), (2) whether a customer's download of the App constituted a qualifying disposition under either of the exceptions for online software under Reg. section 1.199-3(i)(6)(iii), and (3) whether Taxpayer derived DPGR from download of the App.

a. Analysis of whether download of taxpayer's application constituted a qualifying disposition under Reg. section 1.199-3(i)(6)(i)

The IRS began its analysis of whether a customer's download of  the App constituted a qualifying disposition by applying the general rules of Reg. section 1.199-3(i)(6)(i) and (iii). Reg. section 1.199-3(i)(6)(i) states that DPGR includes only those receipts “derived from the lease, rental, license, sale, exchange, or other disposition of computer software [manufactured, produced, grown or extracted (MPGE)] by the taxpayer in whole or in significant part within the United States…even if the customer provides the computer software to…others over the Internet.” Reg. section 1.199-3(i)(6)(iii) states that providing customers with online software (defined as “access to computer software MPGE in whole or in significant part…within the United States for the customers' direct use while connected to the internet…”) is not a disposition for purposes of Reg. section 1.199-3(i)(6)(i).2 Therefore, if the App fell within the definition of online software, its download would not be considered a qualifying disposition.   

In analyzing the App, the IRS focused on a couple of factors. First, it noted that the App did not function unless the user was connected to the Internet. Second, it noted that the App did not provide the user with any benefit other than access to Taxpayer's banking services. For these reasons, the IRS determined that the App fell within the definition of online software, and its download was not a qualified disposition under Reg. section 1.199-3(i)(6)(i).3

b. Analysis of whether taxpayer's application constituted a qualifying disposition under either of the exceptions under Reg. section 1.199-3(i)(6)(iii) 

After determining that a customer's download of the App did not qualify as a disposition under  Reg. section 1.199-3(i)(6)(i), the IRS analyzed whether the download of the App could qualify as a disposition under the self-comparable or third-party comparable exceptions of Reg. section 1.199-3(i)(6)(iii)(A) and (B). Online software qualifies for the self-comparable exception if a taxpayer also derives gross receipts from software that “(1) has only minor or immaterial differences from the online software; (2) was MPGE by the taxpayer in whole or in significant part within the United States; and (3) has been provided to such customers affixed to a tangible medium…or by allowing them to download the computer software from the Internet.”4 Online software qualifies for the third-party comparable exception if “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 compared to the taxpayer's online software) to its customers,” either affixed to a tangible medium or by allowing them to download it.5

Since Taxpayer did not produce any software comparable to the App, it did not meet the requirements for the self-comparable exception. Taxpayer did argue, however, that it met the requirements of the third-party comparable exception because another company produced online software similar to the App for sale to other banks. Upon comparison of the App to the other company's software, the IRS determined that Taxpayer did not meet the third-party comparable exception because the other company's software was not “substantially identical” to the App.

For purposes of the third-party comparable exception, substantially identical software is computer software that “(1) from a customer's perspective, has the same functional result as the online software; and (2) has a significant overlap of features of purpose with the online software.”6 In comparing Taxpayer's software to that of its competitor, the IRS noted that the users of Taxpayer's software were account holders accessing the software for individual banking services, while the users of the competitor's software were banks who used the competitor's software to provide banking services to multiple account holders. Therefore, from the perspective of Taxpayer's customers and competitor's customers, the two software packages provided different functional results and lacked a significant overlap in purpose.

c. Analysis of whether taxpayer derived gross receipts from the application

Despite concluding that a customer's download of the App was not a disposition, the IRS continued its analysis, arguing that even if a customer's download of the App qualified as a disposition for purposes of Reg. section 1.199-3(i)(6)(i) or Reg. section 1.199-3(i)(6)(iii), Taxpayer would derive no gross receipts from this disposition.

For purposes of section 199, income “‘derived from the disposition' of [qualified production property] is limited to the gross receipts directly derived from the disposition.”7 Under this definition, the only receipts that would typically be included in DPGR for a software application would be those related to application-specific download fees. Since Taxpayer allowed customers to download the App free of charge, there would be no gross receipts derived from the disposition of the App.

In taking its analysis a step further, the IRS noted that even if Taxpayer had charged customers a fee to download the App, the result would be the same. Since the sole purpose of the App was to provide Taxpayer's customers with access to its banking services, receipts from download of the the App would be considered receipts connected to Taxpayer's banking services and, therefore, would not be includable in DPGR.8

Comparing the GLAM with the examples contained in Reg. section 1.199-3(i)(6)(v)

Although the GLAM provides some specific insight into the IRS' analysis of computer software applications for purposes of section 199, the conclusions stated within are not surprising. A comparison of Taxpayer's facts with the examples contained in Reg. section 1.199-3(i)(6)(v) demonstrates that the IRS' conclusions in this GLAM are consistent with the intended interpretation of Reg. section 1.199-3(i)(6).

a. Reg. section 1.199-3(i)(6)(v), examples 1, 2 and 3

Examples 1, 2 and 3 of Reg. section 1.199-3(i)(6)(v) relate to a bank, an internet auction company and a telecommunications provider, respectively. Although these entities operate in different industries, all are service providers that produce computer software enabling customers to access their services. In all three examples, the gross receipts directly resulting from use of the software are considered attributable to a service and, therefore, not includable in DPGR.

The taxpayer discussed in the GLAM was also a service provider that developed an application enabling its customers to access banking services. In characterizing any gross receipts derived from the disposition of the App as service-related income, the IRS' position in the GLAM is consistent with these examples.

b. Reg. section 1.199-3(i)(6)(v), examples 4 and 5

Example 4 relates to a company that produces tax preparation software in the United States. This company generates gross receipts from the sale of software that is affixed to a compact disc, as well as the online sale of downloadable software. Additionally, the company provides customers access to software for their direct use while connected to the internet. The version of the software available to customers while connected to the internet differs immaterially from the versions affixed to a compact disc or available for download, and the company does not provide any additional goods or services in connection with the online software. Since the company in this example meets all the requirements of Reg. section 1.199-3(i)(6)(iv)(A), the online software qualifies as a disposition, and the revenues generated by the online software are includable in DPGR.

Example 5 involves a similar fact pattern to Example 4. However, instead of selling the tax software on a compact disc or online via download, the company only makes the software available for direct use while connected to the Internet. Additionally, in this example, one of the company's competitors derives gross receipts from the sale of substantially identical tax preparation software on a compact disc or online via download. Since the company in this example meets all of the requirements of Reg. section 1.199-3(i)(6)(iv)(B), the online software qualifies as a disposition, and the revenues generated by the online software are includable in DPGR.

These examples differ greatly from the facts described in the GLAM. The taxpayer in the GLAM did not, as illustrated in example 4, sell software similar to the App in a tangible format. Furthermore, Taxpayer was unable to show that any of its competitors produced software substantially identical to the App. Given these differences, the IRS' conclusion that Taxpayer did not qualify for either of the exceptions under Reg. section 1.199-3(i)(6)(iii) is consistent with the regulations.

Conclusion

Although this GLAM may not be used as legal precedent, it demonstrates that the IRS' analysis of software for purposes of section 199 is consistent with that of Reg. section 1.199-3(i)(6). Therefore, in determining whether gross receipts from online software qualify for inclusion in DPGR, it is important to consider the issues raised by these regulations and their related examples. Specifically, it is crucial to examine (1) the software's relationship to any services being offered by the taxpayer, (2) whether the same (or immaterially different) software is being sold on a tangible medium or via online download, and (3) whether a taxpayer's competitor sells substantially identical software on a tangible medium or via online download.

11 Released Dec. 5, 2014, and dated Nov. 21, 2014.
2
Reg. section 1.199-3(i)(6)(iii).
3
In analyzing whether a customer's download of App constituted a disposition, the IRS acknowledged that there are some instances in the section 199 regulations where downloads are treated as dispositions. However, the IRS noted that “the intent is to include downloaded software that has independent functionality after customers have downloaded it and are no longer connected to the Internet.” AM 2014-008, citing Reg. sections 1.199-3(i)(6)(iii) and (v), Ex. 4.
4
Reg. section 1.199-3(i)(6)(iii)(A)(1)-(3).
5
AM 2014-008; see also Reg. section 1.199-3(i)(6)(iii)(B).
6
  Reg. section 1.199-3(i)(6)(iv)(A).
7
 AM 2014-008.
8
See Reg. section 1.199-3(i)(6)(v), Ex. 2.

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