| Treasury Decision 9262 |
June 12, 2006 |
Computer Software Under Section 199(c)(5)(B)
Internal Revenue Service (IRS), Treasury.
This document contains temporary regulations concerning the application
of section 199 of the Internal Revenue Code, which provides a deduction for
income attributable to domestic production activities, to certain transactions
involving computer software. The regulations will affect taxpayers engaged
in certain domestic production activities involving computer software. The
text of these temporary regulations also serves as the text of the proposed
regulations (REG-111578-06) set forth in the notice of proposed rulemaking
on this subject in this issue of the Bulletin.
Effective Date: These regulations are effective
June 1, 2006.
Applicability Date: For date of applicability,
see §1.199-8T(i)(4).
FOR FURTHER INFORMATION CONTACT:
Paul Handleman or Lauren Ross Taylor, (202) 622-3040 (not a toll-free
number).
SUPPLEMENTARY INFORMATION:
This document amends 26 CFR part 1 to provide rules relating to the
deduction for income attributable to domestic production activities under
section 199 of the Internal Revenue Code (Code). Section 199 was added to
the Code by section 102 of the American Jobs Creation Act of 2004 (Public
Law 108-357, 118 Stat. 1418), and amended by section 403(a) of the Gulf Opportunity
Zone Act of 2005 (Public Law 109-135, 119 Stat. 25) and section 514 of the
Tax Increase Prevention and Reconciliation Act of 2005 (Public Law 109-222,
120 Stat. 345). On January 19, 2005, the IRS and Treasury Department issued
Notice 2005-14, 2005-1 C.B. 498, providing interim guidance on section 199.
On November 4, 2005, the IRS and Treasury Department published in the Federal Register proposed regulations under section
199 (REG-105847-05, 2005-47 I.R.B. 987 [70 FR 67220]). On January 11, 2006,
the IRS and Treasury Department held a public hearing on the proposed regulations.
Written and electronic comments responding to the proposed regulations were
received. Contemporaneous with the publication of these temporary regulations,
final regulations have been published under section 199.
Section 199(a)(1) allows a deduction equal to 9 percent (3 percent in
the case of taxable years beginning in 2005 or 2006, and 6 percent in the
case of taxable years beginning in 2007, 2008, or 2009) of the lesser of (A)
the qualified production activities income (QPAI) of the taxpayer for the
taxable year, or (B) taxable income (determined without regard to section
199) for the taxable year (or, in the case of an individual, adjusted gross
income (AGI)).
Qualified Production Activities Income
Section 199(c)(1) defines QPAI for any taxable year as an amount equal
to the excess (if any) of (A) the taxpayer’s domestic production gross
receipts (DPGR) for such taxable year, over (B) the sum of (i) the cost of
goods sold (CGS) that are allocable to such receipts; and (ii) other expenses,
losses, or deductions (other than the deduction under section 199) that are
properly allocable to such receipts.
Section 199(c)(4)(A)(i) defines DPGR, in part, to mean the taxpayer’s
gross receipts that are derived from any lease, rental, license, sale, exchange,
or other disposition of qualifying production property (QPP) that was manufactured,
produced, grown, or extracted (MPGE) by the taxpayer in whole or in significant
part within the United States. Section 199(c)(5) defines QPP to mean: (A)
tangible personal property; (B) any computer software; and (C) any property
described in section 168(f)(4) (certain sound recordings).
Section 4.04(7)(d) of Notice 2005-14 provides that gross receipts derived
from computer software do not include gross receipts derived from Internet
access services, online services, customer support, telephone services, games
played through a website, provider-controlled software online access services,
and other services that do not constitute the lease, rental, license, sale,
exchange, or other disposition of computer software that was developed by
the taxpayer. Consistent with Notice 2005-14, the proposed regulations in
§1.199-3(h)(6)(i) state that the provision of online computer software
does not rise to the level of a lease, rental, license, sale, exchange, or
other disposition as required under section 199, but is instead a service.
On 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.
Numerous commentators have suggested that the provision of computer
software for online use should qualify under section 199. Some commentators
proposed that gross receipts derived from providing online access to computer
software should qualify under section 199 if the substance of the transaction
that gives rise to the gross receipts is the distribution of the computer
software’s functionality to end users. These commentators suggested
that factors to be considered in determining the substance of the transaction
should include: (1) whether an agreement exists, regardless of its form, between
the computer software producer and the customer that gives the customer permission
to use the computer software; (2) whether the use of computer software is
merely incidental to the provision of a separate service or transaction; (3)
whether the end user has made a payment to the computer software producer
directly for the right to access and use the computer software’s functionality,
as opposed to a payment for a separate service or good in which the use of
the underlying computer software is only incidental to the separate service
or transaction; (4) whether the computer software producer holds itself out
to the public as being in the computer software business; (5) whether the
computer software producer uses alternate channels for distributing its computer
software product or functionality other than through online access; and (6)
whether a competitive marketplace exists for the same or similar computer
software functionality that provides customers with alternative distribution
choices in addition to online access. The commentators explained that this
proposed list of factors is not exhaustive and there may be other relevant
factors. The commentators suggested that no single factor should control
and that failure to satisfy one or more factors should not necessarily result
in gross receipts derived from online access to computer software being non-DPGR.
Other commentators suggested that a customer’s use of computer
software is tantamount to a license of the computer software. In addition,
several commentators asserted that the phrase “other disposition”
in section 199(c)(4)(A) is broad enough to include the provision of computer
software for online use.
Explanation of Provisions
The temporary regulations do not adopt these comments. However, as
a matter of administrative convenience, the temporary regulations provide
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 lease, rental, license,
sale, exchange, or other disposition of such computer software. Such gross
receipts will be treated as DPGR if all the other requirements of section
199 are met (for example, the taxpayer MPGE computer software in whole or
in significant part within the United States).
The first exception applies to a taxpayer that derives gross receipts
from providing computer software to customers for the customers’ direct
use while connected to the Internet (online software) and also derives gross
receipts from the lease, rental, license, sale, exchange, or other disposition
to customers that are unrelated persons of computer software that has been
provided to such customers affixed to a tangible medium or by allowing them
to download the computer software from the Internet. The second exception
applies if a taxpayer derives gross receipts from providing online software
and an unrelated person derives on a regular and ongoing basis in the unrelated
person’s business gross receipts from the lease, rental, license, sale,
exchange, or other disposition of substantially identical software to its
customers affixed to a tangible medium or by allowing its customers to download
the substantially identical computer software from the Internet.
The temporary regulations define substantially identical software as
computer software that, from a customer’s perspective, has the same
functional result as the online software and has a significant overlap of
features or purpose with the online software. To avoid controversy between
taxpayers and the IRS, the temporary regulations provide a safe harbor under
which all computer software games are deemed to be substantially identical
software.
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 or providing telephone support, then the taxpayer
must allocate its gross receipts between DPGR and non-DPGR using any reasonable
method.
These rules are specifically limited to the deduction under section
199 and no inference can be drawn with respect to any other provision of the
Code (such as the tax treatment of these transactions under those provisions
regarding character, timing, or source).
Section 199 applies to taxable years beginning after December 31, 2004.
These temporary regulations are applicable for taxable years beginning on
or after June 1, 2006. A taxpayer may apply these temporary regulations to
taxable years beginning after December 31, 2004, and before June 1, 2006.
The applicability of these temporary regulations expires on or before May
22, 2009. Section 1.199-8(i)(1) of the final regulations issued contemporaneous
with these temporary regulations provides that, in certain circumstances,
a taxpayer may rely on the guidance in Notice 2005-14, 2005-1 C.B. 498, the
proposed regulations under section 199 that were published in the Federal Register on November 4, 2005 (70 FR 67220),
or the final regulations. Regardless of which guidance a taxpayer applies,
the taxpayer may apply these temporary regulations.
It has been determined that this Treasury decision is not a significant
regulatory action as defined in Executive Order 12866. Therefore, a regulatory
assessment is not required. It also has been determined that section 553(b)
of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to
these regulations. For applicability of the Regulatory Flexibility Act (5
U.S.C. 601 et seq.), refer to the cross-reference notice
of proposed rulemaking published elsewhere in this issue of the Bulletin.
Pursuant to section 7805(f) of the Code, these temporary regulations will
be submitted to the Chief Counsel for Advocacy of the Small Business Administration
for comment on their impact on small business.
Amendments to the Regulations
Accordingly, 26 CFR part 1 is amended as follows:
Paragraph 1. The authority citation for part 1 is amended by adding
entries in numerical order to read, in part, as follows:
Authority: 26 U.S.C. 7805 * * *
Section 1.199-3T also issued under 26 U.S.C. 199(d). * * *
Section 1.199-8T also issued under 26 U.S.C. 199(d). * * *
Par. 2. Section 1.199-3T is added to read as follows:
§1.199-3T Domestic production gross receipts (temporary).
(a) through (h) [Reserved]. For further guidance, see §1.199-3(a)
through (h).
(i) Derived from the lease, rental, license, sale, exchange,
or other disposition. (1) through (5) [Reserved]. For further
guidance, see §1.199-3(i)(1) through (5).
(6) Computer software—(i) [Reserved].
For further guidance, see §1.199-3(i)(6)(i).
(ii) Gross receipts derived from services. Gross
receipts (as defined in §1.199-3(c)) 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 a lease, rental, license, sale,
exchange, or other disposition of computer software (as defined in §1.199-3(j)(3)).
(iii) Exceptions. Notwithstanding paragraph (i)(6)(ii)
of this section, if a taxpayer derives gross receipts from providing to customers
computer software MPGE in whole or in significant part by the taxpayer within
the United States for the customers’ direct use while connected to the
Internet (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—
(A) 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 unrelated persons
(as defined in §1.199-3(b)(1)) of computer software that—
(1) Has only minor or immaterial differences from
the online software;
(2) Has been MPGE (as defined in §1.199-3(e))
by the taxpayer (as defined in §1.199-3(f)) in whole or in significant
part (as defined in §1.199-3(g)) within the United States (as defined
in §1.199-3(h)); 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
(B) An unrelated person derives, on a regular and ongoing basis in
the unrelated person’s 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.
(iv) Definitions and special rules—(A) Substantially
identical software. For purposes of paragraph (i)(6)(iii)(B) of
this section, substantially identical software is computer
software that—
(1) From a customer’s perspective, has the
same functional result as the online software described in paragraph (i)(6)(iii)
of this section; and
(2) Has a significant overlap of features or purpose
with the online software described in paragraph (i)(6)(iii) of this section.
(B) Safe harbor for computer software games.
For purposes of paragraph (i)(6)(iv)(A) of this section, all computer software
games are deemed to be substantially identical software. For example, computer
software sports games are deemed to be substantially identical to computer
software card games.
(C) Regular and ongoing basis. For purposes of
paragraph (i)(6)(iii) of this section, in the case of a newly-formed trade
or business or a taxpayer in its first taxable year, the taxpayer is considered
to be engaged in an activity described in paragraph (i)(6)(iii) of this section
on a regular and ongoing basis if the taxpayer reasonably expects that it
will engage in the activity on a regular and ongoing basis.
(D) Attribution. For purposes of paragraph (i)(6)(iii)(A)
of this section—
(1) All members of an expanded affiliated group
(as defined in §1.199-7(a)(1)) are treated as a single taxpayer; and
(2) In the case of an EAG partnership (as defined
in §1.199-9(j)), the EAG partnership and all members of the EAG to which
the EAG partnership’s partners belong are treated as a single taxpayer.
(E) Qualified computer software maintenance agreements.
Section 1.199-3(i)(4)(i)(B)(5) does not apply if the
computer software is online software under paragraph (i)(6)(ii) of this section.
(v) Examples. The following examples illustrate
the application of this paragraph (i)(6):
Example 1. L is a bank and produces computer software
within the United States that enables its customers to receive online banking
services for a fee. Under paragraph (i)(6)(ii) of this section, gross receipts
derived from online banking services are attributable to a service and do
not constitute a lease, rental, license, sale, exchange, or other disposition
of computer software. Therefore, L’s gross receipts derived from the
online banking services are non-DPGR.
Example 2. 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 services are attributable
to a service and do not constitute 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.
Example 3. N provides telephone services, voicemail
services, and e-mail services. N produces computer software within the United
States that runs all of these services. Under paragraph (i)(6)(ii) of this
section, gross receipts derived from telephone and related telecommunication
services are attributable to a service and do not constitute a lease, rental,
license, sale, exchange, or other disposition of computer software. Therefore,
N’s gross receipts derived from the telephone and other telecommunication
services are non-DPGR.
Example 4. O produces tax preparation computer
software within the United States. O derives, on a regular and ongoing basis
in its business, gross receipts from both the sale to customers that are unrelated
persons of O’s computer software that has been affixed to a compact
disc as well as from the sale to customers of O’s computer software
that customers have downloaded from the Internet. O also derives gross receipts
from customers from providing the computer software to its customers for the
customers’ direct use while connected to the Internet. Assume that
the computer software sold on compact disc or by download has only minor or
immaterial differences from the computer software provided over the Internet,
and O does not provide any services in connection with the computer software
provided over the Internet. Under paragraph (i)(6)(iii)(A) of this section,
O’s gross receipts derived from providing its computer software to customers
over the Internet will be treated as derived from the lease, rental, license,
sale, exchange, or other disposition of computer software and are domestic
production gross receipts (DPGR) (as defined in §1.199-3) (assuming all
the other requirements of §1.199-3 are met).
Example 5. The facts are the same as in Example
4, except that O does not sell the tax preparation computer software
to customers affixed to a compact disc or by download and O’s only method
of providing the tax preparation computer software to customers is over the
Internet. P, an unrelated person, derives, on a regular and ongoing basis
in its business, gross receipts from the sale to customers of P’s substantially
identical tax preparation computer software that has been affixed to a compact
disc as well as from the sale to customers of P’s substantially identical
tax preparation computer software that customers have downloaded from the
Internet. Under paragraph (i)(6)(iii)(B) of this section, O’s gross
receipts derived from providing its tax preparation computer software to customers
over the Internet will be treated as derived from the lease, rental, license,
sale, exchange, or other disposition of computer software and are DPGR (assuming
all the other requirements of §1.199-3 are met).
Example 6. P produces payroll management computer
software within the United States. For a fee, P provides the payroll management
computer software to customers for the customers’ direct use while connected
to the Internet. This is P’s sole method of providing its payroll management
computer software to customers. In conjunction with the payroll management
computer software, P provides storage of customers’ data and telephone
support. Q, an unrelated person, derives, on a regular and ongoing basis in
its business, gross receipts from the sale to customers of Q’s substantially
identical payroll management software that has been affixed to a compact disc
as well as from the sale to customers of Q’s substantially identical
payroll management software that customers have downloaded from the Internet.
Under paragraph (i)(6)(iii)(B) of this section, P’s gross receipts
derived from providing its payroll management computer software to customers
over the Internet will be treated as derived from the lease, rental, license,
sale, exchange, or other disposition of computer software and are DPGR (assuming
all the other requirements of §1.199-3 are met). However, P’s
gross receipts derived from the fees it receives that are properly allocable
to the storage of customers’ data and telephone support are non-DPGR.
Par. 3. Section 1.199-8T is added to read as follows:
§1.199-8T Other rules (temporary).
(a) through (h) [Reserved]. For further guidance, see §1.199-8(a)
through (h).
(i) Effective dates. (1) through (3) [Reserved].
For further guidance, see §1.199-8(i)(1) through (3).
(4) Computer software. Section 1.199-3T(i)(6)(ii)
through (v) are applicable for taxable years beginning on or after June 1,
2006. A taxpayer may apply these temporary regulations to taxable years beginning
after December 31, 2004, and before June 1, 2006. The applicability of §1.199-3T(i)(6)(ii)
through (v) expires on or before May 22, 2009.
Mark E. Matthews,
Deputy
Commissioner for
Services and Enforcement.
Approved May 2, 2006.
Eric Solomon,
Acting
Deputy Assistant
Secretary of the Treasury.
Note
(Filed by the Office of the Federal Register on May 24, 2006, 11:47
a.m., and published in the issue of the Federal Register for June 1, 2006,
71 F.R. 31074)
The principal authors of these regulations are Paul Handleman and Lauren
Ross Taylor, Office of the Associate Chief Counsel (Passthroughs and Special
Industries), IRS. However, other personnel from the IRS and Treasury Department
participated in their development.
* * * * *
Internal Revenue Bulletin 2006-24
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