Online Software – Latest IRS Thinking – Section 199 Domestic Production Activities Deduction

Currently the IRS is working on updating its guidance regarding online software which we expect some additional guidance early in 2016. Online software under Section 199 is generally not qualified for the Domestic Production Activities Deduction (Section 199 deduction) unless certain exceptions are met (which the IRS has been recently challenging those exceptions via Counsel memos and GLAMs – General Legal Advice Memos). For example a 2014 GLAM (2014-008) discussed a bank’s effort to qualify their online banking app under the online software exceptions for Section 199 benefit.

The software industry has changed quite a bit since the online software Section 199 regulations were first issued in 2007. Gone are the days of walking into a retail store to purchased shrink-wrapped software and more recently, the model of a software download is changing to become more of a software as a service (Saas) where the company hosts software and storage in the cloud – better business model, better price points for customers, easier to maintain and push out software updates. So this newer model has been the contentious point with the IRS where the IRS argues a company offering their software as a ‘service’ is only performing a service and does not qualify.

Moreover, the online software Section 199 regulations exception for comparable third party software has gotten difficult to administer. When it comes down to attorneys and accountants arguing over whether a software company’s product is ‘substantially identical’ to its competitors, that becomes an issue difficult to resolve. Plus, software companies generally have a business model where they are offering new and different features in their software products to distinguish themselves from the competition, yet the IRS regulations want that same taxpayer to compare to substantially identical software that’s on the market. So that exception provides little help and is hard to administer.

Another aspect that has been a recent contention point is the IRS current thinking that even a downloaded software app is still considered online software if the app would not work without some of the server-side software on the back end. This is a pretty common architecture to have functionality both in the app itself and on the server where both pieces are needed to allow the software to function. Again this is industry practice to not have a ‘heavy’ front end app consuming battery power, CPU and storage on small devices, so it’s industry norm to move some of that to the server side. So the question of whether the software would function without the back end doesn’t seem like that should be the test for whether it’s online software and could qualify for the Domestic Activities Production Deduction. The front end and back end components are quite different and both are needed in many cases. In our view, if there’s a software download such as from the App Store, this download constitutes a qualified disposition of the software and hence it would not be online software by nature of this download.

These are really important areas for the IRS to review when considering software development as a production activity given that many other consumer goods related manufacturing has moved overseas and the intent of the Section 199 Domestic Production Deduction is to keep production (including software) domestic.

This entry was posted in Blog and tagged , , , , , , , . Bookmark the permalink.

Leave a Reply

Your email address will not be published. Required fields are marked *