Taxpayers who manufacture and produce computer software in whole or in significant part in the U.S. can qualify for the Section 199 deduction.
A taxpayer producing software will be treated as having produced the software ‘in significant part’ in the U.S. if:
- Based on all the taxpayer’s facts and circumstances, the production of the software performed by the taxpayer in the U.S. is substantial in nature; or
- Under the safe harbor test, the labor and overhead costs incurred by the taxpayer in the U.S. are at least 20 percent of the total cost of goods sold of the property produced.
Section 199 and Online Software
In general, ‘online software’ does not qualify for 199 benefits. However, the regulations offer 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.
- Downloadable or Shrink Wrap Equivalent: Taxpayers deriving gross receipts from providing computer software to customers for the customers’ direct use while connected to the Internet (online software) can qualify if that taxpayer also derives gross receipts from customers that are unrelated to the taxpayer from the lease, rental, license, sale, exchange, or other disposition of computer software affixed to a tangible medium or downloaded from the Internet.
- Substantially Identical Software: Even if the taxpayer does not produce similar software that is downloadable or available as a shink-wrapped (tangible medium) form, the taxpayer can still qualify its online software if there is an equivalent in the marketplace – if an unrelated person derives 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, then the taxpayer’s online software can qualify for 199 deductions.
Substantially identical software is defined as software with the same functional result as the online software and has a significant overlap of features or purpose with the online software.
Note: There is also a safe harbor for computer gaming software, all of which is treated as qualifying if the other Section 199 criteria are met.
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