This week the IRS released a new Chief Counsel Advisory Opinion (CCA) regarding Online Software and Section 199. The key issue was applying the exception for software that is ‘substantially identical’ available from third parties via download or shrink-wrap. Thus, a taxpayer who only offers their software online can still qualify for the Section 199 Domestic Production Deduction if the taxpayer can find other third party software that is substantially identical to its software that is available via download or via shrink-wrapped tangible form. Otherwise, without finding similar software, the taxpayer would not be able to establish a valid ‘disposition’ of the software and cannot claim the online software as qualifying for the Domestic Production Deduction under Section 199.

In applying this exception, the taxpayer looked to comparable third party software and found several products that had similar functionality but not identical. However, a combination of the third party software features could establish that in aggregate there was third party substantially identical software available on the market.

The IRS rejected this approach and required the taxpayer to find a single third party vendor software that is substantially identical.

The term ‘substantially identical is defined under Treas. Reg. § 1.199-3(i)(6)(iv)(A) as:

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.

However, the CCA did provide for a ‘shrink-back’ approach – to the extent the taxpayer can show that an individual component of its online software has a substantially identical  counterpart, gross receipts attributable to that component would qualify as DPGR (assuming all other section 199 requirements are met).

This is an interesting development with respect to software and the Section 199 Domestic Production Deduction, although only in a CCA. The CCA however was authored by the lead National Office attorney on the Section 199 issue thus providing the National Office view on this exception for online software.  Below is the CCA…..

CCA Online Software – June 2012

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