Under existing IRS regulations on Section 199, the Domestic Production Deduction, software qualifies for 199 treatment, but online software may or may not depending upon whether certain exceptions are met. As with other qualifying domestic production property under section 199, there must be a ‘disposition’ of the qualifying item, in this case software. This can occur via a download or via selling shrink-wrapped discs containing the software.
In Chief Counsel Advice 201226025, released June 29, 2012, the IRS found that the taxpayer did not dispose of its online software and could not show that the comparable third party software rule was met. Under this rule found in Section 1.199-3(i)(6)(ii), DPGR does not include gross receipts 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 books, newspapers, etc.) does not qualify as a ‘disposition’ of the software unless there is comparable third party software which is downloaded or shrink-wrapped and therefore disposed in the manner described in Section 199.
Section 1.199-3(i)(6)(iii)(B), commonly called the third-party comparable exception,
provides gross receipts are from a disposition if another person derives, on a regular
and ongoing basis in its business, gross receipts from the disposition of substantially
identical software (as described in § 1.199-3(i)(6)(iv)(A)) (as compared to taxpayer’s
online software) to its customers pursuant to an activity described in § 1.199-
3(i)(6)(iii)(A)(3) (i.e., by a tangible medium such as a disk or DVD or download from the
Internet).
In this Chief Counsel IRS Advice, the IRS did not agree with the taxpayer that its cited comparable software was substantially identical. However, the IRS did state that the shrink back rule could be applied if a sub-set of the taxpayer’s software was substantially identical to the third party software.
This substantially identical software rule under Section 199 is of course a grey area and subject to IRS’ and taxpayer’ interpretation as to whether the comparable software is substantially identical but this advice is the first to opine on this exception and shows the IRS is seeking specific documentation showing the identical software. In a competitive software environment, many companies seek to distinguish their software in some respect, so this rule may be very difficult to apply in practice if the IRS finds any differences in functionality. Attached is the CCA document.