Online Software Provider Comments on Production Activities Deduction Rules

Re: Treatment of Online Computer Software Maintenance Agreements for Purposes of Section 199

To Whom It May Concern:

We are writing to respectfully request that the Proposed Treasury Regulation § 1.199-3T(i)(6)(iv)(E) be clarified to explicitly provide that domestically produced updates, cyclical releases, and rewrites of online computer software code are not excluded from the Section 199 production incentive. We submit this letter in accordance with the public comment process and pursuant to the specific request for comments on the "clarity of the proposed rules and how they can be made easier to understand."

We wish to thank the Treasury Department and the Internal Revenue Service for specifically including online computer software within the scope of Section 199. Online computing is becoming the preferred method of utilizing software, and the recent modifications to Section 199 will be of great benefit to both the software industry and the public as a whole.

I. Background

Treasury and the IRS recently issued temporary regulations providing guidance under Section 199 for taxpayers that provide computer software to customers for the customers' direct use while connected to the Internet. The temporary regulations establish two exceptions under which gross receipts derived from providing such online software will be treated as domestic production gross receipts (DPGR). The first exception applies where the taxpayer delivers the same software to its customers via Internet download or affixed to a tangible medium. The second exception applies where the taxpayer has a competitor that produces substantially identical software that is delivered to customers via Internet download or affixed to a tangible medium. See Proposed Treasury Regulations §§ 1.199-3T(i)(6)(iii)(A) and (B).

Section 199 generally provides that revenue from the performance of services do not qualify as domestic production gross receipts. See § 1.199-3(i)(4)(i)(A). In instances in which a taxpayer combines the sale of qualified property with the sale of a service for one price, referred to as an "embedded service," the taxpayer must allocate a part of the gross receipts to the nonqualified service. Id. However, in instances in which the taxpayer produces software or other qualified production property, Section 199 lists six exceptions ("safe harbors") to the general rule that it must allocate receipts to nonqualified embedded services. See § 1.199-3(i)(4)(i)(B). The six safe harbors are: (1) warranties; (2) deliveries; (3) operating manuals; (4) installations; (5) computer software maintenance agreements; and, (6) de minimis service revenues that are less than five percent of the gross receipts. See §§ 1.199-3(i)(4)(i)(B)(1)-(6). In order to qualify for a safe harbor exception, the embedded service must be bundled with the underlying product and not separately offered, negotiated, or priced by the taxpayer.

The recently issued temporary regulations exclude from online software providers the fifth safe harbor for embedded computer software maintenance agreements. See Proposed Treasury Regulation § 1.199-3T(i)(6)(iv)(E). We understand that Treasury and the IRS were concerned that receipts attributable to customer support services for online software could be perpetual DPGR given the potentially continuous nature of online software agreements. Section 1.199-3T(i)(6)(v), Example 6 reflects this concern in its illustration that gross receipts for fees derived from telephone support for online computer software must be allocated as non-DPGR.

However, the temporary regulations inadvertently create an ambiguity that should be clarified. Specifically, Section 199 defines a computer software maintenance agreement as broadly including not simply the right to receive customer support, but also the right to receive "future updates, cyclical releases, [and] rewrites of the underlying software . . ." See § 1.199-3(i)(4)(i)(B)(5). Thus, the temporary regulations could mistakenly be read to exclude these traditional software production activities from the benefits of Section 199. Because we do not believe that this exclusion is the intended result, we offer proposed revisions to the regulation and the relevant example to clarify the language and harmonize it with the entirety of Section 199.

II. Our Business

Salesforce.com provides a comprehensive customer relationship management software product to companies of all sizes and industries worldwide. Our software helps customers to manage more effectively critical operations of their businesses, including sales force automation, customer service and support, marketing automation, document management, analytics, and custom application development. Instead of making copies of our software and shipping it to customers or requiring a download, salesforce.com makes the program available via a secure Internet connection on its Web site. Customers pay a subscription fee, input their business data into the salesforce.com application located on the salesforce.com servers, and manage the data remotely through a standard Web browser and Internet connection.

Online software provides benefits to users that are not available to users of software that is shipped or downloaded. One benefit that is relevant to the issue at hand is the ability of the customer always to use the most current version of the software program. Salesforce.com, and most other online software providers, assemble one set of technology infrastructure (software and hardware) that is shared by all customers that access the system. By contrast, software that is shipped or downloaded requires a customer to run its own version of the software on its own separate computer hardware infrastructure and to deploy upgrades to the software itself each time a new version is released.

When salesforce.com distributes a software upgrade, all of our customers simultaneously receive and utilize it because only one version of the software is running at any given time. The right and ability to operate the most current version of the software, and to take advantage of the added functionality and other improvements, is a feature of online software that is included in the license fee. Updates to software that is shipped or downloaded over the Internet often take two to three years to be individually deployed by the majority of customers. Indeed, most customers of shipped software are usually one or more releases behind the latest version.

III. Why Clarification is Requested

The issue of concern here is that the proposed regulations can possibly be read to exclude from DPGR revisions to online software code because the computer maintenance agreement safe harbor -- which does not apply to online software providers -- is defined in the regulations to include not only customer support services, but also a customer's right to receive "future updates," "cyclical releases," and "rewrites" of the underlying software code. As with software delivered on a disk or via Internet download, each revision, update, or modification to online software code adds to a foundation of pre-existing code that, in many cases, was written years ago when the original program was developed. Virtually all software, irrespective of whether it is accessed over the Internet or shipped to an end user, is developed through this type of accretive process in which new versions are built upon a base of versions that preceded it.

Treasury and the IRS have recognized elsewhere in Section 199 that domestic production of updates to code provided to customers pursuant to software maintenance agreements are considered DPGR and thus entitled to Section 199 production incentives. This recognition is illustrated in two locations within the regulations.

The first location is in Section 199's Summary of Comments and Explanation of Provisions at pages 26-27, which provides:

These acknowledgements that receipts associated with computer software updates are "properly treated as DPGR," even when provided in a software maintenance agreement, demonstrate what is intuitively clear -- that revenue from software updates are not treated differently than revenue from the underlying code. The Summary of Comments and Example 1 in § 1.199-1(e)(3) apply equally to all domestic software manufacturers, including providers of online software. Thus, Section 199 already provides that domestic production costs of software updates are deductible when they are bundled with customer support -- the issue is one of allocation of revenue, not deductibility.

This stands to reason because the question of whether the online software code was domestically developed as part of the original software application, or developed to update the program at a later date, should not be determinative of whether revenues from its sale are considered qualified receipts. All otherwise qualifying software production activities should be subject to Section 199 deduction irrespective of whether they involve developing original code, or enhancements or modifications to it.

IV. Proposed Clarification

We request that the final regulations make clear that development of updates to online software code are not excluded from DPGR. This can be accomplished by slight modifications to the regulation and Example 6 which clarify that only customer support services that are embedded in online computer software maintenance agreements are excluded from the safe harbor (alterations in italics):

This clarification of the proposed regulation will make explicit what we believe is consistent with the balance of Section 199 and implicit in the proposed regulations -- that domestic production of otherwise qualified online software updates are entitled to Section 199 production incentives. The suggested changes are necessary to eliminate any ambiguity and to ensure that gross receipts relating to online computer software updates provided under a software maintenance agreement qualify as DPGR.

Again we are grateful to Treasury and the IRS for addressing online software in Section 199, and we hope that these comments are helpful in further crafting guidance.