Company Challenges Production Activities Deduction Determination

J2 GLOBAL, INC., FORMERLY KNOWN AS J2 GLOBAL HOLDINGS, INC., AS AGENT FOR J2 GLOBAL, INC.  AND SUBSIDIARIES (A CONSOLIDATED GROUP)
Petitioner,
v.
COMMISSIONER OF INTERNAL REVENUE,
Respondent.

Filed
05/24/21

UNITED STATES TAX COURT

PETITION

J2 Global, Inc., formerly known as J2 Global Holdings, Inc., as agent for J2 Global, Inc. and subsidiaries (a consolidated group) (“Petitioner”) hereby petitions for a redetermination of the deficiency in income tax for the taxable year ended December 31, 2014 (“2014”) determined by the Commissioner of Internal Revenue (“Respondent”) in its Notice of Deficiency, dated February 24, 2021. As a basis for its case, Petitioner alleges as follows:

1. Petitioner. Petitioner is a corporation organized under the laws of the State of Delaware. Petitioner's principal place of business is located at 700 S. Flower Street, 15th Floor, Los Angeles, California 90017. Petitioner timely filed its federal income tax return for 2014 electronically.

2. Notice of Deficiency. The Notice of Deficiency upon which this Petition is based was mailed to Petitioner on or about February 24, 2021 by the Office of Appeals of the Internal Revenue Service at 300 North Los Angeles Street, MS LA-8000 Room 3054, Los Angeles, CA 90012. A copy of the Notice of Deficiency is attached.

3. Amount in Dispute. The amount of tax in controversy is set forth below:

3.a. Notice of Deficiency. In the Notice of Deficiency, Respondent determined a deficiency in the following amount:

Tax Year Ended	Deficiency: Increase in Tax
December 31, 2014	$1,849,365

The entire amount of the deficiency is in dispute.

3.b. Affirmative Claim. Petitioner and Respondent have agreed to increase Petitioner's taxable income under section 482 of the Internal Revenue Code of 1986 (the “Code”) in the amount of $9,684,655, pursuant to terms set forth in a Form 906 Closing Agreement between the parties (the “Agreed Adjustment”). The Agreed Adjustment results in additional qualified production activity income (“QPAI”) (as defined in Code section 199(c)(1)) in the amount of $9,684,655. In 2014, Code section 199(a)(1) generally provided for a deduction equal to nine percent of a taxpayer's QPAI for the taxable year. Thus, if Petitioner prevails in this case, the Agreed Adjustment results in an increase to Petitioner's Code section 199 deduction equal to nine percent of the Agreed Adjustment for 2014.

Tax Year Ended	Increased Code Section 199 Deduction
December 31, 2014	$871,619

4. Assignments of Error. The determination of deficiency in income tax is based upon the following errors:

4.a. Respondent erred in determining that Petitioner did not have QPAI in 2014. As a result of this error, Respondent erroneously increased Petitioner's taxable income in the amount of $5,283,901.

4.b. Respondent did not provide Petitioner or this Court with an explanation in the Notice of Deficiency for its position, other than a conclusion that Petitioner did not have QPAI in 2014. Petitioner assumes, upon information and belief, that Respondent's position is consistent with its audit position.

I. Petitioner satisfied the statutory requirements of Code Section 199.

4.c. Respondent erred in determining that Petitioner did not have QPAI because, under the plain language of Code section 199, Petitioner has satisfied the requirements of the statute. Petitioner (1) developed computer software in the United States, (2) granted its customers the right to use this computer software, and (3) in exchange for this right, derived gross receipts. Petitioner did exactly what was required under the statute, and exactly what Congress sought to incentivize through the enaction of Code section 199.

4.d. Respondent erred during the audit in determining that Petitioner failed to satisfy Code section 199's requirement that a taxpayer derive gross receipts from “any lease, rental, license, sale, exchange, or other disposition” of computer software. Petitioner granted its customers the right to use its computer software. In exchange, Petitioner's customers paid a fee. Thus, under the plain meaning of the statute, Petitioner has satisfied the “any lease, rental, license, sale, exchange, or other disposition” requirement of Code section 199.

II. Petitioner satisfied the regulatory requirements of Treasury Regulation section 1.199-3(i)(6)(iii).

4.e. Respondent further erred in determining that Petitioner did not have QPAI under Treasury Regulation (“Treas. Reg.”) section 1.199-3(i)(6)(iii) (hereinafter referred to as the “Competitor Rule”). Petitioner satisfied the Competitor Rule because: (1) Petitioner provided its customers with access to its computer software for their direct use while connected to the Internet or any other public or private communications network; and (2) third parties derived gross receipts from substantially similar computer software affixed to a tangible medium or by download.

4.f. Respondent erred during the audit in determining that Petitioner failed to satisfy the Competitor Rule because, according to Respondent, Petitioner did not provide its customers with access to its computer software for their “direct use” while connected to the Internet or any other public or private communications network. Respondent erred because Petitioner granted its customers with access to a user interface while connected to the Internet or any other public or private communications network. Through this user interface, Petitioner's customers had discretion and control to direct Petitioner's computer software to achieve their desired objectives (e.g., to send or receive a fax). Thus, Petitioner's customers directly used the computer software.

4.g. Respondent's error is further demonstrated through its own prior conclusions. For the taxable years ended December 31, 2008 through December 31, 2011, Respondent evaluated Petitioner's position under the Competitor Rule and concluded that Petitioner satisfied each requirement. Based on this conclusion, Respondent affirmed Petitioner's claimed deductions. The facts for 2014 have not materially changed.

5. Supporting Facts. Petitioner relies on the following facts as the basis for this proceeding:

I. Code Section 199 and its History

5.a. In 2004, Congress passed the American Jobs Creation Act (the “Jobs Act”). As part of the Jobs Act, Congress enacted Code section 199. In its General Explanation of the Jobs Act, the Congressional Joint Committee of Taxation (the “JCT”) explained that the reason for Code section 199 was to incentivize the creation of jobs in the United States through a tax benefit related to domestic production activities. Specifically, the JCT explained that “creating new jobs is an essential element of economic recovery and expansion, and that tax policies designed to foster economic strength also will contribute to the continuation of the recent increases in employment levels.” H.R. Rep. No. 108-548, at 114-115 (2004).

5.b. Under Code section 199(c)(1), QPAI is equal to the taxpayer's domestic production gross receipts (“DPGR”) for the taxable year, less the sum of the cost of goods sold that are allocable to such receipts, and other expenses, losses, or deductions properly allocable to such receipts. Code section 199(c)(4) provides that DPGR includes gross receipts from “any lease, rental, license, sale, exchange, or other disposition” of qualified production property (“QPP”) manufactured, produced, grown, or extracted (in whole or in significant part) in the United States.

5.b.1. Code section 199(c)(5)(B) broadly defines QPP to include “any computer software.” Code section 199(c)(5)(B) is explicit in that it includes “any” computer software, with no exclusions for computer software online, software as a service (known in the industry as “SaaS”), via tangible medium or download, affixed to the taxpayer's servers, other servers, or that exists by any other means.

5.b.2. Code section 199(c)(4) provides that DPGR includes gross receipts from “any lease, rental, license, sale, exchange, or other disposition” of any computer software. Code section 199(c)(4), therefore, provides for numerous ways to satisfy this statutory requirement.

5.b.3. The legislative history makes clear that the phrase “lease, rental, license” in Code section 199(c)(4) provides taxpayers with a way to satisfy the statutory requirement that is different from a “sale, exchange, or other disposition.” The Congressional Conference Report, dated May 19, 2004, provides that DPGR means gross receipts “derived from — (A) any sale, exchange, or other disposition of, or (B) any lease, rental or license of” computer software. S. 1637, 108th Cong. § 102 (2004) (emphasis added). Notably, the phrase “lease, rental or license” allows a taxpayer to satisfy the statutory requirement through the grant of a limited right to use qualifying property developed in the United States, which includes any computer software.

5.b.4. After Congress enacted Code section 199, the JCT confirmed the legislative history and explained that DPGR generally means gross receipts “derived from: (1) any sale, exchange, or other disposition, or any lease, rental, or license of [computer software].” STAFF OF J. COMM. ON TAXATION, 108TH CONG., GENERAL EXPLANATION OF TAX LEGISLATION ENACTED IN THE 108TH CONG. 171-175 (J. Comm. Print 2005); STAFF OF J. COMM. ON TAXATION, TECHNICAL EXPLANATION OF THE REVENUE PROVISIONS CONTAINED IN THE “AMERICAN JOBS AND CLOSING TAX LOOPHOLES ACT OF 2010,” FOR CONSIDERATION ON THE FLOOR OF THE H.R. 80 (J. Comm. Print 2010); STAFF OF J. COMM. ON TAXATION, BACKGROUND ON BUSINESS TAX REFORM 12 (J. Comm. Print 2016) (emphasis added).

II. Facts that Support Petitioner's Deduction Under Code Section 199

A. Petitioner developed computer software in the United States.

5.c. Petitioner was founded in 1995 as a Delaware Corporation. Since then, Petitioner has developed computer software in the United States. Between 2004 (i.e., the year Congress enacted the Jobs Act) and 2014, Petitioner invested approximately $72 million in the development of computer software. During 2014, Petitioner employed approximately 130 software engineers in the United States.

5.d. During 2014, Petitioner's computer software allowed its customers to send, create, and/or receive facsimile and voice communications through the Internet or any other public or private communications network. Through this computer software, Petitioner offered its customers an alternative to technologies that existed before the Internet. For example, Petitioner's computer software that allowed its customers to send and receive facsimile communications through the Internet was an alternative to the traditional fax machine. Similarly, Petitioner's computer software that allowed its customers to create and receive voice communications through the Internet was an alternative to the traditional answering machine.

5.e. Petitioner's computer software was also an alternative to other computer software that was affixed to a tangible medium. For example, Petitioner's computer software that allowed its customers to send and receive facsimile communications through the Internet was an alternative to a fax server. Similarly, Petitioner's computer software that allowed its customers to create and receive voice communications through the Internet was an alternative to a private branch exchange (“PBX”) phone system.

5.f. During the audit, Respondent did not challenge that Petitioner developed computer software, in whole or in significant part, in the United States.

B. Petitioner derived gross receipts from any lease, rental, license, sale, exchange, or other disposition of computer software.

5.g. During 2014, Petitioner granted its customers the right to use, while connected to the Internet or any other public or private communications network, three computer software platforms that Petitioner developed, in whole or in significant part, in the United States.

5.g.1. First, Petitioner granted its customers the right to use a computer software platform to send, receive, edit, and manage facsimile communications through the Internet under the brand names eFax® (there were several variations of eFax® including, but not limited to eFax® Pro, eFax® Plus, and eFax® Corporate), MyFax®, MetroFax®, and jConnect®. This computer software platform is hereinafter referred to as the “eFax Software Platform.” Petitioner's customers paid fees to Petitioner for the right to use the eFax Software Platform to send, receive, edit, and manage facsimile communications for themselves.

5.g.2. Second, Petitioner granted its customers the right to use a separate computer software platform that similarly allowed its customers to send, receive, edit, and manage facsimile communications through the Internet under the brand names TrustFax®, UniFax®, Fax.com®, Send2Fax®, RapidFax®, and SmartFax®. This computer software platform is hereinafter referred to as the “DOC Fax Software Platform.” Functionally, the eFax Software Platform and the DOC Fax Software Platform are substantially similar. The two platforms differ in that they rely on a different sequence of machine-readable code that allows Petitioner's customers to perform the desired function or set of functions (e.g., send a fax). Petitioner's customers paid fees to Petitioner for the right to use the DOC Fax Software Platform to send, receive, edit, and manage facsimile communications for themselves.

5.g.3. Third, Petitioner granted its customers the right to use a computer software platform to create, receive, and manage voice communications through the Internet or any other public or private communications network. Petitioner derived gross receipts from this computer software platform under the brand names eVoice®, Onebox®, and Phone People®. This computer software platform is hereinafter referred to as the “eVoice Software Platform.” Petitioner's customers paid fees to Petitioner for the right to use the eVoice Software Platform to create, receive, and manage voice communications for themselves.

5.h. During 2014, each of the eFax Software Platform, DOC Fax Software Platform, and eVoice Software Platform consisted of millions of lines of machine-readable software code designed to cause a desired function or set of functions. Each of the eFax Software Platform, DOC Fax Software Platform, and eVoice Software Platform resided on a network of secure software servers, primarily located in datacenters throughout the United States.

C. Petitioner satisfied the statutory requirements of Code section 199.

5.i. In sum, Petitioner developed each of the eFax Software Platform, DOC Fax Software Platform, and eVoice Software Platform in the United States, granted its customers the right to use each computer software platform, and derived revenue from any lease, rental, license, sale, exchange, or other disposition of each computer software platform. Under the plain language of Code section 199, Petitioner is entitled to its claimed deduction.

III. The Competitor Rule

5.j. In 2007, Treasury finalized regulations under Code section 199 related to computer software. Recognizing that “the computer software industry [was] evolving,” Treasury promulgated rules to address computer software provided by taxpayers to their customers over the Internet (as opposed to via tangible medium or download). Computer Software Under Section 199(c)(5)(B), 72. Fed. Reg. 12969-12970 (Mar. 20, 2007). In Treasury's view, such regulations were necessary to “give meaning to the statutory language requiring a lease, rental, license, sale, exchange, or other disposition” as it relates to online computer software (as opposed to computer software available on a CD or by download). Id.

5.k. Under Treas. Reg. section 1.199-3(i)(6)(ii), gross receipts derived from “telephone and other telecommunication services, online services (such as Internet access services, online banking services, providing access to online electronic books, newspapers, and journals), and other similar services” do not constitute gross receipts derived from “any lease, rental, license, sale, exchange, or other disposition” of computer software.

5.l. The Competitor Rule is an exception to Treas. Reg. section 1.199-3(i)(6)(ii). Under the Competitor Rule, a taxpayer that has developed computer software in the United States and derives gross receipts from online services and other similar services as described in Treas. Reg. section 1.199-3(i)(6)(ii) “will be treated” as having satisfied the “lease, rental, license, sale, exchange, or other disposition” requirement of Code section 199 if: (1) the taxpayer granted customers access to the computer software for their “direct use” through the Internet or any other public or private communications network (the “Direct Use Test”); and (2) a third party offered substantially identical computer software via tangible medium or download (the “Competitor Test”) (together, the Direct Use Test and the Competitor Test form the Competitor Rule). Treas. Reg. section 1.199-3(i)(6)(iv) defines “substantially identical software” as software that: (1) from a customer's perspective, has the same functional result as the taxpayer's software; and (2) has a significant overlap of features or purpose with the taxpayer's software.

III. Facts that Support Petitioner's Deduction Under the Competitor Rule.

5.m. Petitioner incorporates by reference all facts described in paragraphs 5.c through 5.i, above.

A. Petitioner satisfied the Direct Use Test.

5.n. Each of the eFax Software Platform, DOC Fax Software Platform, and eVoice Software Platform featured a user interface in 2014. Petitioner granted its customers with access to the user interface for each computer software platform while the customer was connected to the Internet or any other public or private communications network. Petitioner generally granted this access through either a website or a downloadable application for the customer's computer and/or mobile device.

5.o. Petitioner designed each of the eFax Software Platform, DOC Fax Software Platform, and eVoice Software Platform to perform a desired function or set of functions at the direction of Petitioner's customers. Through the user interface, Petitioner's customers were the direct users of the computer software, with discretion and control to use the computer software to achieve its designed purpose. Petitioner's personnel did not participate or intervene in this process. During 2014, the customer agreements for the eFax Software Platform, DOC Fax Software Platform, and eVoice Software Platform stated that Petitioner “simply acts as a passive conduit” for the customer to send and receive “information of [the customer's] choosing.”

5.o.1. Petitioner's customers used the eFax Software Platform and DOC Software Platform to send faxes through the Internet, receive faxes through the Internet, edit faxes, organize faxes, and manage account preferences. Specifically, the eFax Software Platform and DOC Fax Software Platform were tools that enabled Petitioner's customers to achieve, among other things, the following end results for themselves:

5.o.2. Petitioner's customers used the eVoice Software Platform to create voice communications through the Internet or any other public or private communications network, receive voice communications through the Internet or any other public or private communications network, deploy call center capabilities, set professional greetings, and manage account preferences. Specifically, the eVoice Software Platform was a tool that enabled Petitioner's customers to achieve, among other things, the following end results for themselves:

B. Petitioner satisfied the Competitor Test.

5.p. During 2014, there were numerous third parties that, on a regular and ongoing basis, derived gross receipts from the lease, rental, license, sale, exchange, or other disposition of computer software affixed to a tangible medium or available via download from the Internet (the “Competitor Software”). From a customer's perspective, the Competitor Software had the same functional result as the eFax Software Platform, DOC Fax Software Platform, and eVoice Software Platform. The Competitor Software also had a significant overlap in features or purpose with the eFax Software Platform, DOC Fax Software Platform, and eVoice Software Platform.

5.p.1. For the eFax Software Platform and DOC Fax Software Platform, the market for Competitor Software included numerous third parties. These third parties offered Competitor Software affixed to fax appliances, fax servers, software-driven fax machines, CDs, and via download. For example, in 2014, companies like FaxCore and FaxAgent derived gross receipts from the sale of fax appliances.

5.p.2. Below is an image of a FaxCore fax appliance. Similar to the eFax Software Platform and the DOC Fax Software Platform, this fax appliance was comprised of machine-readable code affixed to a tangible medium that allowed the customer to send, receive, edit, and manage facsimile communications through the Internet. Specifically, the fax appliance was a tool that enabled the customer to achieve, among other things, the following end results for themselves:

5.p.3. Another example of Competitor Software affixed to a tangible medium is a fax server. In 2014, companies like RightFax, Kofax, FaxFacts, and Genifax all derived gross receipts from the sale of fax servers. A fax server is comprised of machine-readable code affixed to a tangible medium that is designed to cause the server to send and receive faxes through the Internet.

5.p.4. Below is an image that depicts a RightFax fax server. This fax server is an example of third party software affixed to a tangible medium that had the same functional purpose as the eFax Software Platform and DOC Fax Software Platform for Petitioner's corporate customers. This fax server was a tool that enabled the customer to achieve the end results described in paragraph 5.p.2 and, for corporate customers, create individual user accounts, set permissions for each user, and create usage reports.

5.p.5. For the eVoice Software Platform, the market for Competitor Software included numerous third parties. These parties offered Competitor Software affixed to a PBX phone system, CDs, and via download. For example, in 2014, companies like Cisco, Mitel, and ShoreTel derived gross receipts from the sale of PBX phone systems.

5.p.6. Below is an image that depicts a Cisco PBX phone system. A PBX phone system is comprised of machine-readable code affixed to a tangible medium that allowed the customer to create, receive, and manage voice communications through the Internet. Specifically, the PBX phone system was a tool that enabled the customer to achieve, among other things, the following end results for themselves:

5.q. During the audit, Respondent did not challenge that Petitioner satisfied the Competitor Test.

C. Petitioner satisfied the Competitor Rule.

5.r. The facts described in paragraphs 5.m through 5.o demonstrate that Petitioner granted its customers with access to each of the eFax Software Platform, DOC Fax Software Platform, and eVoice Software Platform for their direct use while connected to the Internet or any other public or private communications network (i.e., Petitioner satisfied the Direct Use Test). Further, the Competitor Software described in paragraph 5.p demonstrates that, in 2014, numerous third parties that derived revenues from substantially similar computer software affixed to a tangible medium or via download (i.e., Petitioner satisfied the Competitor Test). Thus, Petitioner falls squarely within the Competitor Rule and is entitled to its claimed deductions.

WHEREFORE, Petitioner prays that this Court should find as follows:

WHEREFORE, Petitioner requests that this Court determine that no tax deficiency is due from Petitioner.

WHEREFORE, Petitioner requests that this Court grant its affirmative claim and increase Petitioner's Code section 199 deduction for 2014 by $871,619.

Respectfully submitted,

Jonathan A. Welbel
T.C. No. WJ1276

Brian A. Houlihan
T.C. No. HB0352

Peter S. Liu
T.C. No. LP20015

Baker & McKenzie LLP
300 East Randolph Street
Suite 5000
Chicago, Illinois 60601
(312) 861-8000

Attorneys for Petitioner

Dated: May 24, 2021