Firm Wants to Discuss Manufacturing Deduction for Cloud Computing

At your suggestion, we are sending you this letter to respectfully request a meeting with Mr. Mazur and/or Ms. McMahon to discuss guidance relating to the application of section 199 of the Internal Revenue Code of 1986, as amended (the "Code"), to United States taxpayers that develop and distribute software applications and their associated computing capabilities through means other than by traditional disc or download. The software marketplace has changed dramatically in the 11 years since section 199 was introduced into law, and the Internal Revenue Service (IRS) rules and regulations relating to software development and its delivery have been slow to adapt to the changing marketplace. We understand from statements made by personnel from the Department of the Treasury and the IRS, and from the inclusion of an item on the 2015-2016 Priority Guidance Plan, that the tax offices of both agencies are considering how to bring the section 199 rules up to the level of the current operating practices of the software industry.

The section 199 domestic production activities deduction was added to the Code as part of the American Jobs Creation Act of 2004. Congress enacted section 199, in part, to support the domestic production activities of United States taxpayers by reducing the effective tax rate on property manufactured, produced, grown or extracted in the United States. One such sector identified in the legislative history for inclusion in this tax expenditure incentive was the software industry. However, what became obvious at the time of writing rules specific to the software industry was that it was very difficult to distinguish a service using software capabilities from the delivery of software to customers in a means other than by disc or download, i.e., how to treat cloud-based software delivery models.

In the regulations as finalized by the Secretary, the section 199 rules for software transactions place undue emphasis on the presence of a disc or download transaction. The current regulations, in relevant part, provide as follows. First, Treas. Reg. § 1.199-3(i)(6)(i) provides that gross receipts derived from the sale, lease, license or other disposition of software would qualify as DPGR. Second, Treas. Reg. § 1.199-3(i)(6)(ii) provides an exception for nonqualifying service transactions. This list, in full, now reads as follows --

What ultimately became the current set of section 199 software regulations, in the view of the IRS,¹ bases the qualification of software revenue for the benefits of section 199 solely on whether the software in question, or substantially identical software products of competitors, are available by disc or download. Apparently, in the view of the IRS, software that is not provided by disc or download cannot be considered to be leased or licensed under Treas. Reg. § 1.199-3(i)(6)(i), nor can cloud-based software qualify if the same or substantially identical software is not provided by disc or download. What makes this rule unworkable is that an increasing number of software companies are providing software products to customers only through a cloud-based model, yet these software producers are clearly developing and producing this software in the United States as required by the statute and the real value to the customers of such cloud-based software is in the software and not any associated delivery or other services. How can software that qualified last year lose its qualification merely because of a change in delivery options that are prompted by market conditions? As the marketplace continues to move away from disc or download delivery systems to cloud-based delivery of software products, the reference marker of disc or download fails to adequately address the Congressional intent to apply section 199 to U.S. developers of software products who dispose of their software in the ordinary course of business. With the increasing interconnectedness of software to the internet, the presence of a downloaded copy is an inappropriate and underinclusive touchstone to distinguish property transfers from the use of software to render services, consistent with Congressional intent.²

In addition, the current regulations have been difficult to apply in practice, as reflected in the recent pronouncements emanating from the IRS. For example, in GLAM 2014-008 (December 12, 2014), the IRS took a limited interpretation of downloaded software as that which has functionality only when it is disconnected from the internet. As stated in the GLAM, software will be eligible for benefits of section 199 (or able to qualify other software under the substantially identical test) only to the extent it has independent functionality apart from the internet. This GLAM fails to take into account that a computer program downloaded to the customer's computer for the purpose of performing functions while connected to the internet still constitutes a downloaded piece of software. Similarly, CCA 201226025 (Mar. 9, 2012) illustrates the practical difficulty of applying the substantially identical test to complex software programs with multiple functions, even where substantially identical components of the software are available by disc or download.

Interestingly, Treasury and the IRS seem to be moving in a more modern direction in the proposed regulations released on January 16, 2015 (the "2015 proposed regulations") addressing qualification for the research credit under section 41 for costs to develop internal use software.³ If software is internal use software, then it is more likely to be used by the software developer in the performance of a service provided to a customer. Software that is not internal use software, however, is essentially used by the customer in some form or fashion, and even though not provided to the customer by disc or download, effectively allows the customer to use the computing capabilities of the software for such customer's own individual business operations. These proposed regulations provide helpful guidance -- including, inter alia, a definition of internal use software that focuses more on how a customer interacts with the software rather than whether the software is delivered to a customer by disc or download or through an online access mechanism. The 2015 proposed regulations state that computer software is not developed primarily for the taxpayer's internal use if either: (1) the software is developed to be commercially sold, leased, licensed, or otherwise marketed to third parties; or (2) the software is developed to enable a taxpayer to interact with third parties or to allow third parties to initiate functions or review data on the taxpayer's system.⁴ This same set of guidance is needed in the section 199 context to modernize the rules and remove the reliance on a distinction that is increasingly archaic and disconnected from current industry practices.

Please consider allowing Fenwick & West to meet with Mr. Mazur and/or Ms. McMahon to discuss the current factual context of the software industry and the type of guidance that would be most expedient in applying these rules to the current software marketplace.

We look forward to your response.

²See Congressional Letter to the IRS and Treasury regarding Notice 2005-14, dated July 21, 2005.

³ REG-153656-03, 80 Fed. Reg. 2624.

⁴ Treas. Reg. § 1.41-4(c)(6)(iv)(A) (2015 proposed).