Piper Rudnick Requests Clarification of Proposed Domestic Production Activities Regs

We are pleased to submit these comments on the Proposed Regulations issued under section 199. These comments derive from our representation of various clients affected by certain aspects of the Proposed Regulations.

We have two principal comments:

Background

Congress included computer software within the meaning of qualified production property (QPP). When including computer software within the definition of QPP, Congress did not limit the types of computer software that qualify as QPP nor did Congress limit the types of computer software transactions that create domestic production gross receipts (DPGR) for purposes of section 199. With respect to computer software, Congress required that the taxpayer's income be derived from the lease, rental, license, sale, exchange or other disposition of computer software that has been developed in whole or in significant part in the United States.

Treasury appears to take the position that some form of actual transfer of computer software is required in order for a transaction to qualify under section 199. In this regard, Notice 2005-14 and Prop. Reg. Sec. 1.199-3(h)(6) exclude the provision of internet access services, online services, customer support, online books, journals, games and similar services from the definition of qualifying computer software. The Preamble notes that Treasury believes that the use of online software does not rise to the level of a lease, rental, sale, license, etc but is in the nature of a service. Moreover, Treasury believes that service characterization is still appropriate even if the actual form of the transaction is a license and the customer must agree to customary terms and conditions associated with a license.

We understand Treasury's position with respect to the provision of basic online services or online access. In these circumstances, a customer is simply accessing data that has been made available to the public or group of customers. While the customer may be using a search engine or other similar tool to access different aspects of the data or may otherwise be manipulating the data through a search engine, the customer is simply accessing data which has been made available in a passive environment by the software provider.

The position of hosted software differs substantially from the position of online services. The use of hosted software is identical to the actual sale or license of computer software except that there has not been an actual physical transfer of the software to the customer. The customer is using the same functionality as software which has been physically transferred except that the software provider is enabling the customer to access, store, manipulate and transfer data using hosted applications provided by the software provider. In fact, hosted software often has more functionality than physically transferred software because the software provider can manage viruses, piracy, upgrades and maintenance directly for the customer and can often provide greater data capacity through its own servers.

Examples

Two examples of hosted software illustrate the similarities with software that has been physically transferred:

• An insurance company provides property, casualty or medical insurance coverage and risk management services to companies and employers. The insurance company has developed a proprietary software application that enables a client to manage insurance risk. Development of the software took place entirely in the United States. The software enables a company to monitor the claims process, capture and manipulate loss information and evaluate its risk position. Use of the software enables the company to make informed insurance and risk management decisions. The insurance company provides the software through a hosted environment by making the software available to its clients through a secure internet site.

• Both the insurance company and the client upload and download information onto the hosted software application. The client then accesses and manipulates the data through the hosted software. Proprietary client information is then updated and stored for future analysis on the server of either the insurance company or its client. The data stored is proprietary data of its client. The hosted application may be customized to meet the specific needs of the client.

  While there has been no actual physical transfer of the software, there has been an exchange of data by the insurance company and its client such that each client is essentially using its own proprietary version of the software by uploading, maintaining and storing its own proprietary data on the hosted software application. While the insurance company could have simply licensed an actual version of the software to its clients, by providing the software through a hosted environment, the insurance company is able to improve functionality by adding its own data and other information directly into the client's proprietary platform and minimize the client's need for data storage by maintaining the software and data on its own servers. As noted above, by providing the software in a hosted environment, the insurance company is also able to more quickly provide general and client specific improvements to the software, monitor for viruses and prevent piracy.

  The insurance company may provide the hosted software as part of its traditional service offering. Alternatively, the insurance company may charge separately for the hosted software. The insurance company may require a formal license for the use of the software. However, where the insurance company maintains the hosted software on its server, the need for a formal license is less important since the source code is protected by the insurance company itself.

  Regardless of how the software is made available to its clients, the development and exploitation of the software helps the insurance company stay competitive with other insurance companies in the United States and around the world.

• A property management company manages commercial buildings on behalf of building owners. The property management company has developed a proprietary software application which enables a property owner to manage occupancy, improvements, repairs and other similar information. Development of the software took place entirely in the United States.

• The property management company and the owner upload information into the software application so that the owner can then analyze and manipulate the data in order to make informed leasing and ownership decisions. The data enables the owner to evaluate profit or loss on a lease-by-lease basis as well as maintain real time information on lease related issues. As in the case of the insurance company example, proprietary owner and property specific information is updated and stored for future analysis on the server of either the property management company or its client. The data stored is proprietary data of the client.

  Again, while no actual physical transfer of the software to the owner has taken place, there has been an exchange of data between the property management company and the owner such that each owner is essentially using a proprietary version of the software through the access, manipulation and storage of its own proprietary data.

  As with the insurance company, the property management company could simply have licensed the software to the property owner and allowed the property owner to upload, manipulate and store data on its own. However, by providing the software through a hosted environment, the property management company can maximize functionality and also improve its competitive position vis-a- vis other property management companies around the world.

As noted, section 199 defines DPGR as gross receipts "derived from . . . any lease, rental, license, sale, exchange or other disposition" of QPP. Because of this language, we recognize the need to distinguish between a transaction involving computer software and a service. As noted in the Preamble, one of Treasury's concerns with respect to online software is that "if online software were permitted to qualify as DPGR, it would be difficult to distinguish this online software from software that is used to facilitate a service."

Treasury elaborates on its position through two examples involving an online edition of a newspaper. The examples note that the gross receipts attributable to the online edition, whether made available to print subscribers only or charged separately, do not qualify as domestic production gross receipts.

The online newspaper examples illustrate the fundamental difference between simple online access and hosted software. The provision of software through a hosted environment is identical to the actual sale or license of computer software. While there has been no actual physical transfer of the underlying software, the user has effectively taken dominion and control over a proprietary version of the software. While the developer will engage in similar transactions with other users, hosted software is a one-to-one relationship between the developer and the user where the user downloads its own data onto the application and stores that data on either its own server or the server of the provider. This is fundamentally different than a passive offering of information in an online setting.

We believe that the nature of hosted software sufficiently rises to the level of a disposition because the user has so entwined its proprietary data and information into the software application. Because the developer of a hosted application must create a one-to- one relationship with each client, the developer has effectively disposed of a customer specific version of the software. Accordingly, we believe that Treasury has the necessary authority under section 199 to expand the definition of computer software DPGR to include hosted software transactions.

We also note that since Congress intended section 199 to apply to the computer software industry, the phrase "derived from . . . any lease, rental, license, sale, exchange or other disposition" must be read in the context of the industry itself. Computer software is made available to users in a variety of forms some of which involve actual transfers and some which do not, in particular hosted software. The software industry and their customers focus on functionality rather than the mechanism through which the software is delivered. We believe the determination of whether a transaction or component of a transaction qualifies should be based not on the distinction of whether an actual transfer is involved but whether the functionality of the application and the relationship between the developer and the user rises above the mere provision of a service. While we understand Treasury's position in the context of online subscriptions and simple internet access, we believe most hosted software applications rise above the mere performance of a service.

Allocation Issues

We note the difficulty Treasury acknowledges in distinguishing computer software transactions from services. However, this difficulty is inherent in all aspects of section 199. The statute provides that DPGR includes gross receipts derived from transactions involving QPP. As a result, allocation issues are embedded throughout section 199 and the Proposed Regulations are replete with situations where allocations must be made. In particular, allocations are required to separate qualifying components of an overall transaction which does not in itself qualify.

The "coffee footnote" in the legislative history to section 199 illustrates this issue. There, a retail sale of a prepared coffee drink does not qualify for section 199 benefits. However, the footnote explains that the taxpayer may allocate part of the gross receipts from the retail sale to gross receipts which do qualify as DPGR. The legislative history indicates that section 482 principles can be used to allocate the gross receipts between qualified and nonqualified receipts. The legislative history indicates that Congress intended that if the taxpayer's overall transaction did not qualify on its face, the transaction could be broken down into its component parts to determine which components qualified. This is the case even if the taxpayer does not separately charge for the component parts, e.g., the taxpayer selling a prepared coffee beverage does not separately itemize the cost of the roasted beans, cup, lid, etc.

These allocation issues are no different in the hosted software examples discussed above. In both cases, the gross receipts generated by the taxpayer would likely be in the nature of fees for the performance of services. However, a component of those fees can be allocated to the hosted software application. The taxpayer can use the principles of section 482 in the same manner as the taxpayer in the coffee footnote to determine the portion of its gross receipts attributable to the hosted software.

As noted, we recognize the difficulties in inherent in this allocation but these difficulties are no more extensive or challenging than any of the other allocation issues inherent in section 199 as a whole. Congress intended a broad application of section 199 and anticipated the challenges in identifying the qualifying components of a transaction. If a taxpayer can establish, using principles of section 482 or by other means, that a component of an otherwise nonqualifying transaction should qualify under section 199, the taxpayer should be able to claim section 199 benefits for the qualifying portion.

Prefiling Agreement/Private Letter Ruling Option

As discussed, Congress intended a broad application of section 199 and through the Proposed Regulations Treasury has defined the broad parameters of the statute. However, the regulations when finalized will not be able to deal with every taxpayer situation or industry issue. As a result, taxpayers and industry groups will continue to face uncertainty as to whether section 199 applies to their transactions or how to apply the final regulations to their fact patterns.

This uncertainty is significant because taxpayers may be required to make material investments in their accounting systems in order to perform the necessary allocations and collect the necessary information to calculate their section 199 amounts.¹ Given the long phase-in period of section 199, taxpayers will need to balance the benefits under section 199 with the costs of achieving those benefits. If taxpayers or industry groups are uncertain as to the application of section 199 to their transactions, they will be less inclined to make the necessary investments to secure section 199 benefits. Congress enacted section 199 to encourage investment in production activities in the United States. It would be unfortunate if taxpayers were deterred from making this investment as a result of lingering uncertainties in the regulations.

Treasury will not be able to deal with every situation in the final regulations. To ameliorate this uncertainty, we recommend that Treasury add a prefiling agreement or private letter ruling option to enable a taxpayer to achieve certainty with respect to the application of section 199 to its transactions or to achieve certainty on one or more section 199 issues. Because of the fact intensive nature of section 199 and the allocation issues inherent in calculating section 199 amounts, a prefiling agreement or private letter ruling option would greatly assist taxpayers in determining whether to make the necessary investment in section 199 accounting.

A prefiling agreement or private letter ruling option would be similar to the private letter ruling mechanism under the branch profits tax regulations.² In those regulations, Treasury recognized that the enumerated tests might exclude taxpayers who should otherwise qualify for qualified resident status. To deal with these situations, Treasury added a private letter ruling mechanism to allow taxpayers to establish that their specific situations qualify.

We believe that similar considerations are present here and recommend that Treasury consider a similar mechanism in the final regulations.

² Reg. Sec. 1.884-5(f).