Sec. 199 generally provides for an extra deduction of 9% of the income from certain production activities, in addition to the otherwise allowable deduction for production costs. The activities that qualify for this deduction are not limited to what might be thought of as traditional manufacturing but include construction, engineering, architectural services, film production, some utility company activities, and producing certain other qualifying production property.
Domestic production gross receipts on which the deduction is based include gross receipts derived from qualified film and qualifying production property, such as tangible personal property, sound recordings, and computer software. More and more businesses are being established to develop or distribute computer software, possibly because of the low overhead required to enter the industry. With the resulting increased business activity and technological advances being made in software development (especially in the field of accounting), and the new methods of distribution, it is increasingly important for tax practitioners to be familiar with the rules for the domestic production activities deduction (DPAD) for computer software, which are specialized and require some unique considerations.
The general rules
The DPAD is calculated as 9% of the lesser of qualified production activities income or taxable income. Individuals use adjusted gross income (as defined by Sec. 199(d)(2)) instead of taxable income. The deduction is further limited to 50% of the employer’s W-2 wages for the tax year, as defined by Sec. 199(b)(2). Qualified production activities income is calculated as the excess of domestic production gross receipts (DPGR) over the allocated cost of goods sold, direct costs, and allocable indirect costs. DPGR consist of amounts received from the sale, exchange, lease, rental, license, or other disposition of qualifying production property manufactured, produced, grown, or extracted by the taxpayer in whole or significant part within the United States.
As often happens in allocating costs, properly allocating them to the qualified production activity may be challenging. Extensive guidance is provided by Regs. Sec. 1.199-4 and the regulations under Sec. 861. The application of those rules and the multiple alternative methods is beyond the scope of this article.
Taxpayers eligible for the deduction include corporations, individuals, estates, trusts, and cooperatives. For partnerships and S corporations, the deduction is generally determined at the partner or shareholder level. The deduction is claimed on Form 8903, Domestic Production Activities Deduction. For more information, see “Maximizing the Section 199 Deduction,” JofA, Sept. 2010, page 44.
The rules for computer software
Computer software is qualified production property (Sec. 199(c)(5)(B) and Regs. Sec. 1.199-3(j)(1)(ii)), and thus gross receipts derived from computer software may give rise to qualified production activity income. DPGR include gross receipts from the lease, rental, license, sale, exchange, or other disposition of computer software (Sec. 199(c)(4) and Regs. Sec. 1.199-3(i)(6)(i)).
For purposes of the DPAD, “computer software” means any program or routine or any sequence of machine-readable code that is designed to cause a computer to perform a desired function or set of functions, and the documentation required to describe and maintain that program or routine (Regs. Sec. 1.199-3(j)(3)(i)). Computer programs such as operating systems, executive systems, monitors, compilers, translators, assembly routines, utility programs, and application programs are included within the definition of computer software. Qualifying software is not limited to the type that is run only on equipment such as a desktop (see also the definition of “computer” in Sec. 168(i)(2)(B)). It also includes the machine-readable code for video games and similar programs, for equipment that is an integral part of other property, and for typewriters, calculators, adding and accounting machines, copiers, duplicating equipment, and similar equipment.
In contrast, an electronic book available online or for download does not qualify as computer software under the deduction rules. An electronic book does not, in and of itself, cause a computer to perform any function. A program that makes it possible to read an electronic book, however, would qualify as computer software.
Computer software also does not include a database or similar accumulated information unless it is in the public domain and is incidental to the computer software. However, for this purpose, copyrighted or proprietary data will be treated as being in the public domain if it does not significantly add to the cost of the underlying program. An example provided by the regulations is a dictionary included with a word-processing program (Regs. Sec. 1.199-3(j)(3)(iii)).
Incidentals and embedded services
It is important to know which ancillary services or incidentals are included within the term “computer software” because amounts received for such things will increase qualifying DPGR and be a positive factor in computing the deduction allowed by Sec. 199. Computer software includes any incidental and ancillary rights that are necessary to effect the acquisition of title to, ownership of, or right to use the computer software, and that are used only in connection with that specific computer software (Regs. Sec. 1.199-3(j)(3)(ii)).
However, the general rule is that gross receipts from services are not included in DPGR (Regs. Sec. 1.199-3(i)(4)(i)(A)). When customers purchase computer software, they frequently also gain access to technical support and other user-related services. Income from customer and technical support, telephone and other telecommunication services, online services (such as internet access services, online banking services, or providing access to electronic books, newspapers, and journals), and other similar services are not considered gross receipts for purposes of the deduction (Regs. Sec. 1.199-3(i)(6)(ii)).
Since the amount received for services is not generally included in the gross receipts used to determine the deduction under Sec. 199, a problem arises in calculating the amount received for “embedded services” included in the amount charged for the software or other qualified production property. Regs. Sec. 1.199-3(i)(4)(i)(B) provides exceptions to the general rule that taxpayers must make a reasonable allocation of gross receipts to the fair market value of the embedded services. These exceptions include a qualified computer software maintenance agreement that is not separately offered by the taxpayer or bargained for by customers and the price of which is not separately stated from the amount charged for the computer software.
An interesting related matter is how to treat advertising and product placement income, which is defined as compensation for placing or integrating advertising or a product into computer software (Regs. Sec. 1.199-3(i)(5)(ii)(B)). An increasingly common business model includes embedding advertising as part of other products including software. The regulation generally allows such ancillary income to be DPGR if income from disposition of the underlying software would be DPGR. However, advertising will not be DPGR if it is implemented in connection with access to online software (discussed below), unless the underlying online software is accompanied by the software in a tangible medium or by download (Regs. Sec. 1.199-3(i)(6)(iv)(F)).
A potential problem for software providers is that the delivery or access method of their product might be viewed more as a nonqualifying service than as qualifying computer software. As a result, the IRS and Treasury in 2007 issued complex regulations (T.D. 9317) to limit when receipts from providing online software will be treated as receipts from selling or leasing computer software for purposes of the DPAD.
Online computer software is defined as software provided to customers for their direct use while they are connected to the internet or any other public or private communications network (Regs. Sec. 1.199-3(i)(6)(iii)). Gross receipts from online software will be treated as DPGR only if the taxpayer either (1) regularly also has gross receipts from software provided to customers in a tangible medium such as on a DVD or by authorized internet download, that is not materially different from the online software (Regs. Sec. 1.199-3(i)(6)(iii)(A)); or (2) if another person derives, on a regular and ongoing basis in its business, gross receipts from software substantially identical to the taxpayer’s online software that is distributed according to those same methods: either in a tangible medium or through authorized download (Regs. Sec. 1.199-3(i)(6)(iii)(B)). This may present some unusual audit circumstances, in that the proper application of tax rules to a particular taxpayer will depend on what another taxpayer is doing.
Cloud computing is one of the fastest growing models of data storage and access today. With the dramatic decrease in the cost of digital storage, establishing facilities for immense data storage and server farms is spawning the rapid growth of new businesses. This growth is due in part to the convenience of providing ready access to software from multiple remote platforms and includes not only data storage and retrieval but also housing application programs that can be accessed from remote locations. Other benefits of cloud computing include on-demand self-service, broad network access, resource pooling, rapid resource elasticity, and measurable service (see the IRS webpage, “IRS Safeguards Technical Assistance Memorandum: Protecting Federal Tax Information (FTI) in a Cloud Computing Environment,” June 2013). Some companies have even started selling access to their programs only on the cloud rather than by providing their programs on a disc or by download.
The issue in cloud computing is whether the gross receipts from providing access to software will qualify as DPGR and thus be included in the calculation of the production activity deduction. The 2007 regulations cited above envisioned a different world in which people were mostly downloading software (also available on CD-ROM) and using it on their local computers. The requirement that a taxpayer “regularly also has gross receipts from software provided to customers in a tangible medium such as on a DVD or by authorized internet download” could be a problem. If access to cloud software does not qualify as online software, then the Sec. 199 deduction will not be available. However, based on definitions provided in the 2007 regulations, cloud computing might in certain instances qualify as what the regulations are referring to as “online software” eligible for the DPAD. Customers do have direct use of software while connected to the internet.
Although the provider might not offer the same software in a tangible medium or by download, income from offering access to cloud software may qualify as DPGR if one or more competitors are offering a substantially identical product in a tangible medium or by download (see Regs. Sec. 1.199-3(i)(6)(v), Examples (5)–(7)). Substantially identical software, for this purpose, is defined as software that from a customer’s perspective performs the same functional result as the online software and overlaps significantly with the online software’s features or purpose (Regs. Sec. 1.199-3(i)(6)(iv)(A)). Regs. Sec. 1.199-3(i)(6)(iv)(B) provides a safe harbor for all computer games as substantially identical to one another. The biggest hurdle to the taxpayer will be overcoming the self-defeating notion of having to argue that a competitor’s product is substantially identical to its own—not something taxpayers would relish doing.
Another use of technology that has grown exponentially in recent years is mobile computing. Smartphones are becoming ever “smarter,” and some have internal processors rivaling those of desktop computers. Many people use their smartphones, tablets, or laptops to run the same computer programs they use on their traditional desktops. These mobile devices should meet the definition of computer found at Sec. 168(i)(2)(B), and software for mobile devices should qualify as computer software under Regs. Sec. 1.199-3(j)(3). The question is whether a company that develops and sells mobile applications (“apps”) obtains DPGR from that activity.
It is common for mobile apps to be sold and distributed only by download from the internet. Customers pay for the app, download it to their mobile devices, and then in many cases use it without the necessity of being connected to the internet or having subsequent interaction with the software provider. As such, the income produced should be DPGR, since the mobile app activity does not meet the definition of online software and is therefore not subject to those restrictive rules. There would be a different result if the app were of a type that required maintaining a direct connection to the internet for use. In that case, the rules for online software discussed above should apply. Partly for that reason, a recent IRS legal advice memo concluded that a bank did not have DPGR from a banking services app it provided to its customers. For more, see "Tax Matters: Domestic Production Gross Receipts Not Derived From Free Phone App."
A challenge to advisers
The DPAD provides taxpayers with a deduction in addition to the costs incurred in their production activities. Highly specialized considerations are involved in claiming the deduction by businesses in the computer software industry. This results not only from the nature of computer software but also from the increasingly varied methods of its development and distribution.
Current modes of software distribution and access include not only providing hard media such as discs, but also allowing program downloads or online use only. Devices using software have mushroomed and, in addition to desktops, now include laptops, tablets, and smartphones.
Each mode of software distribution and access, and each device using the software, presents a challenge to the tax adviser to consider complex rules that will determine whether the taxpayer is entitled to the deduction for domestic production activities.
Donald L. Rosenberg (firstname.lastname@example.org) and Seth Hammer (email@example.com) are professors of accounting, and Charles J. Russo (firstname.lastname@example.org) is an assistant professor of accounting, all at Towson University in Towson, Md.
To comment on this article or to suggest an idea for another article, contact Paul Bonner, senior editor, at email@example.com or 919-402-4434.
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