June 22, 2017 IRS concludes taxpayer derives certain gross receipts from online services and not online software In a heavily redacted Chief Counsel Advice (CCA 201724026), the IRS concluded that a taxpayer derives certain gross receipts from online services and not online software under Section 199. This CCA is specifically directed to the taxpayer involved and is not binding authoritative guidance, although it indicates an interpretive view that the IRS could apply to others. Based on the heavily redacted facts in the CCA, however, it may not be possible for the IRS to apply the analysis or results to another taxpayer's facts. Facts Taxpayer operates online software platforms (platforms) that enable the operation of websites, user and non-user interfacing software applications, servers hosting computer software (e.g., data centers), hardware, and the computer network. Taxpayer treated certain fees from the platforms as qualified gross receipts that are eligible for the Section 199 deduction. To use these platforms, customers must accept Taxpayer's terms and conditions as set forth in its user agreements. Taxpayer does not separately charge for computer software provided by the platforms, but does charge customers certain fees to use the platforms. In addition, depending on the platform, certain features and functions are offered to its customers for free, while certain other features and functions are required and subject to mandatory fees. Taxpayer also charges for optional features, such as tools that allow customers to better manage their activities on the platforms. Taxpayer asserts that those features and tools are in the form of applications and are computer software. Taxpayer concluded that its gross receipts from the platforms did not satisfy, on an aggregate basis, the third-party comparable exception as provided in the regulations. Taxpayer identified, however, discrete features and functions provided by certain software on the platforms that it believed met the requirements provided by the regulations. Accordingly, Taxpayer treated the gross receipts derived by such software on the platforms as qualified gross receipts under Section 199. To determine the amount of its qualified gross receipts, Taxpayer used a methodology of allocating gross receipts to each software application based on the estimated number of development days. Law and analysis Under Section 199, qualified gross receipts include gross receipts that are derived from the lease, rental, license, sale, exchange, or other disposition of computer software produced by the taxpayer in whole or in significant part within the United States. Under Treas. Reg. Section 1.199-3(i)(6)(ii), gross receipts derived from services are not gross receipts derived from a disposition of computer software and are, therefore, not qualified gross receipts. According to the CCA, Treas. Reg. Section 1.199-3(i)(6)(iii) "provides that, notwithstanding Treas. Reg. Section 1.199-3(i)(6)(ii), if a taxpayer derives gross receipts from providing customers access to computer software produced in whole or significant part by the taxpayer within the United States for the customers' direct use while connected to the internet or any other public or private communications network (online software), then such gross receipts will be treated [as qualified gross receipts] if [either Treas. Reg. Section 1.199-3(i)(6)(iii)(A) or (B) (commonly referred to as the self-comparable or third-party comparable exceptions, respectively)] is met." The IRS concluded that Taxpayer had incorrectly interpreted and applied the self-comparable and third-party comparable exceptions by failing to first establish that it had gross receipts from customers' access and direct use of Taxpayer's software while connected to the internet. After considering the substance of the transactions between Taxpayer and its customers, including the language in the user agreements and schedule of fees, the IRS determined that none of Taxpayer's gross receipts from the platforms were derived from providing customers access to computer software for the customers' direct use. Rather, the IRS concluded the gross receipts were exclusively for online services that the customers accessed via Taxpayer's computer software, such that the gross receipts were non-qualified gross receipts. Further, the IRS analyzed certain fees that Taxpayer attributed to specific software applications. Taxpayer did not determine qualified gross receipts related to these specific fees, but instead used a methodology of allocating gross receipts to each application based on the estimated number of development days. In the process, Taxpayer allocated gross receipts to an application it offered for free, and potentially more gross receipts to other applications than was warranted. The IRS concluded that Taxpayer's allocation of gross receipts was inconsistent with the item-by-item allocation of gross receipts requirement provided by the regulations. The IRS noted that Taxpayer must first make an allocation of gross receipts to the applications before applying other rules of Section 199. Finally, the IRS determined that, because all of Taxpayer's gross receipts derived by Taxpayer's platforms were from online services, the IRS concluded there was no need to determine whether the gross receipts derived from any separate software components within the platforms would have qualified under Section 199. Implications Based on the heavily red cted facts in the CCA, it may not be possible for the IRS to apply the analysis or results to another taxpayer's facts. Although we cannot tell with any certainty, the page and a half of redacted hazards of litigation discussion seems to indicate that the IRS acknowledges that its position may be subject to challenges. Taxpayers should carefully review and evaluate their specific facts related to online software Section 199 analyses, including determining how the software is accessed by external customers and determining how software is used to derive gross receipts. ———————————————
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