In a highly-redacted Legal Advice issued by Field Attorneys (LAFA 20174201F), the IRS concluded that a taxpayer derives certain gross receipts from online services and not online software under Section 199. This LAFA 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.

Facts

Taxpayer processes credit and debit card payment transactions, a service known as merchant acquiring services, for its customers, which include retailers, service providers and other entities that wish to accept payment by credit or debit card (collectively referred to as merchants). Using Taxpayer's proprietary software (the Platform), Taxpayer gathers sales information from the merchant, obtains authorization for the transaction, collects funds from the card-issuing bank (less any interchange fee retained by the bank), and reimburses the merchant. Taxpayer receives a fee from the merchant — a merchant discount fee — for providing this service. Merchants can only access the Platform through an internet connection.

Taxpayer contended that that merchant discount fees paid by the merchants qualified as domestic production gross receipts (DPGR) under the third-party comparable software exception of Treas. Reg. Section 1.199-3(i)(6)(iii)(B).

Law and analysis

Under Section 199(c)(4)(i)(I), DPGR means the gross receipts 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.

Treas. Reg. Section 1.199-3(i)(6)(ii) provides that gross receipts derived from online services, such as online banking services and other similar services, do not constitute gross receipts derived from a lease, rental, license, sale, exchange or other disposition of computer software.

Treas. Reg. Section 1.199-3(i)(6)(iii) provides that, "[n]otwithstanding [Treas. Reg. Section 1.199-3(i)(6)(ii)], if a taxpayer derives gross receipts from providing customers access to computer software … 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 being derived from the lease, rental, license, sale, exchange or other disposition of computer software only if" the taxpayer meets either the self-comparable exception (Treas. Reg. Section 1.199-3(i)(6)(iii)(A)) or the third-party comparable exception (Treas. Reg. Section 1.199-3(i)(6)(iii)(B)). To meet the third-party comparable exception, a third party must derive gross receipts from the disposition of substantially identical software, which is software that has the same functional result as the taxpayer's online software from a customer perspective and has a significant overlap of features or purpose with the taxpayer's online software.

First, the IRS concluded that Taxpayer failed to establish that there was an actual disposition of the Platform, either by affixing it to a tangible medium or allowing a download from the internet.

Second, the IRS concluded that the merchant-acquiring services "are a form of banking services and the provision of such services online constitutes the provision of 'online banking services'" that are described in Treas. Reg. Section 1.199-3(i)(6)(ii). As such, the IRS concluded the gross receipts derived from the Platform did not constitute gross receipts derived from the disposition of software.

Third, the IRS concluded that Taxpayer had incorrectly interpreted and applied the third-party comparable exception by failing to first establish that it had gross receipts from a deemed disposition of the Platform (i.e., gross receipts from customers' access and direct use of the Platform while connected to the internet). The IRS stated the agreements between Taxpayer and the merchants showed that the merchant discount fees were not derived from providing merchants access to the Platform, but rather for providing merchants the merchant-acquiring services.

Although the IRS concluded that Taxpayer had not provided merchants with access to the Platform, such that no conclusion was drawn about whether the merchants had "direct use" of the Platform, the IRS did discuss direct use in a footnote. The IRS interpreted the regulations as inferring that the merchants' direct use of the Platform was, at best, highly indirect, while pointing out that the term "direct use" was not defined in the regulations. The IRS further stated that the merchants themselves did not operate or manipulate the software comprising the Platform to perform the authentication, authorization, clearance and settlement functions necessary to process the card transactions. The IRS stated the merchants' "use" of the Platform was limited to transmitting requests for authorization and settlement to the Platform so that the Platform could process the merchants' card transactions. Even this "use," the IRS added, was "actually performed by [point-of-sale] devices or, in some cases, [redacted] or third-party software."

Finally, the IRS concluded, even assuming that Taxpayer derived the merchant discount fees from providing merchants with access to the Platform for the merchants' direct use, the fees would still not come within the third-party comparable exception since, according to the IRS, the comparable software proffered by Taxpayer was not substantially identical software because the software did not have the same functional result from the customers' perspective. Although the IRS stated the publicly available information was insufficient to make a detailed comparison of the software, the IRS noted the Platform's functional result was the authentication, authorization, clearance, settlement, and, payment of card transactions, while the functional result of the third-party software was the processing of large volumes of card transactions for third parties.

Implications

The IRS seems to be attempting to determine the proper application of the Treas. Reg. Section 1.199-3(i)(6)(iii) exception that allows gross receipts to be treated as being derived from a qualified disposition of computer software, if customers access the computer software for their own direct use while connected to the internet.

The analysis in the LAFA implies that, for online software to qualify, the agreements between the taxpayer and its customers must explicitly state that customers are being provided access to the software. This approach does not take into account how taxpayers operate in today's digital environment and is not required by the statute or regulations.

Taxpayers should carefully review and evaluate their specific facts related to online software under Section 199, including determining whether and how the software is accessed by external customers and determining how software is used to derive gross receipts.

In addition, taxpayers should review and evaluate the third-party comparable software used to qualify their own software, paying particular attention to whether the software has the same functional result from the customers' perspective.

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