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The IRS Chief Counsel has rejected the application of the third-party comparable exception to a seller of online software, which effectively denies the Section 199 domestic production activities deduction (DPAD) for income from the software.

Domestic Production Activities Deduction Nixed for Online Software

  • 7/18/2012

Domestic Production Activities Deduction Nixed for Online Software

The IRS Chief Counsel has rejected the application of the third-party comparable exception to a seller of online software. This effectively denies the Section 199 domestic production activities deduction (DPAD) for income from the software. However, the Chief Counsel allowed the taxpayer to apply the exception to components of the software, if the taxpayer could show that the component has a substantially identical offline counterpart.

CCH take away: The DPAD is available for domestic production gross receipts (DPGR) from the lease, license, sale, or disposition of an item, including computer software. The regulations provide that the provision of online services is not treated as the disposition of computer software; thus, receipts for these services are not DPGR. However, if a taxpayer can demonstrate that a third party provides similar software through a computer disk or download ("offline" software), then the online software can qualify for the DPAD. The taxpayer attempted to satisfy this test, known as the third-party comparable exception. The DPAD is currently 9 percent of qualified production activities income, which is derived from DPGR.

Computer software

DPGR does not include gross receipts from online services such as internet access services, online banking services, or online books. However, under the third-party comparable exception, direct use of computer software is treated as a disposition if another person derives gross receipts from the disposition of substantially identical software to its customers, by a tangible medium (such as a disk or DVD) or internet download.

Substantially identical software is software that has the same functional result as online software and has a significant overlap of features or purpose with the online software.

Taxpayer argument

The taxpayer attempted to identify third parties that have similar computer software products. The taxpayer’s software had a unique feature and had more features than the third-party software it described. The IRS noted that the unique feature was not the only feature that had value to customers. The taxpayer claimed the receipts from the sale of the unique feature were DPGR.

The IRS concluded that the taxpayer’s software’s functionality, features, and purpose were not replicated by a single competitor’s offline software and was not substantially identical under the third-party comparable exception.

However, the IRS also concluded that a component of the property could be treated as the item, and generate DPGR, if the component has a substantially identical offline counterpart. A component that is treated as a separate item cannot be combined with a component that does not meet the relevant requirements.

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