Online transaction processing falls outside narrow software exceptions

Plain-English summary

Chief Counsel analyzed whether receipts from a taxpayer's Internet-based transaction processing could qualify under section 199 as receipts from the disposition of computer software. The regulations generally exclude receipts from online services, even when software facilitates those services. Narrow exceptions apply when customers directly use taxpayer-produced software while connected to the Internet and the taxpayer or another person also disposes of comparable software on a tangible medium or by download. Counsel advised that those exceptions do not override the online-services exclusion. Based on the presented facts, the taxpayer appeared to facilitate transaction processing rather than license software for customers' self-use, making the facts similar to the regulation's nonqualifying online-banking example.

Ruling snapshot

• Question: Do the online-software exceptions allow section 199 treatment for receipts from Internet-based transaction processing?
• Outcome: Counsel advised that the receipts appeared attributable to nonqualifying online services, not a disposition of software
• Key authorities: IRC § 199; Treas. Reg. § 1.199-3(i)(6)

Full text (IRS public release)

ID: CCA_2015102314520742
UILC: 199.03-07

Number: 201603028
Release Date: 1/15/2016
From:
Sent: Friday, October 23, 2015 2:52:07 PM
To:
Cc:

Bcc:
Subject: --------

                           In addition to the specific comments marked in the draft, I think

the following analysis of the regulations and how they evolved should be helpful in responding
to your taxpayer’s interpretation of the relevant regulations under -3(i)(6).

Let’s discuss when you have a moment after your trial.

First, Notice 2005-14 and the first proposed regulations, the Treasury took a position that the
disposition requirement for computer software is met only when computer software is
provided to customers on a tangible medium (disk or CD) or by download over the Internet.
See T.D. 9262 at 3 and 4. All software accessed over the Internet only was treated as a service
(non-qualifying for 199). This different treatment of computer software based on the method
of its delivery was criticized in the public comments and in a letter to Treasury some members

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of Congress asked the Treasury to reconsider the different treatment of computer software
that is solely accessed on the Internet v. downloaded or sold in a box. “[O]n July 21, 2005, the
Chairman and Ranking Member of the Senate Finance Committee and the Chairman of the
House Ways and means Committee sent a letter to the Treasury Department suggesting that
the Treasury Department consider further the treatment of online access to computer software
and, in particular, whether such treatment should be similar to the treatment of computer
software distributed by other means, such as by physical delivery or delivery via Internet
download. The letter notes that gross receipts from the provision of services are not treated as
DPGR, regardless of the fact that computer software may be used to facilitate such service
transactions.” See T.D. 9262.

Next, the Treasury issued temporary regulations (T.D. 9262) providing for the first time “two
exceptions under which gross receipts derived by a taxpayer from providing computer software
to customers for the customers’ direct use while connected to the Internet will be treated as
being derived from the [disposition] of such computer software.” The published preamble
explains that the exceptions were made “as a matter of administrative convenience.” At the
same time, the temporary regulations did not modify the rule that the gross receipts from the
provision of online services do not qualify. This rule was retained in Treas. Reg. § 1.199-
3(i)(6)(ii) and it provides that gross receipts derived from services – Gross receipts derived from
customer and technical support, telephone and other telecommunication services, online
services (such as Intent access services, online banking services, providing access to online
electronic books, newspapers, and journals), and other similar services do not constitute gross
receipts derived from the disposition of computer software.

The final regulations adopted the temporary regulations and added nine examples illustrating
the rules. T.D. 9317 The preamble to the final regulations provides:
[t]o give meaning to the statutory language requiring [disposition], the online software
exceptions have been narrowly tailored and are intended to apply only to gross receipts
derived from providing customers access to computer software for the customers’ direct use
while connected to the Internet and only when the taxpayer(or another person) also derives
gross receipts from the [disposition] of the computer software (or substantially identical
software) affixed to a tangible medium or by download.” The “narrowly tailored” exceptions
are now known as the “self-comparable exception” (in A) and the “third party comparable
exception” (in B) of Treas. Reg. § 1.199-3(i)(6)(iii) (collectively, Exceptions).

Although this taxpayer appears to take a position that the Exceptions override exclusion of
online services income, there is no objective evidence that this is the case. As a general matter,
all service gross receipts are treated as non-DPGR. The Exceptions apply “notwithstanding” the
online services exclusion because all online access to software was treated as a service in the
Notice and proposed regulations. The Exceptions apply only if a taxpayer derives gross receipts
from providing customers access to computer software MPGE in whole or in significant part by
the taxpayer within US for the customer’s direct use while connected to the Internet. See the

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introductory language in Treas. Reg. § 1.199-3(i)(6)(iii). In taxpayer’s presentation, this
threshold requirement is entirely ignored.

Examples that follow -3(i)(6) rules demonstrate how all of the rules in that section apply,
including when the Exceptions are relevant. Example 1 through 3 hold that a taxpayer that
produces computer software to enable online banking, participation in online auction, or
provision of telecommunication services generates fees that are entirely “attributable to
services” and such gross receipts do not constitute as DPGR. Treas. Reg. § 1.199-3(i)(6)(v)
Examples 1, 2, 3. The analysis contained in these examples demonstrates that the Exceptions
are irrelevant under those facts. The facts in this case appears to be closely aligned with the
online banking example. In substance, unless there are facts that are not presented in the write
up, --------------------------------------------------------------------------------------------------------------------------
------------------------------------------- It is not the case that the taxpayer simply licenses software
under SaaS model, the taxpayer appear to in fact facilitate transaction processing using data
etc.

Other examples illustrate when the exceptions are relevant. The examples include: (1) fees
from providing tax preparation computer software for the customers’ direct use over the
Internet when the taxpayer does not provide any other goods or service in connection with the
online software, (2) fees from providing access to payroll management computer software for
the customers’ direct use over the Internet when the taxpayer does not provide any other
goods or service in connection with the online software, and (3) fees from providing customers
access to the computer software games for the customers direct use while connected to the
Internet when the taxpayer does not provide any other goods or services in connection with
the online software games. Treas. Reg. § 1.199-3(i)(6)(v) Examples 4, 5, 6, 7, 8. ----------------------

                                                             I am not convinced that -----------------

---------------------actually falls within the SaaS model. SaaS truly contemplates provision of
computing capabilities that a customer can unilaterally execute. Here, the taxpayer’s
customers are not getting access to computer application that they self-use.

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Thank you!