Online platform fees do not qualify as domestic production gross receipts

Plain-English summary

A taxpayer treated fees from several online platforms as domestic production gross receipts eligible for the former IRC § 199 deduction, reasoning that customers directly used software comparable to software sold by third parties. Chief Counsel concluded that the customers paid for online services enabled by software, not for direct use or disposition of the software itself. The memorandum also concluded that the taxpayer improperly allocated platform receipts among software components based on estimated development days instead of first applying the item-by-item rule in Treasury Regulation § 1.199-3(d)(1). Downloaded applications were outside the memorandum's scope, and the factual question whether one online application had substantially identical third-party software was left to the examination team.

Ruling snapshot

• Question: Do the taxpayer's online platform fees qualify as domestic production gross receipts from software, and did the taxpayer properly apply the item rule?
• Outcome: Advice given. The fees at issue were receipts from online services, and the taxpayer improperly applied the item rule.
• Key authorities: IRC § 199; Treas. Reg. §§ 1.199-3(d)(1), 1.199-3(i)(5), 1.199-3(i)(6)

Full text (IRS public release)

       Office of Chief Counsel
       Internal Revenue Service
       memorandum
       Number: 201724026
       Release Date: 6/16/2017
       CC:PSI:B5: JHolmes                               Third Party Communication: None
       POSTU-121624-15                                  Date of Communication: Not Applicable

UILC: 199.00-00, 199.03-00, 199.03-05

date: February 27, 2017

 to:   Rex K. Lee
       Senior Counsel
       (San Francisco, Group 1)
       (Large Business & International)

from: Nicole R. Cimino
Branch Chief, Branch 5
(Passthroughs & Special Industries)

subject: ----------------------------- Section 199

       This Chief Counsel Advice responds to your request for assistance. This advice may
       not be used or cited as precedent.


       LEGEND

       Taxpayer                        =       -------------------------------------

       Taxable Years at Issue          =       --------------------------------------------------------
                                               --------------------

       Platform A                      =       --------------

       Platform B                      =       --------------

       Platform C                      =       ----------

       Fee X                           =       -------------------

       Fee Y                           =       ----------------------

POSTU-121624-15 2

Group L Fees = ------------------------------

Group S Fees = -----------------------

Application A = --------------------------------------------

Application B = -----------------

Application C = --------------------------------------

Application D = ----------------------

Application E = ------------------------------------------------------------------------

Application Grouping A = --------------------------------

ISSUES

(1) Whether any of Taxpayer’s gross receipts derived from online ------------------- and
online --------------------------are gross receipts derived from providing customers access
to computer software that was manufactured, produced, grown, or extracted (MPGE) by
Taxpayer in whole or in significant part within the United States for the customers’ direct
use while connected to the Internet or private communications network (online software)
under § 1.199-3(i)(6)(iii) of the Income Tax Regulations?

(2) Whether Taxpayer properly applied the “item” rule in § 1.199-3(d)(1)?

CONCLUSIONS

(1) None of Taxpayer’s gross receipts derived from online ------------------- and online ----
--------------------------are gross receipts derived from providing customers access to
computer software that was MPGE by Taxpayer in whole or in significant part within the
United States for the customers’ direct use while connected to the online software under
§ 1.199-3(i)(6)(iii).

(2) Taxpayer improperly applied the “item” rule in § 1.199-3(d)(1).

FACTS

Taxpayer operates online ------------------- for the -----------------------------------------------------
--------------------------------------------------------------------------------------------through an array
of websites and also offers online --------------------------. Taxpayer acts as an ---------------
--------------------------------------------------------to facilitate the ----------------------------------------

POSTU-121624-15 3

----------------------------------------------------------------------------------------------------------------by
providing a -----------------------------------------------------------------------------------------------------

-----------------------------------------------------------------------------------------------.

Generally, Taxpayer’s online --------------------provide the infrastructure to enable global
online --------------- on Platforms A and B. Platform C comprises Taxpayer’s online -------
--------------------------. Taxpayer’s infrastructure enabling the operation of Platforms A, B,
and C includes websites, user interfacing software applications, non-user interface
software applications, servers where computer software is hosted (data centers), other
hardware, and the computer network. For purposes of this advice, the infrastructure, in
the aggregate, is referred to as the respective Platform.

The terms and conditions for customers’ use of each Platform are set forth in the User
Agreement contracts. Customers must accept the terms and conditions before they
may use any Platform. Taxpayer controls all of the terms and conditions and has the
right to change them at any time.

Taxpayer charges a variety of fees for the features and functions offered to customers
on each Platform. Fee Schedules in the User Agreements identify the fees for each
feature and function. Taxpayer does not separately or directly charge for computer
software on Platforms A, B, and C or the enabling infrastructure. Depending on a
Platform, some features are offered for free. For example, for Platform A, these
features and services may be grouped into four main categories: (1) --------------------------
-----------------------------------------------------------------------------------------------------------------;
(2) -------------------------; (3) ---------------------------------------------; and (4) ------------------------
--------------------------------------------------------------------------------------------------------------------.
Some features are required for customers’ use of a Platform and are subject to
mandatory fees. Other features are offered on an optional basis and are subject to
various fees that customers may choose to pay.

Before --------------------------------------on Platform A, ---------- must register. ---------- pay
no fee to register. ---------- pay no fee to access Platform A. Before ---------------- ---------
------------------------------must register. -----------pay no fee to -----------. Taxpayer does
not charge ---------- a fee for any ----------------made on Platform A. ----------------------------

------------- are offered for free. Taxpayer charges ---------- Fee X for ---------------------------
on Platform A. The amount of Fee X depends on --------------------------------------------------
----------------------------------------. Taxpayer also charges ---------- Fee Y -----------------------
---------------------------. Generally, Fee Y is ------------------------------------------.

POSTU-121624-15 4

Taxpayer also charges for optional features. For a few optional features, Taxpayer
charges ------------------. For example, Taxpayer charges --------------------for features and
tools that enable customers to better manage their activities on Platform A. Taxpayer
claims that those features and tools are enabled by Applications A and C, and are
computer software within the meaning of § 1.199-3(j)(3). Typically, the total cost of ------
-----------------------------on Platform A includes Fee X and Fee Y, plus any fees for
optional features chosen by the --------.

Transactions on Platform B are similar to ones on Platform A. For purposes of
simplifying this advice with respect to online -------------------, we only specifically
describe fees charged on Platform A.

For online --------------------------, Taxpayer generally charges ----------------------------for
completed ------------------------------. Generally, the fee is a ---------------------------------------
------------------------------------------------------------------------------. The applicable fee -----------
---------------- varies depending on a variety of factors. For example, Taxpayer may
charge -----------------------------------------------------------------------------------------------------------
----------------------------------------------------------------------------------------------------. The
applicable fee -----------------may also differ based on -----------------------------------------------
-----------------------------------------------------------------------------------------------------.

Specific Description of Platform A Fees and Applications

Fee X is charged when a ----------------------, that is, when some ---------------------------------

------------------------------------------------------------using Platform A. The amount of the fee
depends on how the -----------------------------------------------------------------------------------------
---------------------------------------------------------------------------------------------------------------. It
also depends on the -----------------------------------------------------------------------------------------
----------------------------------. The total amount of Fee X also depends on the duration of --
--------------. Fee X is generally charged every ---- days. Fee X is non-refundable and is
charged even if the --------------------------------. The ----------however, may receive a credit
if the -------- ---------------------------------------------------.

Fee Y is charged when the -----------------------------------. The amount charged depends
on the ---------------------------------------------------------------, and is usually computed based
on ----------------------------------------. Fee Y is non-refundable. The --------, however, may
receive a credit if ---------------------------------------------------------------------------------------------
-----------------------------------------------------------------------------------------------------------------.

POSTU-121624-15 5

Generally, Taxpayer charges many different optional fees that, for example, can help
increase ----------------or a ---------- chances for a ----------------------. This advice analyzes
two groups of such fees, Group L Fees and Group S Fees.

Group L Fees are charged for, among other things, ------------------------------------------------
---------------------------------------------------------------------------------------------------------------and
---------------------------------------------------------. Various fees are charged for ------------------

---------------------------------------------------------------------------------------------------------------------

-----. Further, various fees are charged for ------------------------to --------------------------------

-----------------------------------------------------.

Group S Fees are a group of fees that includes fees for features enabled by Application
A, B, and C. When describing Group S Fees, this advice assumes Applications A, B,
and C are discrete computer software applications that Taxpayer separately offers to
customers and in that way Applications A, B, and C are not integrated components of
computer software on Platform A.

Application A offers a bundle of features and functions that allows ----------to help ---------

• ------------------------------------, as well as (depending on the version) to -----------------------

-----------------------------. ---------- can ---------------------------------------------------------------------
-------------------. Application A is accessed by Taxpayer’s customers online only and is
optional for -----------------------------on its Platform A. Application A enables ---------- to
manage, interface, and conduct business with Taxpayer. Taxpayer charges ---------------
------------------------ to subscribe to Application A.

Application B is a software----------tool to help --------------------------------------------------------

• --------------------------------------------------------- Taxpayer offers this software tool by
  download only and at no charge.

Application C includes software that is downloaded to subscribers’ computers. The
software enables ---------- to -------------------------------------------------------------------------------

POSTU-121624-15 6

-----------------------------------------------------------------------------------. Taxpayer charges ------
----------a monthly fee to subscribe to Application C.

Third-Party Applications Identified by Taxpayer

Application D is a third party -----------------building and hosting software. Application E
is a software platform to create and host ----------- websites. Third parties offer
Applications D and E for disposition via tangible medium or download on a regular and
ongoing basis in their businesses. Application D and E offer many functions, some of
which Taxpayer has identified as substantially identical to Application A. Taxpayer also
identified these applications as substantially identical software for many other identified
functions that purportedly correspond to separate components of computer software on
Platform A. Thus, Taxpayer treated Application A and many other features enabled by
separately identified computer software components as substantially identical to
Applications D and E.

Overview of Taxpayer’s Domestic Production Gross Receipts (DPGR) Determination

To establish that qualified computer software on each of its Platforms was produced in
whole or in significant part in the United States, Taxpayer estimated the cumulative
number of days that it would take to re-create computer software that enables each
identified function (which Taxpayer treated as qualified for § 199 purposes). Based on
estimated development days, Taxpayer estimated that roughly --------- percent of the
qualified computer software on each Platform was produced outside the United States.1
Accordingly, Taxpayer concluded that its qualified software was produced in whole or in
significant part in the United States for purposes of § 1.199-3(g)(3)(i).

Taxpayer acknowledged that some computer software on each Platform was purchased
from third parties. Also, some computer software on each Platform was developed
pursuant to contracts, for which Taxpayer claims it had the benefits and burdens of
ownership for § 199 purposes. To limit DPGR to computer software that was produced
by Taxpayer, Taxpayer excluded a small portion of revenues that it allocated to the
third- party purchased computer software. The allocation is similarly based on
Taxpayer’s estimate of development days needed to re-create the third-party software.

1
We note that determining whether Taxpayer produced the software in whole or in significant part within the
United States is outside the scope of this CCA. Taxpayer must separately show it meets such requirements.
Further, including these facts is not intended to imply that we agree that Taxpayer’s method of substantiation is
reasonable.

POSTU-121624-15 7

Generally, Taxpayer treated its revenues from online ------------------- (including Fee X,
Fee Y, and optional fees (Group L and Group S) and similar fees from Platform B), and
online --------------------------for -----------------------------services and certain other fees as
DPGR eligible for the § 199 deduction. Taxpayer treated fees from downloaded
computer software as DPGR, but excluded revenues such as advertising and interest
from other business operations. Taxpayer assumed that the fees it derived from online
--------------------and online --------------------------are gross receipts derived from providing
customers access to computer software for the customers’ direct use while connected
to the Internet for purposes of § 1.199-3(i)(6)(iii)(B) (referred to as the “Third-Party
Comparable Exception”). Taxpayer relied on the Third-Party Comparable Exception to
establish that these fees are derived from the disposition of computer software.

Taxpayer claims that the item it offers in the normal course of its business to its
customers is the access to, and the direct use of, the computer software provided
through Platforms A, B, and C. Because no other person derives gross receipts from
offering to customers’ substantially identical computer software, Taxpayer concluded
that it does not satisfy the Third-Party Comparable Exception on the aggregate level.
However, Taxpayer identified discrete features and functions enabled by user-
interfacing computer software on Platforms A, B, and C that correspond to discrete
functions offered by third-party computer software. On a function-by-function basis,
Taxpayer identified about two dozen different computer software programs offered for
disposition to customers by third parties, which Taxpayer claims as satisfying all of the
requirements of the Third-Party Comparable Exception.

Taxpayer traced many functions to the same third-party computer software programs.
After comparing functions of its identified user-interfacing computer software
components to the identified third party software components’ functions, Taxpayer
concluded that all of its computer software on Platforms A, B, and C have substantially
identical software. Taxpayer concluded that it satisfied the Third-Party Comparable
Exception, and treated gross receipts from Platforms A, B, and C as derived from the
disposition of computer software.

Taxpayer does not separately offer to its customers for their direct use computer
software that enables functions for which Taxpayer identified a third-party comparable.
Except for Application A and C, Taxpayer does not separately charge fees for the
discrete software components it identified. Instead, Taxpayer charges fees for different
features customers may choose, and equates these features to identified groupings of

POSTU-121624-15 8

computer software applications. Taxpayer separately ------------------------------for
Applications A and C, but Taxpayer did not determine DPGR based on these separately
stated fees.2

Taxpayer computed DPGR by allocating the total gross receipts from each Platform that
it treated as qualified to each identified grouping of computer software components
based on a fraction of estimated development days for each component over the
estimated development days for all user-interfacing computer software on the Platform.
Thus, Taxpayer allocated gross receipts from each Platform that it treated as qualified
for § 199 purposes proportionately to each user-interfacing computer software
application for which Taxpayer identified a substantially identical third-party comparable.
In the process, Taxpayer allocated gross receipts to many computer software functions
that it offers for free. Taxpayer allocated no gross receipts to any non-user interfacing
computer software (such as security or encryption software) or enabling infrastructure
(such as servers, hardware, and network).

LAW

Section 199(c)(4)(A)(i)(I) defines DPGR as gross receipts of a taxpayer which are
derived from the lease, rental, license, sale, exchange, or other disposition (collectively
“disposition”) of qualifying production property (QPP), which was MPGE by the taxpayer
in whole or in significant part within the United States. Section 199(c)(5) defines the
term QPP as including computer software.

Section 1.199-3(i)(1)(i) defines the term “derived from the disposition” of QPP as limited
to the gross receipts directly derived from the disposition. Applicable Federal income
tax principles apply to determine whether a transaction is, in substance, a disposition, or
whether it is a service, or whether it is some combination thereof.

Section 1.199-3(i)(5)(ii)(B) provides that a taxpayer’s gross receipts that are derived
from a disposition of computer software that is MPGE in whole or in significant part
within the United States include advertising income and product-placement income with
respect to that computer software, but only if the gross receipts if any, derived from the
disposition of computer software are (or would be) DPGR. For this purpose, advertising

2
Applications A and C were included in the Application Grouping A, which also included
eight other software components.

POSTU-121624-15 9

income and product-placement income mean compensation for placing or integrating
advertising or integrating advertising or a product into the computer software. Section
1.199-3(i)(5)(ii)(B) does not extend to the exceptions provided in § 1.199-3(i)(6)(iii). See
also § 1.199-3(i)(6)(iv)(F).

Section 1.199-3(i)(6)(i) provides that DPGR includes gross receipts of the taxpayer that
are derived from the disposition of computer software MPGE by the taxpayer in whole
or in significant part within the United States.

Section 1.199-3(i)(6)(ii) provides that gross receipts derived from customer and
technical support, telephone and other telecommunication services, online services
(such as Internet 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 a disposition of computer software.

Section 1.199-3(i)(6)(iii) provides that, notwithstanding § 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 derived from the
disposition of computer software only if § 1.199-3(i)(6)(iii)(A) or (B) is met.

Section 1.199-3(i)(6)(iii)(A) (referred to as the “Self-Comparable Exception”), requires
that a taxpayer also derive, on a regular and ongoing basis in the taxpayer’s business,
gross receipts from the disposition to customers that are unrelated persons of computer
software that (1) has only minor or immaterial differences from the online software;
(2) was MPGE by the taxpayer in whole or in significant part within the United States;
and (3) has been provided to such customers affixed to a tangible medium or by
allowing them to download the computer software from the Internet.

Section 1.199-3(i)(6)(iii)(B) (defined above as the “Third-Party Comparable Exception”)
requires that another person derives, on a regular and ongoing basis in its business,
gross receipts from the disposition of substantially identical software (as compared to
taxpayer’s online software) to its customers pursuant to an activity described in § 1.199-
3(i)(6)(iii)(A)(3) (i.e., by a tangible medium or download from the Internet). Section
1.199-3(i)(6)(iv)(A) defines substantially identical software as computer software that
(1) from a customer’s perspective, has the same functional result as the online software;
and (2) has a significant overlap of features or purpose with the online software.

POSTU-121624-15 10

Section 1.199-3(i)(6)(v), Example 1, provides: L is a bank and produces computer
software within the United States that enables its customers to receive online banking
services for a fee. Under § 1.199-3(i)(6)(ii), gross receipts derived from online banking
services are attributable to a service and do not constitute gross receipts derived from a
disposition of computer software. Therefore, L's gross receipts derived from the online
banking services are non–DPGR.

Section 1.199-3(i)(6)(v), Example 2, provides: M is an Internet auction company that
produces computer software within the United States that enables its customers to
participate in Internet auctions for a fee. Under § 1.199-3(i)(6)(ii), gross receipts derived
from online auction services are attributable to a service and do not constitute gross
receipts derived from a lease, rental, license, sale, exchange, or other disposition of
computer software. M's activities constitute the provision of online services. Therefore,
M's gross receipts derived from the Internet auction services are non–DPGR.

Section 1.199-3(i)(6)(v), Example 3, provides: N provides telephone services, voicemail
services, and e-mail services. N produces computer software within the United States
that runs all of these services. Under § 1.199-3(i)(6)(ii), gross receipts derived from
telephone and related telecommunication services are attributable to a service and do
not constitute gross receipts derived from a lease, rental, license, sale, exchange, or
other disposition of computer software. Therefore, N's gross receipts derived from the
telephone and other telecommunication services are non–DPGR.

Section 1.199-3(i)(6)(v), Example 4, provides: O produces tax preparation computer
software within the United States. O derives, on a regular and ongoing basis in its
business, gross receipts from both the sale to customers that are unrelated persons of
O's computer software that has been affixed to a compact disc as well as from the sale
to customers of O's computer software that customers have downloaded from the
Internet. O also derives gross receipts from providing customers access to the
computer software for the customers' direct use while connected to the Internet. The
computer software sold on compact disc or by download has only minor or immaterial
differences from the online software, and O does not provide any other goods or
services in connection with the online software. Under § 1.199-3(i)(6)(iii)(A), O's gross
receipts derived from providing access to the online software will be treated as derived
from the lease, rental, license, sale, exchange, or other disposition of computer software
and are DPGR (assuming all the other requirements of this section are met).

Section 1.199-3(i)(6)(v), Example 5, provides: The facts are the same as in Example 4,
except that O does not sell the tax preparation software to customers affixed to a

POSTU-121624-15 11

compact disc or by download. In addition, one of O’s competitors, P, derives, on a
regular and ongoing basis in its business, gross receipts from the sale to customers of
P’s substantially identical computer software that has been affixed to a compact disc as
well as from the sale to customers of P’s substantially identical tax preparation
computer software that customers have downloaded from the Internet. Under § 1.199-
3(i)(6)(iii)(B), O’s gross receipts derived from providing access to its tax preparation
online software will be treated as derived from the lease, rental, license, sale, exchange,
or other disposition of computer software and are DPGR (assuming all the other
requirements of this section are met).

As with other deductions, the § 199 deduction is strictly a matter of legislative grace,
and the taxpayer has the burden to prove that it meets all the requirements, as well as
the deductible amount. See ADVO, Inc. v. Commissioner, 141 T.C. 298, 322-323
(2013) (citing INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992)); Gibson &
Associates, Inc. v. Commissioner, 136 T.C. 195, 221 (2011).

ISSUE 1 ANALYSIS

Taxpayer asserts that the use of the term “notwithstanding” introducing the Self-
comparable and Third-Party Comparable Exceptions in § 1.199-3(i)(6)(iii) converts all
gross receipts from providing online services as described in § 1.199-3(i)(6)(ii) to gross
receipts from a disposition of computer software if all of the elements described in
§ 1.199-3(i)(6)(iii)(A) or (B) are met. Our office does not agree with Taxpayer’s
application of the rules described in § 1.199-3(i)(6)(ii) and (iii). Taxpayer’s method
overlooks relevant language in § 1.199-3(i)(6)(iii) and is inconsistent with the examples
in § 1.199-3(i)(6)(v) that illustrate the rules of § 1.199-3(i)(6).

Section 1.199-3(i)(6)(iii) is a limited exception to § 1.199-3(i)(6)(ii)

The phrase “notwithstanding [§ 1.199-3(i)(6)(ii],” indicates an exception to § 1.199-
3(i)(6)(ii). The phrase introduces the exception, but the gross receipts excepted from
§ 1.199-3(i)(6)(ii) are limited to those described by the clause that follows that phrase:

   if a taxpayer derives gross receipts from providing customers access to
   computer software MPGE in whole or in 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…

Section 1.199-3(i)(1) requires determining whether a transaction is, in substance, a
disposition, service, or some combination thereof in accordance with Applicable Federal

POSTU-121624-15 12

Income tax principles. The clause in § 1.199-3(i)(6)(iii) limits which gross receipts can
meet the exceptions to be treated as from a disposition and requires Taxpayer to
establish the necessary link between the customer’s payment to Taxpayer (i.e.
Taxpayer’s gross receipts), and the Taxpayer’s online software that customers access
and directly use. The regulations illustrate that there are cases in which a taxpayer
allows customers access to a taxpayer’s online software, but does not derive gross
receipts from that access because the online software is only enabling the provision of
services. In those cases, the gross receipts are not described by the language in
§ 1.199-3(i)(6)(iii).

If gross receipts are described by the clause, § 1.199-3(i)(6)(iii) provides, “then such
gross receipts will be treated as derived from the [disposition] of computer software,” but
“only if” the additional requirements described in § 1.199-3(i)(6)(iii)(A) or (B) are also
met. Any other gross receipts continue to maintain their characterization as gross
receipts from online services under § 1.199-3(i)(6)(ii).

Taxpayer’s method of applying the Third-Party Comparable Exception in § 1.199-
3(i)(6)(iii)(B) did not analyze whether its gross receipts were described by the limitation
in § 1.199-3(i)(6)(iii). This limiting language must be read as part of the Third-Party
Comparable Exception and the Self-Comparable Exception (which is not at issue in this
case). Therefore, we analyze whether any of Taxpayer’s gross receipts are derived
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.
As necessary, we will also comment on the other requirements of the Third-Party
Comparable Exception.

Taxpayer’s gross receipts were not derived from providing customers access to
computer software for the customers' direct use based on Examples 1 and 2 in § 1.199-
3(i)(6)(v)

Providing an online ------------------ is the provision of an online service under § 1.199-
3(i)(6)(ii). Taxpayer acts as an --------------------------------------------------------with respect to
the ------------------------------and Platforms A and B enable Taxpayer to provide different
types of -------------------. For purposes of this advice, we analyzed fees charged with
respect to the online ------------------ accessed via Platform A. Fees charged on the
online ------------------ accessed via Platform B are similar, and are similarly treated for
purposes of § 199.

Fees X, Y, and Group L Fees from Platform A: Taxpayer charged its customers, ---------
---------, each of these fees separately. Therefore, we evaluated them separately for
purposes of § 199 under the rules of § 1.199-3(d)(1). We find that Taxpayer charged

POSTU-121624-15 13

none of these fees for customers’ direct use of computer software as described in
§ 1.199-3(i)(6)(iii). Rather, Taxpayer provided access to the computer software needed
for its customers to participate in the online -----------------, and not for the direct use of
computer software.

Fee X is charged to ---------- to ------------------------------on Platform A, which means it
becomes accessible to ---------- looking to --------------------------------on Platform A. The
amount of the fee depends on the -----------------------------------------------------------------------
--------------. Fee X is non-refundable and charged even if ----------------------------------------
------------------------------------------------------------------------------------------------------------------.
The---------, however, may receive a credit if ----------------------------------------------------------
------. Fee X is a charge that could be avoided by a -------- if it chose to ------------- --------
------------------ available through alternative means, ---------------------------------. Instead, --
--------- pay Fee X to -----------------------------------------------------------------------------------------
-with Platform A. The fee, in substance, relates to -------------------------------------------------

• ------------------------ with Platform A, and-----------use the computer software to provide
  the necessary --------- information (-----------------------------------------------------------------------
  -------------------).

Fee Y is charged when the ------------------------------------on Platform A. The amount
charged depends on --------------------------------------------------------------------, and is usually
--------------------------------------------------------------------. Fee Y is non-refundable. The ------
---------however, may receive a credit -------------------------------------------------------------------
-------------------------. ------------agree to Fee Y before -----------------------------, but the fee
is only finalized -----------------------------------------------------------------------------------------------
----------------------------------------------------------------------------------------------------------. It is
consistent to treat this similarly to Fee X because it must be agreed to when -------------
Like Fee X, this fee is necessary to participate in the online --------------------Fee Y is not
connected to any particular computer software directly used by ------------

Group L gross receipts are fees charged for ----------------------------------------------------------
---------------------------------------------------------. These fees generally relate to how a --------
-------------------------will be featured, and are designed to ---------------------------------- --------
-----------------------------------------------------------------------------------pay Fee X and Fee Y as
part of making ----------------------------------------------------on Platform A, and pay the Group
L fees to further ----------------------------------------on Platform A. These fees represent
additional service fees relating to participating in the online ------------------ on Platform A.

POSTU-121624-15 14

Alternatively, if not considered as additional fees to participate in the online ----------------
------------------the rule in § 1.199-3(i)(5)(ii)(B), related to advertising income, should be
considered. While Fee X and Fee Y also share some of the characteristics of income
described in § 1.199-3(i)(5)(ii)(B), these Group L fees are even more analogous to
classic advertising gross receipts that newspapers, or other print advertisers of products
generate. Section 1.199-3(i)(5)(ii)(B) provides gross receipts from integrating
advertising into online software dispositions are non-DPGR. This section would apply if
you view the ---------- as paying the Group L fees for Taxpayer to integrate the -------------
-----------------the computer software the ---------- on Platform A use. This appears
relevant because the Group L fees are paid for the purpose of ----------------------------------
------- ----------on Platform A will see the -----------------------------—i.e. it is advertising
within the entire online ------------------ on Platform A. If the gross receipts are treated as
advertising income, then § 1.199-3(i)(5)(ii)(B) applies, and the gross receipts are non-
DPGR.

Fee X, Fee Y, and the fees in Group L present an analogous situation to M in Example
2 of § 1.199-3(i)(6)(v) (referred to as “Example 2”). As stated earlier, Taxpayer derived
similar fees from transactions on Platform B. This analysis considers how the rules
apply to Platforms and to the components of Platforms. Example 2 provides:

     M is an Internet auction company that produces computer software within
     the United States that enables its customers to participate in Internet
     auctions for a fee. Under paragraph (i)(6)(ii) of this section, gross receipts
     derived from online auction services are attributable to a service and do
     not constitute gross receipts derived from [the disposition] of computer
     software. M’s activities constitute the provision of online services.
     Therefore, M’s gross receipts from the Internet auction services are non-
     DPGR.

Taxpayer’s computer software allows customers to ------------------------------------------------
-which is similar to the Internet auctions described in Example 2. Customers pay fees
to do this, and --------------------------------------------------- at different levels depending on
the fees they choose to pay (---------------------------------------------). These fees are
analogous to the fees that M would charge to participate in Internet auctions. Similar to
what M’s customers would need to provide to participate in Internet auctions in Example
2, Taxpayer’s customers need to provide the information on -------------------------------------

• -----------------------------, and must also communicate to Taxpayer -----------------------------

---------------------------. Taxpayer’s computer software enables these things. Thus, as

POSTU-121624-15 15

Example 2 illustrates, when computer software enables a customer to participate in a
taxpayer’s service, those gross receipts are considered derived from an online service.

Following the example, Taxpayer’s gross receipts from customers’ use of Platform A are
not gross receipts from providing customers’ access to online computer software for the
customers’ direct use as described in § 1.199-3(i)(6)(iii). Instead, the customers are
paying to participate in Taxpayer’s online -------------------, meaning that the fees are for
an online service. Because the gross receipts from Fee X, Fee Y, and the fees in
Group L are not described in § 1.199-3(i)(6)(iii), the gross receipts cannot be treated as
from the disposition of computer software.

Moreover, this example shows that when it relates to provision of online ------------, a
taxpayer’s transactions with its customers may be characterized only as a service. This
is important, as once characterized as a service, there are also no gross receipts
attributable to any computer software that enables participation in the service. Taken a
step further, there should also be no gross receipts attributable to any components of
the computer software that enables participation in the service. Thus, because gross
receipts from online --------------------are derived from a service, and Platform A only
enabled participation in such service, there are no gross receipts attributable to any of
the components of the Platform.

Online --------------------------Fees: Taxpayer generally charges ----------------------------------
-------------------------------------------------------------------------------------------------------------for
completed --------------------------------Generally, the fee is a ----------------------------------------
--------------------------------------------------------------------------------------.

Taxpayer’s activities are analogous to activities of L in Example 1 of § 1.199-3(i)(6)(v),
which produces computer software that enables its customers to receive online banking
services for a fee. The example concludes that gross receipts derived from online
banking services are attributable to a service and do not constitute DPGR. Again, this
illustrates that Taxpayer does not meet the requirements of § 1.199-3(i)(6)(iii) because
there are no gross receipts from providing customers’ access to computer software for a
customer’s direct use while connected to the Internet. Customers in Example 1 are
paying, in substance, for an online service enabled by computer software. Platform C,
in this case, is the computer software that enables customers to receive the ------------- --
---------------- service. We conclude the same characterization should result for the fees
Taxpayer charges its customers as the fees described in Example 1. Therefore,
Taxpayer’s fees from online --------------------------are non-DPGR.

Taxpayer’s position is a misreading of the examples in § 1.199-3(i)(6)(v)

POSTU-121624-15 16

Taxpayer’s position essentially disregards Examples 1, 2, and 3. Taxpayer suggests
that these examples do not apply because they do not expressly address the
exceptions in § 1.199-3(i)(6)(iii)(A) and (B). However, the flush language preceding the
nine examples which states, “the following examples illustrate the application of this
paragraph (i)(6),” makes it clear that the nine examples illustrate the application of all
rules in § 1.199-3(i)(6) to the facts in each example. Because the rules under § 1.199-
3(i)(6) include the rule in § 1.199-3(i)(6)(ii) and the exceptions in § 1.199-3(i)(6)(iii),
these examples cannot be construed as applying only one of these rules and excluding
another. Substantively, Examples 1, 2, and 3 illustrate circumstances in which a
customer is paying for services and is not paying to use computer software.

Examples 4 and 5 in § 1.199-3(i)(6)(v) also support our interpretation of the regulations.
Examples 4 and 5 discuss fees from providing tax preparation computer software for
customers’ direct use over the Internet, and meeting the Self- and Third-Party
Comparable Exceptions. The gross receipts derived in these examples are
distinguishable from Taxpayer’s gross receipts because the online tax preparation
computer software is not enabling the taxpayer to provide a service to its customers.
Customers are paying for the computer software to complete their tax return. If, in the
examples, customers were only using the online software to enter Form W-2
information, which a tax-return preparer was using to complete the customers’ tax
returns, then the computer software would only be enabling the provision of a service by
the tax-return preparer. None of the other examples in § 1.199-3(i)(6)(v) support
Taxpayer’s reading of the rules.

In summary, after considering the substance of the transactions between Taxpayer and
its customers (including the language in relevant customer user agreements and
schedule of fees), and the rules described in § 1.199-3(i)(6), we conclude that
Taxpayer’s gross receipts from online ------------------- (including Fee X, Fee Y, Group L
Fees and fees from Platform B), and fees in connection with online ---------------------------
are for services enabled in part by computer software, rather than from providing
customers access to computer software for their direct use. Taxpayer cannot treat any
of these fees as from the disposition of computer software under § 1.199-3(i)(6)(iii).
They remain gross receipts derived from online services under § 1.199-3(i)(6)(ii).

Group S Fees from Platform A

We analyze the Group S fees separately because, unlike Fee X, Fee Y, and the Group
L fees, Taxpayer attributes certain Group S Fees specifically to Applications A, B, and
C. Taxpayer separately charges ------------------ for only a few features that are enabled
by Application A and C (and Taxpayer does not charge for Application B). However,
Taxpayer did not determine DPGR based on these separately stated fees. Instead,

POSTU-121624-15 17

Taxpayer allocated all gross receipts proportionately to each user-interfacing computer
software application based on estimated development days. In the process, Taxpayer
allocated gross receipts to Application B, which it offers for free; and, potentially more
gross receipts to Applications A and C than the features performed by these
applications. This allocation is inconsistent with the rule under § 1.199-3(d)(1) that
gross receipts qualify as DPGR on an item-by-item basis (and not, for example on a
division-by-division basis, product-line-by-product line (such as Application Grouping A),
or transaction-by-transaction basis). We find that Taxpayer must first make an
allocation of gross receipts to these applications in accordance with § 1.199-3(d)(1)
before applying other rules of § 199.

Beyond that, as we note above, Applications B and C are downloaded, and outside the
scope of this CCA.

For Application A, LBI has indicated that even if the Taxpayer can substantiate that it
derived gross receipts from customers’ direct use of Application A online, Taxpayer did
not provide an example of computer software that is substantially identical for purposes
of the Third-Party Comparable Exception. Our office is not in a position to evaluate
whether Application D or E is substantially identical within the meaning of § 1.199-
3(i)(6)(iv) due to the factual nature of the inquiry, and we rely on LBI’s determination.

ISSUE 2 ANALYSIS

In addition to the problems identifying gross receipts relating to Group S fees, Taxpayer
misapplied the “item” rules in § 1.199-3(d)(1) by applying the rules of § 1.199-3(d)(1)(ii)
to Platforms A, B, and C with respect to Fee X, Fee Y, Group L fees (and fees from
transactions on Platform B), and the online ------------------------ fees. With respect to
these fees, Platforms A, B, and C were used to enable customers’ participation in online
------------------- and online --------------------------, and we determined that all of such gross
receipts were from online services. Our analysis also applies for purposes of any
computer software components that are integrated into Platforms A, B, and C and are
not separately offered to customers for customers’ direct use. Customers were not
paying to directly use such computer software. The components, similar to the entire
respective platform, only enabled participation.

Application of the rules described in § 1.199-3(d)(1)(ii) is inappropriate in this case with
respect to fees charged for the use of Platforms A, B, and C because all of the gross
receipts are derived from services. The rules of § 1.199-3(d)(1)(ii) only apply in cases in
which a taxpayer derives gross receipts from property offered in the normal course of
business, but the gross receipts from the entire property did not qualify as DPGR. In
those cases, a taxpayer can look to components of the property under § 1.199-

POSTU-121624-15 18

3(d)(1)(ii). In this case, however, Taxpayer only derived gross receipts from services
when it charged fees for the use of Platforms A, B, and C, and therefore, there are no
components of property from which Taxpayer derived gross receipts that could qualify
as DPGR.

CASE DEVELOPMENT, HAZARDS AND OTHER CONSIDERATIONS

POSTU-121624-15 19

Please call James Holmes at 202-317-4137 if you have any further questions.