What s News in Tax Analysis That Matters from Washington National Tax

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1 What s News in Tax Analysis That Matters from Washington National Tax IRS Determines that Software Apps Are Not Qualifying Software under Section 199 In a recent generic legal advice memorandum, the IRS concluded that a taxpayer does not generate qualifying gross receipts under section 199 when the taxpayer allows its customers to download its computer software app free of charge and the app only enables the customers to access the taxpayer s online fee-based services. The memorandum may signal that taxpayers with similar facts will likely have section 199 deductions disallowed on exam and may be forced to defend the position in court if they seek to sustain the tax benefit. This article describes the fact pattern analyzed in the memorandum and the reasoning provided by the IRS for disallowing the benefit. December 9, 2014 by Beth Benko, Carol Conjura, and Connie Cheng, Washington National Tax Beth Benko and Carol Conjura are partners and Connie Cheng is a senior manager in the Income Tax and Accounting group of Washington National Tax ( WNT ). In a generic legal advice memorandum ( GLAM ) 1 issued to Large Business and International ( LB&I ) Division Counsel (AM , dated November 21, 2014), the IRS concluded that a taxpayer does not generate domestic production gross receipts ( DPGR ) under section 199 when the taxpayer allows its customers to download its computer software application ( app ) free of charge and the app only enables the customers to access the taxpayer s online fee-based services. For purposes of explaining its conclusion, the IRS used an example of a taxpayer-bank that offered banking services to its customers through a variety of means, including the taxpayer s app. The GLAM may signal that taxpayers, specifically banks, that seek to claim a section 199 deduction with respect to facts similar to those in the GLAM (software-based services for which there is no downloaded component or comparable other than an app) will likely have the deduction disallowed on exam and may be forced to defend the position in court if they seek to sustain the tax benefit. 1 This GLAM, as is typically the case, responds to a request from LB&I exam to provide general advice on a particular general fact pattern, but without reference to a specific taxpayer under exam. entity. All rights reserved. The KPMG name, logo and cutting through complexity are registered trademarks or trademarks of KPMG International. NDPPS

2 IRS Determines that Software Apps Are Not Qualifying Software under Section 199 page 2 Online Banking App Serves as Main Focus of GLAM In the GLAM, the example taxpayer was a bank that offered banking services to its customers through a variety of means, including bank branches, text, automated teller machines, and over the Internet via the bank s traditional website and app. Using any of these means, a customer would be able to perform common banking transactions such as (1) access accounts, (2) check account balances, (3) make deposits, (4) view account activity, (5) transfer funds, (6) wire funds, and (7) deposit checks. In every case, the bank s internal computer systems (computer hardware, software, equipment, and data), which were not transferred or licensed to the bank s customers, completed the banking transaction. Thus, a customer must be connected to the Internet for any of the bank s online platforms, including its app, to function. To use any of the bank s online platforms, the bank s customers became subject to the bank s online banking agreement. With respect to the bank s app, the bank s customers downloaded the app free of charge after accepting the bank s terms and conditions under which the bank granted a non-exclusive, non-sub-licensable, non-transferable, personal, limited license to install and use the app on mobile devices owned and controlled by the customers, solely for personal use. Although the bank did not charge its customers a fee to download or access the app, customers were still subject to fees for some banking services provided via the bank s app that were equal to the fees the customers incurred for banking services via the bank s traditional website. These fees could vary from the fees the bank charged to provide the banking services at the bank s physical facility. For financial reporting purposes, the bank treated these revenues as arising from the provision of banking services. Unless otherwise indicated, section references are to the Internal Revenue Code of 1986, as amended (the Code ) or the applicable regulations promulgated pursuant to the Code (the regulations ). In the example, it is assumed that the bank developed and produced the bank s app in the United States. In addition, the example provides that an unrelated third party produced a mobile banking software app that it licensed to its customers, which were competitor banks. The competitor banks used the third-party produced app to provide banking services to multiple account holders.

3 IRS Determines that Software Apps Are Not Qualifying Software under Section 199 page 3 Online Banking App Does Not Give Rise to Section 199 Benefit Under section 199, a taxpayer may derive a permanent tax benefit if the taxpayer, among other things, generates gross receipts from a qualifying disposition of qualifying software. Section 199, subject to two specific exceptions, does not apply to receipts generated from a customer s access to or use of online software (i.e., software accessed via the Internet). The GLAM focused on three main questions surrounding the taxpayer-bank s online banking app: Did the download of the bank s app by the bank s customers constitute a qualifying disposition? Did the bank derived gross receipts from the app? Did the bank satisfy either of the two exceptions provided for online software? The IRS focused on the meaning of online software in concluding that the taxpayer-bank did not dispose of computer software in a qualifying manner even though its customers downloaded the app. Under section 199, online software is defined as "providing customers access to computer software... for the customers direct use while connected to the Internet or any other public or private communications network. The IRS found relevant the example in the regulations under section 199 that concludes that gross receipts derived when customers use a bank s website are non-dpgr because the bank is merely providing banking services via the website rather than disposing of computer software. The IRS concluded that the bank s app serves the same function as the bank s website by providing access to the bank s internal computer software, and allowing customers to obtain various banking services. Importantly, the IRS pointed out that the bank s app would not function unless the customer using the app was connected to the Internet, and provided no benefit aside from providing another platform for customers to receive the taxpayer s online banking services. As a result, the IRS found that the app was included in the definition of online software, and therefore, a download of the app does not amount to a qualifying disposition under section 199.

4 IRS Determines that Software Apps Are Not Qualifying Software under Section 199 page 4 The IRS acknowledged that the regulations under section 199 suggest that software downloads are qualifying dispositions, but explained that the intent of those references was to include downloaded software that has independent functionality after customers have downloaded it and are no longer connected to the Internet. Thus, if a downloaded app cannot be materially distinguished from online software (i.e., if it can only be used while the user is connected to the Internet), the IRS views the app to be equivalent to online software. The IRS next found that even if the download were treated as a qualifying disposition, the taxpayer-bank derived no gross receipts from the app, and therefore did not generate DPGR. Citing the section 199 regulations, the IRS explained that term derived from the disposition of qualifying property is limited to the gross receipts directly derived from the disposition. The IRS determined that the taxpayer-bank did not directly derive any gross receipts from allowing its customers to download or use its app because the app was free to customers and only enabled customers to request online banking services. Because the taxpayerbank s internal banking software completes the banking transaction, it is that software which is not qualifying software not the app that gives rise to the banking fees. Finally, the IRS concluded that because the taxpayer-bank s app constituted online software and because the taxpayer-bank did not satisfy either the self-comparable or the third-party comparable exceptions provided under the regulations with respect to its online software, no portion of its gross receipts should be treated as derived from the disposition of computer software. To satisfy the self-comparable exception, a taxpayer must derive gross receipts from providing customers access to the taxpayer s computer software for its customers direct use while connected to the Internet and must also derive gross receipts, on a regular and ongoing basis in its business, from the qualifying disposition (affixed to a tangible medium or downloaded) of computer software that has only minor or immaterial differences from the online software. Under the facts of the GLAM, the taxpayer-bank did not dispose of its internal software system in a qualifying manner, so the taxpayerbank cannot satisfy the self-comparable exception.

5 IRS Determines that Software Apps Are Not Qualifying Software under Section 199 page 5 To satisfy the third-party comparable exception, a taxpayer must derive gross receipts from providing customers access to the taxpayer s computer software for its customers direct use while connected to the Internet and a third party must derive gross receipts, on a regular and ongoing basis in its business, from the qualifying disposition of the third party s computer software that is substantially identical to the taxpayer s online software. Substantially identical software means 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. Under the facts of the GLAM, the third-party produced app licensed to competitor banks was not considered a disposition of substantially identical computer software as compared to the taxpayer-bank s online software, including the taxpayer-bank s app. From the perspective of the customers of the taxpayer-bank and the third party, the computer software provides a different functional result and does not have a significant overlap of purpose. Because the taxpayerbank s customers use the app to order individual banking services while the third-party s customers are competitor banks that use the app to provide banking services to multiple account holders, the taxpayer-bank did not satisfy the third-party comparable exception. The fact that the third-party app was ultimately used by competitor banks customers in the same manner as the taxpayer-bank s app did not affect the decision reached in the GLAM, as the IRS concluded that end users of the thirdparty s app were not the relevant customers for purposes of the thirdparty comparable exception. Observations While the conclusion reached by the IRS is specific to the facts provided, the GLAM serves as a compelling indication that taxpayers attempting to treat software apps that, even though being downloaded onto a customer device, serve only to provide online access to the taxpayer s transactional software, as qualifying section 199 software may face an uphill battle in sustaining their section 199 deduction. Taxpayers with facts consistent with or similar to the taxpayer-bank in the GLAM should be aware that litigation may be required in order to preserve any section 199 benefit. Accordingly, taxpayers will need to be diligent in identifying software being provided to customers versus services being provided to customers, with the likelihood of sustaining the section 199 deduction on exam

6 IRS Determines that Software Apps Are Not Qualifying Software under Section 199 page 6 depending on the extent to which taxpayers are able to differentiate their facts from the scenario described in the GLAM. Some of the key points raised by the IRS that taxpayers should consider in evaluating their section 199 position include the following: In concluding that the downloaded app did not constitute a qualifying disposition of computer software, the IRS found it significant that downloaded software must have functionality separate and apart from that which occurs while connected to the Internet. If customers can only use the downloaded software while connected to the Internet, the IRS will likely assert that the software is online software, which will disqualify the taxpayer s related gross receipts unless the taxpayer can meet at least one of the two online software exceptions. However, if a taxpayer is able to demonstrate that its downloaded software or app has independent functionality and use while disconnected from the Internet, the download of the program should be respected as a qualified disposition for purposes of section 199. The IRS took a strict view of what constitutes gross receipts directly derived from the disposition of qualifying property. Although a taxpayer may be able to establish that its developed software facilitates or contributes to the generation of certain gross receipts, the IRS is likely to challenge a taxpayer s qualification of such gross receipts if the developed software is given away for free. The IRS found a difference between software that is provided to customers for customers to use for their own purposes and software that is merely available to customers so the customers can access the taxpayer s internal software. For purposes of applying the third-party comparable exception, the IRS places emphasis on how the software is used by the relevant customer (e.g., finding a distinction between a banking customer using an app versus a bank using an app to provide services to its customer), rather than merely comparing the functionalities and features of the software programs. As such, taxpayers attempting to rely on the third-party comparable exception should carefully examine how their software is used by their customers and determine whether the customers of third-party comparable software use third-party software in a consistent manner.

7 IRS Determines that Software Apps Are Not Qualifying Software under Section 199 page 7 Given the rapidly evolving nature of the software industry and the factintensive nature of the analysis required under section 199, taxpayers seeking to claim the section 199 deduction for their apps and other similar software programs should expect a significant amount of scrutiny from the IRS. What's News in Tax is a publication from the Washington National Tax practice of KPMG LLP ( KPMG ) that contains thoughtful analysis of new developments and practical, relevant discussions of existing rules and recurring tax issues. The information contained in this article is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser. This article represents the views of the author or authors only, and does not necessarily represent the views or professional advice of KPMG LLP.