IRS and Taxpayers Continue to Battle over the IRC Section 199 Deduction for Computer Software

By and on October 27, 2017

On October 20, 2017, the Internal Revenue Service (IRS) published Office of Chief Counsel Internal Revenue Service Memorandum 20174201F (FSA), legal advice written by a field attorney in the Office of Chief Counsel that was reviewed by an associate office, which deals with a merchant bank’s claim that its revenue from merchant discount fees qualifies as Domestic Product Gross Receipts (DPGR) under Internal Revenue Code (Code) Section 199. According to the FSA, on its amended return the taxpayer claimed a Code Section 199 deduction with respect to its merchant discount fees based on the third-party comparable exception for online software found in Treasury Regulation § 1.199-3(i)(6)(ii)(B). The taxpayer argued that the merchant discount fees were derived from the use of computer software, the software “Platform.” The taxpayer took solace in the fact that third parties derived gross receipts from the disposition of substantially identical software. Accordingly, the taxpayer argued that the merchant discount fees should be treated as DPGR pursuant to the third party comparable exception.

The IRS, however, had a very different perspective. Its analysis began with the threshold question of whether there was a “disposition” of the Platform. The IRS concluded that the taxpayer did not dispose of the Platform because the taxpayer did not lease, rent, license, sell, exchange or otherwise dispose of the Platform as required by Treasury Regulation § 1.199-3(i)(6)(i). Moreover, the IRS concluded that the merchant discount fees represented remuneration for “online services” (e.g., online banking services) per Treasury Regulation §1.199-3(i)(6)(i). Because the taxpayer did not establish that there was a disposition of the Platform, the third party comparability exception in Treasury Regulation § 1.199-3(i)(6)(ii)(B) is inapplicable—the merchant discount fees were derived “from the provision of merchant acquiring services.”

Practice Point: We have reported extensively on the IRS’s attacks on taxpayer’s ability to claim the IRC section 199 deduction for computer software and qualified film production. The issue is also on the IRS’s annual Guidance Plan as an area in which the IRS expects to issue regulations within the next year. The FSA is further proof that taxpayers and the IRS do not see eye-to-eye on these issues. Indeed, there are presently several docketed cases seeking judicial determinations regarding the applicability of the third-party comparable exception. Because we have several clients who have this same issue, we are watching it closely, and will report back with any developments.

Kevin SpencerKevin Spencer
Kevin Spencer focuses his practice on tax controversy issues. Kevin represents clients in complicated tax disputes in court and before the Internal Revenue Service (IRS) at the IRS Appeals and Examination divisions. In addition to his tax controversy practice, Kevin has broad experience advising clients on various tax issues, including tax accounting, employment and reasonable compensation, civil and criminal tax penalties, IRS procedures, reportable transactions and tax shelters, renewable energy, state and local tax, and private client matters. After earning his Master of Tax degree, Kevin had the privilege to clerk for the Honorable Robert P. Ruwe on the US Tax Court. Read Kevin Spencer's full bio.


Robin L. GreenhouseRobin L. Greenhouse
Robin L. Greenhouse represents businesses and individuals in resolving complex, large-dollar federal tax controversies. Robin is adept at using dispute resolution techniques, including fast track mediation, pre-filing agreements, Internal Revenue Service (IRS) appeals and post-appeals mediation, and has been the lead lawyer in significant litigation. Over her 30-year career as a government and private practice tax litigator, she has argued more than 100 cases in federal courts at every level. Read Robin Greenhouse's full bio.

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