• Section 199 Scrutiny Continues: Chief Counsel Concludes that Merchant Discount Fees Don’t Qualify as Domestic Production Gross Receipts
  • November 2, 2017 | Author: Ellen McElroy
  • Law Firm: Eversheds Sutherland (US) LLP - Washington Office
  • On October 23, 2017, the Internal Revenue Service Office of Chief Counsel (Chief Counsel) concluded that certain merchant discount fees earned by a parent company in a consolidated group did not constitute domestic production gross receipts (DPGR) reducing the taxpayer’s section 199 deduction. In this field attorney advice, FAA 20174201F, Chief Counsel found that the merchant discount fees (fees for processing debit and credit payment transactions) were derived from the provision of online services, not the disposition of computer software, regardless of the taxpayer’s attempt to couch the fees as part of its online software offerings or subject to the third-party comparable exception provided for in the section 199 regulations. As such, Chief Counsel concluded that the merchant discount fees were online banking services and outside the scope of the disposition of computer software.
    This FAA is significant because it serves as a reminder to all taxpayers that section 199 remains a focus of the Internal Revenue Service (the Service), although its repeal has been proposed as part of tax reform and the recent trend of limited guidance from the Service. Particularly as technology further pushes the limits of what has historically been considered software, online services, and the like, the Service has taken a restrictive view of section 199. Taxpayers seeking to employ one of the exceptions in the section 199 regulations should take note of the Service’s application and analysis of the regulations in this FAA to ensure that their own use of the exceptions fully satisfy the regulatory requirements.
    Background
    Section 199(a) of the Code provides taxpayers with a deduction equal to 9% of the lesser of their qualified production activities income (QPAI) or their taxable income. Section 199(c)(1) defines QPAI as the excess of the taxpayer’s DPGR for the year over the sum of the cost of goods sold and other expenses, losses, and deductions allocable to such receipts. Section 199(c)(4)(A)(i)(l) defines DPGR, in part, as the gross receipts of the taxpayer that are derived from any lease, rental, license, sale, exchange, or other disposition of qualifying production property which was manufactured, produced, grown, or extracted (MPGE) by the taxpayer in whole or significant part in the United States. Section 199(c)(5) defines qualifying production property as including any computer software.
    The regulations under section 199 provide further clarification of the available deduction and related guidance. Treas. Reg. § 1.199-3(i)(1)(i) provides that the term “derived from the lease, rental, license, sale, exchange, or other disposition is defined as, and limited to, the gross receipts directly derived from the lease, rental, license, sale, exchange, or other disposition of QPP, a qualified film, or utilities.” Treas. Reg. § 1.199-3(i)(4)(i)(A) provides that gross receipts derived from the performance of services do not qualify as DPGR.
    With respect specifically to software and computer technology, Treas. Reg. § 1.199-3(i)(6)(i) provides that DPGR includes the gross receipts of a taxpayer that are derived from the lease, rental, license, sale, exchange or other disposition of computer software MPGE by the taxpayer in whole or in significant part in the United States. Treas. Reg. § 1.199-3(i)(6)(ii) provides that gross receipts derived from computer and technical support, telephone and other telecommunication services, online services (such as Internet access services, online banking services, etc.), and other similar services do not constitute gross receipts derived from a lease, rental, license, sale, exchange, or other disposition of computer software.
    Treas. Reg. § 1.199-3(i)(6)(iii) does provide a clarification to the general rule though by stating that if a taxpayer derives gross receipts from providing customers access to computer software for the customers’ direct use while connected to the Internet, then such gross receipts will be treated as derived from the lease, rental, sale, license, exchange, or other disposition of computer software if the taxpayer meets either the self-comparable exception or the third-party comparable exception.
    • A taxpayer meets the self-comparable exception, provided in Treas. Reg. § 1.199-3(i)(6)(iii)(A) if the taxpayer derives, on a regular and ongoing basis in the taxpayer’s business, gross receipts from the lease, rental, sale, license, exchange, or other disposition to customers that are unrelated persons of computer software that (1) has only minor immaterial differences from the online software, (2) has been MGPE by the taxpayer in whole or in significant part in the United States, and (3) has been provided to such customers affixed to a tangible medium (e.g., a disk or DVD) or by allowing them to download the computer software from the Internet.
    • A taxpayer meets the third-party comparable exception, provided in Treas. Reg. § 1.199-3(i)(6)(iii)(B), if another person derives, on a regular and ongoing basis in its business, gross receipts from the lease, rental, sale, license, exchange, or other disposition of substantially identical software (as compared to the taxpayer’s online software) to its customers by a tangible medium or download from the Internet. “Substantially identical software” is defined by Treas. Reg. § 1.199-3(i)(6)(iv)(A) 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 or features or purpose with the online software.
    Overview of the FAA
    The taxpayer didn’t claim the domestic production activities deduction (DPAD) on its returns, but instead submitted an informal claim for DPADs with respect to DPGRs derived from its credit card processing business. The DPADs were attributable to net merchant discount fees earned in the credit card processing business and other fees or rentals earned in the business. The taxpayer uses a platform, which includes software, to settle various transactions for merchants (the Platform). The taxpayer asserted that the revenue earned in its merchant-acquiring activity, including the net merchant discounts, were received in exchange for the merchants’ use of its Platform. The taxpayer argued that its Platform is online software for section 199 purposes because customers access its functionality through an Internet connection. The taxpayer further argued that the fees paid by merchants fell under the third-party comparable exception for DPGRs under Treas. Reg. § 1.199-3(i)(6)(iii)(B) because its Platform was “substantially identical software” to three other third-party payment processing software applications.
    The Service acknowledged that the taxpayer did not argue that its merchant discount fees fell under the general definition of DPGR in section 199(c)(4)(A)(i)(l), nor that the fees were paid for online services, which are generally excluded from the definition of DPGR. Nonetheless, the Service found that the merchant discount fees failed to qualify under the statutory or regulatory definition of DPGR. Under the general statutory definition, the Service focused on whether the taxpayer’s gross receipts were derived from any disposition of QPP, which requires both a disposition and gross receipts derived from such disposition. The Service found that the taxpayer failed both prongs of the test because the taxpayer maintained sole control, possession of, and the right to the Platform at all times; the main components of the Platform were never provided to the merchants through tangible media or download. Because there was no disposition, there could be no gross receipt derived from dispositions, thereby demonstrating the taxpayer’s failure to satisfy the general definition for DPGRs.

    Not only did the Service find the merchant discount fees fell outside the definition of DPGR, but the Service also concluded that such fees were for online services. Although Treas. Reg. § 1.199-3(i)(6)(ii) does not expressly define the term “online services,” it does provide a list of types of online services, including online banking services, which the Service equated with the taxpayer’s merchant-acquiring service. Even in the event the Service found such services were not online banking services, the Service found them outside the regulatory examples for online services, and not from the disposition of computer software.
    Rather than arguing that its merchant discount fees fell under the statutory or regulatory definition of DPGR, the taxpayer relied on the two exceptions provided for under Treas. Reg. § 1.199-3(i)(6)(iii), the self-comparable and third-party comparable exceptions. With respect to the third-party comparable exception provided in Treas. Reg. § 1.199-3(i)(6)(iii)(B), the Service concluded that the taxpayer hadn’t even satisfied the threshold requirements of the provision—that a taxpayer derived gross receipts from providing customers access to computer software for the customers’ direct use while connected to the Internet. The Service further stated that “the requisite causal connection must still exist between the disposition of the software and the gross receipts; the only difference is that under Treas. Reg. § 1.199-3(i)(6)(iii), the gross receipts may be derived from a deemed disposition (i.e., providing access to software over the Internet), rather than from an actual disposition (e.g., a lease, rental, license, sale, or exchange of software).”
    The Service concluded that the merchant discount fees were derived from the provision of merchant-acquiring services, not from providing customers’ access to computer software. The Service looked to the underlying agreements and contracts between the taxpayer and the merchants, in which the taxpayer contracted to provide certain services, not software or access to software, and described the merchant discount fee as an amount paid for services, not for the use of, or an interest in, the software composing the Platform. Even if assuming, arguendo, that the taxpayer satisfied this requirement, the Service concluded that the taxpayer would not fall within the third-party comparable exception because the comparable software offered by the taxpayer was not “substantially identical software” as required by the regulation because it doesn’t have the same functional result from the customer’s perspective. In assessing the taxpayer’s argument that the exception applied, the Service found that the customers of the comparable software offered by the taxpayer were different from the customers of the taxpayer’s Platform. Therefore, from the appropriate customer’s perspective, the third-party comparable software did not have the same functional result as the taxpayer’s Platform, and was not “substantially identical.”

    Eversheds Sutherland Perspective

    Based on the level of detail and analysis provided in this FAA, the application and use of section 199 and its accompanying regulations remain a focal point for the Service. and an area that is being highly scrutinized. Every taxpayer, particularly those in the online software business seeking to take advantage of one of the exceptions provided in Treas. Reg. § 1.199-3(i)(6)(iii), should pay attention to ensure they satisfy all of the statutory and regulatory requirements of the DPAD before taking such a deduction; the Service remains interested in ensuring that taxpayers are not abusing its potential benefits.