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Software Licensing Arrangement Qualifies for Domestic Production Activities Deduction. (Parker Tax Publishing December 2, 2014)

A taxpayer's revenue from licensing software to contracting parties who use the software to perform services for end users qualified as gross receipts for purposes of the Code Sec. 199 domestic production activities deduction. The taxpayer's license to end users did not mean the taxpayer was providing services to the end users. TAM 201445010 (11/07/14).

The taxpayer designs, develops, and licenses unique computer software for certain contracting parties. End users subscribe to a product or service by entering into a subscriber agreement with both the taxpayer and the respective contracting party. Under such an agreement, an end user submits a service request to the contracting party, who then uses the licensed computer software and their own data to perform the requested service, providing the end user with the results. In some cases, the taxpayer grants the end user a license to use the results. Under the subscriber agreement, the contracting party collects fees from the end users, and pays the taxpayer an amount as provided under the respective master agreement. From time to time, a contracting party will ask the taxpayer to waive the fees relating to the services performed for certain end user projects. The taxpayer's agreement to waive its fees is documented in a letter addressed to the contracting party and is described as a "royalty waiver."

The IRS's Large Business and International (LB&I) division maintained that the taxpayer derives its gross receipts directly from end users as a result of services provided by the taxpayer, and receives no compensation from the contracting parties for the license of computer software. The taxpayer's position was that it derives gross receipts directly from the license of computer software to the contracting parties. The issue before the IRS's National Office was whether, for purposes of the domestic production activities deduction under Code Sec. 199, the taxpayer derived domestic production gross receipts (DGPR) from the license of computer software to contracting parties, or non-DPGR from providing services to end users.

Code Sec. 199(a)(1) allows a deduction equal to 9 percent of the lesser of the taxpayer's:

(1) qualified production activities income (QPAI) for the tax year, or

(2) taxable income for the tax year.

Code Sec. 199(c)(1) defines QPAI for any tax year as an amount equal to the excess (if any) of (1) the taxpayer's DPGR for that tax year, over (2) the sum of (i) the cost of goods sold that are allocable to such receipts; and (ii) other expenses, losses, or deductions that are properly allocable to such receipts.

Code Sec. 199(c)(4)(A)(i)(I) defines DPGR to mean the taxpayer's gross receipts derived from any lease, rental, license, sale, exchange, or other disposition of qualifying production property (QPP) that was manufactured, produced, grown, or extracted (MPGE) by the taxpayer in whole or in significant part within the United States. Code Sec.199(c)(5) defines QPP to include computer software.

The IRS rejected the LB&I division's position, concluding that the taxpayer did derive DPGR from the license of computer software to the contracting parties for the years involved and was thus entitled to deductions under Code Sec. 199.

The IRS noted that the taxpayer's relationships with the contracting parties were not joint ventures. Rather, the agreements were transactions that generally occurred in two steps, with each party performing discrete activities. First, the taxpayer produces computer software for a contracting party, and then licenses that software to that party. Second, the contracting parties use the computer software and its own data to provide services to end users. The IRS also noted that the use of the contracting party's own data in conjunction with the licensed software showed that the services performed for the end users required both the contracting party and the taxpayer, and the taxpayer could not have performed such services on its own. In the IRS's view, the substance of the taxpayer's relationship with the contracting parties was that the taxpayer simply produces the computer software used by the contracting parties to provide services to end users.

The IRS disagreed with LB&I that the taxpayer's license to end users meant the taxpayer was providing services to the end users. Instead, the license indicates the limits of the license provided by the taxpayer to the contracting parties.

The IRS found that the master agreements allow the contracting parties to use the computer software to provide the services to end users only so as long as the taxpayer was able to restrict an end users rights with respect to the results. Thus, the IRS concluded that the taxpayer was directly paid by the contracting parties for the license of computer software, which led to the taxpayer receiving DPGR.

For a discussion of Code Sec. 199 domestic production activities deductions, see Parker Tax ¶96,101. (Staff Editor Parker Tax Publishing)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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