[Federal Register Volume 71, Number 105 (Thursday, June 1, 2006)]
[Rules and Regulations]
[Pages 31074-31077]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 06-4828]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 9262]
RIN 1545-BF57


Computer Software Under Section 199(c)(5)(B)

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Temporary regulations.

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SUMMARY: This document contains temporary regulations concerning the 
application of section 199 of the Internal Revenue Code, which provides 
a deduction for income attributable to domestic production activities, 
to certain transactions involving computer software. The regulations 
will affect taxpayers engaged in certain domestic production activities 
involving computer software. The text of these temporary regulations 
also serves as the text of the proposed regulations set forth in the 
notice of proposed rulemaking on this subject in the Proposed Rules 
section in this issue of the Federal Register.

DATES: Effective Date: These regulations are effective June 1, 2006.
    Applicability Date: For date of applicability, see Sec.  1.199-
8T(i)(4).

FOR FURTHER INFORMATION CONTACT: Paul Handleman or Lauren Ross Taylor, 
(202) 622-3040 (not a toll-free number).

SUPPLEMENTARY INFORMATION: 

Background

    This document amends 26 CFR part 1 to provide rules relating to the 
deduction for income attributable to domestic production activities 
under section 199 of the Internal Revenue Code (Code). Section 199 was 
added to the Code by section 102 of the American Jobs Creation Act of 
2004 (Pub. L. 108-357, 118 Stat. 1418), and amended by section 403(a) 
of the Gulf Opportunity Zone Act of 2005 (Pub. L. 109-135, 119 Stat. 
25) and section 514 of the Tax Increase Prevention and Reconciliation 
Act of 2005 (Pub. L. 109-222, 120 Stat. 345). On January 19, 2005, the 
IRS and Treasury Department issued Notice 2005-14 (2005-7 I.R.B. 498) 
providing interim guidance on section 199. On November 4, 2005, the IRS 
and Treasury Department published in the Federal Register proposed 
regulations under section 199 (70 FR 67220). On January 11, 2006, the 
IRS and Treasury Department held a public hearing on the proposed 
regulations. Written and electronic comments responding to the proposed 
regulations were received. Contemporaneous with the publication of 
these temporary regulations, final regulations have been published 
under section 199.

General Overview

    Section 199(a)(1) allows a deduction equal to 9 percent (3 percent 
in the case of taxable years beginning in 2005 or 2006, and 6 percent 
in the case of taxable years beginning in 2007, 2008, or 2009) of the 
lesser of (A) the qualified production activities income (QPAI) of the 
taxpayer for the taxable year, or (B) taxable income (determined 
without regard to section 199) for the taxable year (or, in the case of 
an individual, adjusted gross income (AGI)).

Qualified Production Activities Income

    Section 199(c)(1) defines QPAI for any taxable year as an amount 
equal to the excess (if any) of (A) the taxpayer's domestic production 
gross receipts (DPGR) for such taxable year, over (B) the sum of (i) 
the cost of goods sold (CGS) that are allocable to such receipts; and 
(ii) other expenses, losses, or deductions (other than the deduction 
under section 199) that are properly allocable to such receipts.
    Section 199(c)(4)(A)(i) defines DPGR, in part, to mean the 
taxpayer's gross receipts that are 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

[[Page 31075]]

significant part within the United States. Section 199(c)(5) defines 
QPP to mean: (A) Tangible personal property; (B) any computer software; 
and (C) any property described in section 168(f)(4) (certain sound 
recordings).

Computer Software

    Section 4.04(7)(d) of Notice 2005-14 provides that gross receipts 
derived from computer software do not include gross receipts derived 
from Internet access services, online services, customer support, 
telephone services, games played through a Web site, provider-
controlled software online access services, and other services that do 
not constitute the lease, rental, license, sale, exchange, or other 
disposition of computer software that was developed by the taxpayer. 
Consistent with Notice 2005-14, the proposed regulations in Sec.  
1.199-3(h)(6)(i) state that the provision of online computer software 
does not rise to the level of a lease, rental, license, sale, exchange, 
or other disposition as required under section 199, but is instead a 
service.

Congressional Letter

    On July 21, 2005, the Chairman and Ranking Member of the Senate 
Finance Committee and the Chairman of the House Ways and Means 
Committee sent a letter to the Treasury Department suggesting that the 
Treasury Department consider further the treatment of online access to 
computer software and, in particular, whether such treatment should be 
similar to the treatment of computer software distributed by other 
means, such as by physical delivery or delivery via Internet download. 
The letter notes that gross receipts from the provision of services are 
not treated as DPGR, regardless of the fact that computer software may 
be used to facilitate such service transactions.

Summary of Comments

    Numerous commentators have suggested that the provision of computer 
software for online use should qualify under section 199. Some 
commentators proposed that gross receipts derived from providing online 
access to computer software should qualify under section 199 if the 
substance of the transaction that gives rise to the gross receipts is 
the distribution of the computer software's functionality to end users. 
These commentators suggested that factors to be considered in 
determining the substance of the transaction should include: (1) 
Whether an agreement exists, regardless of its form, between the 
computer software producer and the customer that gives the customer 
permission to use the computer software; (2) whether the use of 
computer software is merely incidental to the provision of a separate 
service or transaction; (3) whether the end user has made a payment to 
the computer software producer directly for the right to access and use 
the computer software's functionality, as opposed to a payment for a 
separate service or good in which the use of the underlying computer 
software is only incidental to the separate service or transaction; (4) 
whether the computer software producer holds itself out to the public 
as being in the computer software business; (5) whether the computer 
software producer uses alternate channels for distributing its computer 
software product or functionality other than through online access; and 
(6) whether a competitive marketplace exists for the same or similar 
computer software functionality that provides customers with 
alternative distribution choices in addition to online access. The 
commentators explained that this proposed list of factors is not 
exhaustive and there may be other relevant factors. The commentators 
suggested that no single factor should control and that failure to 
satisfy one or more factors should not necessarily result in gross 
receipts derived from online access to computer software being non-
DPGR.
    Other commentators suggested that a customer's use of computer 
software is tantamount to a license of the computer software. In 
addition, several commentators asserted that the phrase ``other 
disposition'' in section 199(c)(4)(A) is broad enough to include the 
provision of computer software for online use.

Explanation of Provisions

    The temporary regulations do not adopt these comments. However, as 
a matter of administrative convenience, the temporary regulations 
provide two exceptions under which gross receipts derived by a taxpayer 
from providing computer software to customers for the customers' direct 
use while connected to the Internet will be treated as being derived 
from the lease, rental, license, sale, exchange, or other disposition 
of such computer software. Such gross receipts will be treated as DPGR 
if all the other requirements of section 199 are met (for example, the 
taxpayer MPGE computer software in whole or in significant part within 
the United States).
    The first exception applies to a taxpayer that derives gross 
receipts from providing computer software to customers for the 
customers' direct use while connected to the Internet (online software) 
and also derives gross receipts from the lease, rental, license, sale, 
exchange, or other disposition to customers that are unrelated persons 
of computer software that has been provided to such customers affixed 
to a tangible medium or by allowing them to download the computer 
software from the Internet. The second exception applies if a taxpayer 
that derives gross receipts from providing online software and an 
unrelated person derives on a regular and ongoing basis in the 
unrelated person's business gross receipts from the lease, rental, 
license, sale, exchange, or other disposition of substantially 
identical software to its customers affixed to a tangible medium or by 
allowing its customers to download the substantially identical computer 
software from the Internet.
    The temporary regulations define substantially identical software 
as computer software that, from a customer's perspective, has the same 
functional result as the online software and has a significant overlap 
of features or purpose with the online software. To avoid controversy 
between taxpayers and the IRS, the temporary regulations provide a safe 
harbor under which all computer software games are deemed to be 
substantially identical software.
    If a taxpayer's provision of computer software for online use meets 
the requirements set forth in the temporary regulations, then an 
allocation of gross receipts between DPGR and non-DPGR will be 
necessary if, as part of the same transaction, the taxpayer derives 
gross receipts other than from providing computer software to a 
customer for the customer's direct use while connected to the Internet. 
For example, if in connection with providing computer software to a 
customer for the customer's direct use while connected to the Internet, 
a taxpayer also provides a service such as storing its customers' data 
or providing telephone support, then the taxpayer must allocate its 
gross receipts between DPGR and non-DPGR using any reasonable method.
    These rules are specifically limited to the deduction under section 
199 and no inference can be drawn with respect to any other provision 
of the Code (such as the tax treatment of these transactions under 
those provisions regarding character, timing, or source).

Effective Date

    Section 199 applies to taxable years beginning after December 31, 
2004. These temporary regulations are applicable for taxable years 
beginning on or after June 1, 2006. A taxpayer may apply these 
temporary regulations to

[[Page 31076]]

taxable years beginning after December 31, 2004, and before June 1, 
2006. The applicability of these temporary regulations expires on or 
before May 25, 2009. Section 1.199-8(i)(1) of the final regulations 
issued contemporaneous with these temporary regulations provides that, 
in certain circumstances, a taxpayer may rely on the guidance in Notice 
2005-14 (2005-7 I.R.B. 498), the proposed regulations under section 199 
that were published in the Federal Register on November 4, 2005 (70 FR 
67220), or the final regulations. Regardless of which guidance a 
taxpayer applies, the taxpayer may apply these temporary regulations.

Special Analyses

    It has been determined that this Treasury decision is not a 
significant regulatory action as defined in Executive Order 12866. 
Therefore, a regulatory assessment is not required. It also has been 
determined that section 553(b) of the Administrative Procedure Act (5 
U.S.C. chapter 5) does not apply to these regulations. For 
applicability of the Regulatory Flexibility Act (5 U.S.C. 601 et seq.), 
refer to the cross-reference notice of proposed rulemaking published 
elsewhere in this issue of the Federal Register. Pursuant to section 
7805(f) of the Code, these temporary regulations will be submitted to 
the Chief Counsel for Advocacy of the Small Business Administration for 
comment on their impact on small business.

Drafting Information

    The principal authors of these regulations are Paul Handleman and 
Lauren Ross Taylor, Office of the Associate Chief Counsel (Passthroughs 
and Special Industries), IRS. However, other personnel from the IRS and 
Treasury Department participated in their development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Amendments to the Regulations

0
Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

0
Paragraph 1. The authority citation for part 1 is amended by adding 
entries in numerical order to read, in part, as follows:

    Authority: 26 U.S.C. 7805 * * *
    Section 1.199-3T also issued under 26 U.S.C. 199(d). * * *
    Section 1.199-8T also issued under 26 U.S.C. 199(d). * * *


0
Par. 2. Section 1.199-3T is added to read as follows:


1.199-3T  Domestic production gross receipts (temporary).

    (a) through (h) [Reserved]. For further guidance, see Sec.  1.199-
3(a) through (h).
    (i) Derived from the lease, rental, license, sale, exchange, or 
other disposition.
    (1) through (5) [Reserved]. For further guidance, see Sec.  1.199-
3(i)(1) through (5).
    (6) Computer software--(i) [Reserved]. For further guidance, see 
Sec.  1.199-3(i)(6)(i).
    (ii) Gross receipts derived from services. Gross receipts (as 
defined in Sec.  1.199-3(c)) 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 lease, rental, license, sale, exchange, or other disposition of 
computer software (as defined in Sec.  1.199-3(j)(3)).
    (iii) Exceptions. Notwithstanding paragraph (i)(6)(ii) of this 
section, if a taxpayer derives gross receipts from providing to 
customers computer software MPGE in whole or in significant by the 
taxpayer within the United States for the customers' direct use while 
connected to the Internet (online software), then such gross receipts 
will be treated as being derived from the lease, rental, license, sale, 
exchange, or other disposition of computer software only if--
    (A) The taxpayer also derives, on a regular and ongoing basis in 
the taxpayer's business, gross receipts from the lease, rental, 
license, sale, exchange, or other disposition to customers that are 
unrelated persons (as defined in Sec.  1.199-3(b)(1)) of computer 
software that--
    (1) Has only minor or immaterial differences from the online 
software;
    (2) Has been MPGE (as defined in Sec.  1.199-3(e)) by the taxpayer 
(as defined in Sec.  1.199-3(f)) in whole or in significant part (as 
defined in Sec.  1.199-3(g)) within the United States (as defined in 
Sec.  1.199-3(h)); and
    (3) Has been provided to such customers either affixed to a 
tangible medium (for example, a disk or DVD) or by allowing them to 
download the computer software from the Internet; or
    (B) An unrelated person derives, on a regular and ongoing basis in 
the unrelated person's business, gross receipts from the lease, rental, 
license, sale, exchange, or other disposition of substantially 
identical software (as described in paragraph (i)(6)(iv)(A) of this 
section) (as compared to the taxpayer's online software) to its 
customers pursuant to an activity described in paragraph 
(i)(6)(iii)(A)(3) of this section.
    (iv) Definitions and special rules--(A) Substantially identical 
software. For purposes of paragraph (i)(6)(iii)(B) of this section, 
substantially identical software is computer software that--
    (1) From a customer's perspective, has the same functional result 
as the online software described in paragraph (i)(6)(iii) of this 
section; and
    (2) Has a significant overlap of features or purpose with the 
online software described in paragraph (i)(6)(iii) of this section.
    (B) Safe harbor for computer software games. For purposes of 
paragraph (i)(6)(iv)(A) of this section, all computer software games 
are deemed to be substantially identical software. For example, 
computer software sports games are deemed to be substantially identical 
to computer software card games.
    (C) Regular and ongoing basis. For purposes of paragraph 
(i)(6)(iii) of this section, in the case of a newly-formed trade or 
business or a taxpayer in its first taxable year, the taxpayer is 
considered to be engaged in an activity described in paragraph 
(i)(6)(iii) of this section on a regular and ongoing basis if the 
taxpayer reasonably expects that it will engage in the activity on a 
regular and ongoing basis.
    (D) Attribution. For purposes of paragraph (i)(6)(iii)(A) of this 
section--
    (1) All members of an expanded affiliated group (as defined in 
Sec.  1.199-7(a)(1)) are treated as a single taxpayer; and
    (2) In the case of an EAG partnership (as defined in Sec.  1.199-
9(j)), the EAG partnership and all members of the EAG to which the EAG 
partnership's partners belong are treated as a single taxpayer.
    (E) Qualified computer software maintenance agreements. Section 
1.199-3(i)(4)(i)(B)(5) does not apply if the computer software is 
online software under paragraph (i)(6)(ii) of this section.
    (v) Examples. The following examples illustrate the application of 
this paragraph (i)(6):

    Example 1. 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 paragraph (i)(6)(ii) of this section, 
gross receipts derived from online banking services are attributable 
to a service and do not constitute a lease, rental, license, sale, 
exchange, or other disposition of computer software. Therefore, L's 
gross receipts derived from the online banking services are non-
DPGR.

[[Page 31077]]

    Example 2. 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 services are attributable to a service and do not constitute 
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.
    Example 3. 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 paragraph (i)(6)(ii) 
of this section, gross receipts derived from telephone and related 
telecommunication services are attributable to a service and do not 
constitute 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.
    Example 4. 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 customers from providing the computer 
software to its customers for the customers' direct use while 
connected to the Internet. Assume that the computer software sold on 
compact disc or by download has only minor or immaterial differences 
from the computer software provided over the Internet, and O does 
not provide any services in connection with the computer software 
provided over the Internet. Under paragraph (i)(6)(iii)(A) of this 
section, O's gross receipts derived from providing its computer 
software to customers over the Internet will be treated as derived 
from the lease, rental, license, sale, exchange, or other 
disposition of computer software and are domestic production gross 
receipts (DPGR) (as defined in Sec.  1.199-3) (assuming all the 
other requirements of Sec.  1.199-3 are met).
    Example 5. The facts are the same as in Example 4, except that O 
does not sell the tax preparation computer software to customers 
affixed to a compact disc and O's only method of providing the tax 
preparation computer software to customers is over the Internet. P, 
an unrelated person, derives, on a regular and ongoing basis in its 
business, gross receipts from the sale to customers of P's 
substantially identical tax preparation 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 paragraph 
(i)(6)(iii)(B) of this section, O's gross receipts derived from 
providing its tax preparation computer software to customers over 
the Internet 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 Sec.  1.199-3 
are met).
    Example 6. P produces payroll management computer software 
within the United States. For a fee, P provides the payroll 
management computer software to customers for the customers' direct 
use while connected to the Internet. This is P's sole method of 
providing its payroll management computer software to customers. In 
conjunction with the payroll management computer software, P 
provides storage of customers' data and telephone support. Q, an 
unrelated person, derives, on a regular and ongoing basis in its 
business, gross receipts from the sale to customers of Q's 
substantially identical payroll management software that has been 
affixed to a compact disc as well as from the sale to customers of 
Q's substantially identical payroll management software that 
customers have downloaded from the Internet. Under paragraph 
(i)(6)(iii)(B) of this section, P's gross receipts derived from 
providing its payroll management computer software to customers over 
the Internet 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 Sec.  1.199-3 
are met). However, P's gross receipts derived from the fees it 
receives that are properly allocable to the storage of customers' 
data and telephone support are non-DPGR.

    Par. 3. Section 1.199-8T is added to read as follows:


Sec.  1.199-8T  Other rules (temporary).

    (a) through (h) [Reserved]. For further guidance, see Sec.  1.199-
8(a) through (h).
    (i) Effective dates. (1) through (3) [Reserved]. For further 
guidance, see Sec.  1.199-8(i)(1) through (3).
    (4) Computer software. Section 1.199-3T(i)(6)(ii) through (v) are 
applicable for taxable years beginning on or after June 1, 2006. 
Taxpayers may apply these temporary regulations to taxable years 
beginning after December 31, 2004, and before June 1, 2006. The 
applicability of Sec.  1.199-3T(i)(6)(ii) through (v) expires on or 
before May 25, 2009.

Mark E. Mathews,
Deputy Commissioner for Services and Enforcement.
    Approved: May 2, 2006.
Eric Solomon,
Acting Deputy Assistant Secretary of the Treasury.
[FR Doc. 06-4828 Filed 5-24-06; 11:47 am]
BILLING CODE 4830-01-P