SoFTEC Letter to Treasury

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SoFTEC Letter to Treasury

  1. 1. February 9, 2005 Mr. Eric Solomon Acting Assistant Secretary of the Treasury for Tax Policy Department of the Treasury 1500 Pennsylvania Avenue Washington, DC 20220 Hon. Donald L. Korb Chief Counsel Internal Revenue Service Room 3026 1111 Constitution Avenue, NW Washington, DC 20224 Re: Treatment of Computer Software for Purposes of Section 199 Dear Messrs. Solomon and Korb: I write on behalf of the Software Finance and Tax Executives Council (SoFTEC) concerning the treatment of computer software for purposes of the deduction relating to income attributable to domestic production activities under Section 199, which was enacted as part of HR 4520, the American Jobs Creation Act. Recently, Treasury and the IRS issued interim guidance under Section 199 that included provisions dealing with software. We believe that this interim guidance, for the most part, reflects a correct application of Section 199 to many transactions currently conducted by software companies. However, in some respects the interim guidance is unduly restrictive and fails to take into account advances in technology, discriminates between different types of software transactions and, with respect to entertainment oriented software products, discriminates between different segments of the entertainment industry. The net result is that the incentive will inappropriately exclude an increasingly significant part of software revenues. Respectfully, we ask that future guidance on Section 199 alleviate these concerns. In addition, there are areas where additional guidance is needed. SoFTEC is a trade association providing software industry focused public policy advocacy in the areas of tax, finance and accounting. Because its member companies all undertake activities eligible for the Section 199 domestic production activity deduction, they all are keenly interested in the Treasury Department’s recent and future guidance. Our fundamental concern is that the interim guidance, to the extent it excludes online access to software products is not in accord with legislative intent embodied in HR 4520. In addition, we request that further guidance be issued with respect to contract software development and software maintenance contracts.
  2. 2. Mr. Eric Solomon February 9, 2005 Page 2 1. Summary: Notice 2005-14, issued by the Treasury Department and the Internal Revenue Service on January 19, 2005, interprets the deduction for domestic production activities of Section 199 does not apply to fees received by software companies for allowing customers remote access to computer programs. This interpretation is not apparent from the statutory language and is at odds with the statute’s legislative history which provides that eligibility for the deduction is not dependant on the “means or methods of distribution.” This interpretation discriminates between software companies that have competing software products that choose one distribution model over another. By finding that eligibility for the deduction requires a “transfer” to the customer of software copies, the interpretation subjects Section 199 to technological obsolescence by excluding emerging software distribution methods that are not dependant on such a transfer. Future guidance should provide a special rule for computer software that interprets Section 199 allowing a deduction for software revenues regardless of the means or methods by which the software is distributed. The Notice also provide guidance on the application of the contract manufacturing rules to the Section 199 deduction and holds that the taxpayer which has the benefits and burdens of ownership of property will be considered as having conducted the qualifying activity. This guidance applies only to tangible personal property and the rule articulated does not work very well in the context of the use by a software company of an independent software developer. Further guidance is needed on when the activities of an independent software developer will be attributed to its client software company. Last, the notice is silent on how the Section 199 deduction is to be applied to “software maintenance contracts.” Software maintenance contract typically obligate a software company to provide the customer with software updates and upgrades along with technical support services. Guidance is needed on how to separate the components of a software maintenance contract into the qualifying software element and the non- qualifying service element. We suggest that financial accounting rules, the taxpayers own facts and circumstances and safe harbor would provide appropriate methods of making such a differentiation. 2. Section 199 and Software: As you know, Section 199 provides a deduction equal to a percentage of the taxpayer’s qualified production activities income for the taxable year. Such income includes receipts from “any lease, rental, license, sale, exchange, or other disposition of qualifying production property.” Qualifying production property specifically includes “any computer software.” See. Sec. 199(a), (c)(4), (c)(5). The statement of the conference managers that accompanied passage of HR 4520 does not offer any direct guidance on how application of Section 199 to computer software is to be construed. However, in describing both computer software and
  3. 3. Mr. Eric Solomon February 9, 2005 Page 3 “qualified films,” the Statement of Managers says that income from “any sale, exchange or other disposition, or any lease, rental or license” of either will qualify. (Statement of Managers, p. 12). It is thus clear that Congress did not intend to place limits on distribution methods for computer software that were not also imposed on qualified films. With regard to transactions involving qualified films, the managers’ statement provides: The conferees intend that the nature of the material on which properties described in section 168(f)(3) are embodied and the methods and means of distribution of such properties shall not affect their qualification under this provision. (Id at fn. 30.) Concerned that footnote 30 of the Statement of Managers might be construed as providing special treatment for qualified films by allowing the Section 199 deduction for other types of distribution methods, the Chairman and Ranking Member of the Senate Finance Committee engaged in a colloquy on the Senate floor to clarify that such was not their intent. (S. 11036, Oct. 10, 2004). With regard to computer software, the foregoing legislative history demonstrates that Congress, when it used the broad phrase “any lease, rental, license, sale, exchange, or other disposition” of computer software, did not intend to place limits on the allowance of the Section 199 deduction based on means or methods of distribution. Put another way, by definition, not only does the deduction apply to situations in which software is licensed, but also in situations where there is not a license. 3. The Interim Guidance: Notice 2005-14, effective for tax years beginning after December 31, 2004, is the first piece of guidance issued by Treasury and the IRS with regard to interpreting Section 199. With regard to computer software, it provides: (d) Computer software. Gross receipts derived from computer software (as defined in section 4.04(8)(c)) do not include gross receipts derived from Internet access services, online services, customer support, telephone services, games played through a website, 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. (Notice 2005-14, Sec. 4.04(7)(d), January 19, 2005.) In its “explanation” of the interim guidance, the Notice explains: (d) Computer software. The determination of whether a transfer of computer software is a sale or exchange of property, a license generating royalty
  4. 4. Mr. Eric Solomon February 9, 2005 Page 4 income, or a lease generating rental income is made taking into account all facts and circumstances. The form adopted by the parties to a transaction, the classification of the transaction under copyright law, and the physical or electronic or other medium used to effectuate the transfer of computer software are not determinative. See § 1.861-18. A service provided using computer software that does not involve a transfer of the computer software does not result in gross receipts that are derived from the lease, rental, license, sale, exchange, or other disposition of computer software. Thus, with respect to computer software that is developed in the United States and sold to customers who take delivery of the software by downloading the software from the Internet, the manufacturer’s gross receipts from the sales are DPGR (assuming all other requirements of § 199(c) are met). Except as provided in the safe harbor described in section 3.04(7)(b) of this Notice, gross receipts derived by a taxpayer from software that is merely offered for use to customers online for a fee are not DPGR. In addition, gross receipts derived from the lease, rental, license, sale, exchange, or other disposition of computer software do not include gross receipts derived from: (i) providing customer support in connection with the sale of computer software; (ii) online services; or (iii) providing Internet access or telephone services over the Internet. These receipts are not DPGR because these receipts are attributable to the provision of a service and are not derived from the lease, rental, license, sale, exchange, or other disposition of the software. (Id at Sec. 3.04(7)(d)) At the time Notice 2005-14 was issued, the Treasury Department’s Office of Public Affairs released a “Fact Sheet” that summarized the interpretative guidance on software contained in the notice as follows: What income derived from computer software is eligible for the deduction? In general, income from a lease, rental, license, sale, exchange, or other disposition of software developed in the United States qualifies for the deduction, regardless of whether the customer purchases the software off the shelf or takes delivery of the software by downloading the software from the Internet. Computer software is not limited to software for computers and includes, for example, video game software. However, subject to certain de minimis rules, the following income does not qualify for the deduction because the income is attributable to the provision of a service and is not derived from a lease, rental, license, sale, exchange, or other disposition of the software: 1• Fees for on-line use of software; 2• Fees for customer support with respect to computer software;
  5. 5. Mr. Eric Solomon February 9, 2005 Page 5 3• On-line services; 4• Fees for telephone services provided in part through use of software; 5• Fees for playing computer games on-line; and 6• Provider-controlled online access services. As can be seen, the interim guidance circumscribes allowance of the Section 199 deduction to situations where a copy of the software has been “transferred” to the end user either by a license or through some “other disposition.” This position would result in the denial of the Section 199 deduction to those taxpayers who choose to distribute their domestically developed software without delivering copies to the end users. This results in the denial the deduction where the software developer allows its customers to obtain online access to their software’s functionality in a hosted environment even though Congress intended to benefit such a developer. As the fact sheet makes clear, no Section 199 deduction will be available with respect to “fees for online use of software” or “fees for playing computer games on-line.”1 As technology advances, there are sure to be other methods of distributing software to end users without transferring to them a physical copy of the software. 4. Transfer of Software Copies Is Not a Necessary Element of Section 199: Our fundamental disagreement with Notice 2005-14 is its conclusion that a “transfer” to the customer of a copy of a computer program is necessary in order to establish entitlement to a deduction under Section 199. Consider for example, Software Company A that develops a popular small business analysis program. It distributes the program by making and packaging copies and sending them to retail outlets for sale to customers. The same company also makes copies of the program available on its website so that customers can download copies to their office computers. Company A clearly is eligible for the Section 199 deduction with respect to revenues it receives from making and selling copies of the computer program that it developed. Consider Company B that develops a small business analysis computer program that it believes will displace Company A’s product in the marketplace. However, instead of making copies and selling them to customers, Company B decides to make the program available on its website so that customers can, for a fee, use the program without downloading a copy. It does this because increases in broadband networking capacity and speed make this method a more efficient distribution method and requires less computer capacity on the customer’s part. The fees that Company B earns, according to the restrictions in Notice 2005-14, would not be eligible for the Section 199 deduction even though it engaged in the same software development activity as Company A. This 1 The Fact Sheet also provides that fees for “online services” and “provider-controlled online access services” also are not to be allowed. We are unsure just to what types of existing or perceived future products these two exclusions are intended to apply. Further guidance explaining the scope of these two exclusion categories would be helpful.
  6. 6. Mr. Eric Solomon February 9, 2005 Page 6 guidance places Company B at a tax disadvantage based on its chosen method of distributing its software. There is nothing in the statute or the legislative history that compels this result nor is there any policy reason that justifies it. In fact, we believe that the statute and the legislative history lead to a contrary conclusion. As noted above, Congress intended that “the methods and means of distribution” would not effect qualification under Section 199. There is no indication that Congress intended to treat the methods and means of distributing “qualified films” differently from computer software. The Statement of Managers uses identical language in describing the types of transactions that would give rise to qualified revenues from both films and software. The interim guidance with respect to films does not provide that “transfer” of a copy of a film is needed in order to qualify for the deduction. A producer of a qualified film could make it available to viewers over the Internet on a pay-per-view basis where a copy of the film is not delivered to the viewer. The fee paid by the viewer appears to be eligible for the Section 199 deduction under the “means and methods” gloss of footnote 30 to the managers’ statement. The statute places no limits on the means and methods that a producer of a qualified film can use to exploit its film and have the revenues qualify under Section 199. Yet, the guidance appears to permit distribution methods for producers of qualified films that are denied to producers of computer software. Not only does the guidance set up discrimination between different players in the entertainment industry, it also sets up discrimination between software vendors dependant on the chosen method of distribution. Going forward, this discrimination, an improper denial of the benefits of Section 199, will only become more pronounced. As computer processing power, storage capacity, and networking capacity continue to increase and their costs decrease, more and more distribution methods will become available that permit software companies to make their products available to their customers, and provide the value inherent in the those products, without having to go through the expense of “transferring” a copy of the software. Such distribution methods also reduce the capital investment customers need to make in computing equipment. There does not appear to be anything in the statute or its legislative history that conveys congressional intent to exclude emerging and future technologies and distribution methods from qualifying for the Section 199 deduction. Software companies that want to provide online access to their products and still be able to claim the Section 199 deduction, under the interim guidance, will be forced to do so through an independent third-party. If a software company licensed its product to a separate online access company with the license fee based on the level of usage of the software by the third-party’s customers, then the revenue earned by the software
  7. 7. Mr. Eric Solomon February 9, 2005 Page 7 company would qualify for the Section 199 deduction. The restrictions in the interim guidance would force software companies to contort their business models for tax purposes, creating inefficiencies and increasing costs to the ultimate end user of the software. We believe that the focus should be on the activity that gave rise to the qualifying revenue, not the method of deriving the revenue itself. In the case of computer software, so long as the development of the software took place in the United States, any revenue generated from that software, from whatever source, should qualify under Section 199. The interim guidance contains several examples of revenues that qualify under Section 199 that do not flow from the production of tangible personal property. For instance, the guidance provides that revenue associated with certain warranties with respect to tangible personal property will qualify. A warranty is a contract that typically obligates a seller to perform repair services and is an intangible. Also, revenue from newspaper and magazine advertising also has been found to qualify under Section 199 when such revenue does not flow from a sale, lease, rental, license or other disposition of the newspapers or magazines. Nothing in the statute suggests that advertising revenue would be qualifying income under Section 199. Guidance on the application of Section 199 should not be restrictive when it comes to distribution methods. Guidance should make it clear that the benefits of Section 199 are available with respect to computer software regardless of the method of distribution and regardless of whether a copy of the software is “transferred” to the customer. Guidance should make clear that Section 199 is applicable with regard to software revenues whenever the vendor has made the software’s functionality available for the use of the end user. With regard to computer software, making the functionality available to the end user is the functional equivalent of “transfer” of a copy. Computer software is specially called out in the statute as qualifying property under Section 199. Computer software is a unique type of property because of its inherent intangible characteristics which make it susceptible of many different distribution techniques. Special guidance applicable only to software that makes it clear that the means or methods of distribution are not to be taken into account when determining whether software revenues qualifying under Section 199 is entirely appropriate under the statutory scheme. 5. Contract Software Development: Notice 2005-14 provides interim guidance on how “contract manufacturing” is to be handled with respect to Section 199. However, there is no guidance with regard to how the concept of “contract manufacturing” is to be applied with respect to a computer program that contains significant source code developed by an independent contractor.
  8. 8. Mr. Eric Solomon February 9, 2005 Page 8 Under Sections 3.04(4) and 4.04(4) of the Notice, if one taxpayer performs qualifying activity pursuant to a contract with an unrelated party, then only the taxpayer that has the benefits and burdens of ownership of the property under federal income tax principles during the period the qualifying activity occurs is treated as engaging in the qualifying activity. This “benefit and burdens of ownership” test does not fit very well with regard to contract software development activities. Consider the example of computer software developed by Company A that includes a significant feature that was not developed in-house but was developed under contract by a domestic independent software developer. Every copy of Company A’s software that it sells to its customers contains this feature developed by the independent contractor. Does this fact pattern implicate the contract manufacturing provisions of the interim guidance? Or is the use of the independently developed software no different than an automobile manufacturer buying parts, such as fuel pumps, shock absorbers and tires, and incorporating those parts into a finished car. A slight change in the fact pattern described above raises a different set of issues. Assume that Company A is a foreign software company and that the independent software developer is domestic. Is a portion of the revenue earned by Company A from selling its software which contains both foreign content and domestic content eligible for the Section 199 deduction? If the intent of Section 199, as applied to software development, is to encourage domestic software development, not allowing a Section 199 deduction for a portion of the income allocable to the source code written by domestic independent developers would provide an incentive for foreign software developers to shun US based independent programmers. Clearly, if the foreign software company had used domestic employees to develop a part of its product, it would be entitled to claim a Section 199 deduction for a portion of its revenue. Does that result change when the foreign software company chooses to use independent programmers instead of employees? Another possibility is to interpret the “benefit and burdens of ownership” test as requiring an inquiry into which party to the contract bears the technological risk that the independent programmer will be unable to produce the functionality to be developed under the contract. If the independent programmer gets paid whether it is successful or not, then the risk lies with the other party to the contract and it should be treated as the developer of the software written by the independent programmer. One additional fact pattern involves a foreign software company that opens a domestic R & D subsidiary that does software development in the US on behalf of the parent on a cost plus basis. It would seem that the revenues earned by the subsidiary from its parent for US software development activities would be eligible for the Section 199 deduction on the subsidiary’s US tax return. 6. Software Maintenance Contracts:
  9. 9. Mr. Eric Solomon February 9, 2005 Page 9 Guidance also is needed with respect to the application of Section 199 to “software maintenance contracts.” A software maintenance contract generally is a contract that obligates the software vendor to provide a customer with software updates (such as bug fixes and patches), software upgrades (which provide additional functionality) and technical support services. Many times these different elements are bundled for single price and neither the contract nor the invoice given to the customer provides any allocation of the price among the various software and service components. Also, the software vendors many times do not separately market the various elements of the contract. For financial accounting purposes, software companies are required to allocate the software maintenance contract price to software license fees and service fees. See S.O.P. 97-2. In addition, they are required to make a determination as to the delivered elements and the non-delivered elements of the contract. For financial accounting purposes, software companies are only permitted to recognize as current revenue only the portion of the software maintenance contract that was delivered during the current accounting period; they are required to defer the remainder to future period as the other elements are delivered. Deferred revenue attributable to software maintenance contracts shows up as a separate category on the balance sheets of software companies that sell them. When a software company is unable to separate the various components of a maintenance contract into its service and software components, the currently recognized portion shows up on the income statement under a separate category described as “revenue from software license updates and product support” or similar designation. In this situation, the revenue that shows up under this separate category will be comprised of revenue from qualifying computer software and non-qualifying services. Guidance on how to separate a software maintenance contract into its qualified and nonqualified components is needed. Initially, we suggest that a company be able to refer to its own facts and circumstances in “unbundling” maintenance contracts. The company may have internal accounting methodologies or other information that management uses to track the profitability of these contracts. In the alternative, we suggest that a safe-harbor 50/50 split between the separate elements of maintenance contracts be included in future guidance. In addition, consider the fact pattern of a domestic software company that has a foreign distribution affiliate. The distribution affiliate not only markets its domestic parent’s software products but also markets maintenance contracts. The foreign affiliate performs the product support services obligations of the maintenance contract but uses software supplied by the parent to fulfill the update and upgrade obligations. The foreign affiliate remits a royalty to its domestic parent in connection with the sale of the maintenance contract. Under this fact pattern, because the foreign affiliate is performing the nonqualified product support services obligations itself, but is using software supplied
  10. 10. Mr. Eric Solomon February 9, 2005 Page 10 by the parent to fulfill the update and upgrade obligations, most if not all of the royalty ought to be qualifying revenues under Section 199. We propose that future guidance on Section 199 provide specific guidance on its application to software maintenance contracts. Permitting software companies to use the methodology required by the financial accounting rules for separating revenue from these contracts into the various categories provides an adequate basis for determining applicable revenue for purposes of the Section 199 deduction. In addition, if “vendor specific objective evidence” of a separate price exists with respect to one element of a software maintenance contract but not another, the residual method would provide an appropriate basis for assigning revenue to both elements. If there is no vendor specific objective evidence of separate prices for the various elements of the contract, reference to the taxpayer’s own facts and circumstances, with a 50/50 split safe-harbor, would provide an adequate basis for separation of the elements into their qualified and nonqualified components. Additionally, guidance is needed that ensures that the costs associated with performance of a software maintenance contract are allocated appropriately among the various components. 7. Conclusion: We thank you for the opportunity to submit these comments and we hope you find them helpful in crafting future guidance with respect to Section 199. We look forward to working with you and the staffs on these and other issues. I can be reached at (202) 331-9533 or mnebergall@softwarefinance.org with any questions. Respectfully submitted, Mark E. Nebergall President Software Finance and Tax Executives Council
  11. 11. Mr. Eric Solomon February 9, 2005 Page 11 Cc: Helen Hubbard Tax Legislative Counsel Department of the Treasury George Manousos Office of Tax Legislative Counsel Department of the Treasury Nicholas J. DeNovio Deputy Chief Counsel Internal Revenue Service Cary D. Pugh Special Counsel to the Chief Counsel Internal Revenue Service Paul Handleman Lauren Ross Taylor Heather Malloy Office of Associate Chief Counsel Passthroughs and Special Industries

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