IRS Positions on DPAD Increase Exam Controversy

On January 31, 2017, the IRS Large Business & International (“LB&I”) division released a list of 13 compliance issues on which it is focused.  One of these issues, or campaigns, focuses on DPAD claims involving multichannel video programming.  The LB&I’s campaign is likely the result of private guidance issued in recent years, including Technical Advice Memorandum (TAM) 201646004 and TAM 201647007.  

Multichannel video programming distributors and television broadcasters have claimed that groups of channels or programs constitute “qualified film” under IRC § 199(c)(6) for purposes of the deduction.  Conversely, the IRS National Office has taken the position that qualified film pertains to individual films.  As a result, the Service views the multichannel video programming as the distribution of film, as opposed to the production of qualified film.  Under this interpretation, the IRS contends that multichannel video programming is neither property described in IRC § 168(f)(3) (any motion picture file or video tape) nor “live or delayed television programming” within the meaning of Treasury Regulation § 1.199-3(k)(1).  Since the IRS contends such programming, also referred to as a “24-hour feed,” does not constitute the production of qualified film, it takes the position that the gross receipts attributed to such programming do not constitute domestic production gross receipts (DPGR). 

In support of its position, the IRS has cited legislative history to contend that Congress intended to incentivize the production of film in the U.S., as opposed to the transmission of signals and the distribution of films within the U.S.  However, the IRS has provided that a taxpayer may still claim DPAD for individual films within the distributed package that it has produced, if it can establish that an individual film meets the definition of qualified film.

Taxpayers have noted the apparent change in the IRS National Office’s interpretation of qualified film.  In TAM 201049029, the IRS National Office determined that gross receipts received by a taxpayer for licensing programming packages to cable and satellite television providers, referred to as multiple system operators, constituted DPGR.  The IRS stated it was consistent to test a programming package, which included multiple programs, offered by a taxpayer in the normal course of business as a single qualified film for purposes of IRC § 199(c)(6).  The Service asserted that regardless of the fact that a programming package includes multiple films, Treasury Regulation § 1.199-3(d)(2)(i) provides that a single item can consist of two or more properties if those properties are offered for disposition in the normal course of the taxpayer’s business as a single item.  As support, the Service cited Example 3 in Treasury Regulation § 1.199-3(d)(4).  In that example, a taxpayer packages a toy car it manufactures with two purchased toy cars and offers the three-car set for sale to customers in the normal course of its business.  The example provides that if the gross receipts derived from the sale of three-car set do not qualify as DPGR, then the taxpayer must treat the one manufactured car as the item for calculating DPGR.  In the TAM, the Service provided the converse position that as long as the taxpayer can determine the gross receipts from the three-car set in the aggregate qualify as DPGR, then the taxpayer does not have to show that gross receipts from the individual cars qualify as DPGR.   

Taxpayers have not only objected to the IRS’s substantive position, but they have also taken issue with the procedural manner in which the IRS has established this position.  The IRS has announced its position in nearly identical technical advisory memoranda (TAM 201646004 and TAM 201647007) which do not require Treasury review or approval.  The Treasury Secretary, Steven Mnuchin, has received criticism regarding these TAMs which contends that the IRS had previously treated a “24-hour feed” as an “item” to be tested for qualification under IRC § 199.  Of particular concern is the lack of involvement of the Treasury in the new IRS position, as well as the absence of any suggestion of a change in position in the 2015 Proposed Regulations.  Moreover, it is asserted that there is an absence of case law or statutory change related to the application of IRC § 199 to a “24-hour feed.” It has been contended that if the IRS seeks a change in position, it should first issue proposed regulations that provide taxpayers the opportunity to review and comment.  Finally, any change brought through this regulatory process should be prospective, thus preventing the retroactive application of this standard to returns under exam.

Despite taxpayers’ arguments as to the substantive and procedural issues, the IRS has been resolute with its position.  As a result, taxpayers that claim a deduction under IRC § 199 for multichannel video programming or packaged programming should unfortunately anticipate a contentious debate on the issue if under exam.

With regard to online software, the main point of IRS contention is that, unless a taxpayer can meet an exception (self-comparable or third-party comparable), online software constitutes the means of delivering a service as opposed to constituting qualified production property (QPP).  Therefore, gross receipts generated from providing access to online software generally do not qualify as DPGR. 

While Treasury Regulation § 1.199-3(i)(6)(i) provides that DPGR includes gross receipts derived from the disposition of computer software manufactured, produced, grown, or extracted (MPGE) by the taxpayer in whole or significant part within the U.S., Treasury Regulation § 1.199-3(i)(6)(ii) excludes gross receipts from ancillary services, including online services, such as Internet access services, online banking services, and providing access to online electronic books, newspapers, and journals.  Nonetheless, gross receipts derived from providing a customer such access while the customer is directly connected to the Internet or any other public or private communications network will qualify if the computer software meets an exception:

Self-Comparable Exception – The taxpayer also derives gross receipts from the disposition of computer software that has only minor or immaterial differences from online software that is MPGE by taxpayer in whole or significant part in the U.S., AND the software has been provided to customers affixed to a tangible medium, or by allowing customers to download the computer software from the Internet. Treasury Regulation § 1.199-3(i)(6)(iii)(A).

  • Third-Party Comparable Exception – Another party derives gross receipts from the disposition of computer software that it MPGE in whole or significant part in the U.S, and provides the software to customers affixed to a tangible medium or by download, which is substantially comparable to taxpayer’s online software. Treasury Regulation § 1.199-3(i)(6)(iii)(B).

Due to the recent advancements in the computer software industry, e.g. Cloud Computing and Software-as-a-Service, taxpayers contend that computer software no longer operates as it did when the DPAD provisions and regulations were drafted (2004-2005).  However, the IRS has refused to apply a more liberal position with respect to online software.  Rather, it continues to apply the Code and regulations as written by Congress.

The IRS reiterated its position on software under DPAD in a recent Chief Counsel Advice Memorandum (CCA 2001724026).  In the redacted memorandum, the taxpayer claimed the DPAD for gross receipts derived from online “platforms.”  The taxpayer charged a variety of fees for the features and functions offered to customers on each platform.  The IRS made several arguments in denying the deduction.

The IRS analyzed several fees charged by the taxpayer.  The IRS concluded the fees were not gross receipts from providing customers access to computer software for direct use while connected to the Internet.  Rather, it concluded the fees were for an online service.  The IRS concluded that the self-comparable and third-party comparable exceptions DID NOT apply, since the taxpayer failed to demonstrate the pre-requisite that the fees were gross receipts for the customers’ access to computer software for direct use while connected to the Internet.

In reaching its conclusion, the IRS found the taxpayer to be similar to “taxpayer M” in Example 2 of Treasury Regulation § 1.199-3(i)(6)(v).  Therein, taxpayer M generates fees for providing customers access to software that allows them to participate in online auctions.  The example concludes that since M’s activities constitute the provision of online services, they generate gross receipts that are non-DPGR.

The IRS also focused on the taxpayer’s method for allocating gross receipts to specific computer applications within a computer platform for a particular group of fees.  The taxpayer allocated all gross receipts for such fees among three applications, including one application for which it does NOT charge a fee, based on estimated development days.  The IRS found this method to be inconsistent with the item-by-item basis required by Treasury Regulation § 1.199-3(d).  

As taxpayers have argued, the Code and Treasury regulations may be outdated when it comes to the availability of DPAD for computer software.  Most software companies no longer produce computer software for disposition via a tangible medium.  In addition, computer software is commonly hosted in the Cloud, as opposed to being downloaded.  Nonetheless, if a taxpayer produces software that a customer can access only via the Internet, as opposed to downloading and accessing when off-line, the online computer software provisions will apply.  Based on the IRS’s position, gross receipts for such online computer software will qualify for DPAD only if the taxpayer (1) establishes that the gross receipts are for providing customers access to online software for direct use when connected to the Internet, AND (2) demonstrates the applicability of either the self-comparable or the third-party exception.  Otherwise, the IRS will deem the gross receipts for the online software to be receipts for services, and thus non-DPGR.  As a result, taxpayers should be aware of the IRS position and potential for controversy upon audit.

If you have any questions regarding the potential availability of the DPAD for a software client, please contact Dan Laughlin at or 312-638-2916.

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