A Look at Tax Code Section 199's Last Stand - McDermott Will & Emery

A Look at Tax Code Section 199’s Last Stand



Kevin Spencer, Andrew Roberson, and Emily Mussio authored this bylined article on the Tax Cuts and Jobs Act’s repeal of Section 199 and the impact it has made.

This article was originally published in Law360 on November 6, 2018.

In Depth

The Internal Revenue Service has been battling taxpayers for more than a decade on their Internal Revenue Code Section 199 deductions. Indeed, nearly every taxpayer, other than manufacturers, has been questioned in some fashion about their Section 199 deduction. In the wake of the Tax Cuts and Jobs Act, which repealed Section 199, taxpayers are taking a last stand to claim the benefit and, in many instances, claiming substantial refunds for all open years. Listing Section 199 refund claims as a “campaign” was the IRS’ newest way of telling taxpayers: Let’s get ready to rumble!

Where It All Began

In 2004, Congress enacted Code Section 199 to tip the scales of global competitiveness in favor of doing more business in the United States. The primary purpose of the statute was to create jobs in the United States by encouraging businesses to manufacture and produce their products in the United States to strengthen the economy. And so, a tax deduction was born! The legislative history explains that the tax benefit, however, was not available for revenue earned for the provision of services. As the controversial history of Section 199 demonstrates, the line between providing services and producing property can be blurry in the modern business paradigm.

Before being repealed by the TCJA — effective for tax years beginning after Dec. 31, 2017 — IRC Section 199 allowed qualifying businesses to claim a tax deduction calculated as 9 percent of the lesser of qualified production activities income, or QPAI, or the taxpayer’s taxable income. The deduction was also limited to 50 percent of the W-2 wages paid by the taxpayer that were allocable to domestic production gross receipts, or DPGR. QPAI is defined as the taxpayer’s DGPR for the year less the costs of goods sold and expenses allocable to DPGR. DGPR is defined as the gross receipts of a taxpayer that are derived from the lease, rental, license, sale, exchange or other disposition of qualifying production property, or QPP, which was manufactured, produced, grown or extracted (“MPGE”) by the taxpayer in whole or in significant part within the U.S. Accordingly, the calculus by which the Section 199 deduction is determined is the amount of “profit” that a taxpayer made on the stream of qualifying revenue. Enumerated MPGE activities whose revenues qualify under Section 199 are: Qualified film, computer software, electricity, natural gas, potable water, tangible personal property and certain sound recordings.

The IRS’ Enhanced Scrutiny of the Section 199 Deduction

There are some areas of tax law that are marred with significant controversy with the IRS. It is no secret that the IRS has coordinated efforts to challenge transfer pricing and research and development credits. Section 199 is another one of the IRS’ areas of enhanced scrutiny. Indeed, the IRS has released a plethora of “guidance” relating to its interpretation of the contours of Section 199.

Recently, the IRS has put Section 199 on its “Most Wanted” list, making it a “campaign” of the Large Business and International, or LB&I, division. In January 2017, LB&I announced a campaign for the “Domestic Production Activities Deduction, Multi-Channel Video Program Distributors and TV Broadcasters.” This campaign targeted taxpayers who claimed that they were producers of a qualified film when distributing channels and subscription packages that often included third-party content. Following the repeal of Section 199, in September 2018, LB&I rolled out an additional Section 199 campaign. This campaign focuses on all businesses filing a refund claim for additional domestic production activity deductions, or DPAD. The IRS explained: “[t]he campaign objective is to ensure taxpayer compliance with the requirements of IRC Section 199 through a claim risk review assessment and issue-based examinations of claims with the greatest compliance risk.”

Controversy regarding Section 199 has centered on a few issues. We highlight these areas as we expect that they will garner the IRS’ focus as it audits tax returns and refund claims for tax years prior the repeal of Section 199.

Contract Manufacturing

The Section 199 deduction is permitted not only when the taxpayer does the MPGE itself, but also when the taxpayer hires another — a contract manufacturer — to perform the MPGE on its behalf. This is in line with the purpose of the statute — it encourages taxpayers to manufacture and produce within the U.S. In contract manufacturing arrangements, Congress specified that only one of the parties, either the contracting corporation or the contract manufacturer, would be entitled to the deduction on the same QPAI. Pursuant to Treasury regulations, the party with the “benefits and burdens” of ownership, or BBO, of the property during the production activity is entitled to the deduction.

In ADVO Inc. v. Commissioner, the U.S. Tax Court delivered a blow to taxpayers. There, the taxpayer contracted with a printer to print advertisements that the taxpayer delivered in free mailers to potential customers. The taxpayer designed the layout, colors, content, etc. for the ads, and delivered the ads ready to print to the printer. The printer took the ads and printed them according to the specifications of the taxpayer on paper purchased by the taxpayer. The Tax Court performed a BBO analysis to determine if the taxpayer was entitled to the Section 199 deduction. The court used well-established legal precedent and applied a nine factor test to analyze who “owned” the printed advertisements during the production process. In a highly fact-intensive analysis, the court determined that the taxpayer did not have the BBO of the printed ads during the printing process, and therefore was not entitled to the Section 199 deduction.

The tax bar has almost universally criticized the analysis applied in ADVO, asserting that the Tax Court misunderstood how Section 199 and its calculus works. The Section 199 deduction is premised upon each stream of QPAI, and is not product specific. Accordingly, numerous taxpayers can claim a deduction relating to the same product, but each producer’s QPAI is determined on a different part of the multi-stage production process. Because many taxpayers believe that the IRS’ position on this issue is wrong, there has been substantial controversy at the administrative level and in court. The BBO analysis will be revisited in a case currently pending in the U.S. Court of Federal Claims involving the contract printing of the “Yellow Pages” by a third party. That case is expected to be tried in 2019, and its decision may shape other contract manufacturing cases that are in the pipeline.

Computer Software

One of the most contentious areas of Section 199 has been its application to revenues derived from computer software. Treasury Regulation Section 1-199-3(i)(6)(i) provides that DPGR includes gross receipts of the taxpayer that are derived from the “disposition” of computer software produced by the taxpayer in whole or in significant part within the U.S. However, Treasury Regulation Section 1-199-3(i)(6)(ii) provides that gross receipts derived from customer and technical support, telephone services, online services and other similar services do not constitute gross receipts derived from a disposition of computer software.

Recognizing, however, that a taxpayer can make a disposition of software by placing it on a tangible medium — e.g., a disc — or by providing the customer with access to the software while connected to the internet or a private communications network, the regulations include an exception to this rule in instances when a taxpayer derives gross receipts from providing customers access to computer software produced in whole or significant part by the taxpayer within the United States for the customers’ direct use while connected to the internet or any other public or private communications network — “online software.” The gross receipts will be treated as derived from the disposition of computer software provided the requirements of either the “self-comparable test” or the “third-party comparable tests” are met.

The self-comparable test is met when the taxpayer as part of its business earns gross receipts from the disposition of computer software to a customer that: (1) only has minor or immaterial differences from the online software, (2) was MPGE by the taxpayer in whole or in significant part within the United States and (3) has been provided to customers affixed to a tangible medium or by allowing the customers to download the computer software from the internet.

The third-party comparable is met when a third-party earns gross receipts from the disposition of software to its customers affixed to a tangible medium or downloaded from the internet that is “substantially identical” to the taxpayer’s online software. “Substantially identical” means software that: (1) from a customer’s perspective, provides the same functional result as the online software and (2) has a significant overlap of features or purpose with the online software.

The IRS maintains a very restrictive view of online software. For example, in Generic Legal Advice Memorandum 2014-008, (Nov. 21, 2014), the IRS determined that a taxpayer did not have DPGR when customers downloaded a bank’s online banking app to their computer or device at no cost. The IRS determined that the app was “online software” as described the regulations because the app did not operate unless it was connected to the internet. The IRS explained that downloading the app was not a “disposition” for Section 199 purposes. Further, the IRS determined that the taxpayer did not earn gross receipts from the deployment of the app. And, the IRS determined that the taxpayer did not satisfy either the self or third-party comparable tests.

The GLAM demonstrates the IRS’ view of how online software can qualify for the Section 199 deduction, which severely limits taxpayers’ ability to claim the tax benefit in the context of an ever-changing technological marketplace.

Like with contract manufacturing, numerous taxpayers have challenged the IRS’ position in court. Presently, the following cases are pending in the U.S. Tax Court addressing the computer software issue:

BATS Global Markets Holdings Inc. v. Comm’r, Dkt. No. 1068-17 (Judge Kathleen Kerrigan) (no trial date set; status report track)

Bloomberg LP v. Comm’r, Dkt. No. 3755-17 (Judge Robert Goeke) (no trial date set; status report track)

Vesta Corp. v. Comm’r, Dkt. Nos. 26847-16, 26503-17 (Judge Mary Ann Cohen) (apparently the parties have settled the case, and have until Nov. 9, 2018, to submit stipulations for decision or stipulations of settled issues)
Recently, the following cases settled prior to trial:
HIBU Group (USA) Inc. v. Comm’r, Tax Court Dkt. No. 1043-16 (Judge Albert G. Lauber) (stipulated decision entered Sept. 25, 2018)

Bare Escentuals Inc. v. Comm’r, Tax Court Dkt. No. 30729-15 (Judge David Laro) (stipulated decision entered May 4, 2017)

Limited Brands Inc. v. Comm’r, Tax Court Dkt. No. 17903-10 (Judge Elizabeth Crewson Paris) (stipulated decision entered Apr. 14, 2016)

Qualified Film

Another area of IRS focus relates to its campaign on multi-channel video program distributors, or MVPDs, and television broadcasters who may claim that “groups” of channels or programs are “qualified film” eligible for the Section 199 deduction. The dispute centers on what constitutes “qualified film” — including whether this term should be interpreted in the singular or plural — and who is an MVPD.

Section 199 permits a deduction based upon gross receipts of the taxpayer which are derived from any lease, rental, license, sale, exchange or other disposition of “any qualified film produced by the taxpayer.” Section 199(c)(6) defines “qualified film” as “any property described in section 168(f)(3) if not less than 50 percent of the total compensation relating to the production of such property is compensation for services performed in the United States by actors, production personnel, directors and producers” and includes “any copyrights, trademarks or other intangibles with respect to such film.” However, “qualified film” does not include property with respect to which records are required to be maintained under 18 U.S.C. Section 2257 — i.e., sexually explicit materials. “Qualified film” also includes “live or delayed television programming.” The “methods and means of distributing a qualified film” have no effect on the availability to claim the Section 199 deduction. IRC Section 168(f)(3), entitled “Films and Video Tape,” provides an exclusion from accelerated depreciation for “[a]ny motion picture film or video tape.”

In IRS Technical Advice Memorandum 201049029 (Dec. 10, 2010), the taxpayer licensed programming content consisting of a group of programs produced by the taxpayer, programs produced by third parties, advertisements and interstitials to customers. The primary issue was whether the 24-hour feed should be treated as a single item for purposes of Section 199. The IRS determined that an entire 24-hour programming package was the “item” offered for sale, and that the package should be evaluated as a single qualified film for purposes of Section 199.

However, the IRS issued Technical Advice Memoranda 201646004 (Nov. 10, 2016) and 201647007 (Nov. 18, 2016), the IRS determined that a subscription package of multiple channels of video programming transmitted by an MVPD to its customers via signal was not a “qualified film” as defined in Section 199(c)(6) and Treasury Regulation Section 1.199-3(k)(1). It also determined that an MVPD’s gross receipts from its subscription package are not from the disposition of a qualified film produced by the MVPD and are therefore not DPGR included in calculating the Section 199 deduction. The MVPD would only have DPGR from the subscription package to the extent its gross receipts are derived from an individual film or episode within the subscription package that is a qualified film produced by the MVPD. In the 2016 TAMs, the IRS argued that the definition of “qualified film” is limited to individual films and episodes.

In Revenue Ruling 2018-3 (Dec. 21, 2017), the IRS changed course — again — and ruled that a package of films licensed to customers in the normal course of business may be an item under Treasury Regulation Section 1.199-3(d)(1)(i) for purposes of determining the DPAD under Section 199. The IRS has indicated that it will apply this new guidance as it moves forward with the execution of its Section 199 campaign on MVPD. However, issues remain in this area with respect to certain calculations necessary to claim the Section 199 deduction and what activities are considered “film production.” Thus, it is possible that the IRS may continue to pursue MVPDs and television broadcasters that have claimed the benefits of Section 199.


Although the TCJA repealed Section 199, it remains a contentious issue with the IRS. Because many taxpayers have or will file refund claims to seek the tax benefit before it is gone forever, we expect continued litigation until the issues are fully resolved by the courts. Before the final bell is struck, Section 199 is poised to leave a permanent mark on both taxpayers and the IRS.