Republican Leaders Release Tax Reform Framework
David G. Noren
On September 27, 2017, the White House and Republican congressional leadership released a nine-page outline (the Framework) to guide the coming legislative effort on comprehensive tax reform. While the Framework offers few surprises and leaves critical details open, it does represent incremental progress toward achieving comprehensive tax reform and signals a major intensification of tax reform activity in the coming weeks and months. House Republican leadership is expected to release a comprehensive tax reform bill fleshing out the Framework on November 1, 2017, and to commence Ways & Means committee mark-up the following week.
Key Elements of the Framework
Individuals and Estates
- Three tax brackets (12 percent, 25 percent and 35 percent), with bracket income levels unstated
- Potential surtax or fourth bracket higher than 35 percent for highest-income taxpayers
- Increased standard deduction amount and expansion of child tax credit
- Modified approach to indexation throughout the tax code
- Repeal of the individual alternative minimum tax (AMT)
- General direction to eliminate itemized deductions, presumably including the deduction for state and local taxes, but not including mortgage interest and charitable gift deductions
- No suggestion of any (previously rumored) “Rothification” of retirement plans
- Elimination of estate and generation-skipping transfer taxes
General Business Taxation
- Corporate income tax rate reduced to 20 percent
- Pass-through tax rate (for sole proprietorships, subchapter S corporations and businesses taxed as partnerships) reduced to 25 percent, with unspecified restrictions to limit use of the pass-through rate to avoid the top individual rate
- Repeal of the corporate AMT
- Potential consideration of measures to reduce the double taxation of corporate earnings (an area of particular interest to Senate Finance Committee Chairman Orrin Hatch, who has been developing a corporate integration proposal)
- Accelerated recovery of certain capital expenses, including full expensing for at least a five-year period
- Partial and unspecified limits on deductions for net interest expense
- General direction to eliminate special deductions and credits, including the section 199 deduction for domestic production activities, but not including the R&D credit and the low-income housing credit
- Unspecified modernization of special tax regimes for specific industries
- Territorial dividend exemption for 100 percent of dividends received from foreign subsidiaries (in which a US parent owns at least 10 percent of the stock)
- Transition tax on currently accumulated foreign earnings under a deemed-repatriation model, employing a bifurcated rate (higher rate for earnings considered as held in the form of cash or cash equivalents), with rates and other details unspecified
- Imposition of a minimum tax on foreign earnings on a current basis, at a reduced rate, with rate and other details unspecified
- General direction to adopt measures to “level the playing field” between US-headquartered and foreign-headquartered parent companies
Observations and Likely Next Steps
Although the Framework is a very high-level outline and provides little indication of whether and how its various desired tax-cutting measures might be achieved in view of budget and political limitations, the Framework is a useful first step in structuring what is sure to be an active and contentious phase of tax reform activity as the congressional tax writing committees get down to work.
Congress has agreed on a budget resolution, which will allow tax reform to proceed under a budget reconciliation process (requiring only a simple majority, rather than 60 votes, to clear the Senate). This resolution will allow a $1.5 trillion temporary overall tax cut, but no revenue loss outside the 10-year budget window.
Meanwhile, the tax writing committees have been hard at work in developing detailed legislative language to implement the high-level concepts set forth in the Framework. As these details are filled in, hard choices will need to be made in order to fit a tax reform package within any realistic budget parameters, and countless important technical, timing and transition issues will inevitably arise. The first look at legislative language is expected to come on November 1, 2017, when House Republicans are planning to release a draft bill, for mark-up in the Ways & Means committee the following week.
The process is sure to be contentious, and the outcome uncertain, but it is safe to say that it is time for taxpayers to pay close attention to what is a rapidly intensifying tax reform effort. The McDermott Tax team is closely monitoring activity in this area, and is advising clients on potential impacts and planning responses. We will continue to provide general tax reform updates as circumstances warrant, as well as more detailed examinations of specific aspects of tax reform.
M&A Tax Aspects of Republican Tax Reform Framework
Alejandro Ruiz | Timothy S. Shuman
On September 27, 2017, the White House and Republican congressional leadership released a nine-page outline (the Framework) summarizing the current legislative effort on comprehensive tax reform. The Framework offers few surprises and leaves critical details open, but it is likely to be the starting point as Congress addresses federal tax reform issues in the coming months. It remains to be seen which provisions proposed in the Framework will actually become new law and in what form they will be adopted. Regardless, adoption of several of the key provisions, like a corporate tax rate cut, will have a significant impact on M&A activity. In addition, there are also many less obvious provisions that may indirectly, but powerfully, affect the M&A market if adopted. This memorandum outlines some of the key areas with which the M&A market will be particularly concerned.
Corporate Rate Cut and Individual Rate Cut
A reduction in the corporate income tax rate is expected to have a positive impact on M&A activity. Lower tax rates will induce many corporations that were worried about a high tax bill to be more willing to sell assets or subsidiaries to a prospective buyer. Lower tax rates for corporations may also make corporations more useful as an acquisition vehicle, as compared to partnerships or LLCs, depending on how the pass-through tax rate changes are finalized, as discussed below.
Lower individual rates may also spark additional M&A activity, particularly for individual sellers of LLCs or S corporations. Finally, the potential consideration of measures to reduce the double taxation of corporate earnings (an area of particular interest to Senate Finance Committee Chairman Orrin Hatch, who has been developing a corporate integration proposal) could further reduce corporate tax burdens and increase corporate M&A activity.
However, we note that until an actual rate cut is passed, M&A activity may be chilled in the short term because parties will be hesitant to trigger a tax bill today that could be lower tomorrow if they wait.
The current proposal contains unspecified limits on deductions for net interest expense. Debt plays a large role in M&A transactions and the loss of interest deductions would make companies think differently about how they structure M&A. This proposal would especially impact M&A structuring in the private equity sector where leverage is critical to any acquisition transaction. Restricting interest deductions also could make acquisitions of US companies by foreign buyers somewhat less attractive because of a reduced ability to leverage (either with third-party debt or intercompany debt) the US target on a tax-advantaged basis. Interestingly, the current proposal only applies limitations to C Corporations, with the applicability of such limitations to non-corporate taxpayers remaining subject to further consideration. Any difference in such treatment between corporations and partnerships may drive decision making regarding the type of ownership structures used in M&A. Further, unlike the immediate expensing provisions (described below), restrictions on the deductibility of interest expense may result in an increase in a C corporation’s effective tax rate for financial statement reporting purposes. Finally, it is interesting to note that some taxpayers might favor incurring debt prior to the passage of any tax reform in case the deduction for interest on existing debt is “grandfathered.”
Immediate Expensing of Capital Expenditures
The Framework contemplates full deductions for the cost of certain capital expenses by businesses incurred after September 27, 2017, for a five-year period. The change to expensing of capital investments will impact the economics of M&A, particularly if the treatment is extended to goodwill and other intangible assets. The effect of this change will likely be greatest for privately held companies, as public companies may be more likely to view full expensing as providing only a timing, and not a permanent, financial statement impact.
Pass-Through Tax Rate
The pass-through tax rate (sole proprietorships and entities treated as S Corporations or partnerships) would be reduced to 25 percent, with unspecified restrictions to limit use of the pass-through rate to avoid the top individual rate. Many companies in the private equity and healthcare areas purchase interests in small and family owned businesses and these changes could lead to very different results for such businesses than the current treatment. It is not clear from the Framework whether sellers of pass-throughs would be able to avail themselves of the lower pass-through tax rate on ordinary (as opposed to capital) gain recognized on the disposition of a business, or instead whether the higher individual rates would apply in this scenario.
The proposal does not include any mention of changes to the taxation of carried interest, which is of particular interest to private equity and other investment funds. Some politicians have intimated that any new legislation should include some carried interest changes. Whether it is added to the current proposal remains to be seen, but this may be dependent on the desire or need for bipartisan support and whether carried interest provisions would be viewed as raising a material amount of revenue as part of the overall package.
The Framework would exempt from tax 100 percent of dividends received from foreign subsidiaries, defined as companies in which a US parent owns at least 10 percent of the stock (Territorial System). In order to protect the US tax base, the Territorial System would be backstopped by an unspecified reduced tax rate on foreign profits of US multinationals. There would be a transition tax (to be paid over a several year period) on currently accumulated foreign earnings under a deemed-repatriation model, employing a bifurcated rate (higher rate for earnings considered as held in the form of cash or cash equivalents), with rates and other details unspecified. M&A deals are often structured with tax-efficient repatriation or integration in mind; changes to our international tax system (e.g., territorial) could drastically change how parties structure transactions or integrations. The parties will have to change how they typically deal with cash trapped in foreign subsidiaries. In addition, companies may desire that targets restructure themselves to take advantage of the new treatment of foreign subsidiaries under a territorial system. Careful planning may be required for foreign subsidiary earnings that could potentially be subject to the reduced tax rate. It is important to note that changes in the rules regarding foreign earnings will likely impact the collateral packages when financing transactions and may affect pricing. Finally, many companies consider the cost of repatriating cash to the United States (e.g., to be used for stock buybacks or for other corporate purposes) when considering a disposition of foreign operations; making repatriation of cash tax-free for US tax purposes may make currently cost-prohibitive dispositions more likely to occur.
Observations and Likely Next Steps
The Framework is a very high-level outline with few details. Further, it can be expected that the political process will result in many changes before final legislation is enacted and, indeed, it is possible that, in the current political climate, no significant tax reform legislation will be adopted. The congressional tax-writing committees will be working hard during the coming weeks (and possibly months) in developing detailed legislative language to implement the Framework’s high-level concepts. Reports indicate that the House Ways and Means Committee plans to mark-up tax reform legislation by the end of October, with the goal of passage of a tax reform bill in mid-November, followed by approval by the Senate, and the hope of signing final legislation by year-end—though this timing is both aggressive and non-binding. As the details are filled in, hard choices will have to be made in order to fit a tax reform package within any realistic budget parameters, and many technical, timing and transitional issues will have to be addressed.
McDermott’s Corporate and Tax teams are closely monitoring activity in this area and are advising clients on potential impacts and planning responses. We will continue to provide general tax reform updates as circumstances warrant as well as more detailed examinations of specific aspects of tax reform.
State and Local Tax Aspects of Republican Tax Reform Framework
The White House and Republican congressional leadership released an outline on September 27, 2017, to guide forthcoming legislation on federal tax reform. The states conform to the federal tax laws to varying degrees and the extent to which they will adopt any federal changes is uncertain. This article outlines some of the key areas—individual taxation, general business taxation and international taxation—with which the states will be concerned as details continue to unfold.
As discussed elsewhere in this newsletter from a federal tax perspective, on September 27, 2017, the White House and Republican congressional leadership released a nine-page outline (Framework) to guide the coming legislative effort on comprehensive tax reform. The Framework offers few surprises and leaves critical details open, but it is likely to be the starting point as Congress addresses federal tax reform issues in the coming months. The states conform to the federal tax laws to varying degrees and the extent to which they will adopt any federal changes is uncertain. This article outlines some of the key areas with which the states will be concerned.
The compression of tax brackets from seven to three and the reductions in individual income tax rates will not have an immediate impact on the states, but the increased standard deduction amount could affect state revenues.
The Framework indicates that there will be a broader use of indexation throughout the Internal Revenue Code, and this would affect the state income tax base to the extent that states choose to conform to this concept.
The elimination of an income tax deduction for state and local taxes would dramatically affect the impact of those taxes on individual taxpayers. For many individuals, this is the largest itemized deduction that they take. A loss of deductibility would obviously increase the out-of-pocket burden of state taxes on individuals and produce political pressures in high-tax states to lower their rates. It would also eliminate tax planning involving the prepayment of January 15 estimated state income tax payments in December of the preceding year.
The Framework proposes to repeal the federal estate and generation-skipping transfer taxes (although not the gift tax). States that impose estate taxes that are based on the federal estate tax or the federal taxable estate would have to draft new estate tax statutes if they planned to continue to impose an estate tax. States might also have to reconsider their estate tax rates because the impact of the state estate tax would no longer be offset by it being deductible in calculating the federal taxable estate. This would increase the burden of state estate taxes and might lead to pressure to lower those taxes.
General Business Taxation
The proposed reduction in the corporate income tax rate would not have an immediate effect on the states, but the proposed reduced tax rates for income from pass-through entities could because any federal legislation would include adjustments to prevent abuses of the use of pass-through entities by wealthy individuals and investors. These adjustments could lead to a recharacterization of certain income received from flow-through entities and this recharacterization could have state and local tax consequences because states and localities often tax or apportion different types of income differently.
The Framework includes a full deduction for the cost of certain capital expenses by businesses for at least a five-year period. Related to that would be limitations (as yet unspecified) on deducting interest payments. In the past, many states have refused to adopt federal accelerated depreciation rules, reasoning that these were special incentives that were unrelated to the calculation of actual net income. Full expensing would be the ultimate manifestation of accelerated depreciation, and it is likely that some states would decide to decouple from it. If they did, logic would indicate that they would also decouple from limitations on deducting interest, but whether logic would prevail remains to be seen. Depreciation has the effect of reducing taxes over the property’s recovery period. The state and local tax impact of depreciation deductions is affected by varying apportionment factors in different states over the recovery period. In a full expensing regime, the state and local tax benefit would depend entirely on a company’s apportionment factors for the year in which the property was placed in service.
President Trump has announced that he would like to close the “carried interest loophole.” This refers to income received by managers of hedge funds and other partnerships, and limited liability companies that is disproportionate to their capital investments. This would have the effect of converting investment income to business income. States often apportion investment income of a multistate business differently from business income, so any such change could affect the managers’ apportionment factors. It could also subject carried interest income to special state and local taxes on business income such as the New York City tax on unincorporated business income. (There is now a statutory exemption from the New York City tax for carried interest income, which McDermott was instrumental in drafting, but that may be overridden by any forthcoming federal change.)
The Framework would exempt from tax 100 percent of dividends received from foreign subsidiaries, defined as being companies in which a US parent owns at least 10 percent of the stock. There would be a transition tax on currently accumulated foreign earnings under a deemed repatriation model, using a bifurcated rate. Here, too, the states would have to decide whether to conform to the federal approach. Many states have a full or partial deduction for dividends received from subsidiaries and the states would have to consider the extent to which they would conform to the new federal approach.
Observations and Likely Next Steps
The Framework is a very high-level outline with few details. The old saying that “the devil is in the details” is even more important in the tax area than it is generally. Further, it can be expected that the political process will result in many changes before final legislation is enacted and, indeed, it is possible that, politics being what they are, no significant tax reform legislation will be adopted. The congressional tax-writing committees will be hard at work during the coming months in developing detailed legislative language to implement the Framework’s high-level concepts. As these details are filled in, hard choices will have to be made in order to fit a tax reform package within any realistic budget parameters. Many technical, timing and transitional issues will have to be addressed.
It is likely that state legislatures will hold up on any changes until federal changes are finalized. When that happens, however, the legislatures may move quickly and there may not be much time for input by affected taxpayers. Accordingly, companies and individuals should be thinking about how federal changes might affect them.
The McDermott federal and state and local tax teams are closely monitoring activity in this area and are advising clients on potential impacts and planning responses. We will continue to provide general tax reform updates as circumstances warrant as well as more detailed examinations of specific aspects of tax reform.
Grecian Magnesite Mining v. Commissioner: Foreign Investor Not Subject to US Tax on Sale of Partnership Interest
Kristen E. Hazel | Sandra P. McGill
On July 13, 2017, the US Tax Court (TC) issued its opinion in Grecian Magnesite Mining v. Commissioner, 149 TC 3, holding that a foreign corporation was not subject to US federal income tax on gain from the sale of an interest in a partnership that is engaged in a US trade or business. Taxpayers had been anxiously awaiting the court’s decision in this case. Taxpayers were particularly interested to learn how the court would resolve what appeared to be a conflict among tax authorities. In reaching its decision, the court resolved the conflict, criticizing and declining to follow a 25 year old revenue ruling, Revenue Ruling (Rev. Rul.) 91-32, in which the Internal Revenue Service (IRS) considered analogous fact patterns and reached a contrary conclusion.
Under the facts of Rev. Rul. 91-32, a foreign partner realized a gain on the disposition of an interest in a partnership that conducted a US trade or business constituting a “permanent establishment (PE)” in the United States under tax treaty standards. The ruling concluded the gain was taxable to the foreign partner to the same extent as had the partnership itself disposed of all of its US assets at fair market value. The IRS reasoned that since the foreign partner had a US trade or business by reason of section 875(1) (which attributes the US trade or business of a partnership to its partners), the partner’s gain on the sale of the partnership interest was attributable to the foreign partner’s trade or business in the United States and therefore was US-source income under section 865(e)(2). The IRS further concluded that the partner’s US-source gain on the sale of its partnership interest constituted “effectively connected income” because the partnership interest was an asset used or held for use in the partner’s US trade or business (within the meaning of the asset-use test of section 864(c)(2) and Treas. Reg. § 1.864-4(c)(2)). The IRS provided very little authority for this position simply stating that “the value of the trade or business activity of the partnership affects the value of the foreign partner’s interest in the partnership.”
For years, taxpayers questioned the reasoning and conclusions reached in Rev. Rul. 91-32. Nevertheless, the Obama Administration proposed codifying the principles of Rev. Rul. 91-32 and the IRS and the US Department of the Treasury (Treasury) have identified a plan for guidance under Section 864 implementing Rev. Rul. 91-32 relating to sales of certain partnership interests in their 2016-2017 Priority Guidance Plan.
Grecian Magnesite Mining Decision
Against this backdrop, the Tax Court considered the Grecian Magnesite Mining case. The taxpayer, Grecian Magnesite Mining (GMM), a Greek corporation, was a partner in Premier Magnesia, LLC (Premier), a US partnership. Premier was engaged in a US trade or business, and GMM paid US federal income tax on its allocable share of income from Premier’s US trade or business.
In 2008 and 2009, Premier redeemed GMM’s entire interest for $10.6 million and GMM realized $6.2 million of gain. On the advice of its accountant, GMM did not pay US federal income tax on the gain. The IRS issued a notice of deficiency, taking the position that the entire $6.2 million was subject to US federal income tax. At trial, the parties agreed that $2.2 million of the gain was due to US real property interests (USRPI) held by GMM, and was thus subject to US federal income tax under Section 897(g) which expressly provides that gain from the sale of a partnership interest that is attributable to US real property interests held by the partnership is subject to US tax. Thus, the issue at trial was whether the remaining $4 million of gain attributable to US trade or business assets, other than US real property, was subject to US federal income tax.
To determine whether the redemption consideration was subject to tax in the United States, the Tax Court first analyzed whether the partnership should be treated as an aggregate or as an entity. Under an aggregate theory, which the IRS advanced consistent with its ruling in Rev. Rul. 91-32, the transaction would be treated as a disposition of an aggregate interest in the partnership’s underlying property. Under an entity theory, which GMM advanced, GMM would be treated as selling the partnership interest itself.
The Tax Court agreed with GMM that an entity theory should prevail based on the plain language of the partnership provisions of the Internal Revenue Code and thus GMM should be treated as having disposed of its partnership interest, which is a capital asset. In reaching this conclusion, the Tax Court first referred to section 736(b)(1), which provides that payments made in liquidation of the interest of a retiring partner in exchange for that partner’s interest in partnership property are treated as a distribution by the partnership to the partner. The Tax Court next referred to section 731(a), which provides that gain or loss recognized on the distribution by a partnership to a partner is treated as gain or loss from the sale or exchange of the partnership interest of the distributee partner. Finally, the Tax Court referred to section 741, which provides that gain or loss recognized on the sale or exchange of a partnership interest is considered as gain or loss from the sale or exchange of a capital asset. Based on this analysis, the Tax Court determined that the complete redemption of a partner’s interest in a partnership (such as the redemption by Premier of GMM’s partnership interest in Premier) is treated as a sale of a capital asset, except to the extent an exception applies. An example of an exception to this general rule, section 897(g) discussed above, applies an aggregate approach to that portion of the partner’s interest in the partnership attributable to US real property interests (USRPIs). Pursuant to section 897(g), the $2.2 million of gain allocable to the USRPI was taxable. To the extent of the gain realized by GMM in excess of the gain attributable to GMM’s proportionate share of Premier’s USRPIs, however, the court held that GMM sold a singular capital asset—the partnership interest—rather than GMM’s proportionate share of the underlying assets of the partnership.
Having determined how to treat the sale, the Tax Court then addressed whether the sale was subject to US federal income tax. Under the facts of the case, the gain from the sale of GMM would be subject to US federal income tax if it was attributable to Premier’s US office. Under Section 864, the income would be attributable to Premier’s US office if: (1) the US office was a material factor in the production of the income and (2) the US office regularly carried on activities of the type from which the income was derived. The Tax Court determined that neither of these conditions was met, and thus the $4 million of gain was not subject to US federal income tax.
The Tax Court’s decision is in conflict with the conclusions reached in Rev. Rul. 91-32. In rendering its decision, the Tax Court therefore analyzed the level of deference that should be afforded to the revenue ruling. The Tax Court was highly critical of the ruling, noting that “[i]ts treatment of the partnership provisions . . . is cursory in the extreme” and criticizing other parts of the ruling as well. Thus, the Tax Court afforded the ruling no deference.
The decision confirms the general rule of section 741: disposition of a partnership interest is treated as the disposition of a capital asset; thus, the entity theory applies. The decision also confirms that in general the principles that apply to tax a non-US person on the disposition of a capital asset apply to the disposition of a partnership interest just as those principles apply to the disposition of any other capital asset.
The IRS has yet to indicate whether it will acquiesce to the Grecian Magnesite Mining decision. The Tax Court entered final decision in the case on September 21, 2017, and the IRS has 90 days from this date to appeal.
The implications of the Tax Court’s decision in Grecian Magnesite Mining will depend in part on whether the decision is appealed and, if appealed, sustained. In addition, it is possible that Treasury and the IRS could promulgate regulations to reinstate the principles of Rev. Rul. 91-32. As previously noted, the 2016-2017 Priority Guidance Plan released by the IRS and Treasury identifies a plan for guidance under section 864 to implement Rev. Rul. 91-32. Finally, it is possible that Congress could enact legislation codifying Rev. Rul. 91-32.
Despite this uncertainty, taxpayers who followed the guidance of Rev. Rul. 91-32 in an open tax year might consider filing a protective amended return that follows the Tax Court’s guidance.
Finally, of course, the decision should be considered in any structures involving non-US partners. For example, certain private equity structuring decisions may be affected by the increased likelihood that a foreign partner will not be subject to US tax on gain from the sale of an interest in a partnership that has a US trade or business. Private equity funds commonly structure investments in partnerships with a US trade or business through a “blocker” corporation to protect foreign investors from recognizing ECI and US tax-exempts from recognizing unrelated business taxable income (UBTI). The decision of whether to use a US or foreign blocker for a particular investment often takes into consideration any difference in tax treatment between the two during the period the investment is held, and on disposition of the investment. To the extent Rev. Rul. 91-32 or its principles no longer apply, a foreign blocker has a tax advantage on disposition in that its gain on the sale of a partnership interest with a US trade or business would not be subject to US tax.
The IRS Attacks Taxpayers’ Section 199 (Computer Software) Deductions
Taxpayers’ section 199 computer software deductions are under attack! The issue is being coordinated within the IRS, and at Exam and Appeals taxpayers are running into a brick wall. A resource-starved IRS is trying to treat all similarly (and not so similarly) situated taxpayers uniformly. Accordingly, there is an effort to resolve all cases on the same basis, despite factual differences.
The IRS’s hardline approach has spurred substantial controversy. Indeed, there are presently three docketed court cases relating to the section 199 computer software deduction. See Vesta Corp. v. Comm’r, Tax Court docket No. 26847-16; BATS Global Mrkts Hldgs, Inc. v. Comm’r, Tax Court docket No. 1068-17; and Bloomberg LP v. Comm’r, Tax Court docket No. 375-17. Moreover, we are aware of numerous other cases under audit and at IRS Appeals in which taxpayers are pushing back against the IRS’s unreasonable position. Until a court decides this issue, we can expect a continuing increase in controversy in this area.
In 2004, Congress enacted section 199 to encourage taxpayers to manufacture products domestically, with an aim of improving US employment opportunities. The deduction, however, is not available if the taxpayer is merely providing services. The line between what is considered a service as opposed to “production” is sometimes unclear. Section 199 by its terms applies to the production of “any computer software.” The regulations, however, provide a narrow interpretation of the statute that acts to restrict the availability of the deduction.
Section 199(a) provides a deduction equal to 9 percent of the lesser of: (1) “qualified production activities income” (QPAI) of the taxpayer for the year; or (2) taxable income. (Section 199(b) limits the deduction to 50 percent of the wages that are attributable to the domestic production activities.) Section 199(c) defines QPAI as the taxpayer’s “domestic production gross receipts” (DPGR) for the year less the costs of goods sold and expenses allocable to DPGR. DPGR is further defined as gross receipts of a taxpayer that are derived from the lease, rental, license, sale, exchange or other disposition (collectively “disposition”) of “qualifying production property” (QPP), which was “manufactured, produced, grown, or extracted” (MPGE) by the taxpayer in whole or in significant part within the United States. QPP includes “any computer software.”
Section 1.199-3(i)(6)(i) of the US Department of Treasury regulations 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 United States. Section 1.199-3(i)(6)(ii) provides, however, that gross receipts derived from customer and technical support, telephone and other telecommunication services, online services (such as internet access and online banking services), and other similar services do not constitute gross receipts derived from a disposition of computer software. Recognizing that a taxpayer can make a disposition of software by placing it on a tangible medium (a disc) or by providing the customer with access to the software while connected to the internet or private communications network, the regulations include an exception to this rule in instances where, under specified conditions, 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). Such 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 test” are met.
The self-comparable test is satisfied if a taxpayer derives, on a regular and ongoing basis in the taxpayer’s business, gross receipts from the disposition of computer software to customers that are unrelated persons which computer software: (1) has only 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 such customers affixed to a tangible medium or by allowing the customers to download the computer software from the internet.
The third-party comparable test is satisfied if another person derives, on a regular and ongoing basis in its business, gross receipts from the disposition of substantially identical software (as compared to the taxpayer’s online software) to its customers pursuant to a tangible medium or via a download from the internet. “Substantially identical software” is defined as 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 line between what constitutes a non-deductible service and a deductible disposition of computer software is becoming increasingly blurred given the pace of technological advances affecting the development, application and use of computer software since section 199 was enacted in 2004. What was traditionally considered a “computer” is no longer the sole province of software. Today we find sophisticated software in phones, cars, television cable boxes and even our refrigerators. Moreover, the way in which we interact with the world has changed dramatically. Go to any restaurant and count the number of people that are staring at their phones, texting and looking up reviews of the restaurant on Google.
One of the areas that has seen substantial change is online access to computer software. Unlike in 2004, today we spend most of our time shopping, paying bills and banking online through our computers, smart phones and tablets. The amount invested each year by US businesses to develop online software that keeps them connected with consumers, employees and suppliers is in the billions of dollars.
The relevant regulations, however, deny a deduction for this investment unless the taxpayer satisfies one of the two aforementioned “comparables” conditions—provisions that do not reflect technological advances. For example, the current trend in software development is focused on a closed-system with access only through the “cloud.” Because there is no equivalent computer software available on a disc or by download, under the IRS’s formulation, all cloud-based computer software, despite being produced in the United States, might be denied the section 199 benefit.
Moreover, the IRS has interpreted the regulations quite restrictively. It is clear that the IRS does not like section 199, and will interpret the provision as narrowly as possible to deny deductions to taxpayers.
The Banking App GLAM
A good example of the disconnect between Congress’s purpose in enacting the section 199 software deduction and the IRS’s implementation is the so-called “Banking App GLAM.” In 2014, the IRS published AM 2014-008, in which it concluded that a bank did not derive DPGR when the taxpayer permitted its customers to download a free “app” that allows its customers to interact and access its online banking services.
The taxpayer provided customer banking services, and interacted in various ways, including online through its website and an app it developed. Through its app, customers could access their bank accounts, transfer and wire funds and deposit checks. From the bank’s perspective, all of the actions were the same regardless of whether executed in person or virtually—the bank’s internal computers would process the transactions. Accordingly, for the app to have its intended functionality, it had to be connected to the bank’s network via the internet; the app had very little, independent functionality.
Customers who used the app were required to accept the terms and conditions of use under the bank’s nonexclusive, limited license. The app was free to download and to use, and the bank earned revenue from activities that customers performed with the app, for example, wire transfer transactions. For financial reporting purposes, the taxpayer recognized the revenue generated through the app as banking services revenue, and ascribed no portion of the revenue to the licensing of the app. Other banks have similar apps that allow similar banking functions to be performed.
The IRS determined that the app fit squarely within the definition of online software described in section 1.199-3(i)(6)(iii), pointing out that the app did not operate unless it was connected to the internet. The IRS interpreted the regulations as implying that the mere downloading of the app by a customer of the taxpayer is not a “disposition” for section 199 purposes. In the GLAM, the IRS also determined that the bank did not derive any gross receipts from the deployment of the app. Lastly, the IRS determined that the bank satisfied neither the self-comparable test nor the third-party comparable test.
The IRS’s conclusions are incorrect for at least three reasons:
- A disposition occurs when an app is downloaded to a customer’s device: The IRS’s position is too broad, and not supported by the statute or legislative history. Downloading an app onto a customer’s device should be considered a “disposition.” In addition, there is no authority to require that downloaded computer software have free-standing functionality.
- Taxpayers earn revenue from the deployment of apps: Whether a taxpayer directly or indirectly charges for the software customer’s use should not matter. The key question should be whether the taxpayer can reasonably and rationally allocate revenue to the downloaded computer software. Requiring a direct exchange (money for software) is very formalistic and does not comport with the evolving nature of e-commerce. Indeed, commercial enterprises give items away all of the time to entice customers and support their businesses.
- The banking app satisfies the third-party comparables test: The IRS concluded in the Banking App GLAM that the taxpayer failed to satisfy the third-party comparable test, finding that from the customer’s perspective the app provided a different functional result, and did not have substantial overlap in purpose with the third-party comparables. For example, the IRS determined that the taxpayer’s customers used the online software to order individual banking services, whereas the third-party comparable used the software to provide banking services to multiple customers. The IRS’s position is untenable. The taxpayer’s app was substantially the same product (a software portal) and provided the same functionality (access to banking services) as the third-party comparable.
The Banking App GLAM underscores the IRS’s narrow and antiquated approach to the section 199 deduction for computer software.
Defend Your Deduction!
To defend your section 199 computer software deduction, make strategic decisions. First, argue the facts to distinguish your situation from the published guidance and the examples in the regulations. Focus on the technology, and get into the details. Second, argue the law. Published guidance such as the Banking App GLAM is not binding authority and is merely a position taken by the IRS in that specific case. It should not be afforded any deference. Lastly, argue tax policy. Congressional intent should drive the result. The regulations go far beyond what Congress intended. By providing the narrowest of interpretations of the statute, the IRS is thwarting the objectives of the law and taxpayers are being left caught short.
The IRS has substantial hazards of litigation in advancing the extreme positions we are seeing. Depending upon the size of the benefit from claiming the section 199 deduction, strategically it may make sense to claim the benefit and battle with the IRS on Exam and at Appeals pending a favorable court decision.