IRS concludes that banking app does not qualify for sec. 199 deduction.

• Author: Kowal, Christine A.

Subject to a W-2 wage limitation, the Sec. 199 deduction is computed as a percentage (generally, 9% for 2010 and thereafter) of the lesser of a taxpayer's qualified production activities income (QPAI) or taxable income.

In general, a taxpayer's QPAI equals the excess of its domestic production gross receipts (DPGR) over (1) the sum of the cost of goods sold allocable to such receipts and (2) other expenses, losses, or deductions that are properly allocable to such receipts. DPGR are the gross receipts of the taxpayer derived from any lease, rental, license, sale, exchange, or other disposition (qualified disposition) of qualifying production property (QPP) that was manufactured, produced, grown, or extracted (MPGE) by the taxpayer in whole or in significant part within the United States. QPP includes tangible personal property, any computer software, and sound recordings.

Online Software

Computer software provided to customers for their direct use while connected to the internet or other public or private communications network, collectively known as online software, is classified as a service provided to customers. Accordingly, because providing access to online software is classified as the provision of services, gross receipts attributable to the use of online software generally are not considered to be derived from a qualified disposition of software.

However, the Sec. 199 regulations provide two exceptions that, if satisfied, recharacterize the provision of online software as a qualified disposition of the software for Sec. 199 purposes.

Under the first exception (the self-comparable exception), gross receipts derived by a taxpayer from providing customers with access for their direct use of online software are treated as being derived from a qualified disposition of computer software--assuming all other Sec. 199 qualification requirements are met--if the taxpayer also derives on a regular and ongoing basis in its business gross receipts from a qualified disposition to customers (that are not related persons) of computer software that has (1) only "minor or immaterial differences" from the online software and (2) has been provided to such customers affixed to a tangible medium or by download from the internet (Regs. Sec. 1.199-3(i)(6)(iii)(A)).

Under the second exception (the third-party comparable exception), gross receipts derived by the taxpayer from providing access to online software for customers' direct use are treated as being...