Sec. 199 final regs. affect online software and advertising.

• Author: Valestin, Laura

Sec. 199 generally provides a deduction for qualifying domestic production activities equal to 9% (3% for tax years beginning in 2005 or 2006 and 6% for tax years beginning 2007-2009) of the lesser of the taxpayer's (1) qualified production activities income for the tax year or (2) taxable income, determined without regard to Sec. 199.

On March 19, 2007, Treasury issued final regulations under Sec. 199 (TD 9317) regarding online software and the treatment of advertising income. The final regulations, which differ slightly from the temporary and proposed regulations under Sec. 199 issued 10 months earlier, generally are effective for tax years beginning after March 19, 2007, but taxpayers may elect to apply them retroactively to tax years beginning after 2004 (Sec. 199's effective date) and before March 20, 2007.

The final regulations affect taxpayers that produce computer software and provide access to it for a customer's direct use while connected to the Internet or any other public or private communications network.

Online Software Safe-Harbor Exceptions

Shortly after Sec. 199's enactment, the IRS and Treasury issued Notice 2005-14 to provide taxpayers with interim guidance in computing the new deduction. (For a discussion, see Gibbs and Rathnau, Tax Clinic, "Notice 2005-14 Offers Sec. 199 Guidance," TTA, June 2005, p. 339.) That guidance set forth the general position that the use of computer software online by customers is a service, and not a lease, rental, license, sale, exchange or other disposition of the software. Accordingly, gross receipts derived from such customers do not constitute domestic production gross receipts (DPGR), because they are not attributable to a qualifying disposition of the software.

In subsequent guidance (i.e., the temporary regulations and, most recently, the final regulations) regarding the treatment of computer software under Sec. 199, Treasury and the IRS have continued to maintain the position that the use of computer software online by customers is a service. However, such guidance also has included two safe-harbor exceptions that, if met, treat gross receipts derived from the use of computer software online by customers as being derived from a qualifying disposition of the software (and, thus, treat such receipts as DPGR).

Safe harbor #1: Under the first safe-harbor exception, Kegs. Sec. 1.199-3(i)(6)(iii)(A), gross receipts derived from providing computer software for customer use online will be...