The domestic production activity deduction under Section 199 of the Internal Revenue Code of 1986, as amended (hereinafter "Section 199"), provides a deduction equal to nine percent of the lesser of taxable income or income attributable to certain qualified production activities. For the 2016 fiscal year, this deduction was estimated as a $15.8 billion tax expenditure, the third largest corporate tax expenditure behind only the deferral of income on certain foreign earnings and accelerated depreciation. (1) Not surprisingly, with the large tax expenditure comes significant scrutiny from the Internal Revenue Service (IRS), particularly with respect to deductions claimed for making software available to customers.
The IRS has taken a very restrictive view of the type of software and software-related transactions that qualify for the Section 199 deduction, a view that is unwarranted by, and inconsistent with, the language of the statute and the well-established purpose of Section 199. This article begins with a brief discussion of the history of Section 199. The second section describes the IRS' current position on the eligibility of software-related revenues to qualify as domestic production gross receipts, a key input in computing the amount of the Section 199 deduction. This section also includes a discussion of the IRS' most recent articulation of its position, a heavily redacted IRS Chief Counsel Advice (CCA 201724026 (June 6, 2017)). The third section discusses potential paths forward for taxpayers that have claimed a Section 199 deduction with respect to their software activities but are concerned that the deduction may be disallowed on audit, or at Appeals, based on the current IRS position.
History of Section 199
Congress has long recognized that many production activities are significantly more expensive in the United States than in foreign jurisdictions. A combination of higher labor costs and more expensive materials has made it difficult for U.S.-based operations to compete against foreign enterprises. Congress has enacted numerous provisions to attempt to stimulate domestic production, including various tax credits, accelerated depreciation, and bonus depreciation.
Much of Congress's past effort also focused on leveling the playing field with foreign competition. Over the years, Congress attempted a variety of approaches to make U.S. industry more competitive globally. Those efforts included the Domestic International Sales Corporation (DISC) regime, the Foreign Sales Corporation (FSC) regime, and the Extraterritorial Income (ETI) regime. Each was designed to give domestic producers tax incentives that would allow them to compete more effectively with their offshore counterparts. However, none was viable in the long term, as each was successfully challenged by the European Union (or its predecessor).
Faced with the threat of $4 billion of retaliatory tariffs after the United States' most recent defeat before the World Trade Organization, Congress repealed the ETI regime and replaced it with what is now Section 199. The Senate Finance Committee, in reporting on its version of the ETI repeal, stated:
The Committee understands that simply repealing the ETI regime will diminish the prospects for recovery from the recent economic downturn by the manufacturing sector. Consequently, the Committee believes that it is necessary and appropriate to replace the ETI regime with new provisions that reduce the tax burden on domestic manufacturers, including small businesses engaged in manufacturing. (2)
Statements by the relevant Congressional committees on the proposed legislation that would become Section 199 are evidence that Congress's intent in enacting the provision was to stimulate job creation through lowering the overall tax burden on domestic manufacturing activities. For example, in its Report on the JOBS Act, the Senate Finance Committee stated: "The Committee believes that creating new jobs is an essential element of economic recovery and expansion, and that tax policies designed to foster job creation also must reverse the recent declines in manufacturing sector employment levels." (3) The House Ways and Means Committee similarly stated in its report:
The Committee also believes that it is important to use the opportunity afforded by the repeal of the ETI regime to reform the U.S. tax system in a manner that makes U.S. businesses and workers more productive and competitive than they are today. To this end, the Committee believes that it is important to provide tax cuts to U.S. domestic manufacturers and to update the U.S. international tax rules, which are over 40 years old and make U.S. companies uncompetitive in the United States and abroad.
The Committee believes that creating new jobs is an essential element of economic recovery and expansion, and that tax policies designed to foster economic strength also will contribute to the continuation of the recent increases in employment levels. To accomplish this objective, the Committee believes that Congress should enact tax laws that enhance the ability of domestic businesses, and domestic manufacturing firms in particular, to compete in the global marketplace. The Committee believes that a reduced tax burden on domestic manufacturers will improve the cash flow of domestic manufacturers and make investments in domestic manufacturing facilities more attractive. Such investment will create and preserve U.S. manufacturing jobs. (4) Finally, the Conference Report, which reported on Congress's final version of Section 199, stated:
The conferees recognize that manufacturers are a segment of the economy that has faced significant challenges during the nation's recent economic slowdown. The conferees recognize that trading partners of the United States retain subsidies for domestic manufacturers and exports through their indirect tax systems. The conferees are concerned about the adverse competitive impact of these subsidies on U.S. manufacturers. (5) In short, Section 199 was designed to provide incentives to keep jobs at home and encourage expansion of domestic employment and at the same time to remain compliant with the U.S.'s existing trade and treaty obligations. To do so, Congress had to eliminate the international component of the earlier attempts, as those types of regimes had repeatedly failed in international courts. Instead, Congress enacted a broad-based, effective tax rate reduction for all domestic production activities that result in a qualifying disposition of a product manufactured, produced, grown, or extracted (MPGE) in the United States. Any effort to interpret Section 199 should do so with its fundamental purpose in mind.
A PRIMER ON SECTION 199 CALCULATION
Determining whether a taxpayer qualifies for the Section 199 deduction and, if so, the amount of the deduction is a complicated endeavor. At its most basic level, the Section 199 deduction is nine percent of the lesser of the taxpayer's taxable income or qualified production activities income (QPAI). (6) For this purpose, taxable income is determined pursuant to Section 63 and without regard to Section 199. This means that the Section 199 deduction is capped at nine percent of the QPAI amount (i.e., the income from the manufacturing activities that Congress intended to incentivize), unless the QPAI amount exceeds the taxable income of the taxpayer, in which case the lower taxable income amount is used to calculate the deduction. As a simple example, assume a taxpayer operates two divisions, one of which generates one hundred dollars of QPAI and the other of which generates forty dollars of service income. In this example, the Section 199 deduction would be limited to nine percent of the one hundred dollars of QPAI. On the other hand, if the service division were to lose forty dollars instead, the Section 199 deduction would be limited to nine percent of the sixty dollars of the net taxable income generated by the taxpayer, even though the QPAI was significantly larger than the taxable income.
QPAI often determines the amount of the Section 199 deduction, particularly for single-line-of-business taxpayers that do not have a significant amount of non-QPAI-generating activity. QPAI is the excess of the taxpayer's domestic production gross receipts (DPGR) over the sum of (i) the cost of goods sold (CGS) that are allocable to such DPGR; and (ii) other expenses, losses or deductions, which are properly allocable to such DPGR. (7) DPGR is the gross receipts of the taxpayer derived from certain qualifying activities, the most important of which includes the rental, license, sale, exchange, or other disposition of qualifying production property that was MPGE by the taxpayer in whole or in significant part within the United States. (8)
There is another important limitation on the amount of the Section 199 deduction: the deduction cannot exceed fifty percent of the taxpayer's W-2 wages for the year. For purposes of calculating the fifty percent wage limitation, the term "W-2 wages" refers to the sum of the aggregate amount the taxpayer is required to include pursuant to Sections 6501(a)(3) and (8) on the W-2s for its employees that are allocable to DPGR. (9) This wage limitation produces disparate impact depending upon the industry of the taxpayer. For example, a taxpayer in a capital-intensive industry may generate significant QPAI, without incurring any material labor expenses. In other labor-intensive industries, the W-2 limitation will have no impact on the amount of the deduction. This computation confirms that the Section 199 deduction should be viewed as a broad-based incentive for labor, which is fitting for a provision enacted in the JOBS Act.
Putting this all together, for a corporate tax-payer solely engaged in the MPGE of a widget, the Section 199 deduction would be nine percent of the revenues from selling widgets, less the cost of goods sold for such sales...