By Connie Cheng, Managing Director, BDO National Tax Office
Though commonly referred to as the “domestic manufacturing deduction,” the section 199 tax deduction isn’t just for traditional manufacturers. An often-overlooked provision of the section 199 deduction allows taxpayers that develop software to qualify for the tax incentive as well. While the section 199 deduction has traditionally applied to software developers that offer their products embedded in tangible media (such as a CD-ROM or hardware) or downloaded from the internet, it can also apply to taxpayers that derive income from providing customers with access to online software via the internet. This is especially important as the prevalence of online software has grown exponentially in recent years through mechanisms such as such as Software-as-a-Service (“SaaS”) and Platform-as-a-Service (“PaaS”). Further, taxpayers that are in non-software industries but still develop software and provide such software to customers in some manner may also benefit from the section 199 deduction. Thus, a taxpayer does not have to be a “traditional” software developer to qualify for the deduction.
While broad in scope, the section 199 rules applicable to software can be complex for taxpayers to apply in practice. This article provides a brief overview of the section 199 deduction and highlights some key considerations for taxpayers involved in developing software.
Section 199 Overview
The section 199 deduction is a permanent tax deduction and is computed as the least
of the following three amounts:
- 9 percent of Qualified Production Activities Income (“QPAI”);
- 9 percent of taxable income (after any net operating loss deduction); or
- 50 percent of the taxpayer’s W-2 wages allocable to qualifying activities.
In essence, QPAI is a taxpayer’s net taxable income derived from qualifying section 199 activities, defined as domestic production gross receipts (“DPGR”) less allocable cost of goods sold, if any, less allocable expenses, losses or deductions. DPGR includes, among other items, gross receipts derived from any lease, rental, license, sale, exchange, or other disposition of qualifying production property (“QPP”) that is manufactured, produced, grown, or extracted by the taxpayer in whole or in significant part within the U.S.
For purposes of the section 199 deduction, QPP includes computer software if it meets certain criteria. Under section 199 regulations, computer software is broadly defined to include any program, routine or sequence of machine-readable code designed to cause a computer to perform a desired function or set of functions, along with the documentation required to describe and maintain that program or routine. Computer software also includes the machine-readable code for video games; for equipment that is an integral part of other property; and for typewriters, calculators, adding and accounting machines, copiers, duplicating equipment, and similar equipment, regardless of whether the code is designed to operate on a computer.
Note that the manner in which the taxpayer provides computer software to its customers is a critical factor in determining whether the related gross receipts may qualify as DPGR. In particular, section 199 regulations narrow the definition of software to include only software provided to customers on a tangible medium (such as a disk or a piece of hardware) or through an internet download. Generally, software that is accessed by customers via the internet or any other public or private communications network (e.g., SaaS) is treated as a non-qualifying service ineligible for the deduction, unless one of two safe harbors applies. These safe harbors look to whether either the taxpayer or a third party makes essentially the same software available on a disk (or another tangible medium) or through an internet download. The “other” software must be substantially identical to the taxpayer’s online software in terms of functionalities and features. Thus, any taxpayer seeking to claim the section 199 benefit with respect to software must show not only that it produced the software in the U.S., but also that the software is provided to customers either via a disk or an internet download (by either the taxpayer or a third party).
On the flip side, section 199 regulations specify that electronic books available online or for download do not qualify as computer software. In other words, a downloadable e-reading application could qualify, but the books that run on the app would not. Computer software also does not include any data or information base unless the data or information base is in the public domain and incidental to a computer program. A proprietary or copyrighted information base or data only qualifies if it does not significantly contribute to the underlying cost of the program—for example, a dictionary used for spell-check in a word processing program.
Notwithstanding the online software safe harbors mentioned above, gross receipts derived from services such as customer and technical support, telephone and other telecommunication services, and online services (such as internet access services or access to online electronic books) are generally considered non-qualifying as well.
Commonly Asked Questions Regarding Software and Section 199
How much of the software needs to be developed in the United States?
As noted above, section 199 rules require that software be developed “in whole or in significant part” within the U.S. Thus, taxpayers that outsource a portion of their software development overseas may still be able to qualify for the deduction. Depending on the relative significance of the overseas development as compared to the U.S. development, taxpayers may be able to qualify all of the gross receipts derived from the disposition of the software, including any portion attributable to overseas development.
A taxpayer meets the “in significant part” test under one of two methods: 1) A 20 percent safe harbor analysis based on a quantitative comparison of costs incurred to develop software in the U.S. over total costs; and 2) a more subjective, facts-and-circumstances-based analysis that looks to various factors, such as the value added by the taxpayer’s U.S. activities, to determine whether the taxpayer’s activities are substantial in nature. Under the first method, if 20 percent or more of production costs are incurred in the U.S., 100 percent of the gross receipts derived from the software qualifies. If a taxpayer is unable to meet the “in significant part” standard under either approach, it can “shrink back” the gross receipts to the portion attributable only to the U.S. development. The shrink back approach allows a taxpayer to claim the deduction on the portion of the gross receipts allocable to the qualifying component(s), thereby preserving the taxpayer’s ability to benefit from the deduction.
For instance, assume that a taxpayer incurs $100 to develop software in the U.S. This software is then embedded on hardware that the taxpayer purchases from an overseas manufacturer for $20 per unit. Assume that the software is embedded on 10 units, for a per-unit software cost of $10. To apply the quantitative 20 percent safe harbor mentioned above, the taxpayer should compare the cost of the U.S. software development of $10 per unit over the total cost to produce each unit of $30 (hardware of $20 plus software of $10). If this ratio exceeds 20 percent, the taxpayer meets the safe harbor and can qualify all of the proceeds from the sale of the unit as DPGR.
Similarly, taxpayers often embed software developed in the U.S. on hardware produced by a third party and/ overseas. A common misconception arising from this fact pattern is that a taxpayer can only qualify the software portion of the gross receipts. However, under the same “in whole or in significant part” rule described above, if the software component is significant enough in comparison to the final item of software combined with hardware, it is possible for the taxpayer to treat the gross receipts from the entire item—including the portion attributable to hardware—as qualifying.
What if the taxpayer uses third-party software developers?
Under section 199 regulations, a taxpayer that hires a contract developer to develop software in the U.S. may qualify for the deduction if they have the benefits and burdens of ownership over the activities undertaken by the third-party developer. While the regulations do not provide a bright-line test for determining which party has the benefits and burdens of ownership, some of the factors that may be critical in the analysis include determining which party retains ownership of the IP and which party bears the economic risk of the software development process. For purposes of making this determination, tax practitioners generally review any formal agreements between the taxpayer and the contract developers to obtain an understanding of the key terms and conditions of the arrangement. Furthermore, conducting interviews with company personnel familiar with the relationship between the taxpayer and the contract developer may be helpful.
If the taxpayer offers its software via online access only, how “substantially identical” must the other party’s software be to qualify for the safe harbor?
Section 199 regulations provide that substantially identical software has, from a customer’s perspective, the same functional result as the online software and a significant overlap of features or purpose with the online software. Apart from this explanation and several examples, the regulations do not provide additional specifics for determining how closely aligned the two software programs must be for the online software to qualify. As a starting point, it is important to understand the following issues:
- Who is the typical user/customer of the software?
- Is the software specifically geared towards a specific industry?
- What are the primary objectives of the software from the user’s perspective? What is the “end result” of the software?
Marketing materials, such as brochures or the company website, may be instrumental in assessing the key functionalities of the software at issue. As with the benefits and burdens issue discussed above, conducting discussions with company personnel to obtain an understanding of the taxpayer’s software, as well as any potential competitors in the taxpayer’s industry, can be a critical part of the analysis.
The section 199 rules addressing the qualification of computer software can be quite complex and require a detailed understanding of a taxpayer’s unique facts and circumstances. BDO’s Section 199 team has significant experience in assisting taxpayers with navigating these issues. For additional information or to discuss whether specific fact patterns may qualify for the incentive, please contact a member of our national team.
Connie Cheng is a managing director in BDO’s National Tax practice. She can be reached at email@example.com.