IRS Clarifies Application of Sec. 199 Rules for Qualified Film Producers
Despite its repeal for taxable years beginning on or after January 1, 2018, Sec. 199 remains an active and often contentious area between taxpayers and the IRS, particularly with respect to its application within the film and television industry. Since the enactment of the deduction in 2005, the IRS has issued several informal pieces of guidance addressing the availability of the Sec. 199 deduction for taxpayers that develop and broadcast programming content via television, cable and satellite networks. Most recently, the IRS released Rev. Rul. 2018-3, the first precedential ruling on this topic, specifically addressing the qualification of licensing fees derived by taxpayers in the film and television industry for purposes of Sec. 199. As will be further discussed below, the implications of this revenue ruling are generally taxpayer-favorable, and represent a reversal of a prior position taken by the IRS in several private letter rulings.
Overview of Sec. 199
Generally, the computation of the Sec. 199 deduction begins with the determination of a taxpayer’s domestic production gross receipts (DPGR). Treasury Regulations (Regs.) Sec. 1.199-3(a)(1)(ii) defines DPGR to include gross receipts derived from the lease, rental, license, sale, exchange, or other disposition of any qualified film produced by the taxpayer. A qualified film includes any motion picture film or video tape, as well as live or delayed television programming if no less than 50 percent of the total compensation relating to the production of the film is compensation for services performed in the United States by actors, production personnel, directors, and producers. Further, the qualified film must be produced by the taxpayer, meaning the taxpayer has the benefits and burdens of ownership over the film production activities, and the taxpayer’s film production activities must either meet a facts and circumstances-based substantial in nature test provided under Regs. Sec. 1.199-3(k)(6), or a quantitative safe harbor provided under Regs. Sec. 1.199-3(k)(7).
Importantly, DPGR must be determined on an item-by-item basis. This “item” requirement provides a taxpayer with its starting point for applying the Sec. 199 qualification requirements described above (e.g., the substantial in nature test or the quantitative safe harbor). Regs. Sec. 1.199-3(d)(1)(i) defines “item” as the property offered by the taxpayer in the normal course of the taxpayer’s business for disposition to customers, but only if the gross receipts from the disposition of such property qualify as DPGR. Generally, an item can still qualify for Sec. 199 even if certain components are produced outside of the United States and/or produced by a third-party, provided that the taxpayer contributes enough U.S.-produced content to the item. However, if the disposition of the item does not generate DPGR (e.g., because the portion produced by the taxpayer in the United States is insignificant), then taxpayers may apply the so-called “shrink-back rule” under Regs. Sec. 1.199-3(d)(1)(ii) to treat any qualifying component of the original item as the item for purposes of Sec. 199. The shrink-back rule therefore allows taxpayers to claim the portion of the gross receipts attributable to the qualifying component as DPGR.
Prior Guidance Related to Sec. 199 and Television Programming
The determination of the item in the context of the television programming industry has been a critical issue for taxpayers, as many programmers offer a combination of self-produced and third-party-produced content to their customers. If a taxpayer that offers a television package to customers comprised of both self-produced content and third-party-produced content can treat the entire programming package as the item, it can potentially qualify all of the fees derived from the license of the package, including any value ascribed to the third-party-produced content. On the other hand, if only the taxpayer’s self-produced content can be considered the item, the amount of DPGR would be capped at the allocable amount of the license fees attributable to the self-produced content only.
The IRS first addressed the determination of an item in the context of a cable/satellite provider and domestic broadcaster in TAM 201049029. The taxpayer in the TAM licensed a group of programs consisting of programs produced by the taxpayer, as well as programs produced by third parties and commercial advertisements. The taxpayer considered the entire group of programs as the item for Sec. 199, and therefore treated gross receipts attributable to both self-produced content as well as content produced by third parties as DPGR. The IRS National Office agreed with the taxpayer’s argument, noting that in other applications of Sec. 199 (e.g., involving tangible property), property that consists of multiple properties can be tested as a single property, regardless of the fact that some of the properties were produced by third parties.
This conclusion was revisited a few years later when the IRS issued CCA 201446022. In this Chief Counsel advice, the IRS concluded that a multichannel video programming distributor offering various subscription packages, each containing different groups of channels, could not treat all of its revenue from its subscription packages as DPGR, as the taxpayer’s activities with respect to the qualified film were not substantial in nature. In particular, the IRS viewed the taxpayer primarily as a distributor of films rather than a producer, as the taxpayer essentially produced none of the films making up the subscription package. However, the IRS still viewed the subscription package as a valid starting point in the analysis, and noted that the subscription package could be considered a qualified film, assuming the other requirements of Sec. 199 were satisfied.
However, in 2016, the IRS National Office reached a contrary conclusion in TAMs 201646004 and 201647007. In the TAMs, the National Office determined that a subscription package offered by a multichannel video programming distributor did not constitute a qualified film for purposes of Sec. 199. The taxpayers in the 2016 TAMS had similar facts to the taxpayer in the 2010 TAM, although the partially-redacted facts in the 2016 TAMs emphasized that the taxpayers’ self-produced content was relatively minimal in comparison to the amount of content licensed from third parties. In its analyses, IRS National Office agreed with the LB&I division and asserted that the definition of qualified film under the Sec. 199 regulations applied to individual films only. Thus, a package of multiple programs could not constitute a qualified film, and the Sec. 199 deduction would be limited to the gross receipts derived from the taxpayer’s self-produced programs. As the 2016 TAMS did not highlight any materially distinguishing facts from the 2010 TAM or attempt to reconcile the Service’s differing conclusions, taxpayers were left with a significant amount of uncertainty in assessing how the IRS would proceed with future examinations until the issuance of Rev. Rul. 2018-3 in December 2017.
Rev. Rul. 2018-3
In this revenue ruling, the IRS returned to its original conclusion in TAM 201049029 and held that a package of films licensed to customers in the normal course of a taxpayer’s business constituted an item for purposes of Sec. 199. Similar to the fact patterns described in the 2010 and 2016 TAMs, the taxpayer in the revenue ruling derived fees from licensing a package of films (e.g., a television channel) to customers, with the package comprised of films produced by the taxpayer itself as well as by third parties. In the ruling, the IRS noted that the property offered in the normal course of the taxpayer’s business was the entire package of films, versus individual films. Thus, the package of films can be an item for purposes of Sec. 199, provided that the gross receipts derived from licensing the package of films qualify as DPGR.
It is unclear why the IRS came to a different conclusion in Rev. Rul. 2018-3 than it did in the 2016 TAMs, as the facts presented in Rev. Rul. 2018-3 do not appear materially different from the prior technical advice memoranda. Nevertheless, the revenue ruling represents the Service’s current official interpretation of how the Sec. 199 rules are applied to a specific set of facts, and therefore may be relied upon as precedent by taxpayers. Additionally, LB&I announced in early 2017 that it would be commencing several examination campaigns to focus on key issues, with one being the application of Sec. 199 to multi-channel video programming distributors and TV broadcasters. In response to Rev. Rul. 2018-3, LB&I has indicated that it intends to apply the new guidance as it moves forward in the execution of the Sec. 199 examinations. Accordingly, taxpayers with facts that closely mirror those described in the ruling can take comfort in the favorable conclusion and additional certainty provided by Rev. Rul. 2018-3.
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