Editors Note: Amalie L. Tuffin is a member of the Research Triangle Park law firm of Daniels Daniels & Verdonik, P.A. TechLaw is a regular feature in Local Tech Wire.
_______________________________________________________________________________________Last October, Congress passed the American Jobs Creation Act. As I have previously written (see www.localtechwire.com/article.cfm?u=10204 ), one centerpiece of the Act was the creation of a new manufacturing activities tax deduction for a portion of a company’s income related to United States production activities.

The deduction is significant–starting at 3 percent and phasing up to 9 percent of the smaller of a company’s taxable income or “qualified production activities” income in 2010.

The deduction was put into place to encourage the retention of manufacturing jobs in the United States. Congress specifically included the production of computer software within the ambit of the statute, in order to encourage to retention of lucrative high technology employment in the United States.

A twist in how the IRS has interpreted the statute, however, is preventing certain computer software developers from benefiting from the new deduction. Software that is provided on disc, or via Internet download, qualifies for the deduction, but the IRS has denied the deduction to computer software developers who sell or license their software on provider-owned servers. In other words, the deduction is not available to application service providers and other providers of web-based software applications.

IRS Rationale: Online Software Is a Service, not a Product

Why such different treatment? What is the rationale for treating software downloaded from the Internet or purchased on disc differently from software used via access to the developer’s servers? It seems that such software fits within the definition in the statute, which makes the deduction available with respect to gross income from the lease, rental, license, sale, exchange or other disposition of qualifying production property (a term which includes computer software) that was manufactured or produced entirely or in significant part within the United States.

The IRS, in interpreting Code Section 199 (the statute that sets out the terms and conditions of the manufacturing activities tax deduction), has consistently argued that software delivered online isn’t a product but instead is a service…and services do not qualify for the deduction.

The IRS issued its position in early 2005, making a distinction in the delivery methods as part of its initial guidance on the statute. The example it uses in the relevant proposed regulation (which covers matters other than just software), is that income from online delivery of a newspaper’s content is not eligible for the deduction, even though income from paper copies of the exact same content is.

Many commentators and interested organizations objected to this interpretation. For example, both the Information Technology Association of America (ITAA) and the Software Finance and Tax Executives Council (SofTEC) sent comment letters to the IRS arguing against this restrictive interpretation of the statute.

These comment letters are available at www.itaa.org/taxfinance/policy.cfm?ID=128 <.a> and www.softwarefinance.org/agenda/tax/text.htm , respectively.

The ITAA letter, in particular, lays out a persuasive set of arguments as to why the IRS’s interpretation is misguided.

IRS Disregards Software Industry Reaction

Despite the many comments received pushing for a change on this point, in October 2005 the IRS issued proposed regulations setting forth the agency’s interpretation of Code Section 199. These proposed regulations contain the same restrictive limitations on the method of providing access to computer software as were contained in the initial guidance.

However, all is not lost in terms of changing this interpretation. The regulations are still in the “proposed” stage and the IRS is soliciting public comment on them. Further, at least one tax specialist at the IRS has publicly indicated that the IRS is open to compromise on this issue.

Accordingly, providers of online software should press their trade associations and similar entities, such as the ITAA, SofTEC and the like, to reiterate their comments to the IRS and to press for a broader interpretation of the statute. There is no sound policy reason to treat software delivered on disc, software delivered via Internet download and software made available for use on a developer’s servers differently under the law, and every reason to broaden the interpretation of the statute in order to fulfill its primary purpose, that of encouraging the retention of jobs in the United States.

Daniels Daniels & Verdonik, P.A. has been serving the legal needs of entrepreneurial and high technology clients for more than 20 years. Amalie L. Tuffin concentrates her practice in the representation of entrepreneurial and technology-based business, focusing on corporate, taxation and securities matters. Questions or comments can be sent to atuffin@d2vlaw.com.