Editors Note: Amalie L. Tuffin is a member of the Research Triangle Park law firm of Daniels Daniels & Verdonik, P.A.

RESEARCH TRIANGLE PARK, N.C. – 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 three percent and phasing up to nine 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 had been interpreting the statute, however, was 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 had stated it would deny the deduction to computer software developers who sell or license their software on provider-owned servers. In other words, the deduction was not going to be available to application service providers and other providers of web-based software applications.

IRS Allow Some Online Software Providers To Use Deduction

Last month, the IRS released new temporary regulations that ease its previous hard-line position disallowing online software providers the use of the new deduction. The new regulations contain two important exceptions to the general rule that online software providers cannot use the new deduction. The first exception is that if a provider makes software available for use online (while actively connected to the Internet) and sells or licenses substantially similar software on CD or by download from the Internet, then the deduction is available for the online use as well as the sales and licenses. For example, if a company produces tax preparation software in the United States and makes the software available for use online, as well as selling CDs containing the software on its website and through retail outlets, then all of the sales will qualify for the deduction.

The second exception is that if a provider makes software available for use online (while actively connected to the Internet) and a different software provider makes substantially identical software available for sale or license via CD or Internet download, then the provider who sells the software online will be able to take the tax deduction for those sales. For example, if a company produces tax preparation software in the United States and makes it available for use online, and another company distributes substantially identical software that performs the same function in retail outlets, then the first provider will be able to utilize the deduction. This puts software providers who are in direct competition with one another on a level playing field, regardless of the distribution channel that they choose to utilize.

This provision is at least partially intended to help the computer game industry, as the temporary regulations contain a provision that states that all computer software games are deemed to be substantially identical software. In other words, as long as any provider of computer games makes their games available for download or sells them in retail outlets, all providers (even those who only make their games available for use online) will be able to use the deduction, as long as they otherwise qualify for it.

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

Why did the IRS originally propose such different treatment for online software? 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), had 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 used in the relevant proposed regulation (which covers matters other than just software) was 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.

The temporary regulations still do not allow the use of the deduction in many cases. One example given in the regulations is of a company that produces computer software that enables customers to participate in Internet auctions for a fee. The IRS states that this type of software constitutes the provision of online services and thus that the deduction is not available.

Many commentators and interested organizations objected to the IRS’s initial interpretation of Section 199. 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 its restrictive interpretation of the statute. Members of Congress also sent letter to the IRS raising concerns with its interpretation. The IRS’s new position does not go as far as many of these commentators wanted, but it is a significant step in the right direction in terms of making the deduction as widely available as possible. The temporary regulations have also been published as proposed regulations and the comment period on the regulations is thus open, giving providers of online software and the trade associations that represent them the opportunity to push for further positive change prior to adoption of final regulations.

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.