Section 199, also known as the Domestic Production Activities Deduction (DPAD) or the Domestic Manufacturing Deduction, is centered on production and manufacturing activities. The deduction is, however, also applicable to many other activities, including software development. With the proper knowledge and understanding of its intricacies, determining this deduction can be worthwhile and provide substantial benefits for software companies.
DPAD provides a tax deduction for production within the United States and was enacted with the intent to reward and enhance job growth and competitiveness. DPAD generally gives a deduction equal to 9 percent of income from qualifying domestic production activities.
Businesses that operate in the following industries may be eligible: manufacturing tangible property, computer software, sound recordings, construction, engineering or architectural services, qualified film or the production of electricity, natural gas or potable water.
The deduction is allowed for both regular and the alternative minimum tax for corporations – both C and S corporations – individuals, partnerships and limited liability companies. Under a “safe harbor” rule, companies can claim the deduction even if their production activities are only partially produced in the U.S., as long as its domestic labor and overhead related to production activity account for at least 20 percent of its total cost of goods sold (COGS).
Although the benefit was designed to incentivize U.S. production, its limitations, complex rules and potentially onerous compliance requirements have deterred some taxpayers from claiming the deduction. Still, with its many attractive characteristics, companies should seek to claim these benefits and enlist the help of tax professionals, if necessary.
A company producing computer software within the U.S. should consider its eligibility for this deduction. Computer software includes code for video games, equipment that is an integral part of other property, typewriters, calculators, adding and accounting machines, copiers, duplicating equipment and similar equipment. This category further includes any incidental and ancillary rights necessary to effect the acquisition of title to or right to use the software.
With this broad definition, software businesses are well-positioned to take advantage of the DPAD. Treasury has, however, somewhat limited the ability of these businesses to claim the deduction by excluding gross receipts derived solely from online software or software as a service (SaaS) delivery models.
With companies offering more and more software exclusively online, it may be more difficult for them to claim this deduction. Thankfully, there are two exceptions to this general rule:
- The first exception applies if a company generates gross receipts from software provided in a tangible or downloadable form that is nearly identical to the online software in question.
- The second exception applies when an unrelated party offers software in a tangible or downloadable form that is substantially identical to the online software.
- Thus, as long as either the company or a third party offers substantially identical software to the online software and offers it in a tangible or downloadable form, then the online software may also be eligible for the deduction.
In 2012, the IRS released a memorandum addressing whether certain third-party computer software products were equivalent to a taxpayer’s online software in order to meet this second exception. The outcome is that a company cannot aggregate multiple software programs in order to meet the exception. Fortunately, components of the online software can be used if a company can identify other businesses that offer substantially identical features offline.
Furthermore, on Nov. 7, 2014, the IRS National Office released in a Technical Advice Memorandum that a taxpayerconducted qualifying activity from licensing customized software to contracting parties that then used their own data in conjunction with the licensed computer software to provide services to end users.
In addition to the pure software development opportunity, there is also an exception for software that is part of a hardware product. If the software development takes place in the U.S. and the cost of the software development is 20 percent or more of the total COGS of the product, the entire product is eligible for the DPAD regardless of the manufacturing location. This is a significant opportunity for companies that write software for hardware products that may be manufactured offshore.
The DPAD provides software companies an attractive opportunity to effectively lower their tax rate by approximately three percentage points. The Joint Committee on Taxation estimates that the DPAD will cost $78.2 billion in foregone revenue from 2013 through 2017. With this sizable expected benefit and the chance to lower tax rates, software businesses that are not already claiming this deduction should consider reassessing their activities to determine whether or not they are leaving generous benefits on the table.
Talk with your BMSS CPA or one of our Technology professionals about your specific situation.
*By Chai Hoang and Jonathan Forman. This article originally appeared in BDO USA, LLP’s “BDO TECH” newsletter (Winter 2014). Copyright ©2014 BDO USA, LLP. All rights reserved. BMSS is an independent member firm of the BDO Alliance USA.