On October 20, 2017, the Internal Revenue Service (IRS) published Office of Chief Counsel Internal Revenue Service Memorandum 20174201F (FSA), legal advice written by a field attorney in the Office of Chief Counsel that was reviewed by an associate office, which deals with a merchant bank’s claim that its revenue from merchant discount fees qualifies as Domestic Product Gross Receipts (DPGR) under Internal Revenue Code (Code) Section 199. According to the FSA, on its amended return the taxpayer claimed a Code Section 199 deduction with respect to its merchant discount fees based on the third-party comparable exception for online software found in Treasury Regulation § 1.199-3(i)(6)(ii)(B). The taxpayer argued that the merchant discount fees were derived from the use of computer software, the software “Platform.” The taxpayer took solace in the fact that third parties derived gross receipts from the disposition of substantially identical software. Accordingly, the taxpayer argued that the merchant discount fees should be treated as DPGR pursuant to the third party comparable exception.

The IRS, however, had a very different perspective. Its analysis began with the threshold question of whether there was a “disposition” of the Platform. The IRS concluded that the taxpayer did not dispose of the Platform because the taxpayer did not lease, rent, license, sell, exchange or otherwise dispose of the Platform as required by Treasury Regulation § 1.199-3(i)(6)(i). Moreover, the IRS concluded that the merchant discount fees represented remuneration for “online services” (e.g., online banking services) per Treasury Regulation §1.199-3(i)(6)(i). Because the taxpayer did not establish that there was a disposition of the Platform, the third party comparability exception in Treasury Regulation § 1.199-3(i)(6)(ii)(B) is inapplicable—the merchant discount fees were derived “from the provision of merchant acquiring services.”

Practice Point: We have reported extensively on the IRS’s attacks on taxpayer’s ability to claim the IRC section 199 deduction for computer software and qualified film production. The issue is also on the IRS’s annual Guidance Plan as an area in which the IRS expects to issue regulations within the next year. The FSA is further proof that taxpayers and the IRS do not see eye-to-eye on these issues. Indeed, there are presently several docketed cases seeking judicial determinations regarding the applicability of the third-party comparable exception. Because we have several clients who have this same issue, we are watching it closely, and will report back with any developments.