SCOTUS Reports

Tag: I.R.C. § 199

  • Bats Global Markets Holdings, Inc. v. Commissioner, 158 T.C. No. 5 (2022): Domestic Production Gross Receipts under I.R.C. § 199

    Bats Global Markets Holdings, Inc. v. Commissioner, 158 T. C. No. 5 (2022)

    The U. S. Tax Court ruled that Bats Global Markets Holdings, Inc. could not claim transaction, routing, and logical port fees as domestic production gross receipts (DPGR) under I. R. C. § 199. The court determined these fees were derived from services rather than direct use of software, thus not qualifying for the deduction. This decision clarifies the scope of DPGR, impacting how software-related services are treated for tax purposes.

    Parties

    Bats Global Markets Holdings, Inc. and its subsidiaries (Petitioner) v. Commissioner of Internal Revenue (Respondent). Bats Global Markets Holdings, Inc. was the petitioner throughout the litigation in the United States Tax Court.

    Facts

    Bats Global Markets Holdings, Inc. (Bats Global), a Delaware corporation, operated national securities exchanges and developed proprietary computer software for these exchanges. Bats Global charged customers fees for transaction execution, routing to external markets, and logical port connectivity. These fees, collectively referred to as the Fees, were claimed as domestic production gross receipts (DPGR) for the purpose of calculating deductions under I. R. C. § 199 for the tax years 2011-2013. The Commissioner of Internal Revenue determined that none of these fees qualified as DPGR.

    Procedural History

    The Commissioner issued a notice of deficiency to Bats Global, determining deficiencies for the tax years 2011, 2012, and 2013. Bats Global timely sought redetermination in the U. S. Tax Court. After concessions by Bats Global regarding certain fees, the remaining issue was whether the Fees qualified as DPGR. The case proceeded to trial, and the Tax Court issued its opinion on March 31, 2022, under a de novo standard of review.

    Issue(s)

    Whether the Fees charged by Bats Global for transaction execution, routing to external markets, and logical port connectivity qualify as domestic production gross receipts (DPGR) under I. R. C. § 199 and Treasury Regulation § 1. 199-3(i)(6)(iii)?

    Rule(s) of Law

    Under I. R. C. § 199, a taxpayer may claim a deduction based on domestic production gross receipts (DPGR), which includes gross receipts derived from the disposition of qualifying production property (QPP), such as computer software, manufactured, produced, grown, or extracted by the taxpayer in the United States. Treasury Regulation § 1. 199-3(i)(6)(iii) provides that gross receipts derived from providing customers access to computer software for direct use while connected to the internet or other networks are treated as DPGR if the taxpayer or a third party derives gross receipts from the disposition of the same or substantially identical software in a tangible medium or by download.

    Holding

    The Tax Court held that Bats Global’s Fees do not qualify as DPGR under Treasury Regulation § 1. 199-3(i)(6)(iii) because they were derived from services provided to customers rather than from providing customers direct access to computer software for their use. Additionally, the court found that Bats Global did not meet the third-party comparable exception under Treasury Regulation § 1. 199-3(i)(6)(iii)(B), as the software offered by third parties was not substantially identical to Bats Global’s software.

    Reasoning

    The court analyzed the nature of the Fees and found that they were payments for services related to trade execution, routing, and connectivity rather than for the direct use of software by customers. The court emphasized that the logical port fees provided connectivity to the exchanges, the routing fees were for services performed by Bats Trading, Inc. , and the transaction fees were for trade execution services. The court rejected Bats Global’s argument that these fees were derived from the use of its trading software, as customers did not directly use this software but rather interacted with the exchanges through it.

    The court also considered whether Bats Global met the third-party comparable exception. To qualify, a third party must derive gross receipts from the disposition of substantially identical software. The court determined that the software offered by third parties (e. g. , NYSE Technologies, Cinnober, and MillenniumIT) was not substantially identical to Bats Global’s software because it was used to operate exchanges, whereas Bats Global’s customers used the software to trade on the exchanges. The court interpreted “substantially identical” to mean software that achieves the same functional result from a customer’s perspective and has a significant overlap of features or purpose.

    The court’s interpretation was guided by the plain meaning of the regulation and the specific context of the third-party comparable exception. The court also considered the regulatory examples and the safe harbor for computer software games, which did not apply to Bats Global’s situation. The court concluded that the Fees were not eligible for the DPGR deduction because they were derived from services, and Bats Global did not meet the requirements for the third-party comparable exception.

    Disposition

    The Tax Court’s decision was entered under Rule 155, meaning the court ruled against Bats Global’s claim that the Fees qualified as DPGR, and the case was closed with instructions for the parties to compute the tax liability based on the court’s findings.

    Significance/Impact

    The decision in Bats Global Markets Holdings, Inc. v. Commissioner clarifies the scope of DPGR under I. R. C. § 199 and the application of Treasury Regulation § 1. 199-3(i)(6)(iii). It emphasizes that for fees to qualify as DPGR, they must be derived from the direct use of software by customers, not merely from services facilitated by software. This ruling impacts how companies that use software to provide services, particularly in regulated industries like securities exchanges, can claim deductions under § 199. The decision also provides guidance on the interpretation of “substantially identical software” under the third-party comparable exception, which may influence future cases involving software-related deductions. Subsequent courts and taxpayers will likely refer to this case when determining the eligibility of fees for DPGR status.

  • TGS-NOPEC Geophysical Co. v. Commissioner, 155 T.C. No. 3 (2020): Domestic Production Activities Deduction and Engineering Services

    TGS-NOPEC Geophysical Co. v. Commissioner, 155 T. C. No. 3 (2020)

    The U. S. Tax Court ruled that TGS-NOPEC Geophysical Co. could claim a domestic production activities deduction for processing marine seismic data as an engineering service related to U. S. oil and gas construction. However, the court rejected the company’s argument that the data itself qualified as tangible personal property or a sound recording. This decision clarifies the scope of the deduction for engineering services in the context of the oil and gas industry.

    Parties

    TGS-NOPEC Geophysical Company and Subsidiaries (Petitioner) v. Commissioner of Internal Revenue (Respondent). Petitioner was the appellant at the U. S. Tax Court level, challenging the IRS’s disallowance of their claimed deduction.

    Facts

    TGS-NOPEC Geophysical Co. (TGS) and its subsidiaries are engaged in the acquisition, processing, and licensing of marine seismic data. In 2008, TGS claimed a domestic production activities deduction (DPAD) under I. R. C. § 199, asserting that the gross receipts from leasing processed marine seismic data were domestic production gross receipts (DPGR). TGS maintained that the processed data was qualifying production property (QPP) as tangible personal property or sound recordings, or alternatively, that the processing services constituted engineering services related to U. S. construction activities.

    Procedural History

    The IRS disallowed TGS’s claimed deduction of $1,946,324 for the 2008 tax year, determining a deficiency of $858,392. TGS petitioned the U. S. Tax Court for a redetermination of the deficiency, asserting entitlement to a DPAD of $2,467,091. The court’s decision was based on a de novo review of the legal issues.

    Issue(s)

    Whether TGS’s gross receipts from leasing processed marine seismic data qualify as DPGR under I. R. C. § 199(c)(4)(A)(i) as QPP, or under § 199(c)(4)(A)(iii) as gross receipts derived from engineering services performed in the United States with respect to the construction of real property in the United States?

    Rule(s) of Law

    I. R. C. § 199 allows a deduction for income attributable to domestic production activities. DPGR includes gross receipts from the lease, rental, license, or disposition of QPP manufactured, produced, grown, or extracted in the U. S. (§ 199(c)(4)(A)(i)(I)). QPP includes tangible personal property, computer software, and sound recordings (§ 199(c)(5)). Alternatively, DPGR includes gross receipts from engineering services performed in the U. S. related to the construction of real property in the U. S. (§ 199(c)(4)(A)(iii)).

    Holding

    The Tax Court held that TGS’s processed marine seismic data is not QPP within the meaning of § 199(c)(5) because it is neither tangible personal property nor a sound recording. However, the court held that TGS’s processing of marine seismic data constitutes engineering services performed in the United States with respect to the construction of real property under § 199(c)(4)(A)(iii). TGS’s gross receipts from such services are DPGR to the extent that the services relate to construction activities within the United States.

    Reasoning

    The court reasoned that the processed seismic data, despite being delivered on tangible media, is inherently intangible and does not meet the statutory definition of tangible personal property or sound recordings. The court applied the “intrinsic value” test from Texas Instruments I, concluding that the data’s value is not dependent on the tangible medium. Regarding sound recordings, the court found that the processed data does not result from the fixation of sound as required by § 168(f)(4). However, the court recognized that TGS’s processing activities met the definition of engineering services under § 199(c)(4)(A)(iii) and the related regulations, as they required specialized knowledge and were performed in connection with the construction of oil and gas wells. The court rejected respondent’s arguments that TGS’s services were not provided at the time of construction or were too removed from the construction activity. The court also distinguished between TGS’s own clients and services provided to its parent company’s clients, limiting the DPGR to the former.

    Disposition

    The Tax Court granted TGS a DPAD for 2008, subject to the limitations discussed in the opinion, and directed the parties to calculate the exact amount under Rule 155.

    Significance/Impact

    This case clarifies the scope of the DPAD under I. R. C. § 199, particularly for the oil and gas industry. It establishes that the processing of seismic data can qualify as an engineering service related to U. S. construction activities, but the data itself does not qualify as tangible personal property or a sound recording. The decision has implications for how companies in the industry structure their operations and claim deductions, emphasizing the importance of the location and nature of services provided. Subsequent cases may further refine the boundaries of what constitutes engineering services under § 199(c)(4)(A)(iii).

  • ADVO, Inc. & Subsidiaries v. Commissioner, 141 T.C. 298 (2013): Domestic Production Activities Deduction under I.R.C. § 199

    ADVO, Inc. & Subsidiaries v. Commissioner, 141 T. C. 298 (2013) (United States Tax Court, 2013)

    In ADVO, Inc. & Subsidiaries v. Commissioner, the U. S. Tax Court ruled that ADVO, a direct mail advertising company, could not claim a domestic production activities deduction under I. R. C. § 199 because it did not bear the benefits and burdens of ownership of the printed materials during production. This decision clarified the eligibility criteria for the deduction, emphasizing that only the party with ownership during the manufacturing process can claim it, impacting how companies structure their production agreements.

    Parties

    ADVO, Inc. & Subsidiaries, as the petitioner, challenged a decision by the Commissioner of Internal Revenue, the respondent, in the United States Tax Court. ADVO was the common parent of a consolidated group, and at the time of filing, its principal place of business was in Connecticut.

    Facts

    ADVO, Inc. was engaged in the distribution of direct mail advertising in the United States, offering both solo and cooperative mail packages to its clients, which included businesses such as supermarkets and retailers. ADVO either supplied the advertising materials itself or used client-supplied materials. When ADVO supplied the materials, it contracted third-party commercial printers to print them. ADVO’s advertising materials included a “Shopwise” wrap, inserts, and a detached address label (DAL). ADVO’s business model involved selling advertising space, assisting with graphic design, and ensuring the delivery of mail packages to targeted consumers. ADVO claimed a deduction under I. R. C. § 199 for the tax years 2006 and the short 2007 year, asserting that it manufactured the printed materials. The Commissioner disallowed these deductions, arguing that ADVO did not manufacture the materials.

    Procedural History

    ADVO filed a petition for redetermination of deficiencies in income tax determined by the Commissioner for the 2006 and short 2007 tax years. The case was bifurcated, with the sole issue in this opinion being whether ADVO was entitled to a § 199 deduction for the printed materials. The Tax Court conducted a trial and issued its opinion on October 24, 2013, ruling against ADVO’s entitlement to the deduction.

    Issue(s)

    Whether ADVO, Inc. & Subsidiaries is entitled to a deduction under I. R. C. § 199 for the tax years 2006 and the short 2007 year based on the production of qualifying production property?

    Rule(s) of Law

    I. R. C. § 199 allows a deduction for income attributable to domestic production activities, including the manufacture of tangible personal property within the United States. The regulations specify that when a taxpayer contracts with an unrelated party for manufacturing, the taxpayer must have the “benefits and burdens of ownership” of the qualifying production property during the period the manufacturing activity occurs. See 26 C. F. R. § 1. 199-3(e)(1).

    Holding

    ADVO, Inc. & Subsidiaries was not entitled to the § 199 deduction for the tax years in question because it did not have the benefits and burdens of ownership of the direct advertising materials during the printing process.

    Reasoning

    The Tax Court applied a fact-specific benefits and burdens test to determine ownership during the manufacturing process. Factors considered included legal title, the intention of the parties, right of possession and control, risk of loss, and profits from the operation and sale. The court found that the third-party printers had legal title to the printed materials during production, bore the risk of loss, and controlled the actual printing process. Despite ADVO’s involvement in specifying the design and materials, it did not exercise day-to-day control over the printing process. The court distinguished this case from Suzy’s Zoo v. Commissioner, noting that the § 199 test requires the benefits and burdens during manufacturing, a narrower scope than the § 263A test used in Suzy’s Zoo. The court concluded that only the third-party printers had the requisite ownership during the manufacturing activity, and thus, ADVO could not claim the § 199 deduction.

    Disposition

    The Tax Court issued an order denying ADVO’s claim for a § 199 deduction for the tax years 2006 and the short 2007 year.

    Significance/Impact

    The ADVO decision is significant for its clarification of the eligibility criteria for the § 199 domestic production activities deduction. It established that only the party bearing the benefits and burdens of ownership during the manufacturing process can claim the deduction, impacting how companies structure their production agreements. The ruling has implications for industries reliant on contract manufacturing, requiring careful consideration of ownership rights and responsibilities in production contracts. Subsequent cases and IRS guidance have referenced this decision to delineate the boundaries of the § 199 deduction, particularly in scenarios involving contract manufacturing arrangements.

  • ADVO, Inc. & Subsidiaries v. Commissioner of Internal Revenue, 141 T.C. No. 9 (2013): Application of Section 199 Domestic Production Deduction in Contract Manufacturing Arrangements

    ADVO, Inc. & Subsidiaries v. Commissioner of Internal Revenue, 141 T. C. No. 9 (2013)

    In ADVO, Inc. & Subsidiaries v. Commissioner, the U. S. Tax Court ruled that ADVO, a direct mail advertising company, was not entitled to a domestic production deduction under I. R. C. § 199 for its direct mail products. Despite ADVO’s extensive involvement in the design and distribution process, the court determined that ADVO did not possess the requisite benefits and burdens of ownership during the production phase, which was outsourced to third-party printers. This decision highlights the complexities of applying tax deductions in contract manufacturing scenarios, emphasizing the necessity of ownership during production for eligibility under Section 199.

    Parties

    ADVO, Inc. & Subsidiaries, the petitioner, was the common parent of a consolidated group and the plaintiff in the case. The Commissioner of Internal Revenue was the respondent and defendant. ADVO was represented by attorneys Michael P. Walutes, Craig A. Raabe, John R. Shaugnessy, Jr. , Gary D. Yeats, and Scott E. Sebastian, while the Commissioner was represented by Donald K. Rogers, Charles E. Buxbaum, and William T. Derick.

    Facts

    ADVO, Inc. distributed direct mail advertising in the United States, utilizing both solo and cooperative mail packages. For its operations, ADVO either used materials supplied by its clients or materials it supplied itself. When supplying its own materials, ADVO contracted third-party printers to produce the printed advertisements. The company also developed and marketed a portfolio of turnkey products, which included the ‘Shopwise’ wrap and various inserts, and managed the entire process from design to delivery. ADVO’s operations were substantial, distributing 60 to 80 million packages weekly and engaging in significant sales and design activities. The company’s contracts with clients and printers stipulated the specifics of the production and delivery process.

    Procedural History

    The Commissioner disallowed ADVO’s claimed deductions under I. R. C. § 199 for the tax years 2006 and the short 2007 tax year, asserting that ADVO did not manufacture, produce, grow, or extract qualifying production property with respect to its direct advertising mailings. ADVO petitioned the U. S. Tax Court for a redetermination of these deficiencies. The case was bifurcated, with the issue of the Section 199 deduction being addressed in the first trial, while a separate issue regarding a credit under I. R. C. § 41 for increasing research activities was to be resolved in a subsequent trial. The Tax Court’s decision was based on the application of the benefits and burdens of ownership test to determine eligibility for the Section 199 deduction.

    Issue(s)

    Whether ADVO, Inc. & Subsidiaries is entitled to a deduction under I. R. C. § 199 for the tax years 2006 and the short 2007 tax year, given that it contracted with third-party printers to produce its direct advertising mailings?

    Rule(s) of Law

    I. R. C. § 199 allows a taxpayer a deduction for income attributable to domestic production activities, but requires that the taxpayer have manufactured, produced, grown, or extracted qualifying production property. The Treasury Regulations under Section 199, specifically § 1. 199-3(e)(1), define ‘manufactured, produced, grown, or extracted’ to include activities such as manufacturing, producing, improving, and creating qualifying production property. The regulations further stipulate that when a taxpayer contracts with an unrelated third party for manufacturing, the taxpayer must have the benefits and burdens of ownership of the qualifying production property during the period the manufacturing activity occurs, as per § 1. 199-3(f)(1).

    Holding

    The Tax Court held that ADVO, Inc. & Subsidiaries was not entitled to a deduction under I. R. C. § 199 for the tax years in question. The court determined that ADVO did not have the benefits and burdens of ownership of the direct advertising materials during the period of production by the third-party printers, as required by the regulations under Section 199.

    Reasoning

    The Tax Court applied the benefits and burdens of ownership test, which is based on various factors including legal title, possession, control, risk of loss, and active participation in the production process. The court analyzed these factors in the context of ADVO’s relationship with its third-party printers and found that ADVO did not have the requisite control or ownership during the manufacturing process. Specifically, the court noted that legal title to the printed materials did not transfer to ADVO until after production was complete, and ADVO did not have day-to-day control over the printing process. Additionally, the third-party printers bore the risk of loss during production and enjoyed the economic gain from the sales, further supporting the conclusion that they, not ADVO, had the benefits and burdens of ownership during the production phase. The court also distinguished this case from previous cases like Suzy’s Zoo, which involved a different section of the tax code (Section 263A) and a broader test for ownership. The court emphasized that under Section 199, only one taxpayer may claim the deduction, and the facts did not support ADVO’s claim to that status.

    Disposition

    The court denied ADVO’s petition for a redetermination of the deficiencies in income tax determined by the Commissioner for the tax years 2006 and the short 2007 tax year, affirming the disallowance of the Section 199 deduction.

    Significance/Impact

    The ADVO case is significant for its clarification of the application of the domestic production deduction under I. R. C. § 199 in the context of contract manufacturing arrangements. It underscores the necessity for a taxpayer to have the benefits and burdens of ownership during the manufacturing process to be eligible for the deduction. This decision has implications for companies engaged in similar arrangements, potentially affecting their tax planning and the structuring of contracts with third-party manufacturers. The case also illustrates the fact-intensive nature of the benefits and burdens test, which requires a careful examination of each specific relationship between the taxpayer and the contract manufacturer. Subsequent cases and IRS guidance may further refine the application of this test, but ADVO remains a key precedent for understanding the limits of Section 199 in contract manufacturing scenarios.