The IRS Chief Counsel has denied the domestic production activities deduction to a company that sells online software.

The domestic production activities deduction (DPAD) is available for domestic production gross receipts from the lease, license, sale or disposition of an item, including computer software. The deduction is currently 9 percent of qualified production activities income, which is derived from domestic production gross receipts.

The regulations say that providing online services is not treated as the disposition of computer software. Therefore, receipts for these services are not domestic production gross receipts.

However, if a company can demonstrate that a third party provides similar software through a computer disk, DVD or download from the Internet (offline software), then the online software can qualify for the deduction.

The regulations provide that substantially identical offline software is software that has the same functional result as the online software, and its purpose or features significantly overlap those of the online software. 

In its ruling request, the company identified third parties that have similar computer software products. The IRS noted that the company’s software had more features than the third-party software, including a feature that was not available from any of the third parties.

The IRS concluded that the online software’s functionality, features and purpose were not replicated by a single competitor’s offline software, and the company’s online software was not substantially identical to any of the offline products (CCA 201226025).

However, the IRS did conclude that a component of the property could be treated as a separate item and generate domestic production gross receipts if the component has a substantially identical offline counterpart. A component that is treated as a separate item cannot be combined with a component that does not meet the relevant requirements.