Tax Court in Brief | Bats Global Markets Holdings, Inc. v. Commissioner | Deductibility of Domestic Production Gross Receipts

The Tax Court in Brief – March 28th – April 1st, 2022

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Tax Litigation:  The Week of March 28, 2022, through April 1, 2022

• Addis v. Comm’r, T.C. Memo. 2022-24 | March 28, 2022 |Urda, J. | Dkt. No. 12140-20L
• Golditch v. Comm’r, T.C. Memo. 2022-26 | March 29, 2022 |Lauber, J. | Dkt. No. 7726-20L
• Villanueva v. Comm’r, T.C. Memo. 2022-27 | March 31, 2022 |Goeke, J. | Dkt. No. 19781-18
• Porter v. Comm’r, T.C. Memo. 2022-25 | March 28, 2022 |Greaves, J. | Dkt. No. 3544-21

Bats Global Markets Holdings, Inc. v. Comm’r, 158 T.C. No. 5 | March 31, 2022 |Kerrigan, J. | Dkt. No. 1068-17

Short Summary: Bats Global, a registered securities exchange, developed a trading platform software that operated electronic markets for trading equity securities. Bats Global was subject to the Securities Exchange Act of 1934 and the Regulation National Market System rules promulgated by the SEC. Bats Global’s customers were organizations that were members of applicable trading exchanges. The customers were required to accept terms of agreement and to agree to abide by the applicable exchange rules, both of which included authority or terms for the prescription of dues, fees, and charges. Bats Global’s software was paired with other open-source software that Bats Global did not develop. Customers used their own hardware to connect with Bats Global’s hardware in its data center. Bats Global charged a monthly, logical port fees for physical wire connections as well as routing fees for routing orders and transaction fees for when securities orders were executed (collectively, Fees). For each of tax years 2011, 2012, and 2013, Bats Global sought to deduct approximately $1,000,000 in Fees. The IRS denied the request and issued deficiencies for the amounts sought as deductions.

Issue: Whether Bats Global’s gross receipts from the Fees are domestic production gross receipts (DPGR)—and are therefore deductible—pursuant to 26 U.S.C. § 199 and related Treasury Regulations (26 C.F.R. § 1.199-1, et. seq.).

Note: 26 U.S.C. § 199 was enacted in 2004 to provide a tax deduction for certain domestic production activities, but the statute and its related regulations were repealed for tax years beginning after December 31, 2017.

Primary Holdings: 

• The Fees were derived from services, not the direct use of software, see Reg. § 1.199-3(i)(6)(iii), and, except for limited exceptions not met by Bats Global, gross receipts derived from the performance of services do not qualify as DPGR under Treas. Reg. § 1.199-3(i)(4)(i)(A). The fact that the applicable exchanges use software to operate does not convert Bats Global’s trade execution services into the provision of software for customers’ direct use.
• In sum, Bats Global claimed the gross receipts from its Fees as DPGR. All three categories of Fees at issue—transaction fees, routing fees, and logical port fees—were derived from services Bats Global performed for customers in the course of operating Bats Global’s securities exchanges. The Fees were not derived from providing customers access to computer software for their direct use, and they therefore do not meet the requirements of Treasury Regulation § 1.199-3(i)(6)(iii) (repealed, 2017). Thus, Bats Global is not entitled to treat the gross receipts from the Fees as DPGR under Treas. Reg. § 1.199-3(i)(6)(iii) because the Fees were not derived from providing customers access to computer software for their direct use.

Key Points of Law:

• Burdens of Proof. Generally, the IRS’s determinations are presumed correct, and the taxpayer bears the burden of proving the Commissioner’s determinations are erroneous. Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933). The burden of proof may shift to the IRS if the taxpayer establishes that he or she complied with the requirements of 26 U.S.C. § 7491(a) to substantiate items, to maintain required records, and to cooperate fully with the IRS’s reasonable requests.
• Statutory Construction The plain meaning of a regulation governs if the regulation is not ambiguous, and the courts must consider the text, structure, history, and purpose of a regulation before concluding that it is genuinely ambiguous. See Safe Air For Everyone v. EPA, 488 F.3d 1088, 1097 (9th Cir. 2007). Treasury regulations must be interpreted in the context of the statute they are designed to explicate. Bank of New York v. United States, 526 F.2d 1012, 1018 (3d Cir. 1975). Regulations are not an opportunity to amend a statute. United States v. Calamaro, 354 U.S. 351, 359 (1957); Koshland v. Helvering, 298 U.S. 441, 447 (1936).
• DPGR Requirements. To be domestic production gross receipts (DPGR) the Fees must satisfy the requirements of Treasury Regulation § 1.199-3(i)(6)(iii)(B) (repealed, 2017): (1) that they were derived from providing customers access to computer software for the customers’ direct use while connected to the internet or any other public or private communications network; and (2) that a third party derived gross receipts from the lease, rental, license, sale, or other disposition of substantially identical software.
• Section 199 Deduction. As in effect during the years in issue, §199(a) allowed a deduction equal to 9% of the lesser of (1) the qualified production activities income (QPAI) of the taxpayer for the tax year, or (2) taxable income for the tax year. The amount of the deduction is determined pursuant to § 199(b). DPGR includes gross receipts derived from any lease, rental, license, sale, or other disposition of qualifying production property (QPP) that was manufactured, produced, grown, or extracted (MPGE) by the taxpayer in whole or in significant part within the United States. § 199(c)(4)(A)(i)(I). The term “derived from the lease, rental, license, sale, exchange, or other disposition” (collectively, Disposition) is limited to the gross receipts directly derived from the Disposition of QPP, and applicable federal income tax principles apply to determine whether a transaction is a lease, rental, license, sale, exchange or other disposition, a service, or some combination thereof. Treas. Reg. § 1.199-3(i)(1)(i).
• QPP includes computer software, being “any program or routine or any sequence of machine-readable code that is designed to cause a computer to perform a desired function or set of functions, and the documentation required to describe and maintain that program or routine.” § 199(c)(5)(B); Treas. Reg. § 1.199-3(j)(3)(i).
• Generally, gross receipts derived from the performance of services do not qualify as DPGR. Treas. Reg. § 1.199-3(i)(4)(i)(A). There is an exception for receipts derived from engineering or architectural services performed in the U.S. § 199(c)(4)(A)(iii). Gross receipts from construction performed in the U.S. are also included. § 199(c)(4)(A)(ii). In the case of an embedded service, that is, a service for which the price, in the normal course of the taxpayer’s business, is not separately stated from the amount charged for the lease, rental, license, sale, exchange, or other disposition of QPP, DPGR includes only the gross receipts derived from the disposition of QPP and not any receipts attributable to the embedded service.
• Computer Software. DPGR includes gross receipts derived from the Disposition of computer software MPGE by the taxpayer in whole or in significant part within the U.S. § 199(c)(6)(i). With one limited exception, services related to software do not constitute qualified gross receipts for these purposes. Treas. Reg. § 1.199-3(i)(6)(ii), (iii).
• In order for the Fees to be treated as DPGR, the requirements of Treasury Regulation § 1.199-3(i)(6)(iii) must be met. A taxpayer must show (1) that the Fees were derived from providing customers access to computer software MPGE in whole or in significant part by petitioner within the U.S. for customers’ direct use while connected to the internet or any other public or private communications network; and (2) that either a self-comparable exception or a third-party comparable exception within the regulations is met.
• Logical Port Fees. Gross receipts from internet access services do not constitute gross receipts derived from a Disposition of software. See Reg. § 1.199-3(i)(6)(ii). Connection to (for example) the logical ports in Bats Global’s situation, is akin to internet access rather than direct use as described in Treasury Regulation § 1.199-3(i)(6)(iii)(B). The logical port fees in issue are payments for access to Bats Global’s private communications network, and thus, the logical port fees are not DPGR. See Treas. Reg. § 1.199-3(i)(6)(v) (example 3).
• Routing Fees. Routing fees charged for the routing and trade execution services performed for (for example) Bats Global’s customers are not derived from customers’ access to software for their direct use as required for deductibility purposes under section 199 and related Treasury Regulations.
• Transaction Fees. Securities trading transaction fees likely constitute a fee for the execution of services. Thus, such fees are not deductible under section 199 and related Treasury Regulations.
• Third-Party Comparable Exception. Treasury Regulation § 1.199-3 contains exceptions: the self-comparable exception or the third-party comparable exception. See Treasury Regulation § 1.199-3(i)(6)(iii)(B). To qualify for the third-party comparable exception, a third party must derive gross receipts from the Disposition to its customers of software that is substantially identical to the taxpayer’s online software in a tangible medium or by download. See In order to be substantially identical in this regard, a third-party vendor’s computer software must (1) from a customer’s perspective, have the same functional result as petitioner’s online software and (2) have a significant overlap of features or purpose with petitioner’s online software. See id. § 1.199-3(i)(6)(iv)(A).

Insights:  As indicated, the key statute—26 U.S.C. § 199—and related Treasury Regulations in issue in Bats Global were repealed for tax years beginning after December 31, 2017. Thus, the applicability of the technical analysis in Bats Global may be limited on a go-forward basis. However, the Internal Revenue Code currently contains section 199A (Qualified business income), and it, together with Treasury Regulations § 1.199A-1, et. seq., may provide a taxpayer with favorable deductibility for certain domestic production gross receipts. See, e.g., 26 C.F.R. § 1.199A-8 (Deduction for income attributable to domestic production activities of specified agricultural or horticultural cooperatives).

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