Fees Charged by Securities Exchange Were Not Domestic Production Gross Receipts

(Parker Tax Publishing April 2022)

The Tax Court held that the operator of a national securities exchange was not eligible for the domestic production activities deduction under pre-TCJA Code Sec. 199 because the fees it charged in connection with customers' participation in the exchanges and the customers' use of computer software provided by the exchange did not qualify as domestic production gross receipts under Reg. Sec. 1.199-3(i)(6)(iii). The court found that the fees were not derived from providing customers access to computer software for their direct use and that alternatively, the third-party software proposed by the taxpayer as comparable was not substantially identical software as compared to the taxpayer's software. BATS Global Markets Holdings, Inc. v. Comm'r, 158 T.C. No. 5 (2022).

Background

BATS Global Markets Holdings, Inc. (Bats Global) developed and operated electronic markets for the trading of listed cash equity securities in the United States and Europe and listed equity options in the United States. Bats Global's exchanges matched the orders of buyers and sellers, functioned as sources of liquidity to Bats Global's customers, and provided customers with fair and orderly places to trade. Bats Global's customers submitted orders to the exchanges, and Bats

Global provided matching and trade execution services.

The fees Bats Global charged its customers included logical port fees, routing fees, and transaction fees. The logical port fees were fixed monthly payments for logical connectivity to certain ports in order to connect to Bats Global's markets. Routing fees were charged to customers when order that had been routed to other exchanges were executed, and applied only when there was an execution on an external market. Transaction fees - Bats Global's primary source of revenues - were charged for each share executed that, depending on the exchange, added liquidity to or removed liquidity (i.e., the ability of a market participant to buy and sell securities) from the order book.

On its tax returns for years 2011-2013, Bats Global claimed the domestic production activities deduction under Code Sec. 199. The Tax Cuts and Jobs Act of 2017 (TCJA) repealed this deduction, effective for tax years beginning after December 31, 2017. For tax years beginning before January 1, 2018, Code Sec. 199(a) allows a deduction equal to 9 percent of the lesser of (1) the qualified production activities income (QPAI) of the taxpayer for the tax year, or (2) taxable income (determined without regard to Code Sec. 199) for the tax year. The amount of the deduction is limited to 50 percent of the wages of the taxpayer for the tax year that are properly allocable to domestic production gross receipts (DPGR).

Under Code Sec. 199(c)(4)(A)(i)(I), DPGR includes gross receipts derived from any lease, rental, license, sale, exchange, 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. Reg. Sec. 1.199-3(i)(6)(i) provides that DPGR includes gross receipts derived from the lease, rental, license, sale, exchange, or other disposition of computer software MPGE by the taxpayer in whole or in significant part within the United States. However, under Reg. Sec. 1.199-3(i)(6)(ii), DPGR generally does not include gross receipts derived from customer and technical support, telephone and other telecommunication services, online services, and other similar services. A narrow exception is provided in Reg. Sec. 1.199-3(i)(6)(iii), which states that if a taxpayer derives gross receipts from providing customers access to computer software MPGE in whole or in significant part by the taxpayer within the United States for the customers' direct use while connected to the internet or any other public or private communications network, such gross receipts will be treated as derived from the disposition of computer software only if the self-comparable exception under Reg. Sec. 1.199-3(i)(6)(iii)(A) or the third-party comparable exception under Reg. Sec. 1.199-3(i)(6)(iii)(B) is met. The third-party comparable exception applies if another person derives, on a regular and ongoing basis in its business, gross receipts from the disposition in a tangible medium or by download of substantially identical software (as compared to the taxpayer's online software) to its customers.

The IRS determined that none of Bats Global's gross receipts from the fees were DPGR, and Bats Global took its case to the Tax Court. Bats Global argued that its fees qualified as DPGR under Reg. Sec. 1.199-3(j)(6)(iii) because (1) the logical port fees were derived from providing customers access to the order handler component of its trading software for the customers' direct use, (2) the routing fees were derived from providing customers access to the routing-related functionality of its software for the customers' direct use, and (3) the transaction fees were derived from providing customers access to the matching-related functionality of its trading software for the customer's direct use. Bats Global further contended that the regulatory requirements of access and direct use should be interpreted with reference to TurboTax, pointing to examples in the regulations showing that providing customers access to online tax preparation software constitutes access and direct use for purposes of the regulation. According to Bats Global, the way customers interacted with TurboTax was not meaningfully different from how Bats Global's customers interacted with its trading software.

Analysis

The Tax Court held that Bats Global was not entitled to treat its gross receipts from the logical port fees, routing fees, and transaction fees as DPGR under Reg. Sec. 1.199-3(i)(6)(iii) because the fees were not derived from providing customers access to computer software for their direct use but instead were charged for providing services. The court found that the logical port fees were payments for access to Bats Global's private communications network and that Reg. Sec. 1.199-3(i)(6)(v) specifically provides that gross receipts derived from communication services are not derived from a disposition of computer software. The routing fees, in the court's view, were fees for services because they were charged for routing and trade execution services performed for customers and were not derived from customers' access to software for their direct use. The court further found that Bats Global's transaction fees were charged for trade execution services, since they were charged only upon the execution of a customer's order and were not charged according to the extent to which customers made use of the exchanges. The court also noted that Bats Global characterized its fees as fees for providing services rather than for the direct use of software. The Tax Court concluded that Bats Global is an operator of securities exchanges and the fact the exchanges used software to operate did not convert its trade execution services into the provision of software for customers' direct use.

The court also rejected Bats Global's argument that the regulatory requirements of access and direct use should be interpreted with reference to TurboTax. The court said that unlike online software provided for a fee so customers can prepare their tax returns, Bats Global's trading software was used as part of its business to provide services to its customers. The court pointed out that, unlike tax preparation software, Bats Global did not offer customers its trading software on compact disc or by download over the internet, nor did it show that third parties offered customers substantially identical software to its trading software. In the court's view, Bats Global's software was more similar to examples in the regulations involving bank software and internet auction software, both of which enable customers to receive online services for a fee.

For a discussion of the domestic production activities deduction, see Parker Tax ¶96,100.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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