Overview
On March 31, 2022, the Tax Court in BATS Global Markets Holdings Inc. v. Commissioner1 held that the taxpayer, a leading global operator of securities exchanges, was not entitled to treat transaction fees, routing fees and logical port fees from its exchanges as domestic production gross receipts (DPGR) for the purpose of calculating deductions pursuant to section 199 because they were not derived from providing customers with direct use of its software. The court concluded that the fact that the Bats Global's exchanges used software to operate does not convert its trade execution services into the provision of software for customers' direct use.
Background
Bats Global and its subsidiaries2 (Bats) operated an alternative trading system with a trading platform software it developed in 2006. The corporation developed and operated electronic markets for the trading of cash equity securities in both the United States and Europe. Bats' electronic exchanges matched the orders of buyers and sellers, functioned as sources of liquidity to Bats' customers, and provided customers with fair and orderly places to trade. By 2011, Bats had become the third largest operator of equities exchanges in the United States after NYSE[3] and NASDAQ.
On its tax returns for 2011 through 2013, Bats claimed roughly $10.8 million in deductions under section 199 for logical port, routing, and transaction fees (Fees) it charged customers. The IRS denied those deductions and issued a notice of deficiency of $3.6 million for all three tax years, asserting that Bats' online software involved the provision of online services rather than a disposition of software through a lease, rental, or license.
Analysis
The issue to be decided was whether Bats' gross receipts from the Fees were DPGR.4 To be DPGR, the Fees must satisfy the requirements of Treasury Regulation § 1.199-3(i)(6)(iii)(B): first, 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;5 and second, that a third party derived gross receipts from the lease, rental, license, sale, exchange, or other disposition of substantially identical software.6 The parties disputed whether Bats met the threshold requirements of subdivision (iii) and whether Bats met the further requirements of subdivision (iii)(B).7 The definition of DPGR specifically does not include gross receipts derived from services.
The court agreed with the IRS that none of the Fees qualified for section 199 deduction, commenting: "The fact that the Exchanges use software to operate does not convert petitioner’s trade execution services into the provision of software for customers direct use."
Logical Port Fees
Bats claimed its logical port fees qualified as DPGR because it asserted that the logical port fees were derived from providing customers access to the order handler component of its trading software for the customers' direct use. The court found that the logical port fees were nothing more than a connectivity fee that enabled customers to interact with the exchanges, similar to internet access services that enable users to browse the world wide web, to transfer files, and to access e-mail. The court said, citing Treas. Reg. § 1.199-3(i)(6)(ii), that gross receipts from internet access services do not constitute gross receipts derived from a lease, rental, license, sale, exchange, or other disposition of software. Connection to the logical ports is akin to internet access rather than direct use as described in Treasury Regulation § 1.199-3(i)(6)(iii)(B). Since the logical port fees are payments for access to Bats’ private communications network, the logical port fees are not DPGR.
Routing Fees
Bats argued that its routing fees were derived from providing customers access to the routing-related functionality of its trading software for the customers' direct use. The routing fees were charged only upon the execution of a customer’s order on an external market. However, the court found that the routing fees were charged for the routing and trade execution "services" performed for customers. The Tax Court concluded that the routing fees were not DPGR because the routing fees were not derived from customers’ access to software for their direct use.
Transaction Fees
Bats claimed its transaction fees as DPGR because the transaction fees were derived from providing customers access to the matching-related functionality of its trading software for the customers' direct use. The Court disagreed with Bats' argument and instead found that they were fees for participation in its markets.
Finally, the Tax Court held that Bats did not meet the threshold for the third-party comparable exception under Treasury Reg. § 1.199-3(i)(6)(iii), as Bats did not demonstrate that a third-party vendor’s software was substantially identical to its own.
Endnotes
1 158 T.C. 5 (2022)
2 "BATS" was an acronym of "Better Alternative Trading System." The name referred to an alternative trading system, a type of venue for matching buyers and sellers of securities that is subject to regulation different from that of a national securities exchange.
3 Beginning in the late 1990s and early 2000s, the traditional model of in-person trading at a single physical location was replaced by that of computerized trading. By 2004, the volume of electronic trading exceeded that of in-person trading.
4 Congress enacted section 199 as part of the American Jobs Creation Act of 2004, Pub. L. No. 108-357, § 102(a), 118 Stat. 1418, 1424, to provide a tax deduction for certain domestic production activities. Section 199 was intended to stimulate job creation in the United States and strengthen the economy by reducing the tax burden on domestic manufacturers. See ADVO, Inc. & Subs. v. Commissioner, 141 T.C. 298, 311–12 (2013)
5 Treasury Reg. § 1.199-3(i)(6)(iii).
6 Treasury Reg. § 1.199-3(i)(6)(iii)(B).
7 The Tax Cuts and Jobs Act repealed section 199 for tax years after 2018.