Bundled channel receipts are not film DPGR and license fees are not overhead

Plain-English summary

A multichannel video distributor claimed the former IRC § 199 domestic production deduction for subscription packages containing licensed and limited self-produced programming. Chief Counsel concluded that receipts from the packages as a whole were not domestic production gross receipts because the distributor did not substantially produce the films in those packages. The distributor could separately test package components, such as particular channels, under the component rules. Chief Counsel also concluded that fees paid to third-party programming producers were not overhead under the qualified-film safe harbor because those licensed programs were neither produced by the distributor nor inventory or property held for sale. The license fees nevertheless entered the unadjusted depreciable basis used in the alternative safe-harbor calculation.

Ruling snapshot

• Question: Do subscription-package receipts qualify as film DPGR, and are third-party programming license fees overhead under the § 199 safe harbor?
• Outcome: Advice given, no on both questions, with component-level testing still available
• Key authorities: IRC § 199; Treas. Reg. §§ 1.199-3(d), (g), and (k); IRC § 263A

Full text (IRS public release)

       Office of Chief Counsel
       Internal Revenue Service
       Memorandum
       Number: 201446022
       Release Date: 11/14/2014
       CC:PSI:B5:JAHolmes                                         Third Party Communication: None
       PREF-113994-12                                             Date of Communication: Not Applicable

UILC: 199.00-00, 199.08-00

date: July 14, 2014

 to:   Joyce Sugawara, Senior Counsel, Office of Associate Area Counsel - Los Angeles
       (Group 2), (Large Business & International) CC:LB&I:CTM:LA:2

from: Paul Handleman, Chief, Branch 5, Office of the Associate Chief Counsel
(Passthroughs & Special Industries) CC:PSI:5

subject: --------------------------

       This Chief Counsel Advice responds to your request for assistance dated April 15,
       2014. This advice may not be used or cited as precedent.

       LEGEND

       Taxpayer          =          ---------------------------
                                    ----------------------

       Channels          =        ------------------------------------------------------------------------------------------
       -------------------------------------------------------------------

       Network A         =          --------------------------

       Tax Year 1        =          ------

       Tax Year 2        =          ------

       Tax Year 3        =          ------

       Date 1            =          ---------------------

       Shows             =          ------------------------------------------------------------

       Z                 =          -------

PREF-113994-12 2

Y = -----

X = ----

W = -------

V = ---

U = -----

T = ---

S = --

R = --

ISSUES

1. For purposes of the domestic production activities deduction under § 199 of the
   Internal Revenue Code, whether the gross receipts Taxpayer derives from the
   distribution of multiple channels of video programming (Subscription Packages) qualify
   as domestic production gross receipts (DPGR) derived from the disposition of qualified
   films produced by the Taxpayer?

2. Whether license fees that Taxpayer pays to unrelated third-party programming
   producers for the right to broadcast and distribute programming are overhead costs for
   purposes of the safe harbor in § 1.199-3(g)(3)(i) of the Income Tax Regulations?

CONCLUSIONS

1. No. Gross receipts derived from the distribution of Subscription Packages do not
   qualify as DPGR. Taxpayer can apply the rules of § 1.199-3(d)(1)(ii) to components of
   Subscription Packages and determine whether separate components individually qualify
   as an item for purposes of § 199.

2. No. License fees do not constitute overhead costs for purposes of the safe harbor in
   § 1.199-3(g)(1).

FACTS

Taxpayer is categorized as a multichannel video programming distributor (MVPD) under
the FCC rules and regulations. MVPD is “a person such as, but not limited to, a cable
operator, a multichannel multipoint distribution service, a direct broadcast ----------
service, or a television receive-only ---------- program distributor, who makes available
for purchase, by subscribers or customers, multiple channels of video programming.”
PREF-113994-12 3

47 U.S.C § 522(13). For Tax Year 1 through Tax Year 2, Taxpayer filed claims for
refund and for Tax Year 3 filed a tax return claiming the deduction under § 199.
Taxpayer’s position is that it is deriving gross receipts from the disposition of qualified
films produced by the Taxpayer. Taxpayer claimed additional deductions under § 199
relating to other activities, but those activities are not addressed in this Chief Counsel
Advice.

Taxpayer broadcasts roughly Z channels to televisions and other devices and
distributes content over the Internet to individual consumers. Subscription Packages
vary because Taxpayer’s customers have a choice over what and how many channels
they will receive by selecting among different groups of channels.1 A minimum (or
base) Subscription Package consists of around Y channels. The types of available
Subscription Packages, their pricing, and channel composition vary from time to time
and differ based on a customer’s geographic location. The more expensive
Subscription Packages generally include the channels of the cheaper Subscription
Packages plus additional channels.

The programming that Taxpayer distributes can be classified into two categories. First,
video programming that Taxpayer does not produce but licenses for distribution
(licensed programming). Second, a much smaller category, video programming that
Taxpayer produces through related entities (self-produced programming).

Licensed programming: Almost all of the approximately Z channels that Taxpayer
distributes are produced by unrelated third-party video content creators or aggregators.
Generally, these parties are the television and cable networks (Networks). Taxpayer
licenses the channels and then distributes them via its ----------- and other proprietary
technologies, by making the digital channel signals (if included in a customer’s
Subscription Package) available to the customer for viewing on the customer’s
televisions or other devices.

Generally, Taxpayer acquires the rights to broadcast the Network’s channels by
entering into the license agreements, called “carriage contracts,” and paying the
“carriage fees.” The carriage fees are Taxpayer’s biggest expense. In contrast,
Taxpayer’s signal transmission costs were, on average, only about X percent of the
carriage fees for Tax Year 1 through Tax Year 3.

Most contracts require Taxpayer to rebroadcast the channel feed it receives without
altering the content in the signal in any way. Other contracts allow Taxpayer to add
advertisements, including locally based advertisements. Taxpayer does not modify the
licensed channel feed on W channels (V percent of the channels). Taxpayer modifies
the licensed channel feed by embedding advertisements on U channels (T percent of
the channels). Generally, Taxpayer sells this air-time to third-party advertisers who

1. A customer’s agreement provides for other services in addition to the programming/channels, but
   Subscription Package as defined for purposes of this advice does not include those services.
   PREF-113994-12 4

provide advertisements for Taxpayer to integrate into a channel’s signal. Taxpayer
does not produce advertisements for third-parties, but produces advertisements
promoting itself. Some carriage contracts allow Taxpayer to add interstitials into a
channel’s feed. These are brief programs that fill in gaps in a channel’s lineup.
Normally, interstitials are short advertisements for Taxpayer.

Self-produced programming: Besides self-promotional advertising, Taxpayer’s self-
produced content appears to be limited to S Shows. The Shows were produced by
production companies that Taxpayer controls. It is currently not clear from the facts
developed whether the Shows are qualified films, or how Taxpayer distributes or derives
gross receipts from the disposition of this self-produced programming (via its Channels
or otherwise). With respect to these Shows, the production personnel included:
technical directors, graphics personnel, assistant directors, on-air
talent/anchors/analysts, managing and other editors, producers, and camera and
lighting technicians. It appears that the production companies used their equipment and
facilities in producing content for the Shows.

In Date 1, Taxpayer acquired interests in R Channels. Taxpayer distributes the
Channels to some Taxpayer customers via premium Subscription Packages. In
addition to Taxpayer, other MVPDs distribute the Channels programming and pay
license fees. Taxpayer may or may not be considered the producer of these Channels.
It appears the content shown on the Channels consists of: (1) broadcasts -------------------
-------------------- filmed by Taxpayer, (2) Taxpayer’s original programming, and (3)
programming from Network A, an unrelated third party. The facts have not been
established concerning the individual programs Taxpayer or its production studios
produce. Furthermore, it is not known how much of each Channels total programming
was produced by Network A. With respect to the Channels, Taxpayer provides that
“[Channels] derive revenue from fees paid by cable and direct-to-home operators
pursuant to affiliation agreements entered into with the Channels and the sale of
advertising time to local and national advertisers.”

Distribution activities: Taxpayer conducts the multichannel video programming
distribution activities, including distribution of its Subscription Packages, from its
broadcast centers. The activities that take place at the broadcast centers may be
summarized as follows: (1) receive programming via ----------, fiber optic cable or tape
from the Networks; (2) decode and review the incoming content; (3) insert interstitials
and advertisements into the signal, embed metadata, encode the content for outside
broadcast; (4) balance the amount of the outgoing signal; and (5) digitalize, encode and
transmit the signal through its ---------- fleet and the Internet. The technical work at the
broadcast centers is carried out mostly by Taxpayer’s engineers.

LAW AND ANALYSIS

Under § 199(a), the § 199 deduction is determined by applying a percentage to the
lesser of the taxpayer’s qualified production activities income (QPAI) or taxable income
PREF-113994-12 5

(determined without regard to the § 199 deduction). The applicable percentage is
3 percent for taxable years beginning in 2005 and 2006, 6 percent for taxable years
beginning in 2007 through 2009, and 9 percent for taxable years beginning after 2009.

Under § 199(c)(1), QPAI is determined by taking DPGR for the taxable year less cost of
goods sold (CGS) allocable to such DPGR, less other expenses, losses, or deductions,
which are properly allocable to such DPGR.

Section 199(c)(4)(A)(i) provides that DPGR means the gross receipts of the taxpayer
that are derived from any lease, rental, license, sale, exchange, or other disposition of:
(I) qualifying production property (QPP), which was manufactured, produced, grown or
extracted (MPGE) by the taxpayer in whole or significant part within the United States;
(II) any qualified film produced by the taxpayer; or (III) electricity, natural gas, or potable
water produced by the taxpayer in the United States.

Section 199(c)(6) defines the term “qualified film” to mean any property described in
§ 168(f)(3) if not less than 50 percent of the total compensation relating to the
production of such property is compensation for services performed in the United States
by actors, production personnel, directors, and producers. Such term does not include
property with respect to which records are required to be maintained under section 2257
of title 18, United States Code. A qualified film shall include any copyrights, trademarks,
or other intangibles with respect to such film. The methods and means of distributing a
qualified film shall not affect the availability of the deduction under this section.2

Section 168(f)(3) property is any motion picture film or video tape.

Under § 1.199-3(d)(1) of the Income Tax Regulations, a taxpayer may use any
reasonable method satisfactory to the Secretary based on all facts and circumstances
to determine whether gross receipts qualify as DPGR on an item-by-item basis (and not,
for example, on a division-by-division, product line-by-product line, or transaction-by-
transaction basis).

Section 1.199-3(d)(1)(i) defines the “item” as the property offered by the taxpayer in the
normal course of business of taxpayer’s business for lease, rental, license, sale,
exchange, or other disposition (collectively referred to as disposition) to customers, if
the gross receipts from such property qualify as DPGR.

2. The Tax Extenders and Alternative Minimum Tax Relief Act of 2008 (Public Law 110-343, 122 Stat.
   3765 (2008)) revised the definition of qualified film. For taxable years beginning before 2008, the
   definition of qualified film in § 199(c)(6) is any property described in § 168(f)(3) if not less than 50 percent
   of the total compensation relating to the production of such property is compensation for services
   performed in the United States by actors, production personnel, directors, and producers. Such term does
   not include property with respect to which records are required to be maintained under section 2257 of
   title 18, United States Code.
   PREF-113994-12 6

Section 1.199-3(d)(1)(ii) provides that, if § 1.199-3(d)(1)(i) does not apply to the
property, then any component of such property described in § 1.199-3(d)(1)(i) is treated
as the item, provided that the gross receipts that are attributable to the disposition of the
component of such property qualify as DPGR. Each component that meets the
requirements to be treated as the item must be treated as a separate item and may not
be combined with a component that does not meet the requirements of § 1.199-
3(d)(1)(ii).

Section 1.199-3(d)(2)(i) provides that, for purposes of § 1.199-3(d)(1)(i), in no event
may a single item consist of two or more properties unless those properties are offered
for disposition, in the normal course of the taxpayer’s business, as a single item
(regardless of how the properties are packaged).

Section 1.199-3(i)(5)(ii)(C) provides that a taxpayer’s gross receipts derived from the
lease, rental, license, sale, exchange, or other disposition of a qualified film include
advertising income and product-placement income with respect to that qualified film, but
only if the gross receipts, if any, derived from the qualified film are (or would be) DPGR.

Section 1.199-3(k)(1) provides that the term “qualified film” means any motion picture
film or video tape under § 168(f)(3), or live or delayed television programming (film), if
not less than 50 percent of the total compensation relating to the production of such film
is compensation for services performed in the United States by actors, production
personnel, directors, and producers. For purposes of § 1.199-3(k), the term “actors”
includes players, newscasters, or any other persons who are compensated for their
performance or appearance in a film. For purposes of § 1.199-3(k), the term
“production personnel” includes writers, choreographers and composers who are
compensated for providing services during the production of the film, as well as casting
agents, camera operators, set designers, lighting technicians, make-up artists, and
other persons who are compensated for providing services that are directly related to
the production of the film. Except as provided in § 1.199-3(k)(2), the definition of a
qualified film does not include tangible personal property embodying the qualified film,
such as DVDs or videocassettes.

Section 1.199-3(k)(3)(i) provides, in general, that DPGR include the gross receipts from
any lease, rental, license, sale, exchange, or other disposition of any qualified film
produced by such taxpayer.

Section 1.199-3(k)(4) provides for purposes of § 1.199-3(k), the term “compensation for
services” means all payments for services performed by actors, production personnel,
directors, and producers relating to the production of the film, including participations
and residuals. Payments for services include all elements of compensation as provided
in § 1.263A-1(e)(2)(i)(B) and § 1.263A-3(e)(2)(ii)(D). Compensation for services is not
limited to W-2 wages and includes compensation paid to independent contractors.
PREF-113994-12 7

Section 1.199-3(k)(5) provides the not-less-than-50-percent-of-the-total-compensation
requirement under § 1.199-3(k)(1) is calculated using a fraction. The numerator of the
fraction is the compensation for services performed in the United States and the
denominator is the total compensation for services regardless of where the production
activities are performed. A taxpayer may use any reasonable method that is
satisfactory to the Secretary based on all of the facts and circumstances, including all
historic information available, to determine compensation for services performed in the
United States and the total compensation for services regardless of where the
production activities are performed. Among the factors to be considered in determining
whether a taxpayer’s method of allocating compensation is reasonable is whether the
taxpayer uses that method consistently from one taxable year to another.

Section 1.199-3(k)(6) provides that a qualified film will be treated as produced by the
taxpayer for purposes of § 199(c)(4)(A)(i)(II) if the production activity performed by the
taxpayer is substantial in nature within the meaning of § 1.199-3(g)(2). The special
rules of § 1.199-3(g)(4) regarding a contract with an unrelated person and aggregation
apply in determining whether the taxpayer’s production activity is substantial in nature.
Sections 1.199-3(g)(2) and (4) are applied by substituting the term “qualified film” for
QPP and disregarding the requirement that the production activity must be within the
United States. The production activity of the taxpayer must consist of more than the
minor or immaterial combination or assembly of two or more components of a film. For
purposes of § 1.199-3(g)(2), the relative value added by affixing trademarks or trade
names as defined in § 1.197-2(b)(10)(i) will be treated as zero.

Section 1.199-3(g)(2), as modified by § 1.199-3(k)(6) for purposes of determining
substantial in nature with respect to a qualified film, provides that a qualified film will be
treated as produced for purposes of § 1.199-3(k)(6) if the production of the film by the
taxpayer is substantial in nature taking into account all of the facts and circumstances,
including the relative value added by, and relative cost of, the taxpayer’s production
activity, the nature of the qualified film, and the nature of the production activity that the
taxpayer performs. The production of a key component of a qualified film, does not, in
itself, meet the substantial-in-nature requirement with respect to a qualified film under
§ 1.199-3(g)(2).

Section 1.199-3(k)(7) provides that a film will be treated as a qualified film under
§ 1.199-3(k)(1) and produced by the taxpayer under § 1.199-3(k)(6) (qualified film
produced by the taxpayer) if the taxpayer meets the requirements of § 1.199-3(k)(7)(i)
and (ii). A taxpayer that chooses to use this safe harbor must apply all the provisions of
§ 1.199-3(k)(7).

Section 1.199-3(k)(7)(i) is a safe harbor providing that a film will be treated as a
qualified film produced by the taxpayer if not less than 50 percent of the total
compensation for services paid by the taxpayer is compensation for services in the
United States and the taxpayer satisfies the safe harbor in § 1.199-3(g)(3). The special
rules of § 1.199-3(g)(4) regarding a contract with an unrelated person and aggregation
PREF-113994-12 8

apply in determining whether the taxpayer satisfies § 1.199-3(g)(3). Sections 1.199-
3(g)(3) and (4) are applied by substituting the term “qualified film” for QPP but not
disregarding the requirement that direct labor and overhead of the taxpayer to produce
the qualified film must be within the United States. Section 1.199-3(g)(3)(ii)(A) includes
any election under § 181.

Section 1.199-3(g)(3)(i), as modified by § 1.199-3(k)(7)(i) for purposes of the safe
harbor, provides a taxpayer will be treated as having produced a qualified film within the
United States for purposes of § 1.199-3(k)(6) if, in connection with the qualified film, the
direct labor and overhead of such taxpayer to produce the qualified film within the
United States account for more than 20 percent or more of the taxpayer’s CGS of the
qualified film, or in a transaction without CGS (for example, a lease, rental, or license)
account for 20 percent or more of the taxpayer’s “unadjusted depreciable basis” (as
defined in § 1.199-3(g)(3)(ii)) in the qualified film. For taxpayers subject to § 263A,
overhead is all costs required to be capitalized under § 263A except direct materials
and direct labor. For taxpayers not subject to § 263A, overhead may be computed
using any reasonable method that is satisfactory to the Secretary based on all of the
facts and circumstances, but may not include any cost, or amount of any cost, that
would not be required to be capitalized under § 263A if the taxpayer were subject to
§ 263A.

Section 1.199-3(g)(3)(ii) provides that the term “unadjusted depreciable basis” means
the basis of property for purposes of § 1011 without regard to any adjustments
described in § 1016(a)(2) and (3).

Under § 1011, the adjusted basis for determining the gain or loss from the sale or other
disposition of property, whenever acquired, shall be the basis, determined under
§ 1012, or other applicable sections of the Code, adjusted as provided in § 1016. Under
§ 1012, the basis of property shall be the cost of such property, except as otherwise
provided in Code. Under § 1.1012-1(a), the cost is the amount paid for such property in
cash or other property.

Section 1.199-3(k)(7)(ii) provides that the not-less-than-50-percent-of-the-total-
compensation requirement under § 1.199-3(k)(7)(i) is calculated using a fraction. The
numerator of the fraction is the compensation for services paid by the taxpayer for
services performed in the United States and the denominator is the total compensation
for services paid by the taxpayer regardless of where the production activities are
performed. For purposes of § 1.199-3(k)(7)(ii), the term “paid by the taxpayer” includes
amounts that are treated as paid by the taxpayer under § 1.199-3(g)(4). A taxpayer
may use any reasonable method that is satisfactory to the Secretary based on all of the
facts and circumstances, including all historic information available, to determine
compensation for services paid by the taxpayer for services performed in the United
States and the total compensation for services paid by the taxpayer regardless of where
the production activities are performed. Among the factors to be considered in
PREF-113994-12 9

determining whether a taxpayer’s method of allocating compensation is reasonable is
whether the taxpayer uses that method consistently from one taxable year to another.

Issue 1

LB&I asked our Office whether gross receipts derived from the distribution of
Subscription Packages qualify as DPGR derived from the disposition of qualified films
produced by the Taxpayer. Our Office concludes that gross receipts derived from the
Subscription Packages do not qualify as DPGR. However, Taxpayer can apply the
rules of § 1.199-3(d)(1)(ii) to components of Subscription Packages and determine
whether separate components individually qualify as an item for purposes of § 199.

Section 199(c)(4)(A)(i)(II) provides gross receipts derived from a disposition of a
qualified film produced by the taxpayer qualify as DPGR. Taxpayers generally must
determine whether gross receipts qualify as DPGR on an item-by-item basis under
§ 1.199-3(d)(1). Section 1.199-3(d)(1)(i) explains that a taxpayer must identify the
property it offers in the normal course of its business for disposition to customers, and
determine whether the gross receipts derived from that property qualify as DPGR. If the
gross receipts are DPGR, then that property is considered taxpayer’s “item” for
purposes of § 199. Section 1.199-3(d)(1)(ii) provides that, if such property does not
qualify under § 1.199-3(d)(1)(i), then any component of such property described in
§ 1.199-3(d)(1)(i) is treated as the item, provided that the gross receipts that are
attributable to the disposition of the component of such property qualify as DPGR.

LB&I indicates that Taxpayer has inconsistently identified the property that it offers in
the normal course of its business to customers. Taxpayer at times has indicated that it
offers its entire collection of Z channels to customers in the normal course of business,
and at others said the properties offered are various Subscription Packages. In our
view, Taxpayer offers multiple Subscription Packages (containing different groups of
channels) in the normal course of its business to customers. Thus, for purposes of its
§ 199 calculation, Taxpayer must determine whether gross receipts derived from the
Subscription Packages are DPGR.

Section 199(c)(6) and § 1.199-3(k)(1) describe a qualified film as including any motion
picture film or video tape under § 168(f)(3), and live or delayed television programming
(collectively “film”). A qualified film cannot include any property with respect to which
records are required to be maintained under 18 U.S.C. § 2257. Thus, a Subscription
Package must consist entirely of film as described in § 199(c)(6) and § 1.199-3(k)(1).
Our Office notes that any non-qualifying services provided by Taxpayer pursuant to a
customer subscription agreement do not result in immediate application of § 1.199-
3(d)(1)(ii). Gross receipts should be allocated to the non-qualifying services and treated
as non-DPGR, but Taxpayer can still determine whether the Subscription Package
(group of channels) is a qualified film produced by the Taxpayer.
PREF-113994-12 10

If a Subscription Package consists entirely of film, which is required for a “qualified film,”
then Taxpayer must show under § 1.199-3(k)(1) that 50 percent of the total
compensation relating to the production of such film is compensation for services
performed in the United States by actors, production personnel, directors, and
producers. This calculation applies to the entire film, and includes the compensation
paid by third parties to actors, production personnel, directors, and producers for
production of all film included in a Subscription Package. This step is important for
showing that at least 50 percent of film related compensation was paid for services in
the United States. Because this requirement includes compensation for services paid
by all parties (Taxpayer and third parties), meeting this requirement does not mean a
particular taxpayer is considered the producer of such film. In this case, LB&I indicated
to our Office that Taxpayer has not provided information showing any Subscription
Package meets this requirement.

In performing the calculation under § 1.199-3(k)(1), our Office notes the limited types of
compensation included in determinations under § 1.199-3(k) for production personnel.
Compensation for production personnel is limited to persons that are providing services
directly related to the production of the film. This does not include compensation for
services related to the transmission or distribution of the film. This makes sense as
§ 199(c)(6) provides that the methods and means of distributing a qualified film do not
affect the availability of the deduction under § 199. As provided in the facts, Taxpayer
has five activities relating to the distribution of Subscription Packages. These activities
are not part of producing any of the film contained in a Subscription Package, and
compensation related to the activities should not be included under any determination in
§ 1.199-3(k). For example, inserting an advertisement is not the production of a
qualified film, and does not create a new qualified film. See § 1.199-3(i)(5)(ii)(C), which
requires a taxpayer to a producer of the qualified film for gross receipts from any
advertisement in the qualified film to qualify as DPGR. Our Office notes Taxpayer may
have film production activities with respect to its Shows, advertisements or interstitials
promoting Taxpayer, and possibly the Channels.

Even if Taxpayer can demonstrate that a Subscription Package is a qualified film, our
Office does not consider Taxpayer a producer of such film. Section 1.199-3(k)(6)
provides that a qualified film is treated as produced by the taxpayer for purposes of
§ 199(c)(4)(A)(i)(II) if the film production activity performed by the taxpayer is substantial
in nature within the meaning of § 1.199-3(g)(2). The production activity of a taxpayer
must consist of more than the minor or immaterial combination or assembly of two or
more components of a film. For purposes of § 1.199-3(g)(2), the relative value added
by affixing trademarks or trade names as defined in § 1.197-2(b)(10)(i) will be treated as
zero. Based on the facts presented, our Office sees no scenario where any of the
Subscription Packages should be treated as produced by the Taxpayer under § 1.199-
3(k)(6).

Taxpayer is not the producer of a Subscription Package because its production
activities with respect to the film within a Subscription Package are not substantial in
PREF-113994-12 11

nature. Section 1.199-3(g)(2), for purposes of determining substantial in nature with
respect to a qualified film, provides that a qualified film will be treated as produced for
purposes of § 1.199-3(k)(6) if the production of the film by the taxpayer is substantial in
nature taking into account all of the facts and circumstances, including the relative value
added by, and relative cost of, the taxpayer’s production activity, the nature of the
qualified film, and the nature of the production activity that the taxpayer performs. The
production of a key component of a qualified film, does not, in itself, meet the
substantial-in-nature requirement with respect to a qualified film under § 1.199-3(g)(2).

Our Office thinks examining Taxpayer’s business and the nature of the product is
important. Taxpayer’s business involves providing groups of channels to customers
that customers can navigate to choose their program of choice. The nature of
Taxpayer’s product is a group of channels offered for disposition together rather than
one cohesive film. A Subscription Package is made up of various films. Taxpayer
essentially produced none of these films. V percent of the channels distributed are
unaltered by Taxpayer, and the remaining T percent of channels are only altered for
purposes of inserting advertisements and interstitials (excluding the Channels). While it
is allowable for Taxpayer to determine whether it produced enough of the film to be
considered the producer of all of the film in a Subscription Package, it is incorrect to say
Taxpayer is producing a new film. Taxpayer’s disposition of the films as a package
(which is its method of distribution), and its activities enabling that distribution, do not
affect whether Taxpayer is a film producer. Taxpayer argues that distributing a number
of films together as a package can make a taxpayer the producer of the films within that
package. Our Office does not agree with that argument. Our Office views Taxpayer’s
business and activities as the distribution of groups of films, rather than film production.

The facts and circumstances support our position that Taxpayer conducted few film
production activities with respect to any potential Subscription Package. The facts
indicate that Taxpayer, at most, produces the R Channels, S Shows, and
advertisements and interstitials promoting the Taxpayer. The facts indicate that
Taxpayer did not produce roughly Z other channels or any of the advertisements for
unrelated third parties. This is an enormous disparity. Even in the case of a base
Subscription Package, the issue would be whether Taxpayer’s production activities
were substantial with respect to a package that contains around Y channels.3 Again,
the amount of Taxpayer’s film production compared to the whole is minimal. Based on
these facts, Taxpayer’s film production activities with respect to any Subscription
Package are clearly not substantial.

Section 1.199-3(k)(7) provides a safe harbor that treats a film as a qualified film under
§ 1.199-3(k)(1) and produced by the Taxpayer under § 1.199-3(k)(6). Under § 1.199-
3(k)(7)(i), Taxpayer must show that not less than 50 percent of the total compensation
for services paid by the taxpayer is compensation for services performed in the United

3. It would likely be more than Y channels, although we do not have an exact number, as Taxpayer’s
   Channels are only included within premium Subscription Packages.
   PREF-113994-12 12

States and that Taxpayer satisfies the safe harbor in § 1.199-3(g)(3). Based on
Taxpayer’s activities, it appears possible that in some Subscription Packages Taxpayer
may have paid no compensation related to film production for purposes of this safe
harbor. Notwithstanding that note, Taxpayer has maintained that it meets the safe
harbor in § 1.199-3(g)(3). An important part of this argument is whether Taxpayer’s
costs to license unrelated third party produced programming are included within
“overhead” within the meaning of § 1.199-3(g)(3)(i). Based on the facts as presented,
Taxpayer will not meet the safe harbor under § 1.199-3(k)(7) if the costs are not
included within overhead. Our Office addresses this in Issue 2 below.

To the extent that Taxpayer is not the producer of a Subscription Package, Taxpayer
can apply § 1.199-3(d)(1)(ii) to the components of a Subscription Package. Thus, for
example, if Taxpayer can show that it meets the requirements of § 1.199-3(k) with
respect to the Channels, then Taxpayer’s gross receipts attributable to those Channels
could qualify as DPGR.

Lastly, our Office provides an additional reason that gross receipts for Tax Year 1 do not
qualify as DPGR. Tax Year 1 is not subject to the 2008 amendment to § 199(c)(6).
Section 1.199-3(k)(3)(ii) describes the rules that applied prior to the 2008 amendment.
It provides that “the showing of a qualified film (for example, in a movie theater or by
broadcast on a television station) by a taxpayer is not a lease, rental, license, sale,
exchange, or other disposition of the qualified film by such taxpayer. Example 3 of
§ 1.199-3(k)(10) illustrates this rule. In Tax Year 1, Taxpayer’s activities with respect to
its Subscription Packages are similar to those activities described, and are not
considered a disposition. Thus, gross receipts from the Subscription Packages in Tax
Year 1 would not qualify as DPGR.

Issue 2

LB&I also asked our Office whether license fees that Taxpayer pays to unrelated third-
party programming producers for the right to broadcast and distribute programming are
overhead costs for purposes of the safe harbor in § 1.199-3(g)(3)(i). As described
below, we conclude that the license fees paid to unrelated third-parties do not constitute
overhead costs for purposes of the safe harbor.

As indicated in the facts, Taxpayer distributes video programming that can be classified
into two categories. The first category is video programming produced by unrelated
third parties that Taxpayer licenses for distribution (licensed programming). Almost all
of the approximately Z channels that Taxpayer distributes fall into this category. The
second category is video programming that Taxpayer produces through related entities
(self-produced programming).

Section 1.199-3(g)(3)(i) provides two alternative safe harbors for determining whether
QPP is manufactured, produced, grown, or extracted (MPGE) in whole or in significant
part by a taxpayer. Under §1.199-3(k)(7)(i), the § 1.199-3(g)(3)(1) safe-harbor is
PREF-113994-12 13

applied to films by substituting the term “qualified film” for QPP but not disregarding the
requirement that the direct labor and overhead of the taxpayer to produce the qualified
film must be within the United States.

The first safe harbor under § 1.199-3(g)(3)(i) applies for transactions with CGS. Under
this safe harbor, if in connection with the QPP, the direct labor and overhead of such
taxpayer to MPGE the QPP within the United States accounts for 20 percent or more of
the taxpayer’s CGS of the QPP, a taxpayer will be treated as having MPGE QPP in
whole or significant part within the United States. Under the second safe harbor for
transactions without CGS, if in connection with the QPP, the direct labor and overhead
of such taxpayer to MPGE the QPP within the United States accounts for 20 percent or
more of the taxpayer’s unadjusted depreciable basis in the QPP, a taxpayer will be
treated as having MPGE QPP in whole or significant part within the United States.

The first safe harbor in § 1.199-3(g)(3)(i) does not apply to Taxpayer’s video
programming transactions because these transactions do not have any CGS. CGS
arises from the sale of property, and neither category of programming (licensed
programming and self-produced programming) is sold by Taxpayer to its customers.
Although Taxpayer charges fees for distributing its video programming, for federal
income tax purposes such fees are properly characterized as license fees or fees for
service (or are akin to rent) and not as sales receipts.

The second safe harbor in § 1.199-3(g)(3)(i), however, applies to transactions that do
not have CGS, and therefore should apply to Taxpayer’s video programming. As noted
above, this safe harbor is applied by dividing the amount of a taxpayer’s direct labor and
overhead to MPGE the QPP within the United States by the taxpayer’s unadjusted
depreciable basis in the QPP. The question remains, therefore, whether the fees that
Taxpayer pays to unrelated third-party programming producers for the right to broadcast
and distribute programming are overhead costs for purposes of the safe harbor.

License Fees are Not Overhead under § 1.199-3(g)(3)(i): The safe harbor in § 1.199-
3(g)(3)(i) provides two alternative definitions of overhead costs. Which alternative
definition applies to a taxpayer depends on whether the taxpayer is subject to § 263A.
For taxpayers subject to § 263A, overhead is all costs required to be capitalized under
§ 263A, except direct materials and direct labor. For taxpayers not subject to § 263A,
overhead may be computed using any reasonable method that is satisfactory to the
Secretary based on all the facts and circumstances, but may not include any cost, or
amount of any cost, that would not be required to be capitalized under § 263A if the
taxpayer were subject to § 263A.

Taxpayer creates the self-produced programming, and these production activities
subject Taxpayer to § 263A. Because Taxpayer is subject to § 263A, Taxpayer’s
overhead, incurred in connection with its video programming, is all costs required to be
capitalized under § 263A, except direct materials and direct labor. Section 1.199-
3(g)(3)(i).
PREF-113994-12 14

Costs required to be capitalized under § 263A include all direct costs and certain
indirect costs properly allocable to: (1) real property and tangible personal property
produced by the taxpayer, including, for this purpose, films, sound recordings, video
tapes, books, and other similar property embodying words, ideas, concepts, images, or
sounds by the creator thereof, and (2) real property and personal property described in
§ 1221(a)(1), which is acquired by the taxpayer for resale. Sections 1.263A-1(a)(3)(i)
and 1.263A-2(a)(2)(ii).

Unlike the self-produced programming, the licensed programming is not created by
Taxpayer. Rather, the licensed programming is created by third parties and licensed to
Taxpayer for transmission and distribution over Taxpayer’s network.

Furthermore, the licensed programming is not real property or personal property
described in § 1221(a)(1). Section 1221(a)(1) refers to (1) stock in trade of the taxpayer
or other property of a kind which would properly be included in the inventory of the
taxpayer if on hand at the close of the taxable year, or (2) property held by the taxpayer
primarily for sale to customers in the ordinary course of his trade or business.

Taxpayer’s licensed programming is not affixed to a tangible medium for sale. Nor does
Taxpayer sell the copyright in the property or sell its more limited license to broadcast
the licensed programming. Accordingly, the licensed programming is not merchandise
for which the production, purchase, or sale is an income-producing factor for Taxpayer,
and, therefore, is not the type of property that would be included in inventory. See
§ 1.471-1. In addition, because the licensed programming is not sold, the licensed
programming is not property held by Taxpayer primarily for sale to customers in the
ordinary course of Taxpayer’s trade or business.

Because the licensed programming is neither produced by Taxpayer nor described in
§ 1221(a)(1), the costs of the licensed programming are not required to be capitalized
under § 263A. Accordingly, the license fees are not overhead costs for purposes of
§ 1.199-3(g)(3)(i).

Unadjusted Depreciable Basis Includes License Fees: For completeness, our Office
notes that unadjusted depreciable basis in this case includes the license fees Taxpayer
pays to unrelated third parties.

Under § 1.199-3(g)(3)(ii), unadjusted depreciable basis means the basis of property for
purposes of § 1011, without regard to any adjustments described in § 1016(a)(2) or (3).

Under § 1011, the adjusted basis for determining the gain or loss from the sale or other
disposition of property, whenever acquired, shall be the basis, determined under
§ 1012, or other applicable sections of the Code, adjusted as provided in § 1016. Under
§ 1012, the basis of property shall be the cost of such property, except as otherwise
PREF-113994-12 15

provided in Code. Under § 1.1012-1(a), the cost is the amount paid for such property in
cash or other property.

The amounts paid for the licensed programming are the cost of such property, and such
amounts create basis under § 1012 and adjusted basis under § 1011. The amounts
paid to produce the self-produced programming also create basis under § 1012 and
adjusted basis under § 1011. Therefore, Taxpayer’s unadjusted depreciable basis,
determined for purposes of the § 1.199-3(g)(3)(i) safe harbor, should include Taxpayer’s
§ 1011 adjusted basis, without regard to any adjustments described in § 1016(a)(2) or
(3), in both the self-produced programming and the licensed programming.

CASE DEVELOPMENT, HAZARDS AND OTHER CONSIDERATIONS

This writing may contain privileged information. Any unauthorized disclosure of this
writing may undermine our ability to protect the privileged information. If disclosure is
determined to be necessary, please contact this office for our views.

Please call James Holmes at 202-317-4137 if you have any further questions.