On March 31, 2022, the Tax Court issued the full opinion in BATS Global Markets Holdings Inc. v. Commissioner (158 T.C. No. 5). The primary issue presented in BATS Global Markets Holdings Inc. v. Commissioner was whether the petitioner’s transaction fees, routing fees, and logical port fees qualify as domestic production gross receipts (DPGR) for the purpose of calculating deductions pursuant to IRC § 199.
Held: No dice, BATS.
Procedural Background to BATS Global Markets Holdings Inc. v. Commissioner
The IRS issued a notice of deficiency determining deficiencies of $900,000 (2011), $1.3 million (2012), and $1.4 million (2013).
Factual Overview of BATS Global Markets Holdings Inc. v. Commissioner
During the years in issue (2011-2013) BATS Global Markets Holdings, Inc. (Bats Global) owned 100% of BATS Exchange, Inc., BATS Y-Exchange, Inc., and BATS Trading, Inc. It was the common parent of a group of corporations (collectively, the petitioner) which filed consolidated U.S. federal income tax returns for the years in issue.
“BATS” was an acronym of “Better Alternative Trading System.” The name referred to a type of venue for matching buyers and sellers of securities that is subject to regulation different from that of a national securities exchange. Although the petitioner initially operated an alternative trading system, by the years in issue, its exchanges were registered as national securities exchanges. The petitioner operated two marketplaces: BZX and BYX. It also operated a marketplace for trading listed equity options: BATS Options (the Exchanges).
By the years in issue the petitioner had become the third-largest operator of equities exchanges in the United States after NYSE Euronext and NASDAQ OMX Group, Inc. During the years in issue the petitioner 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. The petitioner did not have any physical location where buyers and sellers could meet to engage in trading. In the years in issue the petitioner had 85 to 108 employees.
Regulation of the Exchanges
The Exchanges were registered with and regulated by the U.S. Securities and Exchange Commission (SEC) during the years in issue. They were treated as national securities exchanges pursuant to the Securities Exchange Act of 1934. A national securities exchange is defined as any exchange registered pursuant to 15 U.S.C. § 78f.
The SEC approved BATS Options as part of BZX on January 26, 2010, and trading commenced on October 15, 2010. On August 13, 2010, the SEC approved the application of BYX to register as a national securities exchange, and trading commenced on October 15, 2010.
Securities Exchange Act of 1934
For the Exchanges to be designated national securities exchanges, certain statutory requirements needed to be met. They must comply with the 1934 Act and be able to enforce compliance by its members and persons associated with its members and to ensure that quotation information supplied to investors and the public was fair and informative, and not discriminatory, fictitious, or misleading.
Operation of the Exchanges
The petitioner’s Exchanges matched the orders of buyers and sellers, functioned as sources of liquidity to the petitioner’s customers, and provided customers with fair and orderly places to trade. The petitioner’s customers submitted orders to the Exchanges, and the petitioner provided matching and trade execution services. The number of trades executed on BZX was 951 million in 2011, 747 million in 2012, and 682 million in 2013.
The petitioner developed software that was used in effecting the trading of securities and options on the Exchanges. The Exchanges also incorporated third-party software, such as licensed market surveillance software. In developing its trading software, the petitioner used Linux operating system software and other open-source software, which the petitioner did not develop. Customer orders could not have been executed without this third-party software.
All software requires hardware to run. The petitioner’s trading software was installed on interconnected computer servers in a data center in New Jersey that the petitioner leased from a third party. The petitioner also maintained a backup data center for disaster recovery purposes. The petitioner purchased all the hardware used in its system from outside vendors and did not develop the operating system software used on the computers in its network.
To trade on the Exchanges, exchange members needed both “physical” connectivity and “logical” connectivity to the petitioner’s system. Customers established physical connectivity by placing their own computer hardware in the petitioner’s data center and using a cable to connect their computer hardware to the petitioner’s computer hardware. For part of the years in issue, the petitioner charged customers a monthly physical connection fee for this wired connection.
Customers established logical connectivity by sending specially formatted electronic messages from order management software on their computers to “logical ports” in the petitioner’s system. A “logical port” is a combination of a specific Internet Protocol (IP) address and a Transmission Control Protocol (TCP) port, essentially a unique number used to identify a location where data is to be sent. Together, an IP address and a TCP port number allow a connection to be established between the application software on the computer of the person sending data and a particular instance of the target application software on another computer system.
Customers were able to connect with the Exchanges using order management software. The petitioner did not develop this software. Customers paid the petitioner a monthly logical port fee in relation to this connection.
The petitioner’s trading software was not actually transferred to customers’ computers, nor did customers enter into license agreements with the petitioner. The petitioner did not make copies of any portion of its trading software commercially available to third parties or offer it on a tangible medium or as a hosted arrangement for customers operating an electronic market. The petitioner’s customers were unable to use any of the BATS trading software to operate their own exchange or similar market.
The petitioner published fee schedules that governed the payments required of the petitioner’s customers. The fee schedules did not include the word “software.” However, the petitioner claimed as DPGR the receipts from the following three categories of fees it charged its customers: logical port fees, routing fees, and transaction fees.
Logical Port Fees
Customers paid fixed monthly fees for logical connectivity to certain ports, referred to in the petitioner’s fee schedules as “logical ports.” On its Forms S-1, Registration Statement Under the Securities Act of 1933, filed with the SEC, the petitioner stated that these logical port fees represented fees paid for connectivity to its markets.
If customers wanted to submit more than 5,000 messages per second or to send more than one order in parallel, they could pay to connect to more than one logical port, as needed for their order flow. Customers paid the same flat monthly fee for connectivity to each of these ports regardless of whether they submitted zero orders or the maximum number of orders per second.
The petitioner charged routing fees to customers when orders that had been routed to other exchanges or trading venues were executed, that is, when there was an execution on an external market. Routing fees were charged to customers using the Exchanges according to the number of shares or option contracts routed to another exchange and the routing strategy used. The fee per share or option contract executed varied with the strategy the customer selected.
The primary source of the petitioner’s revenues was its transaction fees. When a customer’s order was executed, the customer was either charged a transaction fee or issued a rebate. These transaction fees were characterized as “Fees for Accessing Liquidity” or “Liquidity Fees.” The rebates for customers on the opposite side of these executions were referred to as “Liquidity Rebates” or “Rebates for Accessing Liquidity.”
In the context of the petitioner’s Exchanges, liquidity referred to the number and price range of orders resting on the Exchanges’ order books that were available to be matched with other orders. The petitioner derived liquidity from orders to buy or sell which customers submitted to the Exchanges electronically. The petitioner offered rebates as an incentive to attract market participants and liquidity to the Exchanges.
The petitioner’s fee schedules provided that the petitioner charged a customer a transaction fee or issued a customer a rebate for each share executed that, depending on the exchange, added liquidity to or removed liquidity from the order book. The price customers were charged per share varied with the type of order the customer submitted.
SEC Form 19b-4 Filings
The securities laws required the petitioner to file copies of any proposed changes to its Exchange Tax Court Rules with the SEC, accompanied by an explanation of the basis and purpose of the proposed changes. The petitioner filed multiple Forms 19b-4 during the years in issue to submit these proposed rule changes.
On its Forms 19b-4 the petitioner described the logical port fees as fees for TCP/IP ports. The petitioner also referred to the logical port fees as fees for connectivity. The routing fees were described as fees for executions of orders routed to external markets using the petitioner’s routing services. The transaction fees were described as fees for executions that removed liquidity from the BZX order book or added liquidity to the BYX order book. The petitioner did not use the word “software” to describe the Fees.
Federal Tax Returns in BATS Global Markets Holdings Inc. v. Commissioner
On its originally filed federal income tax returns the petitioner claimed deductions under IRC § 199 of $2.6 million (2011), $3.8 million (2012), and $4 million (2013). The petitioner attached to its returns Forms 8903, Domestic Production Activities Deduction, and reported DPGR of $683 million (2011), $594 million (2012), and $571 million (2013).
Summary of Issue in BATS Global Markets Holdings Inc. v. Commissioner
To be DPGR the Fees must satisfy the requirements of Treas. Reg. § 1.199-3(i)(6)(iii)(B). First, the fees must have been 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. Second, a third party must derive gross receipts from the lease, rental, license, sale, exchange, or other disposition of substantially identical software.
The IRS determined that none of the petitioner’s gross receipts from the Fees were DPGR.
Generally, the IRS’s determinations are presumed correct, and the taxpayer bears the burden of proving the IRS’s determinations are erroneous. The burden of proof may shift to the IRS if the taxpayer establishes that he or she complied with the requirements of IRC § 7491(a) to substantiate items, to maintain required records, and to cooperate fully with the IRS’s reasonable requests.
The IRC § 199 Deduction
Congress enacted IRC § 199 as part of the American Jobs Creation Act of 2004, to provide a tax deduction for certain domestic production activities. IRC § 199 was intended to stimulate job creation in the United States and strengthen the economy by reducing the tax burden on domestic manufacturers. IRC § 199 was repealed for tax years beginning after December 31, 2017. In its place, eventually came along IRC § 199A, which we discuss here.
As in effect during the years in issue, IRC § 199(a) allows 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 (determined without regard to IRC § 199) for the tax year. The amount of the deduction is limited to 50% of the wages of the taxpayer reported on Form W-2, Wage and Tax Statement, for the taxable year that are properly allocable to DPGR.
QPAI for any taxable year is an amount equal to the excess, if any, of (A) the taxpayer’s DPGR for such taxable year, over (B) the sum of (i) the cost of goods sold allocable to such receipts and (ii) other expenses, losses, or deductions (other than the deduction under IRC § 199) that are properly allocable to such receipts.
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. The regulations specify that the term “derived from the lease, rental, license, sale, exchange, or other disposition” is limited to the gross receipts directly derived from the disposition of QPP and note that 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.
QPP includes any computer software. The regulations define computer software as “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.”
The definition of DPGR specifically does not include gross receipts derived from services; however, there is an exception for gross receipts derived from engineering or architectural services performed in the United States. Gross receipts from construction performed in the United States are also included.
The regulations clarify that except as otherwise provided, gross receipts derived from the performance of services do not qualify as DPGR. 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.
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. Such gross receipts qualify as DPGR even if the customer provides the computer software to its employees or others over the internet.
Consistent with the general treatment of services under IRC § 199, gross receipts derived from customer and technical support, telephone and other telecommunication services, online services (such as internet access services, online banking services, providing access to online electronic books, newspapers, and journals), and other similar services do not constitute gross receipts derived from a lease, rental, license, sale, exchange, or other disposition of computer software.
The regulations provide narrow exceptions to the general rule excluding online services from DPGR. Notwithstanding Treas. Reg. § 1.199-3(i)(6)(ii), 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 (online software), such gross receipts will be treated as derived from the disposition of computer software only if Treas. Reg. § 1.199-3(i)(6)(iii)(A) or (B) is met.
Treas. Reg. § 1.199-3(i)(6)(iii)(A) requires that the taxpayer also derive, on a regular and ongoing basis in the taxpayer’s business, gross receipts from the disposition to customers of computer software that has only minor or immaterial differences from the online software in a tangible medium or by download (the “self-comparable exception”). The petitioner does not assert that it meets the requirements of the self-comparable exception.
Treas. Reg. § 1.199-3(i)(6)(iii)(B) requires that another person derive, 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 “third-party comparable exception”). For purposes of the third-party comparable exception substantially identical software is computer software that (1) from a customer’s perspective has the same functional result as the taxpayer’s online software and (2) has a significant overlap of features or purpose with the taxpayer’s online software.
In order for the Fees to be treated as DPGR, the requirements of Treas. Reg. § 1.199-3(i)(6)(iii) must be met. The petitioner must first show that the Fees were derived from providing customers access to computer software MPGE in whole or in significant part by the petitioner within the United States for customers’ direct use while connected to the internet or any other public or private communications network. If this first requirement is met, the petitioner must show that either the self-comparable exception or the third-party comparable exception is met.
The Tax Court found that the petitioner did not provide its customers direct access to its software as defined in the Code and the regulations.
Logical Port Fees
The logical port fees are payments for access to the petitioner’s private communications network. Accordingly, the logical port fees are not DPGR. The petitioner’s logical port fees are analogous to Treas. Reg. § 1.199-3(i)(6)(v), Ex. 3. Both fees are for services that provide the customer with a connection, and neither fee is DPGR.
The petitioner contends that the 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 for the routing and trade execution services performed for customers. They were not derived from customers’ access to software for their direct use.
The petitioner claimed its transaction fees as DPGR. The petitioner contends that the transaction fees were derived from providing customers access to the matching-related functionality of its trading software for the customers’ direct use.
These fees are analogous to those described in Treas. Reg. § 1.199-3(i)(6)(v), Ex. 2. Both the petitioner and the company in the example charged their customers fees for participation in electronic markets and facilitated this service with computer software. The petitioner’s provision of trade execution services was an online service within the meaning of Treas. Reg. § 1.199-3(i)(6)(ii). Thus, the petitioner’s customers did not directly use its software.
Conclusion to the Fees
The petitioner is an operator of securities exchanges. The fact that the Exchanges use software to operate does not convert the petitioner’s trade execution services into the provision of software for customers’ direct use. The petitioner represented to the SEC that the Exchanges, not customers, were responsible for matching and executing orders. Consistent with the petitioner’s representations, the Fees were derived from services, not the direct use of software.
Third-Party Comparable Exception
The Tax Court held that the petitioner did not meet the threshold requirements of Treas. Reg. § 1.199-3(i)(6)(iii) with respect to the Fees. The Tax Court considered whether the petitioner met the further requirements of the self-comparable exception or the third-party comparable exception. In short, the petitioner failed to meet those requirements, too.
The petitioner in 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 the petitioner performed for customers in the course of operating its 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 Treas. Reg. § 1.199-3(i)(6)(iii).
Even if the Fees could meet the requirements of Treas. Reg. § 1.199-3(i)(6)(iii), they do not meet the further requirements of the third-party comparable exception. The petitioner has not demonstrated that a third party derived gross receipts from the disposition to its customers of software that was substantially identical to the petitioner’s online software.
- See 17 C.F.R. § 242.300(a) (2009). ↑
- Ch. 404, 48 Stat. 881 (codified as amended at 15 U.S.C. § 78a-78pp (2012)). ↑
- 17 C.F.R. § 242.600(b)(45) (2005). ↑
- See 15 U.S.C. § 78f(b). ↑
- See 15 U.S.C. § 78s(b)(1). ↑
- The petitioner initially included gross receipts from certain physical port fees and logical port fees for market data ports, but it has since conceded these fees. Its revised DPGR claimed was $677 million (2011), $585 million (2012), and $559 million (2013). ↑
- Treas. Reg. § 1.199-3(i)(6)(iii). ↑
- Treas. Reg. § 1.199-3(i)(6)(iii)(B). ↑
- Tax Court Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933). ↑
- Pub. L. No. 108-357, § 102(a), 118 Stat. 1418, 1424. ↑
- See ADVO, Inc. & Subs. v. Commissioner, 141 T.C. 298, 311-12 (2013). ↑
- Tax Cuts and Jobs Act of 2017, Pub. L. No. 115-97, § 13305(a), (c), 131 Stat. 2054, 2126. ↑
- IRC § 199(b). ↑
- IRC § 199(c)(1). ↑
- IRC § 199(c)(4)(A)(i)(I). ↑
- Treas. Reg. § 1.199-3(i)(1)(i). ↑
- IRC § 199(c)(5)(B). ↑
- Treas. Reg. § 1.199-3(j)(3)(i). ↑
- IRC § 199(c)(4)(A)(iii). ↑
- IRC § 199(c)(4)(A)(ii). ↑
- Treas. Reg. § 1.199-3(i)(4)(i)(A). ↑
- Treas. Reg. § 1.199-3(i)(4)(i)(A). ↑
- Treas. Reg. § 1.199-3(i)(6)(i). ↑
- Id. ↑
- Treas. Reg. § 1.199-3(i)(6)(ii). ↑
- Treas. Reg. § 1.199-3(i)(6)(iii). ↑
- Cf., e.g., I.R.S. Chief Couns. Adv. Mem. 201603028 (Jan. 15, 2016). ↑
- Cf., e.g., I.R.S. Chief Couns. Adv. Mem. 201603028. ↑
- Treas. Reg. § 1.199-3(i)(6)(iv)(A). ↑
- Treas. Reg. § 1.199-3(i)(6)(iii). ↑
- See 17 C.F.R. IRC § 240.3b-16(a)(1). ↑
- See Treas. Reg. § 1.199-3(i)(6)(iii). ↑
- Treas. Reg. § 1.199-3(i)(6)(iii)(B). ↑