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TGS-NOPEC Geophysical Company v. Commissioner (155 T.C. No. 3)

On August 26, 2020, the Tax Court issued its opinion in TGS-NOPEC Geophysical Company v. Commissioner, 155 T.C. No. 3. The primary issue presented in TGS-NOPEC is whether the IRS’s disallowance of petitioner’s deduction for income attributable to domestic production activities pursuant to IRC § 199 was appropriate.

Business Background

The petitioner is engaged in the business of acquires, processes, and licenses marine seismic data. Raw seismic data is collected through seismic surveys, during which reflected energy waves are recorded on magnetic tapes. The data on those tapes is then processed to develop an image of subsurface geophysical structures. The processed data is ultimately purchased or licensed by companies in the oil and gas industry.

The petitioner generated revenue by, among other activities, licensing the use of the processed seismic data to its clients in the oil and gas industry. Further, a portion of the petitioner’s revenue was for what “reproduction revenue,” which is revenue earned by petitioner with respect to processed seismic data sold or licensed by petitioner but owned by petitioner’s parent company.

Tax Filings and Determination

The petitioner timely filed its Form 1120 for 2008. On the return, petitioner claimed, a domestic production activities deduction (DPAD) of $1.95m pursuant to IRC § 199, on the basis of domestic production gross receipts of $74m. The IRS examined the return, disallowed $1,941,087 of the claimed deduction, and issued a statutory notice of deficiency, determining a deficiency of $858,392 based on the disallowance. The petitioner timely filed a petition with the Tax Court seeking a redetermination.

The petitioner argues that it is entitled to the deduction on the grounds that its gross receipts from the sale or license of processed seismic data constitute domestic production gross receipts, because either (1) the processed seismic data meets the definition of qualifying production property (QPP), either as tangible personal property or sound recordings, that were manufactured, produced, grown, or extracted within the United States pursuant to IRC § 199(c)(4)(A)(i), IRC § 199(c)(5), and IRC § 168(f)(4); or (2) the processing of seismic data is an engineering service performed in the United States with respect to the construction of real property in the United States pursuant to IRC § 199(c)(4)(A)(iii). On the other hand, the IRS contends that petitioner is not entitled to the deduction under any IRC § 199 definition.

Examining IRC § 199

IRC § 199 enacted to provide a tax deduction for certain domestic production activities, and it permits a taxpayer to take a deduction for a specified percentage of the lesser of a taxpayer’s “qualified production activities income” (QPAI) for the taxable year or the taxpayer’s taxable income. IRC § 199(a). For 2008 the specified percentage was 6%. IRC § 199(a)(2).

QPAI means an amount equal to the excess, if any, of the taxpayer’s domestic production gross receipts (DPGR) for the taxable year over the sum of cost of goods sold allocable to such receipts and other expenses, losses, or deductions properly allocable to such receipts. IRC § 199(c)(1).  In turn, IRC § 199(c)(4) defines DPGR as including the gross receipts of the taxpayer which are derived from any lease, rental, license, exchange, or other disposition of QPP which was manufactured, produced, grown, or extracted by the taxpayer in whole or in significant part within the United States. IRC § 199(c)(4)(A)(i)(I).

Qualifying Production Property

QPP is defined as tangible personal property, any computer software, and any sound recording described in IRC § 168(f)(4). IRC § 199(c)(5). The petitioner argued that the processed seismic data that it licenses to its clients constitutes QPP under IRC § 199(c)(5) as either tangible personal property under IRC § 199(c)(5)(A) or as a sound recording within the meaning of IRC § 199(c)(5)(C) and IRC § 168(f)(4).

The property offered for sale or license in this case is the processed seismic data. Treas. Reg. § 1.199-3(d)(1). The petitioner contended that the processed seismic data constitutes tangible personal property because it is delivered to clients via one or more tangible media, such as computer hard drives, compact discs, computer tapes, or magnetic media tape. To support this argument, the petitioner cited the case of Texas Instruments, Inc. v. United States, 551 F.2d 599 (5th Cir. 1977), and argued that the data should be considered tangible personal property because the value of the processed seismic data depends entirely on the existence of the tangible media and the data would not exist without being recorded thereon.

The Definition of Tangible Personal Property

By definition, tangible personal property is that which is “corporeal,” capable of being seen, weighed, measured, felt, touched, or in any other way perceived by the senses. Thus, tangible personal property is property other than land, real property, computer software, sound recordings, qualified films, electricity, natural gas, or potable water, which is capable of being perceived by the senses. Treas. Reg. § 1.199-3(j)(2)(i); see also ADVO, Inc. & Subs. v. Commissioner, 141 T.C. 298, 316 (2013).

Tangible personal property does not include property in a form other than a tangible medium. Treas. Reg. § 1.199-3(j)(2)(iii). The regulations provide, by way of example, that mass-produced books are tangible personal property, but neither the rights to the underlying manuscript nor an online version of the book is tangible personal property. Id.

Similarly, computer software, sound recordings, and qualified films are not, generally speaking, tangible personal property, even if affixed to a tangible medium. Treas. Reg. § 1.199-3(j)(2)(i). Instead, the gross receipts from the sale of such intangible property are only DPGR by virtue of explicit carve-outs within the Code and Treasury Regulations. See Treas. Reg. § 199(c)(4)(A)(i)(II), (5). The tangible medium to which such property may be affixed, however, is tangible personal property. Treas. Reg. § 1.199-3(j)(2)(i).

As with the Texas Instruments case, the property offered for sale or license in this case is the processed seismic data. The intangible nature of this data is not changed by petitioner’s loading the information onto a CD or other tangible medium. Such a medium serves only as the vehicle of transfer for the data; it does not become an embodiment of the data itself. In Texas Intruments, 551 F.2d at 608, the Fifth Circuit found that the seismic field takes constituted tangible personal property for purposes of the IRC § 38 investment tax credit. In reaching its conclusion, the Fifth Circuit articulated what has come to be known as the “intrinsic value” test: property is considered intangible if its intrinsic value is attributable to its intangible elements rather than to any of its specific tangible embodiments. Id. at 609.

Distinguishing Texas Instruments

In Texas Instruments, the original tapes and film contained the original data that was used to produce copies of the data and images that were eventually sold or licensed to the taxpayer’s clients. In contrast, the item in the present case is not the original tapes but the processed seismic data, which petitioner nonexclusively licenses to its clients. Unlike the original data tapes in Texas Instruments, the processed seismic data licensed by petitioner is not inextricably linked to the tangible medium on which it is recorded. Rather, the tangible medium serves only as a delivery vehicle to transmit reproductions of the data from petitioner’s library to the client’s computer system.

Finally, the petitioner maintains at least two copies of the data, in different locations, and is capable of recovering the data should anything happen to the tapes. It is the data itself, and not the tangible medium, that the client is interested in. Once that data has been transmitted to the client, the client is able to load it onto its computers, make its own copies of the data, and share the data within its organization.

(155 T.C. No. 3) TGS-NOPEC Geophysical Company v. Commissioner

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