Federal Appeals Court Weighs Customer Use in $42.9M Software Tax Credit Dispute

A panel of federal appeals court judges on Tuesday closely questioned how customers interact with software developed by a pharmacy benefits management company, weighing a central issue in a dispute over a $42.9 million tax credit for domestic production activities. During oral arguments, the court scrutinized whether the company’s software is directly used by its customers in a manner that qualifies for the now-repealed Section 199 deduction. The outcome of the appeal could have significant implications for how other software and technology companies can claim tax benefits tied to products that customers access online but do not download or install directly. The case revolves around the Domestic Production Activities Deduction (DPAD), which was enacted in 2004 to incentivize manufacturing and other production within the United States. While the law was repealed by the Tax Cuts and Jobs Act of 2017, disputes over its application to tax years prior to 2018 continue to work their way through the courts. The credit allowed for a deduction on income derived from the lease, license, sale, exchange, or other disposition of qualifying production property manufactured, produced, grown, or extracted by the taxpayer in the U.S. For software companies, qualifying for the credit often hinged on proving that their product was not merely a service but a tangible piece of property licensed to customers. The key distinction under scrutiny in Tuesday's hearing is whether the pharmacy benefits company’s software—which facilitates prescription drug management—is an internal tool used to provide a service or a product that customers themselves directly use and control. This kind of judicial scrutiny highlights a persistent challenge for technology companies: tax laws often lag far behind innovation. We frequently see clients with sophisticated software-as-a-service (SaaS) platforms struggle to fit their business models into legal frameworks originally designed for traditional manufacturing. The ambiguity in defining what constitutes a licensed software “product” versus a tech-enabled “service” creates significant uncertainty and risk during tax audits. The government has argued that the company’s customers are paying for a management service, with the software acting as a behind-the-scenes operational tool. The company, however, contends that its clients directly interact with and derive value from the software platform itself, constituting a form of use that should qualify for the production credit. The judges’ questions focused on the nature of this interaction and the level of control customers have over the software’s functions. The legal battle underscores the arduous process companies often face when their tax positions on complex technology claims are challenged by tax authorities. In a separate, landmark case involving software-related research and development tax credits, a company referred to as ClaimCo endured a grueling appeals process that spanned more than a decade. Revenue authorities initially denied the company’s credits after an independent expert concluded it failed to substantiate its R&D claims. The company persisted through multiple rounds of correspondence and appeals before ultimately succeeding. That case highlighted the critical importance of detailed documentation and persuasive oral testimony from technical staff with first-hand involvement in the development work. The final determination, which ran 150 pages, served as a testament to the level of evidence required to defend such claims successfully. The lesson here is that substantiation is everything. Simply developing and deploying software isn't enough; companies must meticulously document how customers directly interact with and derive value from it. This proactive approach to documentation is central to our tax preparation and compliance services. Waiting until an audit notice arrives to build your case is a recipe for a long and costly dispute with the IRS. In our experience, the companies that successfully defend their tax positions are those that build a defensible case from day one. For businesses navigating these complex rules, the team at C&S Finance Group LLC at csfinancegroup.com provides the expert guidance needed to build that foundation. These protracted disputes are not uncommon in high-stakes corporate tax law. The ongoing, multi-billion-dollar audit of Microsoft’s tax strategies from the mid-2000s, for example, has involved years of litigation, Freedom of Information Act requests, and even the IRS hiring an outside law firm for the first time in its history to assist with an audit. Such cases illustrate the lengths both corporations and the government will go to in tax battles that can take a decade or more to resolve. The ruling from the appeals court in the pharmacy benefits manager case is now pending. A decision in favor of the company could provide a favorable precedent for other SaaS and cloud-based software providers arguing that their online platforms qualify for production-related tax incentives. Conversely, a ruling for the government could further narrow the path for such claims, reinforcing the distinction between a licensed product and a technology-enabled service.