A package of films licensed by a taxpayer in the normal course of business can qualify as an item under Reg. §1.199-3(d)(1)(i) for purposes of the domestic production activity deduction under §199 per Revenue Ruling 2018-3.

The ruling looks at the following facts:

X Corporation (X) licenses a package of films (for example, a television channel) to customers for a fee in the normal course of its business. X's package contains films licensed to X by unrelated third parties and films produced by X. X pays license fees for distribution rights of the licensed films.

The IRS rules that:

In the situation described above, the package of films is property offered in the normal course of X’s business for disposition to customers. Thus, the package of films can be an item under § 1.199-3(d)(1)(i) if the gross receipts that X derives from licensing the package of films qualify as DPGR.

The gross receipts that X derives from licensing the package of films may qualify as DPGR under § 199(c)(4)(A)(i)(II) and § 1.199-3(a)(1)(ii) if X establishes that the package of films meets the criteria established under the general rules in § 1.199-3(k)(1) and § 1.199-3(k)(6) or, alternatively, under the safe harbor in § 1.199-3(k)(7) (including the safe harbor in § 1.199-3(g)(3)).

The ruling goes on to discuss the applicability of the safe harbor rule at Reg. §1.199-3(k)(7):

If X relies on the safe harbor in § 1.199-3(k)(7), the “not-less-than-50-percent-of-the-total-compensation” requirement in § 1.199-3(k)(7)(i) is a fraction where the numerator is the compensation X paid to actors, production personnel, directors, and producers for services performed in the United States that are directly related to the films in X's package and the denominator is such compensation regardless of where the film production activities were performed. Furthermore, to satisfy the safe harbor in § 1.199-3(g)(3), X's direct labor and overhead for the package of films must be 20 percent or more of X's unadjusted depreciable basis in the package of films, or 20 percent or more of X's cost of goods sold (CGS) of the package of films if X has CGS for the package of films. Direct labor and overhead include the costs for any films that are treated as self-produced by X, and do not include license fees of the licensed films. Under § 1.199-3(g)(3)(ii), “unadjusted depreciable basis” includes the costs that create basis under § 1012 and adjusted basis under § 1011 without regard to any adjustments described in § 1016(a)(2) or (3). This means that all costs that X paid or incurred for the package of films, including any fees X paid to unrelated third parties to license films included in the package, are included in unadjusted depreciable basis. Thus, X's unadjusted depreciable basis includes costs of self-produced films plus license fees X paid to acquire distribution rights in the licensed films (CGS would also include these costs, in a transaction with CGS). Costs reasonably attributable to transmission and distribution activities should not be included in X's direct labor, overhead, or unadjusted depreciable basis (or CGS, in a transaction with CGS).

X's films are treated as self-produced if X engaged in the film production activities, or if the films were produced pursuant to a contract with an unrelated party and X had the benefits and burdens of ownership as required under § 1.199-3(k)(8) and § 1.199-3(g)(4). X's film production activities include the following activities carried out by actors, production personnel, directors, and producers engaged in film: (1) pre-production (ideation, planning, and scripting); (2) production (shooting and recording images and sounds); and (3) post-production (film editing, scene sequencing, and the addition of audio/visual effects for self-produced films). X's transmission and distribution activities are not film production activities. Transmission and distribution activities include, for example: formatting the channel feed; assembly and transmission of the channel signal by collecting films by satellite, fiber optic cable, tape, and other means; decoding; reviewing; assessing; performing quality control for incoming and outgoing signals; converting to/from high definition and for viewing on mobile and other platforms; compressing and encoding signals for distribution; transmitting signals to customers; creating a seamless viewing format; adding overlay of special features and digital technologies; and inserting transition material