Proposed software regulations.

On Nov. 7, 1996 the IRS issued proposed regulations on the tax treatment of software programs. These long-awaited regulations represent a significant effort on the part of the Service and industry representatives to bring much-needed certainty to the tax consequences of technology transactions.

Effective Date

The regulations will be effective for transactions occurring on or after 60 days after the date final regulations are published in the Federal Register. There are no provisions for elective retroactivity.

Overview

These proposed regulations affect transactions engaged in by software developers, manufacturers, distributors, licensors, producers of hardware with embedded intangibles and end-users, and are relevant for virtually all international tax purposes. (While it appears to have been the Service's intention for the regulations to apply to all international tax provisions, the passive foreign investment company provisions were not specifically referenced.)

The proposed regulations provide that a transaction involving the transfer of a computer program will be classified as either the transfer of a copyright right, the transfer of a copyrighted article, the provision of services relating to the development of a computer program or the provision of know-how. A transaction involving more than one category will be broken into its separate components unless, under the facts and circumstances, the importance of a particular transaction is de minimis.

If the user of a computer program obtains one of four enumerated copyright rights, the transaction will be treated as the transfer of a copyright right. If one of the four rights is not transferred and the transaction does not involve, or involves to only a de minimis extent, the provision of services or know-how, the transaction will be classified solely as the transfer of a copyrighted article. Computer programs are considered similar to other copyrighted articles, such as books, records and motion pictures, that are literary works for purposes of the Copyright Act of 1976. The proposed regulations generally rely on copyright law principles and distinguish between transactions involving the copyright itself and the subject of the copyright (i.e., the software).

If a transfer involves copyright rights, it will be classified further as either a sale or license, depending on whether all substantial rights have passed to the transferee. If a transfer involves a copyrighted article, it will be further classified as either a sale or a lease of a copyrighted article, depending on whether the benefits and burdens of ownership have passed to the transferee.

While the regulations bring an element of certainty to the tax treatment of many software transactions, they leave some questions unanswered and create new questions.

Discussion

A significant issue in the tax treatment of software has been whether the transfer of software should be treated as a license or a sale. Virtually all transfers of software are structured legally and contractually as licenses. However, many types of software transactions, such as the sale of shrink-wrap or prepackaged software, more closely resemble the sale of a copyrighted article, such as a book.

The proposed regulations will treat a transfer of a computer program as a transfer of a copyright right if the transferee acquires one or more of the following rights: (1) the right to make copies of the program for distribution to the public by sale, by other ownership transfer, or by rental, lease or lending, (2) the right to prepare derivative computer programs based on the copyrighted program; (3) the right to make a public performance of the program, or (4) the right to publicly display the program. (This list differs list of rights set out in the Copyright Act of 1976. The copyright law right to copy will be treated as a copyright right for purposes of the proposed regulations only if it is accompanied by the right to distribute such copies to the public.) Accordingly, a transfer of a computer program without any of these rights win be treated as the transfer of a copyrighted article.

Thus, the normal sale of a shrink-wrap computer program to the general public, even though documented as a license, would be treated as the transfer of a copyrighted article, since the customer would not normally have the right to make copies for distribution to the public and would not have the right to prepare derivative programs.

Once the analysis is complete as to whether the transfer consists of a copyright right or a copyrighted article, a determination must be made as to whether the transaction is a sale or exchange or a license or lease. This analysis is important, as dramatically different tax consequences can arise. The standards to be used differ as to whether the transaction is the transfer of a copyright right or a copyrighted article. In the case of the former, the question is whether there has been a transfer of all substantial rights in the copyright. If so, there will be a sale or exchange. If less than all substantial rights are transferred, the transaction will be regarded as a license. In the case of a transfer of a copyrighted article, the test is the standard applicable to transfers of tangible property, that is, whether the benefits and burdens of ownership of the article have been transferred. If such rights have been transferred, a sale or exchange will have taken place@ if not, the transaction will be regarded as a lease.

Whether a transaction involving a new or modified computer program is treated as the provision of services or other transaction is a facts-and-circumstances inquiry that takes into account the intent of the parties, who will own the copyright rights, and the allocation of the risk of loss. The provision of information with respect to a computer program will not be treated as the provision of know-how unless the information relates to computer programming techniques, is not capable of being copyrighted and is subject to trade secret protection.

The proposed regulations take into account the business realities of the software industry and the changing way information is transferred. For example, the method of transferring the computer program (whether by disk or electronically) is not relevant.

Typical Transactions

Sales of shrink-wrap computer software: Under the proposed regulations, a typical shrink-wrap license of computer software will be treated as the transfer of a copyrighted article for tax purposes where none of the enumerated copyright rights are transferred. If the benefits and burdens of ownership are transferred, the transaction will be regarded as a sale rather than as a license. Thus, in the case of a typical shrink-wrap license (in which the purchaser acquires the software for use in perpetuity), the transaction will likely be a sale. In the case of sales to foreign persons, this generally means that at most only 50% of the revenue from such sales win be treated as foreign-source income. (The ability to obtain 50% foreign-source income requires that tide to the articles be transferred outside the U.S. under the Sec. 863(b) rules. There is an issue as to where tide passes on electronically transmitted software. It is hoped that the IRS would accept an agreement between the parties as to tide passage.) In contrast, royalties paid by foreign persons for the use of software outside the U.S. are 100% foreign-source income.

Transfers of software that the Internet: Under the proposed regulations, the means of transferring the program is irrelevant. Assuming that none of the enumerated copyright rights are transferred and the benefits and burdens of ownership are transferred, an electronic transfer of software should be treated as the sale of a copyrighted article.

Transfers subject to limitations: When a copyrighted article is transferred but the transferee does not obtain all of the benefits and burdens of ownership -- that is, when the transferee can us the software for a limited period -- the transaction may be viewed as a lease rather than as a sale.

This determination can have significant tax consequences; a lease may generate foreign-source income if the property is used outside the U.S. or U.S.-source income if used in the U.S., subject to withholding tax (except as modified by treaty).

Site licences: When a site license is granted to a transferee to make multiple copies of program for use only by the transferee's employees and none of the enumerated copyright rights is offered (including the right to reproduce for sale to the public), the transaction will be viewed as the of a copyrighted article notwithstanding the right to reproduce.

Rights to commercially reproduce: When a transferee of a software program obtain the right to reproduce the software for sale to die public, the transaction will be viewed as the transfer of a copyright right rather than of a copyrighted article, as one or more of the enumerated copyright rights has been transferred. Whether the transaction is a sale or license will de end on whether all substantial rights to the software have been transferred.

Development contracts: Whether a development or modification of a software program is a transfer of property or the performance of services is a question of fact. The regulations provide an example in which an existing copyright owned by a licensor is substantially modified to the specifications of a licensee. The licensor is considered as providing services to the licensee because the license bears all risk of loss connected with the modification and owns the copyright in the modified program. The fact that the agreement is labeled as a licence is not controlling.

Some Planning Opportunities and

Issues

FSC benefits: The medium of transfer is not relevant in determining whether a transaction is a sale of a copyright right or of a copyrighted article. Consequently, a transaction involving a site license or Internet transfer that otherwise qualifies as the transfer of a copyrighted article may be eligible for foreign sales corporation (FSC) benefits. However, the proposed regulations do not appear to provide any softening of the Service's view that software commercial reproduction licenses are not eligible for FSC benefits.

Know-how: The proposed regulations limit know-how to computer programming techniques not capable of being copyrighted and, "subject to trade secret protection." The provision of such know-how would be treated as a transfer of intangible property, while if the know-how how did not meet the definition, it would be treated as services. This definition raises a number of interpretive questions. It is unclear from die proposed regulations whether "subject to trade secret protection" means merely that the know-how be eligible for trade secret protection or that it is in fact protected under applicable trade secret law. (U.S. trade secret rules could possibly apply to a very broad range of activities. However, in many cases companies do not take any steps to protect these activities under the applicable trade secret rules, so no actual protection is afforded. Even if a company takes steps to protect the activities or its employees, it may be very difficult to determine whether the know-how is in fact protected under trade secret rules U.S. trade secret rules are an evolving body of law with no clear bounds; foreign trade secret rules are in many cases less well-defined. As a practical practical matter, it may be necessary to obtain an opinion from an intellectual property attorney to know whether the know-how is in fact protected property.) Given the IRS position expressed in Rev. Rul. 64-56 that know-how must be legally protected in order to qualify as property (and not services) for purposes of Sec. 351, the computer know-how will have be protected underpade secret law. The point should be clarified, however, since it it may introduce a narrower definition of intangible property film is found such sections as Secs. 865(d), 936(h)(3)(B) and 197, and Regs. Sec. 1.482-44(b). This issue will also have ramifications for Sec. 367 (particularly Sec. 367(d) and the source-of-income rules.

Special care should be taken in drafting development and modification agreements, as they often include transfers of property and the provision of services.

Double taxation: The new U.S. rules raise the risk of double taxation. A number of countries subject payments for software imports to withholding tax. If a software transfer is a sale of a copyrighted article for U.S. tax purposes, the source of income will be 50% foreign source if title and risk of loss pass outside the U.S., and 100% US. source if title passes within the U.S. For U.S. companies currently with excess foreign tax credits, this will create a need to structure software export agreements, to the extent feasible from a business perspective, in a manner that will enable them to qualify as a license or lease.

State taxation: The Services views could have considerable reverberations in the state tax area. It is unclear whether states will choose to accept the Federal characterization of software transactions. For example, some states have taken the position that license revenue derived by a licensor without physical presence in-state is subject to income tax in the licensee's state. If states accept the IRS position, fewer companies will be subject to state taxation on the basis of their license income.

Maintenance agreements: Surprisingly, the regulations do not contain any specific guidance on maintenance contracts. The typical maintenance contract includes both hotline type services and periodic software updates. The regulations state that transactions that consist of more than one of the four categories will be treated as separate transactions, unless one of the transactions is de minimis. Presumably, a maintenance contract should be separated into two components -- software and service -- unless one can be considered de minimis.

Customs: The proposed regulations apply for purposes of Sec. 1059A, which generally requires that a company reflect the customs valuation in its inventory. It appears that the proposed regulations will not significantly change customs valuations, the only portion of software generally dutiable is the medium, and it does not appear that the characterizations contained in the proposed regulations will have any effect on a medium's dutiable value.

Tangible vs. intangible property -- intercompany pricing: The regulations do not state whether the transfer of a copyrighted article is a transfer of tangible or intangible property, subject to the commensurate-with-income requirement for intercompany pricing purposes. It appears that, at least with respect to shrink-wrap software, the IRS may have limited the definition of intangible property for intercompany pricing purposes. The regulations use terminology associated with tangible property in discussing the transfer of a copyrighted article. For example, a copyrighted article is sold or leased and the determination of whether it is sold or leased is based on who has the benefits and burdens of ownership. These terms are generally associated with tangible property. Alternatively, a copyright right is either sold or licensed, and the determination of whether it is sold or licensed is based on whether there has been a transfer of all substantial rights. These terms are generally associated with intangible property. The only possible guidance in the current transfer pricing regulations on this issue is Regs. Sec. 1.482-3(f), which provides coordination between the tangible and intangible property rules. Under Regs. Sec. 1.482-3(f), if intangible property is embedded in tangible property and the purchaser does not acquire any right to the intangible property other than the right to resell the property, the property will not be considered a transfer of intangible property. If, however, the transfer enables the recipient to exploit the intangible property by using the embedded intangible in its business, it may be necessary to separately value the intangible property under the intangible property rules. (see also Regs. Sec. 1.482-1(d)3(v), which states that the comparability of intangibles embedded in tangible property or services will be determined under the intangible property rules.) The proposed regulations offer no guidance as to whether the software will be considered an embedded intangible.

Whether the intangible or tangible property rules apply has practical implications in numerous situations. For example, if a U.S. manufacturer sells shrink-wrap software to a related distributor for resale in country X, the new proposed regulations state that the transfer will be a transfer of a copyrighted article. For sourcing purposes, the transfer will be considered a sale of inventory property. It would seem that the most appropriate method to use in determining the arms-length price would be the comparable uncontrolled price, resale price or comparable profit method using distribution comparables. If the transfer is treated as a sale or license or intangible property, it is unclear whether these methods would be appropriate. Further, the specter of periodic adjustments looms if the transaction is the transfer of intangible property. Confirmation that copyrighted articles are to be considered tangible personal property would be welcome (if indeed that is what is intended).

Tangible versus intangible property -- lease income: The distinction between tangible and intangible property would also be important to U.S. users of foreign software in transactions characterized as a lease of a copyrighted article under the proposed regulations. Some tax treaties to which the U.S. is a party classify income from leases of tangible property as industrial and commercial profits that would not be subject to U.S. tax (including withholding tax), in the absence of a permanent establishment.

Tangible versus intangible property -- source rule: The tangible/intangible property distinction could also affect the source of income. Sec. 865 provides that the source of inventory sales (which could include intangible property) will generally be determined under Secs. 861, 862 and 863. However, Sec. 865(d) provides that in the case of "any sale of an intangible" for contingent payments, the source of the income win be determined as if the payments were royalties. Thus, although the export sale of a software program treated as a copyrighted article and in inventory would be sourced under Sec. 863(b), if it is considered to be intangible property and is for a contingent payment, the income could be entirely foreign source as a result of Sec. 865(d). (It is at least arguable that the Sec. 865(d) exception for intangible property applies to both inventory and noninventory property.) Again, the fundamental question is whether the software program would be treated as tangible or intangible property. Clarification of this point by the Service would be useful.

Intercompany pricing rules -- services: The proposed regulations appear to suggest that software-related items can only be characterized in four categories: (1) copyrighted program, (2) copyrighted article, (3) know-how related to computer programming techniques and (4) services. Assuming that the item is not within the relatively narrow definition of know-how related to computer programming techniques and is not a copyrighted program or article, it must be classified as a service. However, as noted, it appears the IRS has narrowed the very broad definition of intangible property contained in the transfer pricing rules. Some additional clarification on this point would be welcome.

Scope of application: The regulations are apparently effective for international tax purposes. However, there are many provisions of the Code in which characterization under the proposed regulations, in contrast to the form of the transaction, would not apply. It is conceivable that differences in timing and other matters could arise when the regulations construe a function as a sale for international tax purposes, but not for other purposes of the Code.