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Sale of extended maintenance software contracts: deferral opportunities, international questions and possibilities.

The IRS National Office has issued Letter Ruling (TAM) 9231002 on a software company's method of recognizing revenue on the sale of extended maintenance contracts under which the taxpayer agreed to sell software updates. Based on the facts presented, the Service concluded that the taxpayer's sale of these contracts constituted the sale of an inventoriable good. Accordingly, the taxpayer was allowed to defer recognition of advance payments as revenue from the sales under Regs. Sec. 1.451-5(c). This conclusion creates the possibility of substantial deferrals of income and may be especially attractive to taxpayers who will be adopting deferral methods for book income under AICPA standards promulgated for the current year.

In addition, the IRS's conclusion, if extended to international provisions and to the interpretation of tax treaties, could have significant impact, for example, on the sourcing of income, the calculation of foreign tax credit (FTC) limitations and the imposition of withholding taxes. The Treasury is currently considering how to characterize international transactions involving off-the-shelf software.

Letter Ruling (TAM) 9231002

The taxpayer was in the business of developing and marketing computer software and used the accrual method of accounting. The taxpayer entered into perpetual term, nonexclusive licensing agreements relating to "off-the-shelf" computer software it internally developed. A purchaser of the taxpayer's software (that is, one who received a perpetual license of the underlying software) was entitled to one year of maintenance.

The taxpayer's customers could also enter into contracts ranging from one to five years to continue maintenance. Some customers entered into these contracts when they purchased the original software, while others did so toward the end of the initial year of maintenance.

Under the one-year and extended maintenance contracts, customers were entitled to receive, for no additional consideration, all future updates, cyclical releases and rewrites of the underlying software. Although the contracts did not guarantee a minimum number of new releases of the software, historically the taxpayer issued at least one release per year and averaged two new releases per year for each of its applications.

The taxpayer's customers with contracts were also entitled to telephone support services from technical representatives. The tax treatment of the amounts allocated for support services was not at issue, only the tax treatment of the software updates. An extended maintenance contract did not entitle customers to customized programming or system application services, nor did it entitle a customer to receive training, on-site programming, hardware analysis, on-site visitation, consulting with respect to technical or application software, or customer specific services. These services were provided on a fee-for-service basis.

The taxpayer's customers paid the entire amount for the extended maintenance contract in advance at the time they entered into the contract. For financial reporting purposes, the taxpayer recognized revenue from extended maintenance contracts ratably over the term of the contracts. The taxpayer currently deducted its costs associated with developing computer software in accordance with Rev. Proc. 69-21.

Before requesting technical advice, the taxpayer recognized revenue in accordance with Regs. Sec. 1.451-5(b)(1)(ii), which provides for the method of recognizing advance receipts received in connection with the sale of goods as income. Regs. Sec. 1.451-5(b)(1)(ii) allowed the taxpayer to include in income advance payments from the sale of maintenance agreements either (1) in the tax year of receipt or (2) in the tax year in which the income was properly accruable under the taxpayer's method of accounting for tax purposes, if that method resulted in including advance payments in gross receipts no later than the time they were recognized for financial reporting purposes. Thus, for tax purposes the taxpayer was recognizing revenue ratably over the term of the contracts.

IRS position

On examination, the Service first argued that the taxpayer's extended maintenance contracts did not constitute the sale of a good; rather, they represented the sale of future services. As a result, the IRS believed the taxpayer was required to recognize revenue either currently or in accordance with Rev. Proc. 71-21. In short, this revenue procedure would have mandated that taxpayers recognize revenue on the advance sale of services no later than one year subsequent to the year the advance payment was received. Further, Rev. Proc. 71-21 would not have applied if the contract was longer than one year. Alternatively, the Service argued that the taxpayer's sales of these contracts were royalty income; thus, the taxpayer would be required to recognize income on receipt of the advance payments.

National Office position

The IRS National Office supported the taxpayer's claim that the sale of extended maintenance contracts was an obligation to provide future goods. The taxpayer asserted, and the IRS agreed, that the taxpayer was selling an inventoriable good, thus allowing it to recognize income from the sales up to two years following the year the advance cash payments were received.

The TAM also held that the amounts received were not license or royalty fees. The Service reached this conclusion in the face of the fact that the software was transferred to the customer under a perpetual license allowing the customer to use the software only internally on designated central processing units and the license reserved to the developer all intellectual property rights in the software; the customer did not receive any such rights.

The taxpayer's GAAP basis financial reports accrued amounts received under its extended maintenance contracts on a straight-line basis over the duration of the contracts. For those extended agreements not in effect during the first year of included maintenance, no income was recognized for financial statements or for tax purposes, even though the taxpayer had unrestricted access to the advance payment and did not segregate amounts into a separate account. The taxpayer recognized as income in years 1 and 2 amounts recognized on a pro rata basis over the life of the agreement for financial statements and tax. Regs. Sec. 1.451-5(c) requires the taxpayer to include into income any amounts remaining by the end of the third year of the agreement.

With this decision, the IRS is clearly concluding that the sale of software is the sale of a "good" rather than a "service." This conclusion not only allows taxpayers to defer revenue on the sale of extended maintenance contracts, but also on the sale of its one-year maintenance contracts. The operation of this method may be illustrated as follows.

Example: Taxpayer T receives advance payments for extended maintenance agreements at a contract's inception. At the end of the initial year of maintenance, under a five-year contract, T would recognize 20% of the advance payments in each of the first and second tax years; the remaining 60% is required to be included in its gross receipts by the end of the third tax year.

In certain cases, the taxpayer's customers enter into and pay amounts due under extended maintenance contracts in the same year in which they enter into licensing agreements for the underlying software. Because the taxpayer provides one year of extended maintenance with the initial licensing of the software, these amounts are paid one year before the start of the extended maintenance contracts. For financial reporting purposes, the taxpayer does not recognize any income in the tax year in which the extended maintenance contract is entered into. Thus, in applying these circumstances to the example, T would recognize nothing in the first year (the year the advance payment is received), 20% in the second year and 80% in the third year. Thus, the year in which the contract is entered into will be included in computing the maximum deferral period under Regs. Sec. 1.451-5(c).

International implications

The TAM warns that, for other IRS purposes, amounts earned from extended software maintenance contracts could be considered royalties. The domestic group in the IRS National Office that issued the TAM was aware that there might be international tax implications. The Treasury currently has under consideration a draft revenue ruling that would specifically address some international implications. Thus, the TAM can only be used for guidance on international matters with caution. However, since there currently is little guidance on the treatment of software transfers for purposes of the FTC and source-basis taxation, the TAM is informative for taxpayers in the software industry.

The sale of goods characterization is relevant to many international Code sections, including Secs. 861, 863, 865, 881, 882, 904, 1441, 1442 and 6114, as well as to various tax treaties. Consider, for example, the following issues.

[] For FTC purposes, should the income be

- sourced using the sale of property rule of Sec. 861(a)(6) or the produced-within/sold-without rule of Sec. 863(b), or by looking to where the services were performed or the intangibles were used; and

- placed in the general limitation basket under Sec. 904(d)(1)(I) or in the passive basket, depending on whether the active royalties requirements are met (see Regs. Sec. 1.904-4(b)(2))?

[] Should the income be considered foreign source to a developer/marketer that is a nonresident alien or foreign corporation, depending on whether title passes outside the United States and no U.S. office participates in a sale to the U.S. market (see Sec. 865(e)(2) for details) or on whether the software is used in or out of the United States?

[] If the income is U.S. source to a foreign corporation or nonresident alien, will it be taxable only on a net basis, as effectively connected (that is, a sale of goods is not taxed on a gross basis) or exempt from U.S. tax? Or can it also be taxed on a gross basis as a royalty?

[] The income might automatically be treated as effectively connected to a foreign person under the limited force of attraction doctrine of Sec. 864(c)(3), instead of being tested under the assets or activities tests (as royalties and services income would be).

[] To a foreign person, the income might be treated as business profits rather than as royalties under a tax treaty (the treaty's definitions must be checked).

[] Whether the income might be free from treaty-based return reporting under Sec. 6114 by a foreign person because there is an exemption under the Code. The exemption applies to income from the sale of property if there is no U.S. trade or business activity or there is no U.S.-source income under Secs. 861, 863 and 865. If the income is from services or use of intangibles, different taxing rules would apply and, depending on the facts, a treaty's provisions might be more or less important.

In conclusion, the TAM suggests, but does not actually provide, possible IRS positions on various inbound and outbound international tax issues involving software transfers. We hope many of these issues will be resolved when the Treasury publishes its revenue ruling.
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Article Details
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Author:Kurtenbach, Terry
Publication:The Tax Adviser
Date:Mar 1, 1993
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