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Federal Income Tax Characterization of Transactions Involving Computer Programs

Federal Income Tax Characterization of Transactions Involving Computer Programs

The sale of a computer program—it seems simple.  But, as illustrated by the Treasury Regulations’ computer program characterization rules, the issue of just what a sale of computer program is can become confusing fast.

The Computer Program Characterization Regulations

Treasury Regulation § 1.861-18 provides rules for characterizing primarily cross-border transactions involving computer programs.[1]  For these purposes, a “computer program” means “a set of statements or instructions to be used directly or indirectly in a computer in order to bring about a certain result.”[2]  The term also includes certain items incidental to the operation of a computer program.[3]

In characterizing a transaction involving a computer program, neither general principles of copyright law nor the parties’ characterization of the transaction are determinative.[4]  For instance, it doesn’t matter if the parties label a transaction a license or payments as royalties if factors present in the transaction warrant a different treatment.[5]  The means by which the computer program is transferred also is irrelevant.[6]

Ultimately, there are six possible results from the application of the computer program characterization rules: 1) the sale or exchange of copyright in a computer program, 2) the license of a copyright in a computer program (generating royalties income), 3) the sale or exchange of a copy of a computer program, 4) the lease of a copy of a computer program, 5) the provision of services for the development/modification of a computer program; or 6) the provision of know-how relating to computer programming techniques.[7]

To get to these results, the regulations first require that we distinguish between the transfer of the copyright in a computer program versus the transfer of a copy of a computer program.[8]

A transaction is the transfer of a copyright right if the purchaser acquires any one of the following rights:

  • the right to make copies of the computer program for purposes of public distribution;
  • the right to prepare derivative computer programs based on the copyrighted computer program;
  • the right to make a public performance of the computer program;
  • the right to publicly display the computer program.[9]

If there’s a transfer of all substantial rights in a copyright, then the transaction is sourced as the sale or exchange of the copyright (i.e., the sale or exchange of personal property).[10]  If the transaction doesn’t result in the transfer of all substantial rights in copyright, the transaction is characterized as a license with the resulting income being royalties.[11]

On the other hand, if the purchaser acquires a copy of a computer program but none of the copyright rights mentioned above, then the transaction usually is characterized as the sale of a copyrighted article.[12]  If the benefits and burdens of ownership of the copyrighted article are transferred to the purchaser, then the transaction is characterized as the sale or exchange of the copyrighted article.[13]  But, if the benefits and burdens of ownership of a copyrighted article don’t transfer to the purchaser, then the transaction is characterized as the lease of the copyrighted article, giving rise to rental income.[14]

The computer program characterization regulations give relatively short shrift to determining when a transaction is best characterized as the provision of development or modification services or the provision of know-how. We’re told that determining whether a transaction involving a new or modified computer program should be characterized as the provision of services is based on all the facts and circumstances.[15]  These include which party was intended to own the copyright rights in the computer program and how the parties allocated risks of loss.[16] The provision of information relating to a computer program is to be characterized as the provision of know-how only if the information relates to computer programming techniques, is furnished under specifically contracted for conditions preventing unauthorized disclosure, and is considered property subject to trade secret protection.[17]

Recent Developments in Computer Program Taxation

The computer program characterization regulations were finalized in 1998.[18]  In 2019, the issued proposed regulations that would update the computer program characterization regulations to account for transfers of digital content more generally and to add a new set of rules dealing with the characterization of cloud transactions.[19]

Under the proposed regulations, the term “computer programs” in the current computer program characterization regulations would largely be replaced by the term “digital content,” which would be defined as “a computer program or any other content in digital format that is either protected by copyright law or no longer protected by copyright law solely due to the passage of time.”[20]  The right to make a public performance or display digital content would be added to the list of copyright rights to be used in distinguishing the transfer of a copyright right versus the transfer of a copyrighted article on the one hand and the sale of a copyright versus the license of a copyright on the other.[21]  When a transaction is characterized as the sale of a copyrighted article and the article is transferred electronically, the location where the sale occurs would be determined by where the article was downloaded or installed on the end-user’s device.[22]

Cloud transactions would be characterized either as the provision of services or the lease of property.[23]  A “cloud transaction” would be defined as “a transaction through which a person obtains on-demand network access to computer hardware, digital content . . . , or other similar resources . . . .”[24]  The term would not include network access to download digital content.[25]  In determining whether a cloud transaction is the provision of services or the lease of property, all relevant factors would have to be considered.[26]  Factors indicating that a cloud transaction is the provision of services would include:

  • the customer doesn’t physically possess the property;
  • the customer doesn’t control the property;
  • the provider can determine which property is used in the cloud transaction and replace that property with comparable property;
  • the property is part of an integrated operation in which the provider has other responsibilities, including maintaining and updating the property;
  • the customer doesn’t have any significant economic or possessory interest in the property;
  • the provider bears the risk of substantially diminished receipts or substantially increased expenditures for nonperformance under the contract;
  • the provider uses the property to provide significant services to entities unrelated to the customer;
  • the provider’s fee is primarily based on a measure of work performed or the level of the customer’s use rather than mere passage of time; and
  • the total contract price substantially exceeds the rental value of the property for the contract period.[27]

Parting Thoughts on Computer Program Taxation

With the increasing digitalization of everyday life, rules for characterizing cloud transactions and transactions involving computer programs and digital content will become increasingly relevant.  Expect more on this in the future.

[1] 26 C.F.R. § 1.861-18(a)(1).  The parts of the Internal Revenue Code to which the regulation specifically applies include Chapter 1, Subchapter N (“Tax Based on Income From Sources Within or Without the United States”), Section 367 (“Foreign Corporations”), Section 404A (“Deduction For Certain Foreign Deferred Compensation Plans”), Section [14] I.R.C. § 482 (“Allocation Of Income And Deductions Among Taxpayers”), Section 679 (“Foreign Trusts Having One Or More United States Beneficiaries”), Section 1059A (“Limitation On Taxpayer’s Basis Or Inventory Cost In Property Imported From Related Persons”), Chapter 3 (“Withholding of Tax on Nonresident Aliens and Foreign Corporations”), Section 842 (“Foreign Companies Carrying On Insurance Business”), Section 845 (“Certain Reinsurance Agreements”), and transfers to foreign trusts not covered by Section 679.  Id.

The Internal Revenue Service also intends these rules to apply for purposes of applying and interpreting U.S. tax treaties. 63 Fed. Reg. 52971, 52972 (Oct. 2, 1998).

[2] 26 C.F.R. § 1.861-18(a)(3).

[3] Id.

[4] Id. § 1.861-18(g)(1).

[5] Id. § 1.861-18(h) ex.(5)(ii)(B).

[6] Id. § 1.861-18(g)(2).

[7] See id. § 1.861-18(b)(1), (f)(1), (f)(2).

[8] See id. 26 C.F.R. § 1.861-18(b)(1), (f)(1), (f)(2).

[9] Id. § 1.861-18(c)(1)(i), (2).  A purchaser doesn’t have the right to distribute a computer program to the public if it is only allowed to distribute the program to a related person or identified persons.  Id. § 1.861-18(g)(3)(i).  This applies regardless of the number of the number of employees or independent contractors of the transferee who are permitted to use the computer program.  Id. § 1.861-18(g)(3)(ii).

[10] Id. § 1.861-18(f)(1).  The regulations specify that most of the rules for sourcing sales of personal property apply to the sales of a copyright with the notable exception of the rule that applies to the sale of inventory property.  See id.; 26 U.S.C. § 865(b).

[11] 26 C.F.R. § 1.861-18(f)(1).  Under the income sourcing rules, U.S. source income “includes rentals or royalties from property located in the United States or from any interest in such property, including rentals or royalties for the use of, or for the privilege of using, in the United States patents, copyrights, secret processes and formulas, good will, trademarks, trade brands, franchises, and other like property.”  Id. § 1.861-5; see also 26 U.S.C. § 861(a)(4).

The transfer of nonexclusive rights to reproduce a computer program for a limited period of time is indicative a license. 26 C.F.R. § 1.861-18(h) ex. (6)(ii)(B), (8)(ii).

[12] Id. § 1.861-18(c)(1)(ii).  Among the factors that are considered in determining whether the benefits and burdens of ownership have been transferred to the purchaser is any limitation on the p of the period of time during which transferee may use the computer program.  For instance, if the transferee can only use the program for certain period of time (after which period, the computer program is to be returned, destroyed, or locked), then the transaction is characterized as a lease of a copyrighted article.  Id. § 1.861-18(f)(3), (h) Ex. (3)(ii)(B), Ex. (4)(ii)(B).

[13] Id. § 1.861-18(f)(2).

[14] Id. § 1.861-18(f)(2).  Rental income is sourced in the same way as royalties.  See 26 U.S.C. §§ 861(a)(4), 862(a)(4); 26 C.F.R. § 1.861-5.

[15] 26 C.F.R. § 1.861-18(d).

[16] Id. § 1.861-18(d).  Thus, when Party A enters into a contract Party B pursuant to which Party B will develop a new computer program in which, regardless of whether the Party B completes the program, all copyright rights in the program and any of its constituent elements will belong to Party A and Party B will retain all payments from Party A, Party B is treated as providing services to Party A.  Id. § 1.861-18(h) ex. (15).

[17] Id. § 1.861-18(e).

[18] 63 Fed. Reg. 52971.

[19] 84 Fed. Reg. 40317 (Aug. 14, 2019).

[20] Id. at 40324 (Prop. 26 C.F.R. § 1.861-18(a)(2)).

[21] Id. at 40324 (Prop. 26 C.F.R. § 1.861-18(c)(2)(iii), (iv)).

[22] Id. at 40325 (Prop. 26 C.F.R. § 1.861-18(f)(2)(ii)).

[23] Id. at 40326 (Prop. 26 C.F.R. § 1.861-19(a)).

[24] Id. at 40326 (Prop. 26 C.F.R. § 1.861-19(b)).

[25] Id.

[26] Id. at 40326 (Prop. 26 C.F.R. § 1.861-19(c)(1)).

[27] Id. at 40326 (Prop. 26 C.F.R. § 1.861-19(c)(2)).  These factors are largely adapted from those listed in 26 U.S.C. § 7701(e).  Id. at 40232.


TL Fahring

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