Editor: Rick Klahsen, CPA
Globalization of economies and explosions in the use and application of computer software have created significant need for global distribution networks for participants in the industry. To address this need, software developers have either acquired established foreign distributors or developed wholly owned foreign distribution networks. The proper U.S. tax treatment of a sale or license of computer programs through a foreign subsidiary is challenging and potentially expensive in cash taxes. A practitioner must consider a variety of aspects and value exchanged in transactions and transfers when assessing transactions in software. Items include:
- Intangible value inherent in any transfer;
- The wide variety of methods by which the software can be transmitted; and
- The wide-ranging applications and uses of software programs.
U.S. tax treatment is dependent on classification of revenue under Regs. Sec. 1.861-18 (the software regulations), which have been effective since enactment on October 2, 1998. Accurate assessment and classification of software revenue coupled with planning are critical to software developers’ international tax planning.
Application of the Software Regulations
The software regulations provide for the classification of transactions involving computer programs. The Code and regulations define “software” as a set of statements or instructions to be used directly or indirectly in a computer in order to bring about a certain result (Regs. Sec. 1.861-18(a)(3)). Computer software transactions are one of the following revenue types:
- Transfer of copyright rights;
- Transfer of a copyrighted article;
- Provision of services relating to development or modification of a computer program; or
- Provision of know-how relating to computer programming techniques.
Regs. Sec. 1.861-18(c)(1)(i) classifies a transfer of a computer program as a transfer of a copyright right if, as a result of the transaction, a person acquires certain rights. These rights include:
- The right to make copies of the computer program for purposes of distribution to the public by sale or other transfer of ownership or by rental, lease, or lending;
- The right to prepare derivative computer programs based on the copyrighted computer program;
- The right to make a public performance of the computer program; or
- The right to publicly display the computer program (Regs. Secs. 1.861-18(c) (2)(i)–(iv)).
If a person acquires a copy of a computer program but does not acquire any of the copyright rights as defined above, the transfer is classified as a transfer of a copyrighted article under Regs. Sec. 1.861-18(c)(2). Transactions involving computer programs can consist of both the transfer of a copyright right and the transfer of a copyrighted article and in such cases are subject to certain de mini mis rules.
The transfer of a copyright right is a sale or exchange of property if there has been a transfer of all substantial rights in the copyright. A transfer that does not convey substantial rights to the copyright is classified as a license, generating royalty income.
In contrast, the transfer of a copyrighted article is treated as a sale or exchange generating ordinary income if the benefits and burdens of ownership have been transferred. However, transfer of insufficient benefits and burdens of ownership of the copyrighted article converts the income to a lease, generating rental income.
The regulations further provide two important operating rules:
- Neither the form adopted by the parties in a transaction nor the classification of the transaction under copyright law determines the classification of the software transaction for U.S. tax purposes as set forth in Regs. Sec. 1.861-18(a)(1). Rather, the facts and circumstances of each software transaction will be reviewed in the context of Regs. Secs. 1.861-18(c) and (f) to determine the appropriate classification.
- The medium used to transfer the computer program, whether physical or electronic, should be disregarded when applying the regulations.
Impact of Classification on Subpart F
If a U.S. taxpayer licenses software to customers through a controlled foreign corporation (CFC), the U.S. taxpayer, as a shareholder of the CFC, may be required under subpart F (Secs. 951–965) to include all or a portion of the CFC’s income in its gross income (as a U.S. income inclusion) in the year earned. If income earned by a CFC is not subject to subpart F, the
U.S. shareholder does not incur the income inclusion until the foreign earnings are repatriated as an earnings distribution or other intercompany payment for goods or services. The additional specter of subpart F income inclusions makes proper assessment of the income and subpart F application crucial.
Overview of Subpart F
Sec. 951(a) states that a U.S. shareholder of a CFC shall include in its gross income its pro-rata share of subpart F income. A CFC is defined in Sec. 957(a) as any foreign corporation in which more than 50% of the total combined voting power of all classes of stock or value of stock is owned by U.S. shareholders on any day of the tax year. A U.S. shareholder is defined in Sec. 951(b) as a U.S. person that owns (directly, indirectly, or constructively under Sec. 958(b)) 10% or more of the total combined voting power of all classes of stock entitled to vote of the foreign corporation.
Subpart F provides several categories of income subject to inclusion. Specific to software situations, Sec. 952(a)(2) foreign base company income comes into play. “Foreign base company income” is defined in Sec. 954(a) as foreign base company sales income (FBCSI) and foreign personal holding company income (FPHCI).
FBCSI is income from the sale of property:
- Purchased from or on behalf of, or sold to or on behalf of, a related person; and
- That is both manufactured and sold for use outside the CFC’s country of organization.
Sec. 954(c) defines FPHCI. It includes items of passive income such as dividends, interest, rents, royalties, and gains from property producing such passive income. If, and only if, the foreign corporation is a CFC for an uninterrupted period of 30 days or more during the tax year, every
U.S. shareholder of the CFC who owns stock on the last day of the tax year must include its pro-rata share of the CFC’s subpart F income in gross income.
Impact of Classification Under Software Regs. on Treatment Under Subpart F
If, under the software regulations, the transfer of software is treated as a sale of property, the transaction must be analyzed to determine if the FBCSI rules of Sec. 954(d) are applicable. If the software regulations classify a transfer as a license or lease (generating royalty or rental income, respectively), the FPHCI rules of Sec. 954(c) apply. Each set of rules contains certain exceptions, outlined below, that could prevent the income from constructive dividend treatment in the year earned.
Sale of Software: FBCSI
A transfer of software classified as a sale of property must be assessed for potential FBCSI if the property:
- Is purchased from or on behalf of, or sold to or on behalf of, a related person; and
- Is both manufactured and sold for use outside the CFC’s country of organization.
If the income is FBCSI and no exceptions apply, the U.S. shareholders of the CFC are taxed on the net FBCSI in the year earned, regardless of whether the CFC actually distributes its earnings to its U.S. shareholders.
As an example, income from the sale of software created by the U.S. shareholder and then sold to a CFC and sold outside its country of incorporation is FBCSI and is included in the U.S. shareholder’s income. If the CFC produces software in its country of incorporation, any sales of such software outside the CFC’s country of incorporation would not be FBCSI or subject to current taxation under subpart F, as provided under the manufacturing exception to subpart F in Regs. Sec. 1.954-3(a)(4). Note that under Regs. Sec. 1.954-3(b), an “exception to the exception” may apply (and the income from a sale of software could be treated as FBCSI) if a branch of the CFC writes the software and the branch is located in a jurisdiction with a substantially lower income tax rate than that of the CFC’s country of incorporation.
There is an important caveat to the manufacturing exception that one must carefully consider regarding how the regulations define “manufacturing” in Regs. Secs. 1.954-3(a)(ii)–(iii) and correctly apply the definition to the taxpayer’s current activities. Application of the exception applies when the selling corporation (CFC) has substantially transformed the property prior to sale. Where the purchased part is a component of the sold product, the subsequent sale will be treated as a sale of a manufactured product if the operations conducted by the selling corporation (CFC) in connection with the product are substantial in nature and are considered to constitute the manufacture of a product, based on the facts and circumstances. But if property conversion costs (direct labor and factory burden) of the CFC account for 20% or more of the total cost of sales, the CFC is deemed to sell a manufactured product. Packaging, repackaging, labeling, or minor assembly will not constitute manufacturing in any event. Based on these rules, it would appear that the replication of the software to a new disk (for example) would not be a substantial transformation of the product.
In addition to the manufacturing exception, there is a high-tax exception in which the sale of the product will not generate FBCSI if the CFC is incorporated in a country that has an income tax rate greater than or equal to 90% of the U.S. tax rate outlined in Sec. 11 (Sec. 954(b)(4)). In addition, a de minimis rule may apply in which a CFC’s gross income that would otherwise be foreign base company income will not be treated as such if it is less than the smaller of 5% of the total CFC gross income or $1 million (Sec. 954(b)(3)).
License of Software: FPHCI (Royalty)
If, under the software regulations, the transfer of software is characterized as a license by the CFC to its customer, the CFC is treated as receiving royalty income, which is FPHCI. Absent an applicable exception, such income would be constructively distributed to the U.S. shareholder(s) under the subpart F rules.
However, Sec. 954(c)(2) provides an active royalty exception, which states that royalty income is not FPHCI if it is received from an unrelated person and derived in the CFC’s active conduct of a trade or business. If the CFC earns royalties from licensing property that it has developed, created, or produced or has acquired and added substantial value to, it is not FPHCI (provided that the CFC is regularly engaged in the development, creation, or production of, or in the acquisition of and addition of substantial value to, property of this kind) (see Regs. Sec. 1.954-2(d)(1)(i)). In addition, even if the CFC does not develop, create, or produce property it sells, such royalties are not FPHCI if the CFC derives royalties from licensing property that is licensed as a result of the CFC’s performance of marketing functions. This assumes that the CFC regularly engages in such marketing of the licensed property and that those marketing functions are substantial in relation to the amount of royalties derived from the licensing of the property (see Regs. Sec. 1.9542(d)(1)(ii)).
Lease of Software: FPHCI (Rent)
If, under the software regulations, the transfer of software is characterized as a lease by the CFC to its customer, the CFC is treated as receiving rental income, which is FPHCI. Absent an applicable exception, that income would be constructively distributed to the U.S. shareholder(s) under the subpart F rules.
Under Sec. 954(c)(2), rental income received from an unrelated person and derived in the active conduct of a trade or business is not FPHCI. Regs. Sec. 1.9542(c) states that rent will be considered to be derived in the active conduct of a trade or business if it is derived from the CFC (lessor) leasing property that the CFC has manufactured or produced, or has acquired and added substantial value to, but only if the CFC is regularly engaged in the manufacture, or the acquisition of and addition of substantial value to, property of such kind. Nevertheless, if the CFC does not manufacture a product, such rental income may be considered to be derived in the active conduct of a trade or business if the CFC leases property as a result of marketing functions performed by the CFC. The CFC, through its own staff located in a foreign country, must maintain and operate an organization in that country that is regularly engaged in the business of marketing and servicing the leased property and that is substantial in relation to the amount of rent derived from the leasing of the property.
The classification of income from software transactions made by a CFC under the software regulations can have a significant impact on the treatment of such income to the CFC’s U.S. shareholder. Proper classification of the income is critical to determining how the income will be treated under various provisions of subpart F—as either FBCSI or FPHCI—and what exceptions to subpart F treatment may be available to the taxpayer.
Rick Klahsen is managing director, Tax Services, with RSM McGladrey, Inc., in Minneapolis, MN.
Unless otherwise noted, contributors are members of or associated with RSM McGladrey, Inc.
For additional information about these items, contact Mr. Klahsen at (952) 921-7630 or firstname.lastname@example.org.