CFC’s Software Leasing Income Determined to Be Foreign Personal Holding Company Income

By Anne Chang, CPA, Irvine, Calif.

Editor: Mark G. Cook, CPA, MBA

Foreign Income & Taxpayers

On July 5, 2013, the IRS Office of Chief Counsel released Field Attorney Advice 20132702F, which addresses whether rental income from software leasing to third parties outside the country of a controlled foreign corporation (CFC) is foreign personal holding company income. In this memorandum, the IRS determined the leased software was a copyrighted article (as opposed to a copyright right) under Regs. Sec. 1.861-18, and the CFC did not satisfy the active-leasing exception. Therefore, the rental income was foreign personal holding company income under Sec. 954.


A U.S. software developer and a CFC entered into a cost-sharing agreement with respect to the developed software. Under the agreement, the CFC received a limited, nonexclusive, nontransferable license to transfer the software to third-party customers outside the country where the CFC was organized. The developer retained title and ownership of the software. In consideration, the CFC paid the developer an agreed-upon percentage of profits as a “royalty.” Upon termination of the agreement, the CFC was obligated to return to the developer all copies of and information pertaining to the software and delete any remaining software or information from the CFC’s computer memory. However, the termination of the agreement would not affect any leases between the CFC and its customers in effect on the date of the termination.

Under the agreement, third-party customers or licensees received a perpetual, nonexclusive, transferable (but only among the licensees’ affiliates) license to use, copy, load, execute, and store the software on their computers. Customers paid a one-time licensing fee, as well as annual fees for maintenance and other support services. After a year, customers could terminate the agreement by providing a written statement certifying that they no longer used the software. However, customers could elect to use the software again by either purchasing a new license or by paying all retroactive maintenance and support fees that would have been due between the time of termination and reinstatement.

The CFC had three employees with backgrounds in accounting, financing, or technology. Their job descriptions consisted mainly of administrative and bookkeeping duties. None of the employees were compensated for successful marketing. The CFC had seven customers during the years at issue. Two of them were taken from an affiliate.

Foreign Personal Holding Company Income

Under Sec. 951(a)(1), if a foreign corporation is a CFC for an uninterrupted period of 30 days or more during the tax year, every person that was a U.S. shareholder of the CFC at any time during the tax year and that owned stock in the corporation on the last day of the CFC’s tax year must include in gross income its pro rata share of subpart F income. Subpart F income generally includes:

  • Foreign personal holding company income (FPHCI), including dividends, interest, rents, royalties, and gains from alienation of property that produces or could produce such income;
  • Foreign base company sales income from buying goods from a related party and selling them to anyone or buying goods from anyone and selling them to a related party, where such goods are both made and for use outside the CFC’s country of incorporation;
  • Foreign base company services income from performing technical, managerial, engineering, architectural, scientific, skilled, industrial, commercial, or like services for, or on behalf of, a related person outside the CFC’s country of incorporation;
  • Foreign base company oil-related income; and
  • Insurance income from insurance or annuity contracts related to risks outside the CFC’s country of incorporation.

Sec. 954 defines “foreign base company income” as the sum of a CFC’s FPHCI, foreign base company sales income, foreign base company services income, and foreign base company oil-related income for the tax year.

Generally, FPHCI consists of passive income, such as interest, dividends, annuities, net gains from sale of property that does not generate active income, net commodities gains, net foreign currency gains, certain rents and royalties, and income from personal service contracts. The “active leasing exception” of Sec. 954(c)(2)(A) excludes from income rents and royalties received from unrelated persons in the active conduct of a trade or business.

Regs. Sec. 1.954-2(c)(1) provides four types of property, which if leased by the CFC, give rise to rental income in an active trade or business. One type of property is property leased as a result of the marketing functions of the CFC lessor through its own officers or staff of employees located in a foreign country. This is known as the active-marketing exception. For the lease of property to fall under this exception, the CFC must maintain and operate an organization in a foreign country that is regularly engaged in the business of marketing the leased property, and the marketing activity must be substantial in relation to the amount of rents derived from the leasing of such property.

Classification of Transactions Involving Computer Programs

Regs. Sec. 1.861-18 contains the rules for classifying transactions involving computer programs. Under Regs. Sec. 1.861-18(c)(2), a transfer of a computer program is classified as a transfer of a copyright right if a person acquires one or more of the rights 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;
  • Prepare derivative computer programs based on the copyrighted computer program;
  • Make a public performance of the computer program; or
  • Publicly display the computer program.

If a person acquires a computer program without any of the rights stated in Regs. Sec. 1.861-18(c)(2), the transfer is treated solely as a transfer of copyrighted articles.

A transfer of a copyright right is a sale or exchange of property if all substantial rights in the copyright are transferred. If not, the transfer is treated as a license generating royalty income. A transfer of a copyrighted article constitutes a sale or exchange if the benefits and burdens of ownership have been transferred. Otherwise, the transfer is treated as a lease generating rental income.

Analysis and Implications

The IRS first analyzed the classification of the software that the CFC transferred to the customers. Based upon the terms of the agreement between the CFC and its customers, the customers were provided with a key that allowed them to download the software onto their computers. They were allowed to use the software as long as they continued to pay the annual maintenance and support fees. Because the customers did not acquire any of the rights described in Regs. Sec. 1.861-18(c)(2), the IRS determined that the software was a copyrighted article rather than a copyright right. The IRS applied the rules of Regs. Sec. 1.861-18(f)(2) to determine whether the transfer of the software was a sale or a lease. A sale of software requires a transfer of the benefits and burdens of ownership.

In this case, the IRS determined that the customers did not receive the benefits and burdens of ownership and the transaction was a lease of a copyrighted article. In support of this conclusion, the IRS noted that the customers paid maintenance and support fees in consideration of using the software and that, upon termination of the agreement, customers were required to certify in writing that they no longer wished to use the software and could not distribute or continue to use the software. The rental income generated by the CFC was thus FPHCI, unless it qualified for the active-leasing exception.

The memorandum only considered whether the rental income qualified for the active-leasing exception under the active-marketing exception. By analyzing the CFC’s operation, the IRS determined that the software transfers did not satisfy the first prong of the active-marketing exception, namely, that the CFC must maintain and operate an organization in a foreign country that is regularly engaged in the business of marketing the leased property.

The functions of the CFC that the IRS reviewed in making its determination included the job descriptions and qualifications of the CFC’s employees, salaries and compensation awarded based on successful marketing, the time the employees spent on and the documentation of marketing activities, the number of press releases on the website issued by the CFC compared with the number of those issued by the affiliate group, and the number of customers in the years at issue.

After reviewing these functions, the IRS determined the CFC did not lease the software as a result of its own marketing function and employees and did not maintain and operate an organization in a foreign country that was regularly engaged in the business of marketing. Instead it mainly functioned to collect the rents, keep track of accounting, distribute keys to its customers, and act as a conduit for funds to other entities. Therefore, it did not satisfy the first prong of the active-marketing exception; its third-party rental income was FPHCI; and the U.S. shareholder was required to include its pro rata share of income as subpart F income.

One issue that was not addressed in this memorandum is the active-developer exception of Regs. Sec. 1.954-2(c)(1)(i). This exception excludes rents generated by a CFC from leasing property that it has produced or acquired and to which it has added substantial value. Unlike the active-marketing exception, the active-developer exception does not explicitly require the employees of a CFC to perform relevant activities. Because the CFC in the memorandum had a cost-sharing agreement with the developer, it might be argued
that the CFC had developed or produced the software.


Mark Cook is a partner with SingerLewak LLP in Irvine, Calif.

For additional information about these items, contact Mr. Cook at 949-261-8600, ext. 2143, or

Unless otherwise noted, contributors are members of or associated with SingerLewak LLP.

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