An Overview of the Source-of-Income Rules and the Taxation of Foreign Computer Programs

The source rules play an important role in the taxation of foreign persons and foreign corporations, since they effectively define the boundaries of U.S. taxation. The United States taxes the gross amount of a foreign person’s or foreign corporation’s U.S.-source nonbusiness income at a flat rate of 30 percent. On the other hand, the United States taxes foreign persons at graduated rates on the net income effectively connected with the conduct of a U.S. trade or business. The United States generally only taxes the U.S.-source income of foreign persons and foreign corporations and typically exempts foreign person’s and foreign corporation’s foreign-source income. Determining the source of a foreign person’s and foreign corporation’s income is extremely important to determine their U.S. withholding taxes and U.S. income taxes.

Introduction to the Source Rules

The source rules for income are organized by buckets of income categories, such as interest, dividends, personal services, royalties, and gains from the disposition of property. The first step in determining the source of income is to determine the applicable category or bucket of income at issue. Determining the category of income for purposes of the source rules can be ambiguous. This is because a transaction may exhibit the characteristics of more than one category of income. Properly categorizing income is important because how income is classified may ultimately determine if a transaction is subject to U.S. taxation. For example, a transaction involving a foreign computer program may be classified as either:

1. a transfer of a copyright right in the computer program;
2. a transfer of a copy of the computer program;
3. the provision of services for the development or modification of a computer program; or
4. the provision of know-how relating to computer programming techniques.

If the above transaction involves mass-market computer software, it may be characterized as the transfer of copyrighted articles and the source of income received from the transfer of a copyrighted article will be determined under rules applicable to the sale of tangible personal property if the underlying license is perpetual and a lease of tangible personal property if the use of the copyrighted article is limited in term. See Treas. Reg. Section 1.861-18(h). Once a determination has been made regarding the appropriate category of income, it will be necessary to classify the item of income as either U.S. or foreign-source.

Interest Income

Internal Revenue Code Section 861(a)(1) states the manner in which income is derived for the purpose of the sourcing rules. The source of interest depends generally on the residence of the debtor who pays the interest. Thus, interest payments from U.S. residents and U.S. corporations are generally considered U.S. source. On the other hand, interest paid by foreign corporations or nonresidents is considered foreign source. See IRC Section 862(a)(1). The residence of the debtor is determined at the time of an interest payment. See Treas. Reg. Section 1.861-2(a)(2)(i).

There are a number of exceptions to the above discussed rules. According to the Internal Revenue Code, interest on deposits paid by foreign branches of commercial banking businesses and savings institutions will be treated as foreign-source income even though the payer is a U.S. corporation. See IRC Section 861(a)(1)(B)(i). In addition, interest paid by resident aliens or U.S. corporations will generally be deemed to be foreign-source income if at least 80 percent of the debtor’s gross income (over the three years prior to the tax year in which the interest is paid) was derived from foreign sources and is attributable to the active conduct of a foreign trade or business. See IRC Section 861(a)(1)(A) and (c)(1). Further, if such interest is paid to a related person, only a portion of the interest will be treated as foreign-source. The portion is determined by the ratio of the debtor’s gross income from foreign sources to its worldwide income for a testing period. A related person for these purposes is one owning at least ten percent of the voting power or value of stock of a corporation. See IRC Section 861(c)(2).

Dividends Income

Dividends from U.S. corporations are generally treated as U.S.-source income. See IRC Section 861(a)(2). On the other hand, dividends from foreign corporations are generally treated as foreign-source income. See IRC Section 862(a)(2). Dividends from a foreign corporation will be treated as part U.S.-source if 25 percent or more of the corporation’s gross income from all sources for a base period was effectively connected with the conduct of a U.S. trade or business. In that event, the amount of dividends deemed to be from U.S. sources will be a percentage determined by the ratio between the gross income effectively connected with the U.S. trade or business and the total gross income of the corporation. See IRC Section 861(a)(2)(B). The base period is the three tax years ending with the tax year preceding the declaration of the dividend.

Rentals and Royalties

The source of rental and royalty income is determined by the place where the property is located or used. See IRC Sections 861(a)(4) and 862(a)(4). Thus, the source of rental income for tangible property will depend on the place where the property is physically located. The source of royalty income for intangible properties, such as patents, copyrights, trade secrets, trademarks and good-will, depends on where the rights are used, which is generally the country in which the intangible property derives its legal protection.

Gain from Sale of Foreign Computer Programs

The source of gain realized from the sale of intangible property will generally be determined by the residence of the individual if there is a fixed price. Gain realized from the sale of goodwill will generally be deemed to be from sources in the country where the goodwill was generated. See IRC Section 865(d)(3). To the extent that amortization deductions have been taken against U.S.- or foreign-source income in respect of intangible property other than goodwill, however, gains not exceeding the deductions taken will be treated as U.S. or foreign-source income respectively.

If a foreign corporation delivers software or digital products to a customer on the internet in the United States, the customer can download the product and use the software or digital product. Depending on the nature of the transaction, the income to the corporation could be characterized as a royalty for the use of technology, profit from the sale of a product or a payment for services that it has rendered.

A set of regulations known as the “software rules” provide guidance with respect to computer program transactions. See Treas. Reg. Section 1.861-18. A computer program is defined to be “a set of statements or instructions to be used directly or indirectly in a computer in order to bring about a certain result.” The term includes “any media, user manuals, documentation, data base or similar item if *** [they are] incidental to the operation of the computer program.” See Treas. Reg. 1.861-18(a)(3). Transactions involving computer programs will generally be classified as the transfer of a “copyright right” in a computer program, the transfer of a copy of the computer program, the provision of services for the development or modification of the computer program or the provision of knowhow relating to computer program techniques. See Treas. Reg. Section 1.861-18(b)(1).

Computer programs are generally protected by copyright law. Consequently, the rules for characterizing computer program transactions are guided by copyright principles found in both U.S. and foreign copyright laws. Copyright law generally protects computer programs and distinguishes between transactions in a copyright and in the subject of a copyright. Under U.S. copyright law, exclusive rights, such as the right to reproduce copies of the copyrighted works, are granted to the owner of a computer program copyright. In contrast, the purchaser of a copy of a computer program generally possesses only the right to sell or sell the copy. Under the regulations, a transfer of copyright rights will occur if the transferee obtains any of the following:

1. The right to make copies of the computer program to distribute to the public, for sale, or other transfer of ownership, or by rental, lease or lending;
2. The right to prepare derivative computer programs based upon the copyrighted program;
3. The right to make a public performance of programs; or
4. The right to publicly display the program. See Treas. Reg. Section 1.861-18(c)(2).

If there has been a transfer of copyrights, the issue is whether the transfer is a sale, generating gain or loss, or a license, generating royalty income. The transaction will be a sale or exchange if, taking into account all of the facts and circumstances, all substantial rights in the copyright have been transferred. The principles under Section 1222 relating to capital gains and losses and Section 1235 relating to the sale of patents may be applied when determining whether all substantial rights have been transferred. See Treas. Reg. Section 1.861-18(f)(1).

If the transferee acquires a copy of a computer program, but does not acquire any of the rights discussed above, the transaction is characterized as a transfer of a copyrighted article. A copyrighted article is a copy of a computer program from which the work can be perceived, reproduced or otherwise communicated. See Treas. Reg. 1.861-18(c)(3). Further, the electronic transfer of software can constitute the transfer of copyrighted articles. See Treas. Reg. Section 1.861-18(g)(2). Once it has been determined that there has been a transfer of a copyrighted article, it must be determined if the transaction involves the provisions of services. If not, it must be determined if there has been a sale or lease of a copyrighted article. The transaction will be a sale or exchange if, taking into account all of the facts and circumstances, the benefits and burdens of ownership have been transferred. See Teas. Reg. Section 1.861-18(f)(2). If a transaction does not constitute a sale because insufficient benefits and burdens of ownership of the copyrighted article have been transferred, it will be classified as a lease generating rental income. See Treas. Reg. Section 1.861-18(f)(2).

Specific source rules apply to the income derived from transactions in computer programs. Income from the sale of a copyrighted right will be sourced under the rules that apply to personal property sales. See Treas. Reg. 1.861-18(f)(2). Income from the sale of copyrighted articles where the computer program constitutes purchased inventory property will be U.S. or foreign-source income, depending upon title passes. However, income from the sale of copyrighted articles where the computer program constitutes noninventory personal property will be U.S. or foreign income, depending upon the residence of the seller. Finally, income from either the leasing of computer programs or the licensing of a copyright in a computer program will be U.S. or foreign source, depending upon where the property is located and in the case of rents, it will be the place where the property is used.

Compensation for Personal Services

The source of income from the performance of personal services is the place where the services are performed. See IRC Section 861(a)(3) and 862(a)(3). There is a limited exception to the application of the compensation source for certain individuals who work briefly in the United States. Section 861(a)(3) of the Internal Revenue Code provides that compensation earned by nonresident aliens will not be considered to be from U.S. sources if the individual is present in the United States for a period or periods not exceeding 90 days during a tax year, if the compensation does not exceed $3,000 and if the work is performed on behalf of a foreign individual or entity not engaged in U.S. trade or business or the foreign individual or entity not engaged in a U.S. trade or business or the foreign office or branch of a U.S. person or entity. If the compensation amount exceeds $3,000, the entire amount is treated as U.S.-source income.

If the services are performed partly within and partly outside the United States, the compensation will be apportioned between the U.S. and foreign sources. The Income Tax Regulations provide that the method of apportionment “shall be determined on the basis that most correctly reflects the proper source of income under the facts and circumstances of the particular case.” See Treas. Reg. Section 1.861-4(b)(1)(i). Generally, the apportionment will reflect the number of days worked inside vs outside the United States.

The exercise of nonqualified stock options or restricted stock units (“RSUs”) also gives rise to personal services income. If a nonresident individual performed services both within and without the United States during the period beginning on the grant date and ending on the exercise date, the resulting compensation on the relative number of months worked in the United States and outside the United States from the grant date to the exercise date. See Treas. Reg. Section 1.911-3(e)(4).

Inventory Property

The source of income realized from the purchase and sale of inventory property will generally be determined by the situs of the property at the time of the transfer of title. When the sales transaction is arranged in a particular manner for the primary purposes of tax avoidance, “all factors of the transaction, such as negotiations, the execution of the agreement, the location of the property, and the place of payment, will be considered, and the sale will be treated as having been consummated at the place where the substance of the sale occurred. See Treas. Reg. Section 1.861-7(c). Income from the sale of inventory that the nonresident purchased from resale is sourced on the basis of where the sale occurs.

Source Rules Deductions

Under a number of provisions in the Internal Revenue Code, it is necessary to identify what deductions that may be claimed on a tax return may be claimed against foreign or U.S.-source income. Section 881(b) of the Internal Revenue Code states that “[f]rom the items of gross income specified as being from sources within the United States there shall be deducted the expenses, losses, and other deductions properly apportioned or allocated thereto and a ratable part of [such items] which cannot definitely be allocated to some item class of gross income.” They prescribe a two-step method for making this determination.

Allocation. The deduction at issue must be attributable to a “class of gross income.” For example, deductions for salaries related to the management of income-producing real property should be attributable to rents, which would be the “class of gross income.” A deduction is related, and therefore allocable, to a class of income from which the income is derived. The allocation rules emphasize the factual relationship between a deduction and a class of income.

Apportionment. The deduction that has been allocated to a class of gross income must be apportioned between the appropriate statutory grouping of that class of gross income under applicable Internal Revenue Code provision and residual grouping. A deduction is apportioned by attributing the deduction to gross income (within the class to which the deduction has been allocated).

Depreciable or Amortizable Tangible Personal Property

Section 865(c) of the Internal Revenue Code establishes a form of recapture rule by providing that gain realized from the sale of depreciable or amortizable tangible personal property will be treated as U.S.-source income to the extent that depreciation or amortization deductions were previously allocated against U.S.-source income. If depreciation deductions were taken against both U.S.-and foreign-source income, the recapture of depreciation for tax reasons will be allocated proportionately between the countries.

Interest Expenses

Section 864(e)(2) provides that “all allocations and apportionments of interest expense shall be made on the basis of assets rather than gross income.” Under the asset method, a multinational corporation apportions interest expenses to the statutory grouping of gross income identified under the operative Internal Revenue Code provision on the basis of the average total value of assets within the grouping for the tax year. See Temp. reg. Section 1.861-9T(g)(1)(i) The corporation may use either the tax book value or the fair market value of assets in determining asset values at the beginning and end of the year. A corporation may elect to determine the tax book value by using the alternative method of depreciation discussed in Section 168(g).

Research and Development Expenditures

Any research and development expenditures incurred to satisfy a countries’ legal requirements are typically allocated to that country. Research and development expenses not incurred to satisfy legal requirements are apportioned between U.S. and foreign-source income utilizing a sales apportionment method or, an apportionment method. Under the sales method, one-half of the research and development costs are allocated to the country in which the research and development activities took place and the remaining costs are prorated between the United States and the foreign jurisdiction. Under the gross income method, one-forth of the costs are allocated to the place at which the research and development took place and the remainder is apportioned between United States and foreign sources.

Conclusion

This article is intended to provide the reader with a basic understanding regarding the basic U.S. tax considerations regarding the source-of-income rules and the taxation of foreign computer programs. It should be evident from this article that this is a relatively complex subject. It is also important to note that this area of tax law is constantly subject to new developments and changes. As a result, it is crucial that foreign individuals and foreign corporations doing business in the United States consult with a qualified International attorney. With careful individualized planning, the foreign business may eliminate or substantially reduce its U.S. tax liabilities emanating from U.S. business transactions.

Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi & Liu, LLP. Anthony focuses his practice on domestic and international tax planning for multinational companies, closely held businesses, and individuals. Anthony has written numerous articles on international tax planning and frequently provides continuing educational programs to other tax professionals.

He has assisted companies with a number of international tax issues, including Subpart F, GILTI, and FDII planning, foreign tax credit planning, and tax-efficient cash repatriation strategies. Anthony also regularly advises foreign individuals on tax efficient mechanisms for doing business in the United States, investing in U.S. real estate, and pre-immigration planning. Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or adiosdi@sftaxcounsel.com.

This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.