By Anthony Diosdi
U.S. Taxation of the Digital Economy- a Broad Overview
New technology and new transactions often raise difficult issues of tax policy and administration in part because existing rules were developed to deal with other situations. The dramatic expansion in electronic commerce facilitated by the use of the Internet and other technology is subjecting existing tax principles to new pressures. One area of concern is the application of source rules to electronic commerce transactions. Suppose, for example, that a corporation delivers software or a digital product to a customer on the Internet. The customer can download the product and use it commercially. Depending upon the nature of the transaction and the property interests involved, the income to the corporation might appropriately 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 complex set of regulations provides guidance with respect to computer program transactions. See Treas. Res. Section 1.861-18. A computer program is defined as “a set of standards 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, documents, data base or similar item if *** [they are] incidental to the operation of the computer program.” See Treas. Reg. Section 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 programing techniques. See Treas. Reg. Section 1.861-18(b)(1).
Computer programs are generally protected by copyright law. Consequently, the rules for characterizing computer 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 use 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 copyrighted program;
3. The right to make a public performance of the program; 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 copyright right, 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 or exchange 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 listed 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. Treas. Reg. Section 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, an analysis of the facts and circumstances, including the intent of the parties as evidenced by their agreement and conduct, may lead to the conclusion that the transaction involves the provision of services. See Treas. Reg. Section 1.861-18(d). If not, the issue then becomes whether there has been a sale or lease of the 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 Treas. Reg. Section 1.861-18(f)(2). If a transaction does not constitute a sale or exchange because insufficient benefits and burdens of ownership of the copyrighted article have been transferred, it will be classified as 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 or exchange of a copyright right will be sourced under the rules that apply to personal property sales. See IRC Section 865; Treas. Reg. Section 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 where title passes. See IRC Sections 861(a)(6), 862(a)(6); Treas. Reg. Section 1.861-18(f)(2). On the other hand, income from the sale of copyrighted articles where the computer program constitutes non-inventory personal property will be U.S.- or foreign-source income, depending upon the residence of the seller. See IRC Section 865; Treas. Reg. Section 1.861-18(f)(2). Finally, income from either the leasing of a computer program or the licensing of a copyright in a computer program will be U.S. or foreign-source income, depending upon where the property is located in the case of rents and the place where the property is used in the case of royalties. See IRC Sections 861(a)(4); 862(a)(4); Treas. Reg. Section 1.861-18(f)(1)(2).
Analyzing the Software Rules
Probably the most important rules governing the taxation of digital transactions are the so-called “software rules.” The federal tax rules governing “software” can be found in Treasury Regulation Section 1.861-18. The U.S. Treasury Department has stated that Treasury Regulation Section 1.861-18 “establish[es] a framework applicable to any type of digitized information, at least to the extent it is protectable by copyright.” These have become known as the “Software Rules.”
The so-called Software Rules provide guidance as to how to characterize and source income received from transactions involving “computer programs.” The regulations have defined the term “computer program” to mean:
“a set of statements or instructions to be used directly or indirectly in a computer in order to bring about a certain result. For this paragraph, a computer program includes any media, user manuals, documents, data base or similar item if the media, user manuals, documents, data base or similar item is incidental to the operation of the computer program.” See Treas. Reg. Section 1.861-18(a)(3).
The Software Rules state that a transaction must be based on substance rather than form. In other words, a transaction will not be classified on how it is described in an agreement. Conversely, an agreement stating software will be a “license” will not necessarily be treated as a “license” for tax purposes. Rather, the Software Rules
provide that each transaction must be carefully analyzed. The taxable income relating to a computer program, the services related to the program, or the know-how of the program can be classified as either: 1) the sale of property (inventory or non-inventory; 2) license; 3) lease; or 4) service.
For the purposes of the “sale of property” in the context of the Software Rules, the Treasury Regulations provides after taking into consideration “all of the facts and circumstances,” there must be either: 1) a transfer of “all substantial rights” in the copyrights of the software; or 2) a transfer of a copyrighted article. See Treas. Reg. Section 1.861-18(f)(1). I will discuss each of these two elements in more detail below.
1. Transfer of All Substantial Rights in a Copyright Right
A transfer for the purposes of a Copyright Right will result for federal income tax purposes if an individual acquires any of the following: 1) 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; 2) the right to prepare derivative computer programs based upon the copyrighted computer program; 3) the right to make a public performance of the computer program; or 4) the right to publicly display the computer program. For the transfer of copyright rights to be characterized as a sale, it must be a transfer of “all substantial rights” which essentially requires the transfer to be exclusive and to be for the remainder of the life of the copyright.
Below, see Illustration 1 which provides an example discussed in the regulations a transfer of all the substantial rights in a copyright takes place.
The regulations provide the following example of a transfer of all substantial rights in a copyright: Corp A owns the copyright in a computer program, Program X, and Corp A transfers a disk for the remaining term of the copyright to copy and distribute an unlimited number of copies of Program X to Corp B, a Country Z corporation, and grants Corp B “an exclusive license for the remaining term of the copyright to copy and distribute an unlimited number of copies of Program X in the geographic area of Country X, prepare derivative works based upon Program X, make public performance of Program X and publicly display Program X, Corp B will pay Corp A royalty of $y a year for three years which is the expected period during which Program X will have commercially exploitable value.” The example concludes that the transfer should be treated as a sale by Corp A because Corp A transferred to Corp B copyrights and Corp B received the right in the copyright rights. This example also illustrates that just because an agreement is classified as a license, it is not controlling for federal income tax purposes. As is the fact that Corp A is supposed to receive payment classified as a royalty. See Treas. Reg. Section 1.861-18(h), Example 6.
2. Transfer of a Copyrighted Article
A transfer takes place of a “copyrighted article” if an individual obtains a copy of a computer program. However, the individual does not acquire any copyrights or if he or she does acquire a copyright, it is only a de minimis right. See Treas. Reg. Section 1.861-18(c)(1)(ii). To be treated as a sale, there must be a transfer of the benefits and burdens of ownership in the copyrighted article.
Below, see Illustration 2 and Illustration 3 which are taken from the regulations and provide examples of a transfer of a copyrighted article as a sale.
Corp A owns the copyright in a computer program (“Program X”) and copies Program X onto a disk. The disks are placed in boxes covered with a wrapper on which is printed what is generally referred to as a “shrink wrap license.” The license is stated to be perpetual. The transferee receives the right to use the program on two of its own computers, the right to make one copy of the program on each machine as an essential step in using the program, and the right to resell the copy of the program so long as it destroys any other copies it had made. P, a resident of Country X receives a disk. The example indicates that the label in the contract “license” is not determinative and that since none of the copyrights have been transferred to P, P has acquired a copyrighted article. The same conclusion applies where the software is made available through a website rather than as a disk. See Treas. Reg. Section 1.861-18(h), Example 2.
Corp A transfers a disk containing Program Y to Corp E, a Country Z corporation, in exchange for a lump sum payment. Program Y is a computer program development program, which is used to create other computer programs consisting of several components, including libraries of reusable software components that serve as general building blocks in new software applications. Because a computer program created with the use of Program Y will not operate unless the libraries are also present, the license agreement between Corp A and Corp E grants Corp E the right to distribute copies of the library with any program developed using Program Y. The example concludes that because the copyrights to the libraries are considered de minimis, the transaction is treated as a sale of Program Y. See Treas. Reg. Section 1.861-18(h), Example 17.
Defining the “Rents” for Purposes of Digital Taxation
The Income Tax Regulations use the term “rents” when attempting to classify the lease of software. The term “rents” is an extremely important concept. In this context, the term “rents” typically means the amounts received for the use or the right to use tangible property such as software. In other words, the term “rents” can be defined as a payment or interest reserved by an owner in return for permission to use the property loaned and in proportion to use. For the purposes of defining the lease of software, the Software Rules provide that there must be a transfer of a copyrighted article where all the benefits and burdens of ownership have not been transferred. A transfer will be treated as a lease that generates rental income in a circumstance where the benefits and burdens of ownership of the copyrighted article have been transferred, such that an individual other than the transferee is properly treated as the owner of the copyrighted article. Below, see the example in Illustration 4 in which the regulations described a lease of software.
Corp A owns the copyright in a computer program (“Program X”) and copies Program X onto disks. The disks are placed in boxes covered with a wrapper on which is printed what is generally referred to as a “shrink wrap license.” The transferee receives the right to use the program on two of its own computers and the right to make one copy of the program on each machine as an essential step in using the program. P, a resident of Country X receives a disk but only for one week. The example concludes that the label “license” is not determinative and that none of the Copyright Rights has been transferred to P. P has acquired a copyrighted article and based on all the facts and circumstances is not considered the owner of the copyrighted article. Therefore, there has been a lease of a copyrighted article and Corp A recognizes rental income. See Treas. Reg. Section 1.861-18(h), Example 1. It should be noted that the same conclusion applies where the software is made available through a website rather than as a disk. See Treas. Reg. Sections 1.861-18(h), Examples 3 and 4.
Defining the Term License for Purposes of Digital Taxation
According to the Software Rules, to be a license, all the facts and circumstances must indicate that a transfer of copyright rights took place, and the transfer must be for less than “all substantial rights.” Thus, the difference between a sale and a license for the purposes of the Software Rules is the amount of rights granted. Typically, the grant of nonexclusive copyright right to use electronic software is a license. For tax purposes, the income generated for tax purposes by a license is royalties rather than a sale.
Below, see Illustration 5 which describes a lease of software for income tax purposes.
The Software Rules provide the following example of a transaction treated as a license: Corp A, a U.S. corporation, transferred a disk containing Program X to Corp D, a foreign corporation engaged in the manufacture and sales of personal computers in County Z. Corp A grants Corp D the nonresident right to copy Program X onto the hard drive of an unlimited number of computers which Corp D manufactures and sells to the public. The term of the agreement is for two years, which is less than the remaining life of the copyright in Program X. Corp D pays Corp A an amount based on the number of copies of Program X it loads onto its computers. The example concludes that taking into account all of the facts there has been a license of Program X to Corp D in exchange for a royalty. See Treas. Reg. Section 1.861-1(h), Example 8.
Defining the Term Service for Purposes
Services is another area that is extremely important in the digital economy. It is not uncommon for businesses to have agreements between themselves regarding a copyright. These agreements can be manipulated for tax purposes. In order to avoid manipulation, the Treasury Regulations provide that the determination of whether a transaction is treated as either the provision of services or another transaction is based on all the facts and circumstances of the transaction, including, as appropriate, the intent of the parties (as evidenced by their agreement and conduct) as to which party is to own the copyright rights in the computer program and how the risks of loss are allocated between the parties. See Treas. Reg. Section 1.861-18(d).
Below please see Illustration 6 which discusses how an agreement may be manipulated.
The Software Rules provide the following example of a transaction that is treated as a provision of services: Corp H, a Country Z corporation, enters into a license agreement for a new computer program, Program Q. Program Q is to be written by by Corp A and the parties agree that when Program Q is completed, the copyright in Program Q will belong to Corp H. Corp H agrees to pay Corp A a fixed monthly sum during development of the program. All of the payments are labeled royalties. The example concludes that taking into account all of the facts and circumstances, Corp A is treated as providing services to Corp H because H bears all the risk of loss associated with Program Q and is of all copyrights in Program Q. See Treas. Reg. Section 1.861-18(h), Example 15.
Introduction to the Proposed Regulations on Cloud Computing and Digital Content
Recently, the Treasury Department and the IRS promulgated Proposed Regulations on how to classify cloud computing transactions and other transactions involving on-demand network access. In addition, these new Proposed Regulations extended the Software Rules, the cloud computing transactions and other transactions involving on-demand network access. The Proposed Regulations provided some clarity regarding the sourcing of income in these types of transactions.
The Proposed Regulations and Cloud Computing Transactions
The Proposed Regulations have defined a “cloud transaction” to be “a transaction through which a person obtains on-demand network access to computer hardware, digital content or other similar resources, other than on-demand network access that is de minimis taking into account the overall arrangements and the surrounding facts and circumstances.” See Prop. Reg. Section 1.861-19(b). Examples of a “cloud transaction” are the “streaming music and video, transactions involving mobile device applications, and access to data through remotely hosted software.” See REG-130700-14.
For tax purposes, the Proposed Regulations provide that a cloud transaction is classified solely as either a lease of property or the provision of services, taking into account all relevant factors. See Prop. Reg. Section 1.861-19(c). Each transaction requires a separate classification unless any transaction is de minimis. See Prop. Reg. Section 1.861-19(c)(3). The Proposed Regulations go on to provide a list of factors to determine when cloud transactions will be classified as services for tax purposes rather than a lease of property. The Proposed Regulations provide that the following factors are relevant to determine when a “cloud” based transaction will be classified as a services rather than a lease:
1. The customer is not in physical possession of the property;
2. The customer does not control the property, beyond the customer’s network access and use of the property;
3. The provider has the right to determine the specific property used in the cloud transaction and replace such property with comparable property;
4. The customer bears any risk of substantially diminished receipts or substantially increased expenditures if there is nonperformance under the contract.
5. The provider uses the property concurrently to provide significant services to entities unrelated to the customer;
6. The provider’s fee is primarily based on a measure of work performed or the level of the customer’s use rather than the mere passage of time; and
7. The total contract price substantially exceeds the rental value of the property for the contract period.
The distinction between classifying a transaction as “services” compared to a “lease” is significant. This is because services are taxed at ordinary rates why a lease is taxed as royalties, which in some cases can result in more favorable tax treatment.
The Proposed Regulations also define the term “digital content.” According to the Proposed Regulations, any content that is in digital format and that is either protected by copyright law or is no longer protected by copyright law solely due to the passage of time, whether or not the content is transferred in a physical medium (e.g., books, movies, and music in digital form). See Prop Reg. Section 1.861-18(a)(3). The Proposed Regulations provide that the transfer of the “mere right” to publicly perform or display digital content for the purpose of advertising the sale of the digital content will not constitute a copyright right. See Prop Reg. Sections 1.861-18(c)(2)(iiii) and (iv). When copyrighted articles are sold and transferred through an electronic medium, the sale is deemed to occur at the location of download or installation onto the end-user’s device used to access the digital content. If there is no information on the location of a download or installation onto the end user’s device, then the sale is deemed to have occurred at the location of the customer based on the taxpayer’s recorded sales data for business or financial reporting purposes. See Prop. Reg. Section 1.861-18(f)(2)(ii).
The Importance of the Sourcing Rules in a Digital Transactions
The answer to many questions about the income taxation of international transactions depends upon an identification of the country in which the income is properly deemed to have been generated. Put in the language of tax policy and practice, the task is to determine the source of the income concerned. Almost every country, therefore, has adopted rules for determining the source of income. Although the source rules of different countries are not congruent, many reflect approaches similar to those in the United States. The U.S. source rules in general derive from an attempt to identify the geographic locus of the economic activity or financial arrangements that generate the income. The question is always whether income derives from inside or outside the United States.
Most of the source rules are specified in Sections 861 and 865 of the Internal Revenue Code. Section 862 identifies categories of foreign-source income. Section 863 deals with categories of income that are partially U.S.-partially foreign sources. Section 865 establishes elaborate rules for determining the source of income derived from the sale of personal property.
According to the sourcing rules, if services are performed in the United States, the income is U.S. sourced income, and subject to U.S. federal income tax. On the other hand, if the services are performed outside the United States, then the income is foreign sourced income. In certain cases, this means that the services will not be subject to U.S. taxation. Applying these concepts to digital services and determining where such services are performed for tax purposes can be difficult. For example, computer equipment that facilitates delivery of the digital product might be located in one country, and the employees that maintain and monitor such equipment might be located in another country, and the coders who develop the software might reside in a third country.
General Tax Considerations of Cross-Border Digital Transactions
In determining whether and how tax should be imposed on transactions involving digital goods and services, a threshold question is what degree of “nexus” is required for a country to be able to tax such transactions. The right of each country to impose tax depends on the character of the transaction and the income derived therefrom, as determined under domestic law, but with each country’s taxing jurisdiction potentially limited by the application of an income tax treaty. Most domestic law taxing regimes apply principles that focus on either the “source” of the income or residence of the taxpayer.
If a provider of digital goods and services has sufficient nexus to be taxed in the source jurisdiction, the person generally would be subject to tax on a net basis and be required to comply with local registration and reporting requirements. In the United States, a foreign taxpayer is considered to be subject to the tax jurisdiction of the United States if the person is engaged in a trade or business in the United States, and has income effectively connected to the U.S. trade or business. In the international tax context, “nexus” is often referred to as a permanent establishment in that country. Most income tax treaties embody this principle, that the source country has jurisdiction to tax a non-resident with a local permanent establishment, but only to the extent of the “business profits” attributable to the permanent establishment. Even if the provider does not have a permanent establishment, the provider’s income may nevertheless be subject to local withholding tax on a gross basis.
The taxing of the digital economy will continue to evolve globally. Given the fact that digital taxation is still developing, there are plenty of opportunities for tax planning.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & 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 is a member of the California and Florida bars. He can be reached at 415-318-3990 or email@example.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.