By Anthony Diosdi
Introduction and Summary of the Law Governing Digital Transactions
New technology and new transactions often raise difficult issues of tax policy and administration. The dramatic expansion of 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 electronically 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 rendered.
The Department of Treasury and the Internal Revenue Service (“IRS”) promulgated regulations to provide guidance with respect to computer program transactions. See Treas. Reg. Section 1.861-18. According to the regulations, a computer program is defined to be “a set of statements or instructions to be used directly or indirectly in any 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. 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 programs transactions are guided by copyright principles found in both U.S. and foreign copyright laws. Copyright law generally protects computer programs and distinguishes between the transaction 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 work, 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 transfer 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 the program; or
4. The right to publicly display the program.
If there has been a transfer of copyright rights, 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. 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. See Treas. Reg. Section 1.861-18(c)(3). Further, the electronic transfer of software can constitute the transfer of a copyrighted article. 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. If not, the issue then becomes whether there has been a sale or a lease of the copyrighted article. The transaction will be a sale 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 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 copyright right will be sourced under the rules that apply to personal property sales. Income from the sale of copyright articles where the computer program constitutes purchased inventory property will be U.S. or foreign-source income, depending upon where title passes. 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. Finally, income from either the leasing of a computer program or the licensing of a copyright in the computer program will be U.S.- or foreign-source income, depending upon where the program is located in the case of rents and the place where the property is used in the case of royalties.
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. The facts and circumstances include the intent of the parties as to the ownership of the copyright and how the risks of losses are allocated.
Definition the Transfer of a Copyright Right for the Purposes of a Sale
One of the most important concepts involving the taxation of digital goods and services is to determine whether there is a transfer of a copyright right for the purposes of a taxable sale. Recall that Treasury Regulation 1.861-18 identifies four copyrights “rights” that were necessary for a transaction to be classified as a taxable sale.
1. The right to make copies of computer program for distribution to the public;
2. The right to prepare derivative computer programs based on the copyrighted computer program;
3. The right to make a public performance of the computer program; and
4. The right to publicly display the computer program.
In analyzing how to apply these four copyrights “rights,” the regulations provide an excellent example of a transfer of all substantial rights in a copyright right in Illustration 1. for purposes of determining a taxable sale.
Illustration 1.
Corp A owns the copyright in a computer program, Program X, and Corp A transfers a disk containing 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 performances 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 copyright rights and Corpor B received the right to use them exclusively within Courty Z and for the remaining life of the copyright, so it was a transfer of all substantial rights in the copyright rights. The example further provides that the fact that the agreement is labeled a license is not controlling, nor is the fact that Corp A receives a sum labelled as a royalty. See Treas. Reg. Section 1.861-18(h), Example 6.
See Illustration 2 and Illustration 3. below for more examples discussed in the regulations as to what constitutes a sale of a computer program for tax purposes.
Illustration 2.
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 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 destroyed any other copies it has made. P, a resident of Country X receives a disk. The example concludes that the label “license” is not determinative and that since none of the copyright rights have been transferred to P, P has acquired a copyrighted article. Therefore, there has been a sale of a copyrighted article and Corp A recognizes sales income. See Treas. Reg. Section 1.861-18(h), Example 1. The same conclusion applies where the software is made available through a website rather than as a disk. See Treas. Reg. Section 1.891-18(h), Example 2.
Illustration 3.
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 copyright rights to the libraries are considered de minimis, the transaction is still treated as a sale of Program Y. See Treas. Reg. Section 1.861-18(h), Example 17.
Leasing of a Copyrighted Article
If a transfer of a computer program is not treated as a transfer of a copyright, the transaction may be taxed as a lease. Courts have used the term “lease” and “rents” interchangeably when it comes to the right to receive or use tangible property. In any event, 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 a person other than the transferee is properly treated as the owner of the copyrighted article. The regulations provide an example of a taxable lease of a computer program in Illustration 4.
Illustration 4.
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 in the regulations emphasises 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. Thus, in this case, there has been a lease of a copyrighted article and Corp A will realize rental income. See Treas. Reg. Section 1.861-18(h), Example 1. The results are the same as the software is made available through a website rather than as a disk. See Treas. Reg. Section 1.861-18(h), Examples 3 and 4.
The Taxation of a License
The regulations go into great detail to point out there is a difference for tax purposes between transferring a copyright and the licensing of a copyright. U.S. tax considerations generally do not represent a major incentive to the licensing of intangible property rights by a licensor located in the United States to unaffiliated parties abroad or to the affiliates not controlled by the licensor. On the other hand, in the international tax context, tax considerations may create incentives for the licensing of intangible property to foreign affiliates controlled by the licensor. A U.S. corporation may have an incentive to set up foreign licensing arrangements when a substantial portion of the U.S. corporation’s foreign-source income is in the form of dividends from operating controlled foreign corporations located in high-tax countries. If the foreign taxes on profits distributed as dividends are in excess of the U.S. effective corporate tax rate, the dividend income may generate excess foreign tax credits. This excess tax credit may potentially be used against other sources of foreign income that is taxed at a lower rate than the U.S. corporate rate or at an applicable tax treaty rate.
Whether or not a transfer of a computer program can be classified as a license or not depends on all the facts and circumstances of the transfer. In order for a computer program to be characterized as a license, the transfer must be less than “all substantial right” of the computer program. In general, a grant of nonexclusive copyright is considered a license generating royalties rather than a sale. In Illustration 5, the regulations provide an example of a cross-border transaction that can be classified as a license.
Illustration 5.
Corp A, a U.S. corporation, transfers a disk containing Program X to Corp D, a foreign corporation engaged in the manufacture and sale of personal computers in Country Z. Corp A grants Corp D the non-exclusive right to copy Program X onto the hard drive of an unlimited number of computers which Corp D manufacturers and sells to the public. The term of the agreement is 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 royalty. See Treas. Reg. Section 1.861-18(h), Example 8.
How Services are Taxed in Connection with the Transfer of Copyrighted Articles
As indicated above, at least in the international context, there may be an incentive from a federal tax point of view to treat the transfer of a computer program as a licensing agreement. Even though there may be an incentive to classify a transfer of a computer program as license, the transaction in question may simply be a services contract. The determination of whether a transaction is treated as either the provisions 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 copyrights in the computer program and how the risks of loss are allocated between the parties. See Treas. Reg. Section 1.861-18(d). The regulations provide an example in Illustration 6. of a transaction that is labeled as a licensing agreement but is in fact an agreement to provide services.
Illustration 6.
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 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 examples conclude that taking into account all of the facts and circumstances, Corp A is treated as providing services to Corp H because Corp H bears all of the risks of loss associated with Program Q and is the owner of all copyright rights in Program Q. See Treas. Reg. Section 1.861-18(h), Example 15.
The Department of Treasury and the IRS Issue Proposed Regulations on Cloud Computing and Digital Content
As technology advances, so does the need for the Department of Treasury and the IRS to keep up with the technology by issuing new regulations. On August 9, 2019, the Treasury and the IRS released proposed regulations on characterizing cloud computing transactions and other transactions involving on-demand network access. The Proposed Regulations also extend the classification rules enumerated in Treasury Regulations Sections 1.861-18 to transfers of “digital content” to areas other than computer programs.
The Taxation of a Cloud Computing Transaction
Cloud computing is the delivery of different services through the internet, including data storage, severs, databases, networking, and software. Cloud-based storage makes it possible to save files to a remorse database and retrieve them on demand. The Proposed Regulations promulgated by the Department of Treasury and the IRS provide a similar definition. The Proposed Regulations define “cloud translation” 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 arrangement and the surrounding facts and circumstances.” See Prop Reg. Section 1.861-19(b). The examples in the Proposed Regulations include “streaming music and video, transactions involving mobile device applications, and access to data through remotely hosted software.” See REG-130700-14. However, a cloud transaction does not include “network access to download digital content for storage and use on a person’s computer or other electronic device.” See Prop Reg. Section 1.861-19(d).
For federal income taxation purposes, a cloud transaction can be characterized as either a lease of property or services. All the relevant facts are taken into account in determining the classification of such a transaction for tax purposes. If a transaction consists of multiple cloud computing transactions, then each transaction requires a separate classification unless any transaction is de minimis. See Prop. Reg. Section 1.861-19(c)(3). The Proposed Regulations provide that the following factors are relevant for this determination of whether a cloud transaction can be classified as either a lease of property or the provision of services:
1. The customer is not in physical possession of the property.
2. The customer does not control the property, beyond the customer’s.
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 property is a component of an integrated operation in which the provider has other responsibilities, including ensuring the property is maintained and updated.
5. The provider bears any risk of substantially diminished receipts or substantially increased expenditures if there is nonperformance under the contract.
6. The provider uses the property concurrently to provide significant services to entities unrelated to the customer.
7. The provider’s fee is primarily based on a measure of work performed or the level of the customer use rather than the mere passage of time; and
8. The total contract price substantially exceeds the rental value of the property for the contract period.
The Taxation of Digital Content
Digital content is any content that exists in the form of digital is any content that exists in the form of digital data. Forms of digital content include information that is digitally broadcast, streamed, or contained in computer files. The Proposed Regulations define “digital content” as any content in digital format and that is either protected by copyright law or is no longer protected due to the passage of time, whether or not the content is transferred in a physical medium. See Prop. Reg. Section 1.861-18(a)(3). For example, a book, movie, and music in digital format would be classified as “digital content” for purposes of the Proposed Regulations. When copyrighted articles that are “digital content” 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 for purposes of Treas. Regulation 1.861-7(c). Unlike “cloud computing” transitions, the sale of digital content is not classified solely as either a lease of property or the provision of services. If there is a transmission of copyrights which involves a transfer of “all substantial rights” to “digital content,” a sale takes place for federal income tax purposes.
Sourcing of “Cloud Transactions” and “Digital Content”
Since a “cloud based transaction” or the sale of “digital content” can take place from anywhere in the world, the sourcing rules must be applied to determine a “cloud transaction” or the sale of “digital content” can be subject to U.S. taxation. The “source” of income will have a number of effects on the U.S. taxation of the transactions discussed above. Income from the sale of intangible property is deemed to have its source in the country of the seller’s residence to the extent that the income is not contingent on the productivity, use or disposition of the intangible property right. Therefore, if the services are performed in the United States, the income is U.S. sourced income and subject to U.S. federal income tax; if the services are performed outside the United States, then the income is foreign sourced income. Determining where a digital service is performed, and thus the source of the income derived in connection with such service, can be extremely problematic. It is not difficult to imagine a scenario in which computer equipment that facilitates delivery of the digital product might be located in one country, and employees that maintain and monitor such equipment might be located in another country, and the coders who developed the software might reside in a third country.
When it comes to determining the source of rents and royalties, the sourcing rules source these items of income in the place in which the property is located or used. See Treas. Reg. Section 1.543-1(b)(10). This rule has resulted in many U.S. corporations transferring intellectual property offshore to related entities. Congress has attempted to dissuade this type of behavior by enacting a number of new provisions in the Internal Revenue Code as part of the 2018 Tax Cuts and Jobs Act.
General Taxation of Cross-Border Transaction and It’s Application the Digital Economy
The sourcing rules will continue to be a challenge in determining how to and why to tax a digital transaction. In determining whether and how the U.S. can tax the evolving digital transaction, a threshold question must be asked for each transaction involving “computer programs,” what degree of “nexus” is required for the United States or any other country to be able to tax the transaction in question. If a provider of digital goods and services has sufficient nexus to be taxed in the source jurisdiction, whether in the United States or a foreign jurisdiction, the person or entity generally would be subject to tax on a net basis and be required to comply with local registration and reporting requirements. The sourcing rules do only tax the foreign transactions of U.S. entities. These rules may also result in a foreign entity involved in digital transactions being subject to U.S. income tax. In the United States, a foreign taxpayer is considered to be subject to the tax jurisdiction of the United States if the person or entity is engaged in a trade or business in the United States, and has income effectively connected to a U.S. trade or business. Whether or not a person or entity is engaged in a trade or business in the United States or has income income that is effectively connected with the United States is a question of fact that in certain cases must be carefully analyzed.
The rules discussed above are complicated and continue to evolve. It is imperative that anyone involved in cross-border digital transactions have competent tax counsel.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. As a domestic and international tax attorney, Anthony Diosdi provides international tax advice to closely held entities and publicly traded corporations. Diosdi Ching & Liu, LLP has offices in Pleasanton, California and Fort Lauderdale, Florida. Anthony Diosdi advises clients in international tax matters throughout the United States. Anthony Diosdi may be reached at (415) 318-3990 or by email: 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.