By Anthony Diosdi
The source rules play a prominent role in the U.S. taxation of foreign persons, since they effectively define the boundaries of U.S. taxation.Source rules apply in a number of different contexts. One important application of the source rules is the determination of U.S. income tax liability for foreign persons. The U.S. taxes the gross amount of a foreign person’s U.S.-source nonbusiness income at a flat rate of 30 percent. The U.S. also taxes foreign persons at graduated rates on the net amounts of income effectively connected with the conduct of a U.S. trade or business. In other words, the U.S. taxes the U.S.-source income of foreign persons and does not tax a foreign person’s foreign-source income.
Sourcing of income can also have a significant impact on a U.S. person’s ability to claim foreign tax credits. Because the foreign tax credit is intended to limit or mitigate double taxation of foreign-source income, the credit is generally accorded only with respect to foreign taxes on foreign source income and is primarily applicable to U.S. persons.
The source rules for gross income are organized by categories of income, such as interest, dividends, personal services income, rentals, royalties, and gains for the disposition of property. The first step in the sourcing process is to determine the applicable statutory category. This determination is sometimes ambiguous. For example, the same transaction may exhibit characteristics of both a royalty transaction and the sale of personal property. This distinction is important because the applicable category income from transactions involving computer programs must be characterized as either: 1) a transfer of a copyright 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 the computer program; or 4) the provision of know-how relating to a computer program technique. See Treas. Reg. Section 1.861-18(b)(1).
Selling a significant number of the same software programs can be treated as the transfer of inventory under the regulations. See Treas. Reg. Section 1.861-18(f)(2). In such a case, the source of income received from the transfer of a copyrighted article may be determined under the rules applicable to a 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), Examples 1 and 2. The former is sourced under the title passage rule, whereas the latter is sourced under a place of use rule. See IRC Sections 861(a)(4) and 862(a)(4).
Once a determination in regards to the appropriate sourcing category has been made, the next step is to determine if the item of income is either U.S. or foreign-source. In general, the rules for the sourcing of income is based on the location of the underlying income-producing property or activity.
Computer programs are typically protected by copyrights and are classified as personal property for purposes of the sourcing rules. Internal Revenue Code Section 865 prescribes the rules for determining the source of gain or loss from the sale of personal property. The source determinations on the sale or exchange of U.S. personal property will often depend upon the application of a series of exceptions which reflect a number of variables, including whether the property is inventory and whether the property has been used in connection with a U.S. trade or business. 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 Internet and other new technology is subjecting existing tax principles to new pressures. One area of concern is the application of sourcing 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 interest 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 set of regulations provides 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 * * *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” 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 program transactions are guided by copyright principles found in both U.S. and foreign copyright law. 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 the copyrighted program;
3) The right to make a public performance of the programing; 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. 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.
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 copyrighted articles. 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 or exchange if, taking into account all of the facts and circumstances, the benefits and burdens of ownership have transferred. 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.
Specific source rules apply to 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 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 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 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 used in the case of royalties. See Treas. Reg. Section 1.861-18(f)(1)(2).
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 loss are allocated. See Treas. Reg. Section 1.861-18(d). A provision of knowhow will occur if information respecting a computer program relates to computer programing techniques, is furnished under conditions preventing unauthorized disclosure and is considered “property subject to trade secret protection. See Treas. Reg. Section 1.861-18(e). In such transactions, the issue is whether there has been a sale or a license of the property interest at issue.
The application of source rules to electronic commerce transactions is just one area of international taxation concern to tax attorneys. It should be evident from this summary that this is a relatively complex subject. In addition, it is important to note that this area is constantly subject to new developments and changes.
We have substantial experience advising clients ranging from small entrepreneurs to major multinational corporations in cross-border tax planning and compliance. We have also provided assistance to many accounting and law firms (both large and small) in all areas of international taxation.
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 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 firstname.lastname@example.org.
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.
By Anthony Diosdi