By Anthony Diosdi
The United States taxes U.S. persons on all of their income, from whatever source derived. Therefore, the source of income generally has no effect on the computation of a U.S. person’s taxable income. Sourcing can, however, have a significant impact on the computation of a U.S. person’s ability to claim a foreign tax credit. The source rules play a more prominent role in the taxation of a foreign person or foreign business, since they effectively define the boundaries of U.S. taxation. The U.S. taxes the gross amount of a foreign person’s or foreign business’s U.S.-source passive type income at a flat rate of 30 percent. The U.S. also taxes foreign persons and foreign businesses at graduated rates on the net amount of income effectively connected with the conduct of a U.S. trade or business. As a general rule, the U.S. taxes the U.S.-source income of a foreign person or foreign business and does not tax a foreign person’s or foreign business’s foreign source income.
These sourcing rules discussed in the Internal Revenue Code instruct whether income from payments of a particular transaction will be treated as U.S. source or foreign source or party based on an allocation provision. These sourcing rules are incredibly important in determining how foreign computer programs and cloud computing transactions are taxed in the U.S.
An Overview of the Source Rules
The source rules are organized by categories of income, such as interest, dividends, personal services, rentals, royalties, and gains from the sale of property. Once the appropriate category of income is determined, the next step is to apply the applicable rule to classify the item of income as either U.S. or foreign source. For purposes of the sourcing rules, compensation for personal services performed in the United States is U.S. source income, and compensation for personal services performed outside the U.S. is foreign source income. Personal services generally include compensation for services performed by employees or other agents.
Rentals and royalties are U.S.-source income if the property is located or used in the U.S. and foreign source if the property is located or used outside the U.S. The characterization of income as a royalty not only depends on where the intangible is used, but also where the licensee is legally entitled to use, and the country where the intangible is provided legal protection. Thus, if a foreign licensee receives legal protection in the U.S. in the form of a patent, copyright, or trademark, the characterization of the income is U.S. source royalty income.
The U.S. has special sourcing rules for the purpose of the sale of intangible property by a foreign person or foreign entity. For purposes of the sourcing rules, an intangible is any patent, copyright, secret process or formula, goodwill, trademark, trade brand, franchise, or other like property. Internal Revenue Code Section 865 prescribes the rules for determining the source of gain from the sale of intangible property. Section 865 sets forth an apparent rule of general application based upon the residence of the seller, and a special definition of “residence.” However, source determinations will often depend upon the application of a series of exceptions which reflect a number of variables, including particularly whether the property is inventory and whether the property has been used in connection with a U.S. trade or business.
Challenges of New Technologies
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 the 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. 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, database or similar term if they are incidental to the operation of the computer program. See Treas. Reg. Section 1.861-18-18(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 programming 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 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 Treasury Regulation Section 1.861-18(c)(2), 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 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 stated 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. See Treas. Reg. 1.861-18(d). 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 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 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 copyrighted 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 where the property is located in the case of rents and the place where the property is used in the case of royalties.
Character of Computer Program and Digital Income: Services Income or Royalties
The rapid growth of internet-related businesses adds to the significance to the question whether income generated from these activities should be treated as services income or income from the use of intangibles. The classification is extremely important for U.S. tax purposes when dealing with foreign persons or foreign entities. Income earned from the performance of “services” is sourced according to the place of performance. Therefore, if the services are performed in the U.S., the income is U.S. sourced income, and subject to U.S. tax; if the services are performed outside the U.S., then the income is foreign sourced income and not likely subject to U.S. tax. Income earned by a foreign entity received from rents and royalties are sourced according to the place in which the property is located or used.
As discussed above, the software regulations provide guidance on how to source income from transactions involving computer programs. In determining whether and how to tax digital transactions between a foreign corporation and the United States, the U.S. sourcing rules must be considered. If a foreign internet company earns income in the U.S. from activities such as cloud computing, data warehousing, and web hosting that can be treated as services, the U.S. transactions will not be subject to U.S. tax. For example, assume 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. Taking into account all of the facts and circumstances of this case, 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 the owner of all copyrighted rights in Program Q. See Treas. Reg. Section 1.861-18(h), Example 15.
On the other hand, if a foreign person or foreign business receives U.S. source income from the use or sale of intangible property rather than services, that income will be subject to U.S. taxation. For example, let’s assume that Corp A owns the copyright in a computer program known as “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. P has acquired a copyrighted article and 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. The same conclusion applies where the software is made available through a website rather than a disk. See Treas. Reg. Section 1.861-18(h), Examples 3 and 4.
In another example, let’s assume that 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 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 transfer in this case should be treated as a taxable sale by Corp A because Corp A transferred to Corp B copyright rights and Corp B received the right to use them exclusively within Country Z for the remaining life of the copyright. See Treas. Reg. Section 1.861-18(h), Example 6.
On August 9, 2019, the Treasury and the Internal Revenue Service (“IRS”) released proposed regulations on characterizing cloud computing transactions and other transactions involving on-demand network access. The Proposed Regulations provide that a cloud transaction is classified solely as either a lease of property or the provision of services. The Proposed Regulations provide that a cloud transaction may be classified as the provision of services rather than a lease of property. In determining whether a cloud transaction will be classified as services rather than a lease, the following factors are relevant for this determination:
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 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 customer does not have a significant economic or possessory interest in the property;
6. The provider bears any risk of substantially diminished receipts or substantially increased expenditures if there is nonperformance under the contract;
7. The provider uses the property concurrently to provide significant services to entities unrelated to the customer;
8. 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
9. The total contract price substantially exceeds the rental value of the property for the contract period.
The Proposed Regulations define the term “digital content” as any content in digital form 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 contest is transferred in a physical medium (e.g., books, movies, and music in digital format). See Treas. 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 should not constitute the transfer of a copyright right. When copyrighted articles are sold and transferred through an electronic medium, the sale is deemed to occur at the location of the download or installation onto the end-user’s device to access the digital content.
Applying the principles discussed above to software programs and digital content, it seems that U.S. income received by a foreign person or foreign entity from activities such cloud computing, data warehousing, database access, web-hosting can potentially be treated as income from foreign services transactions rather than from the use of intangible property. This is because in these types of activities, the foreign entity providing the service typically owns, controls, operates, and maintains the equipment on which data is stored. The foreign technology company provides U.S. customers with access to the equipment and software and the foreign technology company has the right to remove the software or digital content at will. Moreover, customers use the equipment and software with other customers and pay a volume or time-based fee.
The problem is determining where digital services are performed can be difficult. For example, computer equipment that facilitates delivery of the digital product might be located in the U.S., and employees that maintain and monitor such equipment might be located in a European country, and the coders who developed the software might reside in a country located in Asia. Thus, a careful analysis must always be made where to source services income and if any portion of the services income can be sourced to the U.S for income tax purposes.
The U.S. taxation of foreign royalties differs from the above discussed rules. Royalties and payments that are made by U.S. users for licenses and similar arrangements for the use of intangible property owned by a foreign entity (or a non-U.S. person), is U.S. source income. This includes payments for the use of patents and copyrights. Royalty payments for the use of intangible property within the U.S. which is not effectively connected income of a U.S. trade or business of a foreign entity or non-resident licensor is subject to a flat tax of 30 percent on the gross amount of income received. Internal Revenue Code Sections 871(a) (for nonresident aliens) and 881(a) (for foreign corporations) impose the 30-percent tax on interest *** dividends, rents, salaries, wages, premiums, annuities, compensations, remunerations, emoluments, and other fixed or determinable annual or periodical gains, profits, and income.” This enumeration is sometimes referred to as “FDAP income.” In certain cases, tax treaties may provide for a reduction or elimination of the 30 percent tax.
Conclusion
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 foreign 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 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.