Sale of extended maintenance software contracts: deferral opportunities, international questions and possibilities.

• Author: Mackles, Glenn

The IRS National Office has issued Letter Ruling (TAM) 9231002 on a software company's method of recognizing revenue on the sale of extended maintenance contracts under which the taxpayer agreed to sell software updates. Based on the facts presented, the Service concluded that the taxpayer's sale of these contracts constituted the sale of an inventoriable good. Accordingly, the taxpayer was allowed to defer recognition of advance payments as revenue from the sales under Regs. Sec. 1.451-5(c). This conclusion creates the possibility of substantial deferrals of income and may be especially attractive to taxpayers who will be adopting deferral methods for book income under AICPA standards promulgated for the current year.

In addition, the IRS's conclusion, if extended to international provisions and to the interpretation of tax treaties, could have significant impact, for example, on the sourcing of income, the calculation of foreign tax credit (FTC) limitations and the imposition of withholding taxes. The Treasury is currently considering how to characterize international transactions involving off-the-shelf software.

Letter Ruling (TAM) 9231002

The taxpayer was in the business of developing and marketing computer software and used the accrual method of accounting. The taxpayer entered into perpetual term, nonexclusive licensing agreements relating to "off-the-shelf" computer software it internally developed. A purchaser of the taxpayer's software (that is, one who received a perpetual license of the underlying software) was entitled to one year of maintenance.

The taxpayer's customers could also enter into contracts ranging from one to five years to continue maintenance. Some customers entered into these contracts when they purchased the original software, while others did so toward the end of the initial year of maintenance.

Under the one-year and extended maintenance contracts, customers were entitled to receive, for no additional consideration, all future updates, cyclical releases and rewrites of the underlying software. Although the contracts did not guarantee a minimum number of new releases of the software, historically the taxpayer issued at least one release per year and averaged two new releases per year for each of its applications.

The taxpayer's customers with contracts were also entitled to telephone support services from technical representatives. The tax treatment of the amounts allocated for support services was not at...