Proposed software regulations.

• Author: Levenson, Alan
• Position: Taxation of software transactions

On Nov. 7, 1996 the IRS issued proposed regulations on the tax treatment of software programs. These long-awaited regulations represent a significant effort on the part of the Service and industry representatives to bring much-needed certainty to the tax consequences of technology transactions.

Effective Date

The regulations will be effective for transactions occurring on or after 60 days after the date final regulations are published in the Federal Register. There are no provisions for elective retroactivity.

Overview

These proposed regulations affect transactions engaged in by software developers, manufacturers, distributors, licensors, producers of hardware with embedded intangibles and end-users, and are relevant for virtually all international tax purposes. (While it appears to have been the Service's intention for the regulations to apply to all international tax provisions, the passive foreign investment company provisions were not specifically referenced.)

The proposed regulations provide that a transaction involving the transfer of a computer program will be classified as either the transfer of a copyright right, the transfer of a copyrighted article, the provision of services relating to the development of a computer program or the provision of know-how. A transaction involving more than one category will be broken into its separate components unless, under the facts and circumstances, the importance of a particular transaction is de minimis.

If the user of a computer program obtains one of four enumerated copyright rights, the transaction will be treated as the transfer of a copyright right. If one of the four rights is not transferred and the transaction does not involve, or involves to only a de minimis extent, the provision of services or know-how, the transaction will be classified solely as the transfer of a copyrighted article. Computer programs are considered similar to other copyrighted articles, such as books, records and motion pictures, that are literary works for purposes of the Copyright Act of 1976. The proposed regulations generally rely on copyright law principles and distinguish between transactions involving the copyright itself and the subject of the copyright (i.e., the software).

If a transfer involves copyright rights, it will be classified further as either a sale or license, depending on whether all substantial rights have passed to the transferee. If a transfer involves a copyrighted article, it will be further classified as either a sale or a lease of a copyrighted article, depending on whether the benefits and burdens of ownership have passed to the transferee.

While the regulations bring an element of certainty to the tax treatment of many software transactions, they leave some questions unanswered and create new questions.

Discussion

A significant issue in the tax treatment of software has been whether the transfer of software should be treated as a license or a sale. Virtually all transfers of software are structured legally and contractually as licenses. However, many types of software transactions, such as the sale of shrink-wrap or prepackaged software, more closely resemble the sale of a copyrighted article, such as a book.

The proposed regulations will treat a transfer of a computer program as a transfer of a copyright right if the transferee acquires one or more of the following rights: (1) the right to make copies of the program for distribution to the public by sale, by other ownership transfer, or by rental, lease or lending, (2) the right to prepare derivative computer programs based on the copyrighted program; (3) the right to make a public performance of the program, or (4) the right to publicly display the program. (This list differs list of rights set out in the Copyright Act of 1976. The copyright law right to copy will be treated as a copyright right for purposes of the proposed regulations only if it is accompanied by the right to distribute such copies to the public.) Accordingly, a transfer of a computer program without any of these rights win be treated as the transfer of a copyrighted article.

Thus, the normal sale of a shrink-wrap computer program to the general public, even though...