Software royalty source and withholding.

• Author: Sair, Edward A.

In Field Service Advice (FSA) 200222011, the IRS concluded that royalties were entirely U.S. source and subject to withholding when paid by a domestic corporation that modified software in the U.S., then sublicensed it to a related manufacturer. Although the manufacturer sold products incorporating the modified software both within and outside of the U.S., the royalty was U.S. source, because the payor had "used" the software in the U.S. The IRS further concluded that even if the "use" rule did not apply, the royalties would be U.S. source, because it could not audit the taxpayer's unreasonable allocation method.

Facts

Corp. B, a domestic corporation, and Corp. X, a foreign corporation, were the largest shareholders in Corp. Y, a foreign corporation. Y, which owned all of the shares of Corp. A, a domestic corporation, created computer-operating software in its home country and licensed to A exclusive worldwide rights (excluding Y's home-country rights) to sell, use, copy, manufacture or sublicense it. A immediately sublicensed its rights to B, a computer manufacturer. Both the license and sublicense agreements were for a one-year term, automatically renewable annually unless terminated by mutual agreement.

In the U.S.A's employees modified the software to make it usable in U.S.-manufactured computers. Y's employees assisted, and A reimbursed Y. In addition, A may also have reproduced the modified software in the U.S. and transferred copies to B, but that was unclear.

B installed the sublicensed software into some of the computers it manufactured, which it then sold to third parties both within and outside of the U.S. When a customer purchased a computer with the software installed (pursuant to licensing and sublicensing agreements), B paid A a royalty; in turn, A paid one to Y.

The taxpayer sourced the royalties paid to Y based on B's accounting of the number of sales in the U.S. and other jurisdictions.

Analysis

The IRS first concluded that A "used" (within the meaning of Sec. 861(a)(4)) the rights it had licensed solely within the U.S., because all of A's activities as to the licensed software (e.g., modification, sublicense and possibly reproduction) occurred there.

It focused on the modification and reproduction activities, rather than on the location of the end-user of the copyrighted product, which apparently contradicts other published guidance in this area. For example, under Rev. Rul. 68-443, a royalty paid by a manufacturer of...