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Federal Taxation of Software and E-Commerce (Portfolio 555)

Tax Management Portfolio, Federal Taxation of Software and E-Commerce, No. 555, describes the U.S. federal income taxation of software and e-commerce transactions.

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DESCRIPTION

Tax Management Portfolio, Federal Taxation of Software and E-Commerce, No. 555, describes the U.S. federal income taxation of software and e-commerce transactions.

 It begins with an introduction addressing background issues relevant to understanding software transactions, in particular terminology and copyright law. Copyright law has been influential in shaping the Software Regulations (1998) characterizing software for most U.S. tax purposes. The main focus of the Portfolio is on the U.S. federal income taxation of software revenue. The first step in the analysis of software revenue is characterization of such revenue as among four primary categories: (i) sales of copyrighted articles, (ii) leases of copyrighted articles, (iii) licenses of copyright rights, and (iv) sales of copyright rights. The Software Regulations issued in final form in 1998 and in proposed form in 1996 both clarified and provided much needed articulation of how to characterize software revenues for U.S. tax purposes. The Organization for Economic Cooperation and Development (OECD) also published Commentary for international withholding tax analysis on the same topic, at first predating the 1996 proposed Software Regulations and then later adapting the Commentary to essentially follow the 1998 final Software Regulations. Thus, other countries struggling with the complex issues of software revenue characterization for tax purposes, can look to the OECD Commentary and develop domestic rules and treaty interpretation rules similar to the U.S. tax rules.

Also addressed in this Portfolio are dispositions of software, source of income, and subpart F (including the definition of manufacturing, focusing on software reproduction), all of which are dependent on the software revenue characterization analysis. The creditability of foreign withholding taxes on software revenue is also covered, in particular the importance of understanding the foreign laws so as to be able to reach a conclusion as to whether the payment was compulsory under those foreign laws and therefore not to be disallowed for credit against U.S. tax liability.

Included within the Portfolio is also a chapter on the applicability in the software context of the §199 domestic production deduction incentive (including the definition of manufacturing, focusing on research and development of software intangibles). The Portfolio also discusses the treatment of software development expenses, including capitalization issues, the R&D deduction under §174 principles and credit under §41, cost recovery under §197, and accounting methods.

The last part of the Portfolio addresses the special analysis of electronic commerce transactions and some of the difficulties in tax analysis presented by new forms of software business.


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AUTHORS

GARY D. SPRAGUE
Gary D. Sprague, Esq., B.A., Stanford University (1977, with honors; Phi Beta Kappa); J.D., Harvard Law School (1981, cum laude); Partner, Baker & McKenzie, LLP; Business Co-Chair of OECD Technical Advisory Group on Treaty Characterization Issues arising from E-Commerce; Business Co-Chair of OECD Technical Advisory Group on Monitoring the Application of Existing Treaty Norms for the Taxation of Business Profits; co-author, Source of Royalty Income and Place of Use of Intangible Property, Tax Management International Journal (August 2007); co-author, Permanent Establishments and Internet-Enabled Enterprises: The Physical Presence and Contract Concluding Dependent Agent Test, Georgia Law Review (Fall 2003); author, Application of Transfer Pricing Rules to Branches and Permanent Establishments—Electronic Commerce and Intangible Property Aspects, The George Mason Law Review (Summer 2002); co-author, General Report on Main Subject I: Taxation of Income Derived from Electronic Commerce, Cahiers de Droit Fiscal International (2001); co-author, United States Taxation of Income from International Electronic Commerce Transactions, Tax Management Memorandum (December 2000); co-author, The Final Software Revenue Characterization Regulations, Tax Management International Journal (February 1999); co-author, Characterization of Computer Software Revenue in International Transactions, TAXES (December 1996); member of American Bar Association; International Fiscal Association, USA Branch; State Bar of California.

ROBIN A. CHESLER
Robin A. Chesler, Esq., B.A., Harvard-Radcliffe University (1986, magna cum laude); J.D., University of California, Boalt Hall School of Law (1989); Partner, Baker & McKenzie, LLP; co-author, The Final Software Revenue Characterization Regulations, Tax Management International Journal (February 1999); co-author, Characterization of Computer Software Revenue in International Transactions, TAXES, The Tax Magazine (December 1996); member, State Bar of California, American Bar Association Section on Taxation.

TAYLOR S. REID
Taylor S. Reid, Esq., B.A., University of California at Berkeley (1986); Graduate Diploma in International Studies, University of Vienna, Austria (1990); J.D., Northwestern University School of Law (1993, cum laude); Partner, Baker & McKenzie LLP; co-author, Internet Law for the Business Lawyer (ABA: 2001); co-author, United States Taxation of Income Derived from International Electronic Commerce Transactions, Tax Management Memorandum (December 4, 2000); member, State Bar of California, Illinois State Bar Association, American Bar Association Section on Taxation.

BRUCE A. COHEN
Bruce A. Cohen, B.A., Case Western Reserve University (1984) (Phi Beta Kappa, summa cum laude); J.D., Columbia University (1987); Associate International Tax Counsel and Attorney Advisor, Office of Internal Tax Counsel, Department of the Treasury, 1995-1997; Partner, Baker & McKenzie LLP, 2001-2007; Harlan Fiske Stone Scholar; member, Internal Fiscal Association; member, State Bar of California, District of Columbia Bar, Illinois State Bar Association, Tax Court Bar, American Bar Association Section on Taxation.

HELEN M. HUBBARD
Helen M. Hubbard, Esq., B.B.A., Texas Tech University (1975); J.D., Southern Methodist University School of Law (1987, magna cum laude); Law Clerk to the Honorable Irving L. Goldberg, U.S. Court of Appeals for the Fifth Circuit (1987-88); Tax Legislative Counsel, United States Department of the Treasury (2002-05); Partner, Baker & McKenzie LLP; member, State Bar of Texas, District of Columbia Bar, American Bar Association Section of Taxation (Council, 2006-present; Chair, Simplification Committee, 2007-present; Assistant Secretary, 2004-05; Chair, Tax Accounting Committee, 1996-98); Adjunct Professor of Law at Southern Methodist University Dedman School of Law (2006) and Georgetown University Law Center (1996-2001); Fellow, American College of Tax Counsel; Certified Public Accountant.

TABLE OF CONTENTS

Detailed Analysis

I. Software

A. Introduction: What Is Software?

1. Terminology

2. Copyright Law Background to Software Transactions

a. Nature of Copyright

b. First Sale Doctrine and the Limits of Copyright Protection

c. Addressing Deficiencies of the Copyright Law: The User License

3. Electronic Commerce Transactions Aspects

B. Taxation of Software Revenue

1. Revenue Characterization

a. Introduction

(1) Background

(2) Definition of Computer Program

(3) The Scope of the Regulations

(4) The Role of U.S. Copyright Law

(5) The Relevance of Foreign Law and of Contractual Agreements

(6) Application to Electronic Commerce and Other Digitized Information Transfers Generally

b. The Six Categories of Transactions

(1) In General

(2) The Two Basic Distinctions

(a) Copyrighted Articles and Copyright Rights

(b) Complete vs. Partial Transfers

(c) Factors Not Taken into Account

c. Four Basic Categories of Transactions

(1) Complete Transfer of Copyright Rights: A Sale of the Copyright

(a) Example

(b) Analysis

(2) Partial Transfer of Copyright Rights: A License

(a) Example

(b) Analysis

(3) Complete Transfer of a Copyrighted Article: A Sale

(a) Source of Income for Sales of Copyrighted Articles

(b) Examples of Sales of Copyrighted Articles

(4) Partial Transfer of a Copyrighted Article: A Lease

(a) Examples of Sales vs. Lease of Copyrighted Articles

(b) Analysis

d. Two Special Types of Transactions: Services and Know-How

(1) Provision of Services

(2) Know-How

e. Special Issues

(1) Enterprise Licenses and Distribution “to the Public”

(a) Examples

(b) Analysis

(c) Additional Examples

(2) Derivative Works and the De Minimis Rule

(a) Examples of Derivative Works Rights and the De Minimis Rule

(b) Non-De Minimis Derivative Work Transactions

(3) Public Performance and Display

(4) Derivative Computer Programs Versus Services or Sales

(5) Services Other Than Programming Services

(6) Software Maintenance

f. Software Hosting and On-line Services

g. Effective Date

h. The OECD's Approach to Software Revenue Characterization

2. Dispositions of Software: Sale vs. License

a. Sale vs. License or Lease

b. Capital Gains Treatment Under Section 1222

(1) Property Held Primarily for Sale to Customers in the Ordinary Course of a Trade or Business

(2) Property Used by the Transferor in Its Business of a Character Subject to Depreciation

(3) Certain Copyrights

c. Capital Gains Treatment Under Section 1231

d. Capital Gains Treatment Under Section 1235

e. Ordinary Income Recapture

f. Ordinary Income Treatment for Related Party Sales Under Sections 1239 and 1249

3. Source of Income

a. Income from Sales of Personal Property

(1) Sale of a Copyright Right

(2) Sale of a Copyrighted Article

(3) Application of the Title Passage Rule

b. Rents and Royalties

(1) Rents

(2) Royalties

c. Services

4. Subpart F

a. Application of Subpart F Categories to Software Revenue

b. Foreign Base Company Sales Income

(1) Transactions with Unrelated Parties

(2) Same Country Exceptions

(3) The Manufacturing Exception

(a) Substantial Transformation

(b) Substantial in Nature / Generally Considered Manufacturing

(c) Substantial Contribution

(d) Application of the Manufacturing Exception to Software

c. Foreign Personal Holding Company Income

(1) Active Rent or Royalty Exception

(a) Rents

(i) The Manufacturing Test

(ii) The Marketing Test

(b) Royalties

(i) The Development Test

(ii) The Marketing Test

(2) Same-Country Exception for Rent and Royalty Income

(a) Rents

(b) Royalties

(c) Section 954(c)(6)

d. Foreign Base Company Services Income

5. Foreign Tax Credits

a. Creditability of Withholding Taxes on Software Revenue: Noncompulsory Amounts

(1) Reasonable Interpretation and Application of Foreign Law

(2) Exhaustion of All Effective and Practical Remedies

b. Impact of Software Revenue on Foreign Tax Credit Limitation

(1) Source

(2) Basket

(a) For Tax Years Beginning On or Before December 31, 2006

(b) For Tax Years Beginning After December 31, 2006

6. Export Tax Incentives Replaced by Domestic Production Incentive

a. Historical Export Tax Incentives Regimes

b. Current Domestic Production Incentive Regime: Section 199

(1) Section 199 in General

(2) Applicability of Section 199 to Computer Software

(3) Definition of Computer Software for § 199

(4) Computer Software Transactions Qualifying for § 199

(5) Treatment of Computer Software Services for § 199

(a) Maintenance Contracts

(b) Customer and Technical Support

(c) Telephone and Other Telecommunication Services

(d) Online Services

(e) Other Similar Services

(f) Online Software, Including Games Software

(g) Installation

(h) Data Storage

(i) Training and Consulting

(j) Warranty

(k) Delivery

(l) Operating Manual

(m) Advertising

(6) De Minimis Exception

(7) Meeting the MPGE Test Within the United States

(a) MPGE

(b) In Whole or In Significant Part

(i) Substantial in Nature

(ii) Safe Harbor

(c) By the Taxpayer

(d) Within the United States

(8) Determining QPAI from Computer Software Transactions

(a) Determining DPGR for Computer Software Transactions

(b) Subtractions from DPGR for Computer Software Transactions

(i) Determining Cost of Goods Sold

(ii) Determining Allocable Expenses, Losses, Deductions

7. Income Accrual: Advance Payments for Maintenance Agreements

8. Section 543(d) - Active Business Computer Software Royalties (PHCI exception)

C. Treatment of Software Development Expenses

1. Capitalization

a. Section 263

b. Rev. Proc. 2000-50

c. Sections 471 and 263A

d. Enterprise Resource Planning Software Costs

e. Web Site Development Costs

(1) Other Costs Subject to Capitalization Under § 263

(2) Other Costs Subject to Capitalization Under § 263A

2. R& D Costs

a. Tax Benefits for Research or Experimental Expenditures

b. Research Qualifying Under § 174

c. Section 41 Expenses Qualifying for the Research Credit

Content

(1) Discovering Information that is Technological in Nature

(2) Process of Experimentation

(3) Permitted Purpose

d. Qualified Research Tests Applied to Business Components

e. Exclusions from Qualified Research

(1) Research After Commercial Production

(2) Adaptation of Existing Business Components to Particular Customer's Requirements

(3) Other Exclusions

f. Documentation

(1) Software as a Business Component

(2) Internal Use Software

(a) Software Used in Qualified Research

(b) Software Developed for Use in a Production Process

(c) Qualification of Internal Use Software Under Regulations

(d) Internal Use Software Qualifying Under the Proposed Regulations

(i) Software Developed as Part of an Integrated Hardware-Software Product

(ii) Software Used in the Provision of Services

(iii) High Threshold of Innovation Test

(A) Unique or Novel

(B) Significant Economic Risk

(C) Commercial Availability

3. Cost Recovery/Section 197

4. Methods of Accounting

a. Section 174

b. Rev. Proc. 2000-50

II. Electronic Commerce

A. Introduction

B. Revenue Characterization

1. Overview

2. Royalties

a. Analogous Treatment to Software Transactions

b. OECD Model Tax Convention and Commentary

c. Distinguishing Services Transactions from Property Transactions

(1) Services Versus Sales of Property

(2) Services Versus Leasing

(a) Distinguishing Service Contracts from Leases Under Section 7701(e)

(b) Additional Factors Under Pre-7701(e) Authorities

(c) Application to Electronic Commerce Transactions

3. Advertising Revenue

4. Segregation Versus Predominant Character Rule

C. Source of Income

1. Overview

2. Income from Sales of Personal Property

3. Income from Use of Property: Rents and Royalties

4. Income from Services

a. Location of Service Provider

b. Allocation Between Locations

c. Scope of Activity Constituting the Service

d. Use of Contractors

D. Jurisdiction to Tax

1. United States Trade or Business

a. Conduct of a Trade or Business in the United States

b. Effectively Connected Income: Existence of a U.S. Office

2. Permanent Establishment

3. Profit Attribution


WORKING PAPERS

Working Papers

Table of Worksheets

Content

Worksheet 1 Final Software Regulations

Worksheet 2 Preamble to the Final Software Regulations

Worksheet 3 Preamble to the Proposed Software Regulations

Worksheet 4 LMSB Industry Directive on FSC Bundle of Rights Argument

Worksheet 5 Coordinated Issue All Industries Research Tax Credit - Internal Use Software

Worksheet 6 Sample Language for Foreign Source Income for Physical Delivery

Worksheet 7 Sample Language for Foreign Source Income for Electronic Delivery

Worksheet 8 IRS Form 3115 Completed - Sample

Worksheet 9 IRS Form 8903 Completed - Sample

Worksheet 10 Paragraphs 12–17.4 of OECD Commentary to Article 12 (Royalties) OECD Model Tax Convention (2003)

Worksheet 11 OECD TAG Report, Treaty Characterisation Issues Arising from E-Commerce (Report Adopted by the Committee on Fiscal Affairs), from Issues in International Taxation, 2002 Reports Related to the OECD Model Tax Convention No. 8 (OECD)

Worksheet 12 Selected Tax Policy Implications of Global Electronic Commerce

Bibliography

OFFICIAL

Statutes:

Treasury Regulations:

Public Laws:

Legislative History:

Treasury Rulings:

Treasury Decisions:

Cases:

OECD Documents:

U.S. Treasury Dept. Documents:

UNOFFICIAL

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