Federal Taxation of Software and Digital Transactions (Portfolio 555)

Description

Bloomberg Tax Portfolio, Federal Taxation of Software and Digital Transactions, No. 555, describes the U.S. federal income taxation of software and digital 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 transactions for certain U.S. federal income 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. The Software Regulations classify transactions involving the transfer of a computer program into 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 proposed form in 1996 and in final form in 1998 provided much-needed articulation of how to characterize software revenues for U.S. tax purposes. Those regulations predated the rise of software-as-a-service (‘‘SaaS’’) business models, however, and the Software Regulations apparently do not include SaaS within their scope.

The Organization for Economic Cooperation and Development (OECD) also published Commentary under Article 12 of the OECD Model Tax Convention to distinguish ‘‘royalties’’ from ‘‘business profits’’ for treaty interpretation purposes. The earliest Article 12 Commentary predated the 1996 proposed Software Regulations. Subsequent revisions aligned the Commentary with the 1998 final Software Regulations. Various other jurisdictions have issued guidance on software revenue characterization in many, but not all, cases consistent with the OECD Commentary.

Also addressed in this Portfolio are dispositions of software, source of income, and subpart F (including the definition of manufacturing or production, 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 application to SaaS revenue) for tax years beginning before January 1, 2018, and after December 31, 2014, and the foreign-derived intangible income (FDII) deduction for tax years beginning after December 31, 2017. The Portfolio also discusses the treatment of software development expenses, including capitalization issues, the research and development deduction under § 174 principles (and the future changes to § 174 for amounts paid or incurred in tax years beginning after December 31, 2021) and credit under § 41, cost recovery under § 197, and accounting methods.

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

Table of Contents

I. Software

a. Introduction: What is Software?

b. Taxation of Software Revenue

c. Treatment of Software Development Expenses

II. Digital Transactions

a. Introduction

b. Revenue Characterization

c. Source of Income

d. Jurisdiction to Tax