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By Gary D. Sprague, Esq.
Baker & McKenzie LLP, Palo Alto, CA
There is room for discussion and controversy whenever the issue arises of where intangible property is "used" for purposes of §956. In CCA 201106007, the Chief Counsel's Office has come to a conclusion in a case dealing with the sale of software products by a controlled foreign corporation (CFC) into the U.S. market which is consistent with an IRS revenue ruling on copyright transactions, but is inconsistent with a more recent field service advice regarding software. Since the CCA doesn't base its conclusion on an analysis of prior authority, it therefore leaves taxpayers wondering about the technical analysis underlying the conclusion.
The taxpayer involved in CCA 201106007 was a distributor of information technology products and services. The taxpayer, a U.S. parent corporation, had entered into a cost-sharing arrangement (CSA) with its wholly owned foreign subsidiary to develop computer software. The development activity took place in the United States. In an unusual element, the CSA allocated to the foreign subsidiary the rights to exploit in the United States the copyrights developed through the CSA. When the U.S. parent completed development of a software product intended for sale to end-user customers, a "gold master" was created that carried the final version of the software code, and the gold master was sent to the CFC. The CFC then reproduced copies of the software program and sold those copies of the software program to end-user customers in the United States.
The issue as stated in the CCA was whether the sale of software products by the CFC to U.S. end-user customers gave rise to an investment in U.S. property for purposes of §956(c)(1)(D). The CCA properly concluded that it did not, but the discussion in the CCA went beyond the sale of the copies and described some circumstances where an investment in U.S. property could arise by virtue of the CFC holding rights, pursuant to the CSA, to use copyrights to duplicate copies for sale into the United States.
The principal intellectual property right protecting the exploitation of computer software is the copyright in the source code. Section 956(c)(1)(D) defines "United States property" for purposes of §956 as including "any right to the use in the United States of … a … copyright … which is acquired or developed by the controlled foreign corporation for use in the United States." The regulations don't add too much to this definition, providing in Regs. §1.956- 2(a)(1)(iv)(d) that whether the right has been acquired or developed for use in the United States "is to be determined based on all the facts and circumstances of each case." The regulations further state that "a right actually used principally in the United States will be considered to have been acquired or developed for use in the United States in the absence of affirmative evidence showing that the right was not so acquired or developed for such use."
In CCA 201106007, the Chief Counsel's Office succinctly sets forth the following conclusions: (1) the CFC made an investment in U.S. property when it acquired or developed the rights to use copyright rights in the United States pursuant to the CSA; (2) the actual sales of the computer software copies by the CFC to end-user customers in the United States did not in themselves give rise to an investment in U.S. property; and (3) the actual transfer of copies of the software by the CFC to the end-user U.S. customers did not affect the calculation of the inclusion amount, if any, attributable to the CFC's original investment in U.S. property, because the CFC did not acquire or develop additional rights (or relinquish any rights) to use the software rights in the United States merely as a result of the sale of copies to a U.S. person. The CCA did not state any authority or elaborate any analysis in support of those conclusions.
This is not the first time the National Office has grappled with the question of the §956 implications of the sale into the United States of software copies produced outside the United States. In PLR 200229030, the IRS considered the case where various CFCs owned "Software that is protected by copyright laws in the United States and foreign countries." The CFCs produced copies of the program outside the United States, and transferred those copies to U.S. users under user agreements that did not transfer to the users any of the rights set forth in Regs. §1.861-18(c)(2).1 In the absence of the transfer of any of those rights, the PLR properly concluded that the user transactions constituted transfers of copyrighted articles, not transfers of copyright rights.
Of much more interest was the PLR's next conclusion that "the Software does not constitute a right to the use in the United States of a copyright, within the meaning of section 956(c)(1)(D)." This conclusion was highly interesting, since the reference to "Software" in the PLR seemed to be to the copyright to the source code, or perhaps to the master copy which contained the source code and which carried the right of reproduction, and thus seemed to represent a conclusion that ownership of the software copyright itself, including the rights which allowed the CFC to reproduce outside the United States but transfer user copies to U.S. persons, did not constitute an investment in a right to use a copyright in the United States.
Shortly after its issuance, PLR 200229030 was revoked, without explanation, by PLR 200411016. The same issue has now arisen in CCA 201106007.
The first conclusion stated in CCA 201106007 and the revocation of PLR 200229030 appear to be based on a consistent view, namely, that the acquisition of the copyright rights that allow a CFC to reproduce and sell software copies into the U.S. market constitutes U.S. property for §956 purposes. That result must be based on the conclusion that the activity of offshore reproduction followed by the transfer of the copies to U.S. persons constitutes the exercise of the right to use the copyright "in the United States," even though the CFC conducts no actual business activities in the United States. The CCA does not state whether title or risk of loss to the copies passed inside or outside of the United States, so that fact may not have been important in the CCA's analysis.
This dichotomy between the location of actual business activity and the location where a business activity may implicate the protections afforded by intellectual property rights reaches the crux of many of the difficult issues in the area of determining where intellectual property rights are "used." Determining the location of the "use" of intangible property rights is required for several purposes of the Code besides §956, including identifying the source of royalty income under §861 and determining the availability of the "same country" exception from foreign personal holding company income under Subpart F for related-party royalties.2
The conclusion in the CCA that the copyright itself constitutes U.S. property is not surprising, as that conclusion is consistent with the analysis set forth in Rev. Rul. 72-232, 1972-1 C.B. 276. That ruling addressed a case of a U.S. publisher which paid royalties to a nonresident for the right to print books and sell those books into a foreign market. The printing activity took place in the United States. The ruling states in the facts that the books were sold "exclusively in the foreign country." As a matter of copyright law, there would seem to be no doubt that the U.S. printing activity could be undertaken only by the owner or authorized licensee of the book copyright. Nevertheless, the IRS justified the conclusion that the royalties were entirely foreign-source income, and thus not subject to withholding when paid to a nonresident licensee, on the following basis:
In the instant case there is no commercial publication of the textbooks within the United States in that the textbooks are not sold within the United States. Without such commercial publication M is engaged solely in printing or manufacturing books within the United States, which books are later sold in the foreign country. In the vending of such books in the foreign country, the foreign country copyrights are used and not the United States copyright.
This analysis is consistent with the conclusion in CCA 201106007 — by transferring the copyrighted articles to U.S. users, the CFC was using a U.S. copyright. This conclusion is consistent with general copyright law principles as well, since the CFC would endeavor to enforce its rights under U.S. copyright law if a pirate attempted to make or distribute unauthorized copies of the software program in the United States. The Chief Counsel's Office did not, however, cite to any authority to support its analysis and conclusion, not even to Rev. Rul. 72-232.
This is not the first time that Rev. Rul. 72-232 seems to have been ignored by the National Office as providing relevant guidance to a subsequent case. In FSA 200222011, the IRS considered a case where the rights to reproduce computer software were licensed to a U.S. person for modification, reproduction, and installation on hardware, which then was sold with the installed software. Some portion of the sales was made to users outside the United States. Despite the export sales, the National Office advised that 100% of the royalty should be characterized as U.S.-source, based principally on the U.S. situs of the activities performed by the licensee. Rev. Rul. 72-232 was not distinguished or even mentioned, despite the fact that the National Office was reaching the opposite result in what seems to be a similar case.
Ultimately, a controversy likely will arise over whether offshore duplication for sale into the United States constitutes the right to use a copyright in the United States, when all of the CFC's actual operations are located outside the United States. Perhaps it could be argued that the CFC in this case exercised its rights under the U.S. copyright when it copied and distributed products for use in the United States, but that such exercise of rights took place entirely outside the United States. That analysis would be consistent with the case of Sanchez v. Comr.,3 in which case the Tax Court determined the source of royalty income by reference to the location of the royalty payor's business activities, rather than by reference to the jurisdictions into which the patented products were sold and which provided the relevant intellectual property protection for the sale and use of the patented process in those territories. That analysis also would be consistent with the result in Sabatini v. Comr.,4 in which case the Board of Tax Appeals concluded that 100% of a royalty payment was U.S.-source income when a U.S. publisher was given book publication rights to both the U.S. and Canadian markets, even though the Board distinguished between payments for U.S. and Canadian theater dramatization rights for one of the same works.
For transactions involving copyrighted computer software, therefore, the conclusions expressed in CCA 201106007 seem to be consistent with Rev. Rul. 72-232 and the revocation of PLR 200229030, but inconsistent with the more recent software FSA. Since there is no discussion of either the prior cases or the IRS's own guidance, the IRS's underlying analytical approach remains unclear. The message for taxpayers is that the right to sell software copies into the United States may be regarded by the IRS as U.S. property for §956 purposes, so that acquisitions of such rights which result in basis in the property must be carefully planned in order to mitigate the possible §956 consequences.
This commentary also will appear in the May 2011 issue of BNA's Tax Management International Journal. For more information, in BNA's Tax Management Portfolios, see Madole, 929 T.M., Controlled Foreign Corporations — Section 956, and in Tax Practice Series, see ¶7150, U.S. Persons — Worldwide Taxation.
(1) The right to make copies of the computer program for purposes of distribution to the public by sale or other transfer of ownership, or by rental, lease or lending;
(2) The right to prepare derivative computer programs based upon the copyrighted computer program;
(3) The right to make a public performance of the computer program; or
(4) The right to publicly display the computer program.
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