Source of Income in International Software Sales

By Philip D. Morrison, Esq.  

Deloitte Tax LLP, Washington, DC

Fourteen years ago Treasury and the IRS promulgated final regulations regarding the classification of transactions involving computer programs.1 While those regulations provided extremely helpful clarity with respect to several concerns regarding how to classify software transactions, they did not provide much in the way of clarity regarding the source of income from an international sale of software that constitutes inventory to the seller. One of the reasons for this is because such clarity could be supplied by taxpayers themselves in drafting terms to their contracts, particularly when software was sold via a transfer of physical media like a disc. Now, of course, software is almost always transferred via electronic download.2 For a variety of reasons, taxpayers cannot or do not engage in self-help. Because of this, sourcing the income from such sales can be difficult.

Under the regulations, most software transactions entered into by software producers are either sales of copyrighted articles or licenses of copyright rights. An end-user customer typically is a buyer of a copyrighted article, as he has no right to copy the software (except, for example, for the specified number of employee-user copies he has contracted for). At the time of the promulgation of the regulations, a sale of software that constituted a sale of a copyrighted article was typically the sale of so-called "shrink-wrapped" software - a box containing a disc and some written material.  That sort of sale is something of a dinosaur today. Now the typical sale of software that constitutes a sale of a copyrighted article is a sale effected through an electronic download of the software over the internet.

The electronic download of software by customers was not unknown at the time the regulations were being drafted. Indeed, commenters on the proposed regulations noted the problems of determining source of income with regard to electronically downloaded, cross-international-border, software sales if the source of income from such sales were to be determined by the place of sale:The commentators also pointed out that the place of sale can be problematic when dealing with sales of computer programs, in part because typical license agreements do not refer to a transfer of property, and in part because an electronic transfer is generally not accompanied by the usual indicia of the transfer of title.

The problem the commenters were pointing out is that sales of inventory property are sourced generally by reference to the place where title or other indicia of beneficial ownership (such as risk of loss) of the property pass from seller to the buyer.  Where there is no disc or other obvious physical property being transferred, as in an electronic download, it is hard to identify where that place may be. The software being "sold" may be downloaded from a U.S. server owned or leased by the software provider. The customers' computers to which it is downloaded may be outside the United States.  In an electronic download, where does "title" pass?

First, as the commenters explained, the "sale" of software is typically styled as a license. Regardless of the transaction's clear tax status under the regulations as a sale of property (a sale of a copyrighted article), intellectual property lawyers frequently insist on this. Specifying in the contract between licensor/seller and licensee/buyer where the place of sale or transfer of title is to take place is, therefore, something that many software producers will refuse to do, on the advice of their intellectual property law advisors who want to avoid a sale characterization for commercial and IP law purposes.

Second, also as the commenters pointed out, the usual indicia of title passage are typically missing. There is nothing physical being shipped so there are no shipping terms. Since there is nothing physical to insure, there is no insurance. Ordinary indications of who has risk of loss and when he has it are irrelevant.  For these reasons -… Several commentators suggested that the place of sale should be deemed to be the location of the customer, or the place where the customer first obtains the opportunity to install the program onto its computer.

Unfortunately, Treasury and the IRS rejected these suggestions. In the final regulations they provided references to the various international Code provisions for sourcing income relevant to the various characterizations set out by the regulations. In less-than-satisfying terms the Preamble described why Treasury and the IRS rejected the suggestion of providing a definitive place-of-sale for software downloads:As to the issue of determining the place of sale under the title passage rule of §1.861-7(c), the parties in many cases can agree on where title passes for sales of inventory property generally. Consistent with the overall policy of the regulations, income from electronic transfers of computer programs that constitute inventory property, classified as sales of copyrighted articles, will be sourced under similar principles.

Given the constraints described by commenters, each of which is still true today, this leaves the typical sale of software via electronic download with considerable uncertainty as to where "title" passes. And without certainty regarding title passage, there can be no certainty for source-of-income purposes.

Perhaps the most practical effective way for taxpayers to deal with this problem is to write their contracts with foreign customers with this issue in mind. Obviously, the best thing from a tax perspective would be to specify in the contract where "title" passes. As noted above, however, many intellectual property advisors will not allow software producers to do that. Even that, however, cannot be completely dispositive, since there may be a "sale" and "title passage" only for tax purposes. For commercial law purposes, the transaction may well be considered a license.

Other actions taxpayers can take for international sales include providing contractual terms that make it as clear as possible that risk of loss, to the extent there is any, remains with the seller until the software resides on the customer's computer.  If the seller is obligated to resend or otherwise generate another copy of the software if the software does not work after the initial download, such an obligation may indicate that risk of loss has not been transferred until a working copy of the software is successfully loaded on the customer's computer. It might also be helpful if the software must be opened by a separately downloaded "key" or password. Because the key is used to unlock the software at the customer's foreign location, it can be argued that risk of loss does not pass to the customer until then, thus "title" passage must occur at the customer's location. Finally, software producers who sell their products via electronic download should have some system for identifying where their foreign customers' computers are physically located when the customers download the software, employ a key or password, and/or click "accept" for the "license" terms.

While these provisions and actions should all help, there still can be no certainty with respect to source of income from cross-border electronic download sales. If a software provider has the luxury of having multiple server locations, it might be sensible to consider a non-U.S. server for sales to its non-U.S. customers.  While local country permanent establishment issues (or local country tax if the server-owner is a separate person) must be considered, an electronic download that both originates and ends outside the United States should provide clarity about the source of income on such sales.

Alternatively, Treasury and the IRS might reconsider the comments on Prop. Regs. §1.861-18 from 14 years ago. Not only are those comments still relevant, but with the widespread use of electronic downloads of software, they address a problem that arises far more often today than 14 years ago.

This commentary also will appear in the October 2012 issue of the  Tax Management International Journal. For more information, in the Tax Management Portfolios, see Blessing and Lubkin, 905 T.M., Source of Income Rules, and in Tax Practice Series, see ¶7150, U.S. Persons - Worldwide Taxation.


  1 Regs. §1.861-18, T.D. 8785, 63 Fed. Reg. 52971 (10/2/98).

  2 Software, of course, is also used in providing cloud computing services. Due to security and reliability concerns, and sometimes technical issues, however, much software is still sold to customers.

  3 T.D. 8785, Preamble.

  4 Id.