# Bulletin No. 1998–42

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- **Document type:** Agency decision

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Bulletin No. 1998–42
October 19, 1998

Internal Revenue

bulletin
HIGHLIGHTS
OF THIS ISSUE

These synopses are intended only as aids to the reader in
identifying the subject matter covered. They may not be
relied upon as authoritative interpretations.

INCOME TAX

EXCISE TAX

T.D. 8784, page 4.

Announcement 98–90, page 21.

Final and temporary regulations under section 274 of the
Code relate to the use of mileage allowances to substantiate
automobile business expenses.

Public comments are requested on proposed changes to
Form 8849, Claim for Refund of Excise Taxes.

T.D. 8785, page 5.

REG–122488–97, page 19.

Final regulations under section 861 of the Code relate to the
tax treatment of certain transactions involving the transfer of
computer programs.

Proposed regulations under section 274 of the Code relate
to the use of mileage rates to substantiate automobile business expenses.

ADMINISTRATIVE

Finding Lists begin on page 33.
Announcement of Disbarments and Suspensions begins on page 29.

Department of the Treasury
Internal Revenue Service

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Mission of the Service
ucts and services; and perform in a manner warranting
the highest degree of public confidence in our integrity, efficiency, and fairness.

The purpose of the Internal Revenue Service is to collect
the proper amount of tax revenue at the least cost; serve
the public by continually improving the quality of our prod-

Statement of Principles
of Internal Revenue
Tax Administration
The Service also has the responsibility of applying and
administering the law in a reasonable, practical manner.
Issues should only be raised by examining officers when
they have merit, never arbitrarily or for trading purposes.
At the same time, the examining officer should never hesitate to raise a meritorious issue. It is also important that
care be exercised not to raise an issue or to ask a court to
adopt a position inconsistent with an established Service
position.

The function of the Internal Revenue Service is to administer the Internal Revenue Code. Tax policy for raising revenue
is determined by Congress.
With this in mind, it is the duty of the Service to carry out that
policy by correctly applying the laws enacted by Congress;
to determine the reasonable meaning of various Code provisions in light of the Congressional purpose in enacting them;
and to perform this work in a fair and impartial manner, with
neither a government nor a taxpayer point of view.

Administration should be both reasonable and vigorous. It
should be conducted with as little delay as possible and
with great courtesy and considerateness. It should never
try to overreach, and should be reasonable within the
bounds of law and sound administration. It should, however, be vigorous in requiring compliance with law and it
should be relentless in its attack on unreal tax devices and
fraud.

At the heart of administration is interpretation of the Code. It
is the responsibility of each person in the Service, charged
with the duty of interpreting the law, to try to find the true
meaning of the statutory provision and not to adopt a
strained construction in the belief that he or she is “protecting the revenue.” The revenue is properly protected only
when we ascertain and apply the true meaning of the statute.

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Introduction
The Internal Revenue Bulletin is the authoritative instrument
of the Commissioner of Internal Revenue for announcing official rulings and procedures of the Internal Revenue Service
and for publishing Treasury Decisions, Executive Orders, Tax
Conventions, legislation, court decisions, and other items of
general interest. It is published weekly and may be obtained
from the Superintendent of Documents on a subscription
basis. Bulletin contents of a permanent nature are consolidated semiannually into Cumulative Bulletins, which are sold
on a single-copy basis.

dures must be considered, and Service personnel and others concerned are cautioned against reaching the same conclusions in other cases unless the facts and circumstances
are substantially the same.
The Bulletin is divided into four parts as follows:
Part I.—1986 Code.
This part includes rulings and decisions based on provisions
of the Internal Revenue Code of 1986.

It is the policy of the Service to publish in the Bulletin all substantive rulings necessary to promote a uniform application
of the tax laws, including all rulings that supersede, revoke,
modify, or amend any of those previously published in the
Bulletin. All published rulings apply retroactively unless otherwise indicated. Procedures relating solely to matters of internal management are not published; however, statements
of internal practices and procedures that affect the rights
and duties of taxpayers are published.

Part II.—Treaties and Tax Legislation.
This part is divided into two subparts as follows: Subpart A,
Tax Conventions, and Subpart B, Legislation and Related
Committee Reports.
Part III.—Administrative, Procedural, and Miscellaneous.
To the extent practicable, pertinent cross references to
these subjects are contained in the other Parts and Subparts. Also included in this part are Bank Secrecy Act Administrative Rulings. Bank Secrecy Act Administrative Rulings
are issued by the Department of the Treasury’s Office of the
Assistant Secretary (Enforcement).

Revenue rulings represent the conclusions of the Service on
the application of the law to the pivotal facts stated in the
revenue ruling. In those based on positions taken in rulings
to taxpayers or technical advice to Service field offices,
identifying details and information of a confidential nature
are deleted to prevent unwarranted invasions of privacy and
to comply with statutory requirements.

Part IV.—Items of General Interest.
With the exception of the Notice of Proposed Rulemaking
and the disbarment and suspension list included in this part,
none of these announcements are consolidated in the Cumulative Bulletins.

Rulings and procedures reported in the Bulletin do not have
the force and effect of Treasury Department Regulations,
but they may be used as precedents. Unpublished rulings
will not be relied on, used, or cited as precedents by Service
personnel in the disposition of other cases. In applying published rulings and procedures, the effect of subsequent legislation, regulations, court decisions, rulings, and proce-

The first Bulletin for each month includes a cumulative index
for the matters published during the preceding months.
These monthly indexes are cumulated on a semiannual basis
and are published in the first Bulletin of the succeeding semiannual period, respectively.

The contents of this publication are not copyrighted and may be reprinted freely. A citation of the Internal Revenue Bulletin as the source would be appropriate.
For sale by the Superintendent of Documents, U.S. Government Printing Office, Washington, DC 20402.

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Part I. Rulings and Decisions Under the Internal Revenue Code of 1986
Section 274.—Disallowance of
Certain Entertainment, Etc.,
Expenses
26 CFR 1.274(d)–1: Substantiation requirements.

T.D. 8784
DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Part 1
Substantiation of Business
Expenses—Use of Mileage
Allowances to Substantiate
Automobile Expenses
AGENCY: Internal Revenue Service
(IRS), Treasury.
ACTION: Temporary and final regulations.
SUMMARY: This document contains
temporary and final regulations relating to
the use of mileage allowances to substantiate automobile business expenses. The
regulations affect payors who make payments and employees who receive payments under reimbursement or other expense allowance arrangements for the
business use of an automobile.
DATES: Effective date: These regulations are effective October 1, 1998.
Applicability date: These regulations
apply to transportation expenses paid or
incurred after December 31, 1997.
FOR FURTHER INFORMATION CONTACT: Donna M. Crisalli, (202) 6224920 (not a toll-free number).
SUPPLEMENTARY INFORMATION:
Background and Explanation of
Provisions
Section 274(d) provides that a taxpayer
is not allowed a deduction or credit for
certain expenses unless the expense is
substantiated. These substantiation requirements apply to the expenses of use
of any listed property (defined in section
280F(d)(4)), which includes any passenger automobile and any other property
used as a means of transportation. The

October 19, 1998

Secretary may issue regulations that provide that some or all of the substantiation
requirements will not apply to expenses
that do not exceed a prescribed amount.
Section 1.274(d)–1 provides, in part,
that the Commissioner may prescribe
rules under which mileage allowances reimbursing ordinary and necessary expenses of local travel and transportation
while traveling away from home will satisfy the substantiation requirements of
§1.274–5T(c), and the requirements of an
adequate accounting to the employer for
purposes of §1.274–5T(f)(4). However,
§1.274(d)–1(a)(3) provides that such
mileage allowances are available only to
the owner of a vehicle.
New §1.274(d)–1T applies these substantiation rules to mileage allowances for
business use of an automobile after December 31, 1997, without the limitation in
§1.274(d)–1(a)(3) that a mileage allowance is available only to the owner of
a vehicle. See Rev. Proc. 97–59 (1997–
52 I.R.B. 24), for rules that implement
these regulations. The regulations also
adopt new §1.62–2T(e)(2) to incorporate
this new rule.
Special Analyses
It has been determined that these temporary and final regulations are not a significant regulatory action as defined in
EO 12866. Therefore, a regulatory assessment is not required. It also has been
determined that section 553(b) of the Administrative Procedure Act (5 U.S.C.
chapter 5) does not apply to these regulations, and, because the regulations do not
impose a collection of information on
small entities, the Regulatory Flexibility
Act (5 U.S.C. chapter 6) does not apply.
Pursuant to section 7805(f) of the Internal
Revenue Code, these temporary and final
regulations will be submitted to the Chief
Counsel for Advocacy of the Small Business Administration for comment on their
impact on small business.
Drafting Information
The principal authors of these regulations are Edwin B. Cleverdon and Donna
M. Crisalli of the Office of the Assistant
Chief Counsel (Income Tax and Accounting). However, other personnel from the

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IRS and Treasury Department participated in their development.
* * * * *
Adoption of Amendments to the
Regulations
Accordingly, 26 CFR part 1 is amended
as follows:
PART 1—INCOME TAXES
Paragraph 1. The authority citation for
part 1 is amended by adding entries in numerical order to read as follows:
Authority: 26 U.S.C. 7805 * * *
Section 1.274(d)–1 also issued under
26 U.S.C. 274(d).
Section 1.274(d)–1T also issued under
26 U.S.C. 274(d). * * *
Par. 2. In §1.62–2, paragraph (m) is
amended by adding a sentence at the end
of the paragraph to read as follows:
§1.62–2 Reimbursement and other
expense allowance arrangements.
* * * * *
(m) * * * Paragraph (e)(2) of this section applies to payments made under reimbursement or other expense allowance
arrangements received by an employee
with respect to expenses paid or incurred
on or before December 31, 1997. For
payments with respect to expenses paid or
incurred after December 31, 1997, see
§1.62–2T(e)(2).
Par. 3. Section 1.62–2T is added to
read as follows:
§1.62–2T Reimbursement and other
expense allowance arrangements
(temporary).
(a) through (e)(1) [Reserved]. For further guidance, see §1.62–2(a) through
(e)(1).
(e)(2) Expenses governed by section
274(d). For further guidance, see §1.62–
2(e)(2) except that each reference to
§1.274(d)–1 is deemed to be a reference
to §1.274(d)–1T.
(e)(3) through (l) [Reserved]. For further guidance, see §1.62–2(e)(3) through
(l).
(m) Effective dates. Paragraph (e)(2)
of this section applies to payments made

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under reimbursement or other expense allowance arrangements received by an employee with respect to expenses paid or
incurred after December 31, 1997. For
payments with respect to expenses paid or
incurred on or before December 31, 1997,
see §1.62–2(e)(2).
Par. 4. Section 1.274(d)–1 is amended
by adding paragraph (b) to read as follows:
§1.274(d)–1 Substantiation
requirements.
* * * * *
(b) Effective date. This section applies
to allowances described in paragraph
(a)(2) of this section for expenses paid or
incurred on or before December 31, 1997.
For allowances for expenses paid or incurred after December 31, 1997, see
§1.274(d)–1T.
Par. 5. Section 1.274(d)–1T is added to
read as follows:
§1.274(d)–1T Substantiation
requirements (temporary).
(a)(1) and (2) [Reserved]. For further
guidance, see §1.274(d)–1(a)(1).
(a)(3) [Reserved].
(b) Effective date. This section applies
to allowances described in §1.274(d)–
1(a)(2) for expenses paid or incurred after
December 31, 1997. For allowances for
expenses paid or incurred on or before
December 31, 1997, see §1.274(d)–1(a).
Michael P. Dolan,
Deputy Commissioner of
Internal Revenue.
Approved September 14, 1998.
Donald C. Lubick,
Assistant Secretary of
the Treasury.
(Filed by the Office of the Federal Register on
September 30, 1998, 8:45 a.m., and published in the
issue of the Federal Register for October 1, 1998, 63
F.R. 52600)

Section 861.—Income From
Sources Within the United States

T.D. 8785
DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Parts 1 and 602
Classification of Certain
Transactions Involving Computer
Programs
AGENCY: Internal Revenue Service
(IRS), Treasury.
ACTION: Final regulations.
SUMMARY: This document contains regulations relating to the tax treatment of certain transactions involving the transfer of
computer programs. The regulations provide rules for classifying such transactions
as sales or licenses of copyright rights,
sales or leases of copyrighted articles, or
the provision of services, or of know-how,
under certain provisions of the Internal
Revenue Code and tax treaties. These regulations are necessary to give taxpayers
guidance on the taxation of computer program transactions. These regulations affect taxpayers engaging in certain transactions involving computer programs.
DATES: Effective date. These regulations
are effective October 2, 1998.
Applicability date. These regulations
apply to transactions occurring pursuant to
contracts entered into on or after December 1, 1998. Taxpayers may elect to apply
this section to transactions occurring pursuant to contracts entered into in taxable
years ending on or after October 2, 1998.
Taxpayers may also elect to apply this section to transactions occurring in taxable
years ending on or after October 2, 1998,
pursuant to contracts entered into before
October 2, 1998, provided the taxpayer
would not be required under this section to
change its method of accounting, or the
taxpayer would be required to change its
method of accounting but the resulting
section 481 adjustment would be zero.
FOR FURTHER INFORMATION CONTACT: Anne Shelburne, (202) 622-3880
(not a toll-free number).
SUPPLEMENTARY INFORMATION:
Paperwork Reduction Act

26 CFR 1.861–18: Classification of transactions
involving computer programs.

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The collection of information in this

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final rule has been reviewed and, pending
receipt and evaluation of public comments, approved by the Office of Management and Budget (OMB) under the
Paperwork Reduction Act (44 U.S.C.
3507) and assigned control number 1545–
1594. An agency may not conduct or
sponsor, and a person is not required to
respond to, a collection of information
unless the collection of information displays a valid control number assigned by
OMB.
The collection of information in this
regulation is in §1.861–18(k) of the regulations. This information is required to
permit taxpayers to obtain an automatic
change in method of accounting. This information will be used to enable the IRS
to determine if taxpayers were entitled to
an automatic change in method of accounting. The likely respondents are organizations.
Comments concerning the collection of
information should be directed to OMB,
Attention: Desk Officer for the Department of the Treasury, Office of Information and Regulatory Affairs, Washington,
DC 20503, with copies to the Internal
Revenue Service, Attn: IRS Reports
Clearance Officer, OP:FS:FP, Washington, DC 20224. Any such comments
should be submitted not later than December 1, 1998. Comments are specifically requested concerning:
Whether the collection of information is
necessary for the proper performance of
the functions of the IRS, including
whether the information will have practical utility;
The accuracy of the estimated burden associated with the collection of information (see below);
How to enhance the quality, utility, and
clarity of the information collected;
How to minimize the burden of complying with the collection of information, including the application of automated collection techniques or other forms of
information technology; and
Estimates of capital or start-up costs and
costs of operation, maintenance, and purchase of services to provide information.
The burden per respondent is reflected in
the burden of Form 3115.
Books or records relating to this collection of information must be retained as
long as their contents may become material in the administration of any internal

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revenue law. Generally, tax returns and
tax return information are confidential, as
required by 26 U.S.C. 6103.
Background
This document contains final regulations to be added to the Income Tax Regulations (26 CFR part 1) under section 861
of the Internal Revenue Code (Code).
These regulations clarify the treatment
under certain provisions of the Code and
tax treaties of income from transactions
involving computer programs.
On November 13, 1996, proposed regulations [REG–251520–96 (1996–2 C.B.
511)] were published in the Federal Register (61 F.R. 58152). The IRS received
written comments on the proposed regulations and held a public hearing on March
19, 1997. Having considered the comments and the statements made at the
hearing, the IRS and Treasury Department adopt the proposed regulations as
modified by this Treasury decision. The
comments and revisions are discussed
below.
I. The Proposed Regulations.
The proposed regulations clarify certain rules for classifying transactions involving computer programs. The regulations generally require that a transaction
involving a computer program be treated
as being within one of four possible categories: (1) transfer of copyright rights, (2)
transfer of a copyrighted article, (3) provision of services relating to development
or modification of a computer program,
or (4) provision of know-how relating to
computer programming techniques.
The regulations distinguish between
transfers of copyright rights and transfers
of copyrighted articles based on the type
of rights transferred to the transferee.
They recognize that computer programs
are subject to copyright protection under
both U.S. and foreign copyright law. See
the Copyright Act of 1976, as amended
(17 U.S.C. 101 et. seq.); see also, EC Directive on Legal Protection of Computer
Programs, Council Directive 91–250,
1991 J.O. (L 122), and the Berne Convention for the Capital Protection of Literary
and Artistic Works, 25 U.S.T. 1341 (Paris
Text, July 24, 1971). Copyright law
grants certain exclusive rights to a copyright owner. The regulations classify a

October 19, 1998

transaction as the transfer of a copyright
right if the transferee acquires one or
more of the copyright rights identified in
§1.861–18(c)(2) of the proposed regulations. If the transferee acquires a copy of
a computer program but does not acquire
any of the rights identified in §1.861–
18(c)(2), the regulations classify the
transaction as the transfer of a copyrighted article.
The proposed regulations further classify transfers of copyright rights as either
a sale or a license of copyright rights.
The proposed regulations require that this
classification be made by examining
whether, taking into account all facts and
circumstances, all substantial rights in
the copyright have passed to the transferee. The proposed regulations also require that transfers of copyrighted articles be further classified as either a sale
or a lease of a copyrighted article. This
classification is made by examining
whether the benefits and burdens of ownership of the copyrighted article have
passed to the transferee.
The specific rules of the proposed regulations are based on certain key principles: that the special features of computer
programs should be recognized and that
functionally equivalent transactions
should be treated similarly. The regulations are also based on the principle that
copyright law should be a factor in classifying transactions for tax purposes, but
should not be determinative.
Finally, the proposed regulations contain 18 examples illustrating the rules.
II. Comments and Final Regulations.
1. Scope and Application of the
Regulations.
a. General Scope.
The proposed regulations classify
transactions in computer programs for
certain international provisions of the
Code. A number of comments addressed
two types of issues involving the scope of
the regulations: the treatment of computer programs under other tax provisions
of the Code and the application of the
principles of the proposed regulations to
products other than computer programs.
As to the treatment of computer programs under other Code sections, comments were mixed. Several commenta-

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tors requested that Treasury expand the
scope of the final regulations to apply the
regulations’ principles for all U.S. tax
purposes. Other commentators, however,
urged caution, stating that issues raised
under other Code sections should be resolved only by legislation or by revising
the regulations under those other sections.
Most commentators recommended applying the regulations for tax accounting
purposes.
Some commentators requested that
Treasury specifically address the relevance of the regulations in a specific context. For example, some commentators
requested that the regulations clarify how
the principles apply in determining the
consequences of computer program transactions under tax treaties.
After consideration of these comments,
the final regulations retain the scope of
the proposed regulations. However, Treasury and the IRS are considering whether
the principles of these regulations should
apply to other tax provisions of the Code.
These regulations are intended to apply
for purposes of applying and interpreting
U.S. tax treaties. United States tax
treaties provide that terms not defined in
the treaty are defined by reference to domestic law. See e.g., U.S. Model Income
Tax Convention of September 20, 1996,
Article 3(2).
The second group of comments generally addressed expanding the scope of the
regulations to apply to transactions in
other types of digitized information. The
proposed regulations are limited to classifying transactions in computer programs.
Section 1.861–18(a)(3) of the proposed
regulations defines a computer program
as “...a set of statements or instructions to
be used directly or indirectly in a computer in order to bring about a certain result.” The definition includes any data
base or similar item only “. . . if the data
base or similar item is incidental to the
operation of the computer program.”
Commentators expressed differing views
as to how to define computer programs.
Several commentators recommended that
the definition be expanded to include data
bases and content provided as part of the
transaction. They note that advances in
technology now permit significant
amounts of content, that are not merely
incidental, to be included in even inexpensive mass-marketed programs. Some

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commentators recommended that the definition be expanded to include data bases
or similar items even if not incidental,
while some stated that data base products
containing only a de minimis amount of
software programming to facilitate access
to the data should be excluded from the
definition.
Several commentators requested that
Treasury expand the regulations more
generally, by applying the same or analogous principles in determining the tax
consequences of transactions involving
copyright rights and copyrighted articles
to entertainment products, or to other digitized information.
The suggestions to expand the scope of
the regulations, either by expanding the
definition of computer programs or by applying the regulations to other types of
digitized information, were not adopted.
Instead, the final regulations generally retain the definition of computer programs
found in the proposed regulations. It is
intended that a computer program includes any media, user manuals or documentation, or similar items (in addition to
data bases) if incidental to and routinely
transferred along with the computer program. Treasury and the IRS are not aware
of specific instances where the failure to
expand the definition of computer program would result in inappropriate consequences to taxpayers for the portion of the
transaction not governed by these regulations. Treasury and the IRS invite comments on this point.
The regulations also continue to apply
only to cross-border transactions involving
computer programs because Treasury and
the IRS believe that such transactions raise
the most pressing need for guidance. Treasury and the IRS may consider whether to
apply the principles of these regulations to
all transactions in digitized information as
part of a separate guidance project.
b. Relationship with Section 482.
Numerous commentators requested
clarification regarding the application of
the regulations for purposes of section
482, requesting that transactions in copyright rights be treated as transactions in
intangibles and transactions in copyrighted articles be treated as transactions
in tangible property, even if delivered
electronically.

1998–42 I.R.B.

This suggestion has not been adopted.
Treasury and the IRS intend to further
consider this issue and may provide additional guidance in the future. See generally, §1.482–3(f).

regulations, income from electronic transfers of computer programs that constitute
inventory property, classified as sales of
copyrighted articles, will be sourced
under similar principles.

c. Source of Income.

2. Relevance of Foreign Law.

Several commentators requested that
Treasury provide explicit guidance in
final regulations on how to source income
arising from transactions in computer programs. Generally, under the current rules,
the source of income from sales of property depends to varying extents upon both
the type of property and, for inventory
property, the place of sale, with the place
of sale generally determined by the place
where title to the property passes. See
§1.861–7(c). Several commentators requested clarification of which source rule
applies to various transactions in computer programs. 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. 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.
In response to comments, the final regulations provide specific source rules.
The regulations provide that income from
transactions that are classified as sales or
exchanges of copyrighted articles will be
sourced under sections 861(a)(6),
862(a)(6), 863, 865(a), 865(b), 865(c), or
865(e), as appropriate. Income derived
from the sale or exchange of a copyright
right will be sourced under sections
865(a), 865(c), 865(d), 865(e), or 865(h),
as appropriate. Income derived from either the leasing of a computer program or
the licensing of copyright rights in a computer program will be sourced under section 861(a)(4) or section 862(a)(4), as appropriate. 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

Several commentators requested that
Treasury clarify that classification of a
transaction involving computer programs
for U.S. tax purposes does not depend on
foreign copyright law. In addition, one
commentator requested that the regulations explicitly state that the terms used in
the regulations, although taken from
copyright law, will be interpreted in a
manner consistent with the purposes of
the regulations and Internal Revenue
Code. In certain cases, terms taken from
copyright law are specifically defined in
the regulations so as to properly implement the regulations’ underlying policy.
Unless specifically defined in the regulations, legal standards taken from copyright law are intended to be given the
same interpretation as under U.S. copyright law. Factual predicates for application of those standards, however, may be
provided by referring to foreign copyright
law. For example, if it were necessary to
determine whether the transferee had acquired the right to create a derivative
work based on a computer program protected under French copyright law, the
facts of the case, i.e. the rights that the
transferee may exercise, are determined
under French law and the agreement between the parties. However, whether or
not the transferee’s rights constitute the
right to create a derivative work for purposes of this regulation is determined by
comparing those rights created under
French law and the agreement between
the parties to the U.S. law definition of
the right to create a derivative work.
In addition, commentators requested
clarification that the determination of
whether a foreign tax imposed on transactions in computer programs is a compulsory payment, eligible for a foreign tax
credit, is not affected by these regulations.
Treasury believes clarification is unnecessary. These regulations do not in any way
modify the requirement of §1.901-2(e)(5)
that substantive and procedural provisions
of foreign law (including applicable tax
treaties) determine the taxpayer’s liability

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under foreign law for tax and thus
whether an amount paid is a compulsory
payment. Moreover, the regulations
under section 904 recognize that a creditable foreign tax may be imposed on an
item of income that is taxed at a different
time or in a different manner in a foreign
country than in the United States. See
§1.904–6(a)(1).
3. Copyright Rights.
The proposed regulations, in §1.861–
18(c)(2), describe four copyright rights:
(i) the right to make copies for distribution to the public, (ii) the right to prepare
derivative programs, (iii) the right to
make a public performance of the program, and (iv) the right to publicly display the program. If a transfer of a computer program results in a transferee
acquiring any one or more of the four
listed rights, the regulations classify the
transaction as a transfer of a copyright
right. Although the commentators agreed
that the right to make copies for distribution to the public is properly included,
they made a number of comments regarding the three other copyright rights.
a. Derivative Programs.
Commentators stated that final regulations should clarify the right to prepare
derivative programs. They recommended
that the regulations more specifically describe the circumstances resulting in the
transfer of such a copyright right.
Some commentators recommended that
a transfer of the right to prepare a derivative program should not be treated as the
transfer of a copyright right unless it is
coupled with the right to distribute the derivative program to the public. That
change, they say, would make the right
more consistent with the right to reproduce copies, which results in the transfer
of a copyright right only if it is coupled
with the right to distribute to the public.
The final regulations do not adopt this
recommendation. Although the final regulations disregard the de minimis right to
make a derivative work, a substantial
right to make a derivative work is appropriately treated as the transfer of a copyright right, regardless of whether it is coupled with the right to distribute to the
public. The regulations generally follow
copyright law in this respect. Although

October 19, 1998

the right to make copies constitutes the
transfer of a copyright right only if coupled with the right to distribute to the public, the regulations treat the right to make
copies differently from the other copyright rights because of the unique characteristics of computer programs, including
the ease by which computer programs can
be copied.
Another set of comments requests clarification of the effect of the transfer of
programs that permit the user to distribute
certain ancillary programs in conjunction
with works created using the underlying
program, or to incorporate certain program elements into new programs created
using the underlying program. For example, certain programs, such as software
development tools, permit the transferee
to distribute certain ancillary programs or
include certain segments of computer
code in new programs created by the
transferee using the development program. Similarly, transferees of computer
programs are sometimes granted access to
the program’s source code in order to permit the transferee to correct minor errors
or incompatibilities in the program.
Under the proposed regulations, the
transfer of a software development tool or
the grant of the right to correct minor errors by modifying the source code might
constitute the right to create a derivative
computer program, resulting in the transfer of a copyright right. Commentators
argued, however, that in both cases, the
overall character of the transaction was
analogous to the transfer of a copyrighted
article. Several commentators recommended that where limited portions of a
development tool are included in an application program, the inclusion should be
considered de minimis, and the resulting
application program not treated as a derivative program of the program development tool.
In addition, several commentators recommended that where no independent
value attaches to exploitation of the right
to prepare derivative computer programs,
such right should be treated as de minimis, and not considered in classifying the
transaction.
In response to these comments, the
final regulations provide in paragraph
(c)(1)(ii) that the de minimis transfer of a
copyright right will not be taken into account in determining whether a transac-

8

tion is considered the transfer solely of a
copyrighted article. Example 17 clarifies
that the right to use software development
tools to create an insubstantial component
of a new program constitutes such a de
minimis copyright right. Example 18
clarifies that the right to modify the
source code to correct minor errors and
make minor adaptations to a computer
program also constitutes a de minimis
copyright right.
However, the final regulations do not
provide that where no independent value
attaches to the exploitation of the right to
prepare derivative computer programs,
such right must be treated as de minimis.
Treasury and the IRS believe that in most
cases where no independent value attaches to the grant of the right to prepare
derivative computer programs, the right is
de minimis. However, this may not be
true in all cases and, therefore, this comment has not been adopted.
b. Public Performance and Display.
Several commentators urged Treasury
to reserve in final regulations on two of
the copyright rights, the right to make a
public performance and the right to public
display of the copyrighted work. Several
commentators recommended that, if Treasury elects not to reserve, a transaction involving either right should result in treatment as a transfer of a copyright right
only if the transfer is for commercial exploitation rather than for internal use.
Commentators also requested clarification of these rights in the entertainment
area. They recommended the regulations
state that the right to publicly perform or
display the computer program should not
be considered the transfer of a copyright
right if the performance or display is limited to the advertisement of a copyrighted
article, and does not permit the public display of the entire article.
These suggestions have not been
adopted. However, Treasury and the IRS
recognize that the definition of these
rights in the context of computer programs is still developing, and in the future
it may be necessary to revisit this issue.
At the present time, Treasury and the IRS
believe it is appropriate to continue to follow copyright law as to these rights. In
many cases, however, the transfer of a
right for public display or performance of

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a computer program, such as marketing or
advertising the program, to the extent it
constitutes the transfer of a copyright
right, would be considered a de minimis
grant of a copyright right under §1.861–
18(c)(1)(ii) of the final regulations, so
that the transaction would not result in the
transfer of a copyright right.
c. Definition of to the Public.
The proposed regulations list the right
to make copies for distribution to the
public as one of the four copyright rights.
Commentators recommended that the regulations clarify the meaning of “to the
public.” They recommended the definition exclude distribution to a related
party, with related party defined to ensure
that transfers to a non-controlled joint
venture would not be considered distribution to the public. They also recommended that distribution to identified distributees not be considered distribution to
the public.
Commentators also recommended the
regulations state that distribution to the
public does not mean distribution to employees. In addition, they urge Treasury
to make explicit that internal distribution
includes distribution to many employees,
including employees of affiliates, at multiple locations.
In light of these comments, the final
regulations provide in new paragraph
(g)(3) that distribution to the public does
not include distribution to a related person, which is defined for purposes of the
regulation as a person who bears a relationship to the transferee specified in section 267(b)(3), (10), (11), or (12), or section 707(b)(1)(B), with “10 percent”
substituted for “50 percent.” The term
also excludes distribution to certain identified persons or to those with a legal relationship to the original transferee. The
number of employees or independent contractors who are permitted to use the program in performance of services for the
transferee is not relevant. The examples
have also been amended to clarify that the
number of permitted users, which includes employees of the transferee, within
the group of related persons is not taken
into account in determining whether the
transferee has the right to distribute
copies of the program to the public. See
e.g., paragraph (h), Example 11.

1998–42 I.R.B.

4. Definition of Copyrighted Article.
The comments on this issue fell into
two categories. One group of comments
recommended that final regulations clarify the consequences of transferring a de
minimis copyright right along with the
transfer of a copyrighted article. The proposed regulations state in §1.861–
18(c)(1)(ii) that if a person acquires a
copy of a computer program but does not
acquire any of the four copyright rights,
the transfer is classified as a transfer of a
copyrighted article. Several commentators requested that the regulations clarify
the statement to say that if the transfer includes only a de minimis copyright right,
the transfer is classified as a transfer of a
copyrighted article. As discussed above,
in response, the final regulations provide
that if the transfer includes only a de minimis copyright right, the transfer is classified as a transfer of a copyrighted article.
The second category of comments concerned the definition of a copyrighted article. Section 1.861–18(c)(3) defines a
copyrighted article as a copy of a computer
program from which the work can be perceived, reproduced, or otherwise communicated, either directly or with the aid of a
machine or device. Several commentators
recommended the regulations be modified
to say that the copy of the program need
not be fixed in a tangible medium, and thus
electronically transferred copies also constitute copyrighted articles.
Treasury and the IRS believe that the
regulations clearly indicate that electronically transferred copies also constitute the
transfer of a copyrighted article. Section
1.861–18(g)(2) of the final regulations
continues to provide that the physical or
electronic medium used to effectuate a
transfer of a computer program shall not
be taken into account. Also, the examples
contained in the regulations, including
paragraph (h), Examples 2, 3, and 4,
specifically conclude that the electronic
transfer of software can constitute the
transfer of copyrighted articles.
One commentator suggested that the
words “carrier medium” should be substituted for the words “the magnetic medium
of a floppy disk” because computer programs may be distributed on a non-magnetic medium, such as a CD-ROM. This
comment has been adopted in §1.861–
18(c)(3) of the final regulations.

9

5. Further Classification of a Copyright
Right as a Sale or License.
In classifying a copyright right as a sale
or license, the proposed regulations look
to whether, considering all the facts and
circumstances, all substantial rights in a
copyright right are transferred. Commentators raised a number of issues regarding
the all substantial rights test, commenting
on the effect of exclusivity, term of transfer, geographic area, and time and manner
of payment.
Several commentators stated that exclusivity is the most important factor in
determining whether all substantial rights
have been transferred. They pointed out
that two examples, Examples 5 and 6, discuss other factors, the term of the transfer
and a transfer in a limited geographic
area, in addition to exclusivity, and requested that the regulations explicitly
state that exclusivity is the most important
factor. One commentator suggested that
the term of the transfer may not be relevant since the useful life of the program
may be shorter than originally believed
due to technological advances.
The final regulations do not incorporate
these comments. The regulations were
not intended to change the generally applicable “all substantial rights” test used
in determining whether a transfer of an intangible, including copyright rights, is a
sale of the intangible or a license of the
intangible.
Another fact mentioned in the examples is the manner of payment. Several
commentators stated that the term over
which payments are made should be irrelevant in characterizing the transaction,
and requested that this be made explicit.
Although the regulations are not intended
to depart from what is the generally applicable rule on this issue, this comment
has been reflected in paragraph (h), Example 5 of the final regulations, thus clarifying that the payment term is irrelevant
on the facts of this example.
Several commentators pointed out that,
in determining whether all substantial
rights are transferred, the regulations state
the principles of section 1222 and section
1235 shall apply. They seek clarification
that section 1222, not section 1235, applies to transfers of copyrights, with section 1235 only applying to qualifying
transfers of patents.

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Although section 1235 by its terms
only applies to patent transfers, the proposed regulations state that “the principles of sections 1222 and 1235” (emphasis added) shall apply. Treasury and the
IRS believe that the all substantial rights
test in the regulations under section 1235,
although a safe harbor under that section,
nevertheless reflects the all substantial
rights test arising from case law generally,
and is, therefore, an appropriate standard
that may be applied. However, in applying the all substantial rights test to transactions in computer programs under these
regulations, relevant case law, other than
that specifically addressing section 1235
or section 1222, may also be applied, and
the final regulations clarify this point.

transferred. One commentator stated that
this test is not helpful here, and proposed
an economic substance test instead, focusing on the right to use a computer program as the economically valuable right.
Under that standard, a copyrighted article
would be considered sold if transferred
with the right to use it indefinitely.
Other commentators, however, believed that the existing authorities applying the benefits and burdens test provide
the correct analytical approach for distinguishing a sale from a lease of a copyrighted article.
The final regulations preserve the benefits and burdens test, and are not intended
to change the generally applicable benefits and burdens test.

6. Further Classification of a
Copyrighted Article as a Sale or
Lease.

7. Related Parties.

a. Lease Character for Copyrighted
Articles.
The proposed regulations treat a nonsale transfer of a copy of a computer program as a lease. Some commentators
urged Treasury to reconsider its decision
to adopt lease characterization for transactions that traditionally have been characterized as licenses. They submitted that
the change creates confusion, is inconsistent with established commercial practice,
and implies that all lease transactions involve tangible property. One commentator asked the IRS to clarify that the regulation is not intended to produce any
differences in income tax consequences
by treating a transfer of a program as a
lease instead of a license.
These comments have not been
adopted. Treasury and the IRS continue
to believe that lease characterization is
correct for non-sale transfers of copies of
computer programs. Any income tax consequences from such characterization
under these regulations will result from
application of generally applicable tax
law to the leasing transaction.
b. Benefits and Burdens Test.
In determining whether the transfer of a
copyrighted article results in a sale, or instead as a lease generating rental income,
the proposed regulations look to whether,
based on the facts and circumstances, the
benefits and burdens of ownership are

October 19, 1998

The examples to the proposed regulations state that they assume the parties are
unrelated. Several commentators requested that final regulations clarify the
treatment of related parties under the regulations. They state that the regulations
should apply to related and unrelated parties in the same way, and that Treasury
should specify any particular concerns.
In response to these comments, the examples to the final regulations do not contain an assumption that the parties are unrelated. The regulations are intended to
apply to related and unrelated parties in
the same manner. The relationship between the parties does not affect the character of the transaction, with the exception of special rules regarding definition
of the term “distribution to the public.”
Of course, if the parties are related for
purposes of section 482, that section may
apply to determine the proper amount of
consideration for the transfer.

Code sections. Thus, the relevance of the
distinction between services and knowhow must be determined under other
Code sections. Compare sections
861(a)(3) and 862(a)(3), looking to place
of performance in sourcing income from
services, with sections 861(a)(4) and
862(a)(4), sourcing income derived from
the transfer of certain know-how based on
where the know-how is used. The distinction between services and know-how
may also be relevant under income tax
treaties. Compare Convention Between
the United States of America and Japan
for the Avoidance of Double Taxation and
the Prevention of Fiscal Evasion with Respect to Taxes on Income, Article 8 (Business Profits) and Article 14 (Royalties).
Some commentators suggested the final
regulations eliminate the requirement in
paragraph (e) of the proposed regulations,
requiring that know-how not be copyrightable as a prerequisite to being treated
as know-how for purposes of this section.
This comment has been adopted to eliminate any inference that only orally transmitted information could be classified as
know-how. The final regulations, however, add two other requirements. Knowhow is of the type covered by these regulations only if the information is
information relating to computer programming techniques, is furnished under conditions preventing unauthorized disclosure,
specifically contracted for between the
parties, and is considered property subject
to trade secret protection. Know-how is
considered a property interest under applicable law, and only if the know-how is
specifically contracted for between the
parties. These additional requirements
should help clarify the definition of knowhow described in these regulations.
9. Mixed Transactions.

8. Services and Know-How.
Some commentators suggested that
final regulations clarify the relevancy of
the distinction between the provision of
services and the provision of know-how.
This suggestion has not been incorporated
in the final regulations. The purpose of
the regulations is only to characterize
transactions involving computer programs. Once the character of the transaction is determined under the regulations,
the taxation of the income arising from
the transaction is determined under other

10

The proposed regulations state that if a
transaction in a computer program consists of transactions in more than one category listed in §1.861–18(b)(1), the transactions, unless de minimis, will be treated
as separate transactions, with the rules applied separately to each. Several commentators requested further guidance on
how to treat transactions that include payments for updates, support, consulting,
education, and training. They pointed out
that in many cases, the extent to which
such transactions or services will be re-

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Page 11

quired by the transferee are unknown at
the time of the initial contract. They
asked that regulations clarify the factors
that will sustain an allocation where these
various options are made available, or
that Treasury consider bundling rules.
These comments have not been
adopted. These regulations are limited to
characterizing transactions relating to
computer programs, and are not intended
to provide rules for allocating income
arising from mixed transactions. Mixed
transactions occur in many circumstances
outside of transactions involving computer programs. Whether income arising
from a mixed transaction, involving computer programs or otherwise, must be allocated to its separate components under
generally applicable principles of taxation, and the method by which such income is allocated to the transaction’s
components, must be determined under
other Code sections.
10. Shrink Wrap License.
Several commentators stated that the
reference to the term shrink wrap license
in the proposed regulations should be
deleted, because the reference can be misinterpreted as ascribing some legal significance to the term. They suggested a
more general reference to a user agreement or a user license. In response to
these comments, the final regulations now
indicate in Example 1 that the term
shrink-wrap license is merely illustrative.
The regulations’ analysis is based on the
terms of the agreement between the parties, and on the nature and extent of the
rights transferred, not the means of packaging or distributing the computer program. In particular, the use of the term
shrink-wrap license in the proposed regulations was not intended to create an inference that the regulations apply only to
mass-marketed software.
11. Pre-Effective Date Transactions.
The proposed regulations draw no inference for transactions prior to the regulations’ effective date. One commentator
recommended that the regulations permit
taxpayers to elect retroactive application
of the regulations. Another commentator
requested a statement that a taxpayer’s
prior treatment of a transaction would be
respected as long as it is reasonably supportable. Another commentator recom-

1998–42 I.R.B.

mended the IRS remedy double tax problems for transactions prior to the effective
date.
The final regulations apply to transactions occurring pursuant to contracts entered into on or after the effective date of
the regulations. A special transition rule
permits taxpayers to elect to apply the
regulations to transactions occurring pursuant to contracts entered into in taxable
years ending on or after the date of publication of this document in the Federal
Register. Taxpayers may also elect to
apply this section to transactions occurring in taxable years ending on or after the
date of publication of this document in the
Federal Register, for contracts entered
into before the date of publication of this
document in the Federal Register, provided the taxpayer would not be required
under this section to change its method of
accounting, or the taxpayer would be required to change its method of accounting
but the resulting section 481 adjustment
would be zero.
With regard to double taxation, taxpayers who believe they are subject to double
taxation may pursue competent authority
relief.
12. Accounting Method Changes.
Commentators suggested that the IRS
issue, simultaneously with the issuance of
the final regulations, a revenue procedure
permitting an automatic change of accounting to allow taxpayers to apply the
principles of these regulations for purposes of accounting for prepaid income
under software maintenance agreements.
Different rules apply depending on
whether the income from such agreements is considered to be derived from
the sale of goods or the performance of
services. Compare, §1.451–5 (sale of
goods) and Rev. Proc. 71–21 (1971–2 CB
549) (performance of services).
In response to comments, the final regulations grant taxpayers consent to
change their method of accounting if necessary to conform the classification of
transactions with these regulations, where
the taxpayer elects one of the transtion
rules in paragraph (i)(2) of the regulations. To obtain automatic consent to
change a method of accounting, the regulations direct taxpayers to file Form 3115
with their returns and send a copy to the
national office.

11

13. Reverse Engineering and
Decompilation.
One commentator stated that the right
to reverse engineer (or decompile) a computer program (i.e., the right to reconstruct the source code from the object
code) should be irrelevant in classifying
transactions in computer programs, and
that references to that right should be
eliminated from the examples.
This comment has not been adopted.
The decompilation of a computer program can result in the creation of a derivative work. Under the regulations, the
right to create a derivative work is a copyright right. Therefore, whether the transferee is prohibited from reverse engineering a computer program could be relevant
in determining if a copyrighted article has
been transferred.
14. Effect of Practices Used to Control
Piracy.
One commentator suggested that certain practices used to control software
piracy, such as a requirement that the
transferee annually contact the transferor
and pay an annual fee, be disregarded in
determining whether a transaction results
in a sale or lease of a computer program.
This comment has not been adopted.
Such a transaction must be analyzed
under the benefits and burdens test, taking
into account all the facts and circumstances. Under that test, the requirement
that the transferee contact the transferor
and pay an annual fee might not result in
lease characterization, if other significant
benefits and burdens of ownership pass to
the transferee.
15. Definition of Computer.
One commentator urged Treasury to
adopt a flexible definition of the term
computer. However, the final regulations
do not define computer. The definition of
software used in the regulations is based
on the definition in the Copyright Act.
The Copyright Act does not define the
term computer.
16. Comments (not otherwise addressed
above) Regarding Specific Examples.
a. Paragraph (h), Examples 6 and 7.
Commentators requested that, given
the ease of reproduction, the distinction

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between paragraph (h), Examples 6 and 7
should be removed. This comment has
not been adopted. Although computer
programs can be easily reproduced, a fact
which the regulations recognize, there is
still an important commercial and legal
distinction between persons who are
granted the right to make copies of a program for distribution and persons who do
not have that right.
b. Example 6.
In response to comments, the final regulations make clear that the party exercising reproduction rights can exercise that
right indirectly by contracting out the reproduction function.
c. Example 8.
In response to a comment, Example 8
has been clarified to indicate that the right
to make back-up copies of the program,
or the fact that a back-up copy of the program is transferred on a disk, is irrelevant
to classification.
d. Example 9.
In response to a comment, paragraph
(h), Example 9 is clarified to indicate that
the mechanics of copying a computer program are irrelevant.
e. Example 10.
Some commentators suggested that in
the case of so-called enterprise licenses,
the fact the transferee can use the program
at multiple locations should not affect the
character of the transaction as the sale of
copyrighted articles. This comment has
been adopted, and paragraph (h), Example
10(ii)(C) of the final regulations has been
amended accordingly.
f. Examples 12 and 13.
Some commentators suggested adding
examples to illustrate so-called software
maintenance or subscription agreements.
Paragraph (h), Examples 12 and 13 of the
proposed regulations, however, were intended to illustrate such agreements, and,
in response to comments, these examples
have been modified in the final regulations. Generally, the provision of an updated program pursuant to a maintenance
agreement is intended to be treated as the
transfer of a copyrighted article. How-

October 19, 1998

ever, this may not always be the case, and
maintenance agreements must be analyzed in the same way as other transactions under the regulations.
g. Example 15.

Associate Chief Counsel (International),
IRS. However, other personnel from the
IRS and Treasury Department participated in their development.
* * * * *

A commentator suggested that the example’s use of a derivative computer program adds complexity, and recommends
the example be redrafted to purely illustrate services. This comment has been
adopted and the example has been revised
accordingly.
h. Additional Examples.
Commentators suggested additional examples. The final regulations add additional examples where clarification was
believed necessary.
Special Analyses
It has been determined that this Treasury decision is not a significant regulatory action as defined in EO 12866.
Therefore, a regulatory assessment is not
required.
It is hereby certified that the collection
of information contained in these regulations will not have a significant economic
impact on a substantial number of small
entities. This certification is based on the
fact that the rules of this section impact
taxpayers who engage in international
transactions in computer programs, and
therefore the rules will impact very few
small entities. Moreover, in those few instances where the rules of this section impact small entities, the economic impact
of the collection of information on such
small entities is not likely to be significant
because it merely requires a copy of the
Form 3115 to be filed with the National
Office. Accordingly, a regulatory flexibility analysis is not required under the
Regulatory Flexibility Act (5 U.S.C.
chapter 6).
Pursuant to section 7805(f) of the Internal Revenue Code, the notice of proposed
rulemaking preceding these regulations
was submitted to the Chief Counsel for
Advocacy of the Small Business Administration for comment on its impact on
small business.
Drafting Information
The principal author of these regulations is Anne Shelburne, of the Office of

12

Adoption of Amendments to the
Regulations
Accordingly, 26 CFR parts 1 and 602
are amended as follows:
PART 1—INCOME TAXES
Paragraph 1. The authority citation for
part 1 continues to read in part as follows:
Authority: 26 U.S.C. 7805 * * *
Par. 2. Section 1.861–18 is added to
read as follows:
§1.861–18 Classification of transactions
involving computer programs.
(a) General—(1) Scope. This section
provides rules for classifying transactions
relating to computer programs for purposes of subchapter N of chapter 1 of the
Internal Revenue Code, sections 367,
404A, 482, 551, 679, 1059A, chapter 3,
chapter 5, sections 842 and 845 (to the extent involving a foreign person), and
transfers to foreign trusts not covered by
section 679.
(2) Categories of transactions. This
section generally requires that such transactions be treated as being solely within
one of four categories (described in paragraph (b)(1) of this section) and provides
certain rules for categorizing such transactions. In the case of a transfer of a
copyright right, this section provides rules
for determining whether the transaction
should be classified as either a sale or exchange, or a license generating royalty income. In the case of a transfer of a copyrighted article, this section provides rules
for determining whether the transaction
should be classified as either a sale or exchange, or a lease generating rental income.
(3) Computer program. For purposes
of this section, a computer program is a
set of statements or instructions to be used
directly or indirectly in a computer in
order to bring about a certain result. For
purposes of this paragraph (a)(3), a computer program includes any media, user
manuals, documentation, data base or
similar item if the media, user manuals,

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documentation, data base or similar item
is incidental to the operation of the computer program.
(b) Categories of transactions—(1)
General. Except as provided in paragraph (b)(2) of this section, a transaction
involving the transfer of a computer program, or the provision of services or of
know-how with respect to a computer
program (collectively, a transfer of a computer program) is treated as being solely
one of the following—
(i) A transfer of a copyright right in the
computer program;
(ii) A transfer of a copy of the computer program (a copyrighted article);
(iii) The provision of services for the
development or modification of the computer program; or
(iv) The provision of know-how relating to computer programming techniques.
(2) Transactions consisting of more
than one category. Any transaction involving computer programs which consists of more than one of the transactions
described in paragraph (b)(1) of this section shall be treated as separate transactions, with the appropriate provisions of
this section being applied to each such
transaction. However, any transaction
that is de minimis, taking into account the
overall transaction and the surrounding
facts and circumstances, shall not be
treated as a separate transaction, but as
part of another transaction.
(c) Transfers involving copyright
rights and copyrighted articles—(1)
Classification—(i) Transfers treated as
transfers of copyright rights. A transfer
of a computer program is classified as a
transfer of a copyright right if, as a result
of the transaction, a person acquires any
one or more of the rights described in
paragraphs (c)(2)(i) through (iv) of this
section. Whether the transaction is
treated as being solely the transfer of a
copyright right or is treated as separate
transactions is determined pursuant to
paragraph (b)(1) and (b)(2) of this section. For example, if a person receives a
disk containing a copy of a computer program which enables it to exercise, in relation to that program, a non-de minimis
right described in paragraphs (c)(2)(i)
through (iv) of this section (and the transaction does not involve, or involves only
a de minimis provision of services as described in paragraph (d) of this section or

1998–42 I.R.B.

of know-how as described in paragraph
(e) of this section), then, under paragraph
(b)(2) of this section, the transfer is classified solely as a transfer of a copyright
right.
(ii) Transfers treated solely as transfers of copyrighted articles. If a person
acquires a copy of a computer program
but does not acquire any of the rights described in paragraphs (c)(2)(i) through
(iv) of this section (or only acquires a de
minimis grant of such rights), and the
transaction does not involve, or involves
only a de minimis, provision of services
as described in paragraph (d) of this section or of know-how as described in paragraph (e) of this section, the transfer of
the copy of the computer program is classified solely as a transfer of a copyrighted
article.
(2) Copyright rights. The copyright
rights referred to in paragraph (c)(1) of
this section are as follows—
(i) 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;
(ii) The right to prepare derivative
computer programs based upon the copyrighted computer program;
(iii) The right to make a public performance of the computer program; or
(iv) The right to publicly display the
computer program.
(3) Copyrighted article. A copyrighted
article includes a copy of a computer program from which the work can be perceived, reproduced, or otherwise communicated, either directly or with the aid of a
machine or device. The copy of the program may be fixed in the magnetic
medium of a floppy disk, or in the main
memory or hard drive of a computer, or in
any other medium.
(d) Provision of services. The determination of whether a transaction involving
a newly developed or modified computer
program is treated as either the provision
of services or another transaction described in paragraph (b)(1) of this section
is based on all the facts and circumstances
of the transaction, including, as appropriate, the intent of the parties (as evidenced
by their agreement and conduct) as to
which party is to own the copyright rights
in the computer program and how the
risks of loss are allocated between the
parties.

13

(e) Provision of know-how. The provision of information with respect to a computer program will be treated as the provision of know-how for purposes of this
section only if the information is—
(1) Information relating to computer
programming techniques;
(2) Furnished under conditions preventing unauthorized disclosure, specifically contracted for between the parties;
and
(3) Considered property subject to
trade secret protection.
(f) Further classification of transfers
involving copyright rights and copyrighted articles—(1) Transfers of copyright rights. The determination of
whether a transfer of a copyright right is a
sale or exchange of property is made on
the basis of whether, taking into account
all facts and circumstances, there has
been a transfer of all substantial rights in
the copyright. A transaction that does not
constitute a sale or exchange because not
all substantial rights have been transferred
will be classified as a license generating
royalty income. For this purpose, the
principles of sections 1222 and 1235 may
be applied. Income derived from the sale
or exchange of a copyright right will be
sourced under section 865(a), (c), (d), (e),
or (h), as appropriate. Income derived
from the licensing of a copyright right
will be sourced under section 861(a)(4) or
862(a)(4), as appropriate.
(2) Transfers of copyrighted articles.
The determination of whether a transfer
of a copyrighted article is a sale or exchange is made on the basis of whether,
taking into account all facts and circumstances, the benefits and burdens of ownership have been transferred. A transaction that does not constitute a sale or
exchange because insufficient benefits
and burdens of ownership of the copyrighted article have been transferred, such
that a person other than the transferee is
properly treated as the owner of the copyrighted article, will be classified as a
lease generating rental income. Income
from transactions that are classified as
sales or exchanges of copyrighted articles
will be sourced under sections 861(a)(6),
862(a)(6), 863, 865(a), (b), (c), or (e), as
appropriate. Income derived from the
leasing of a copyrighted article will be
sourced under section 861(a)(4) or section
862(a)(4), as appropriate.

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(3) Special circumstances of computer
programs. In connection with determinations under this paragraph (f), consideration must be given as appropriate to the
special characteristics of computer programs in transactions that take advantage
of these characteristics (such as the ability
to make perfect copies at minimal cost).
For example, a transaction in which a person acquires a copy of a computer program on disk subject to a requirement that
the disk be destroyed after a specified period is generally the equivalent of a transaction subject to a requirement that the
disk be returned after such period. Similarly, a transaction in which the program
deactivates itself after a specified period
is generally the equivalent of returning
the copy.
(g) Rules of operation—(1) Term applied to transaction by parties. Neither
the form adopted by the parties to a transaction, nor the classification of the transaction under copyright law, shall be determinative. Therefore, for example, if there
is a transfer of a computer program on a
single disk for a one-time payment with
restrictions on transfer and reverse engineering, which the parties characterize as
a license (including, but not limited to,
agreements commonly referred to as
shrink-wrap licenses), application of the
rules of paragraphs (c) and (f) of this section may nevertheless result in the transaction being classified as the sale of a
copyrighted article.
(2) Means of transfer not to be taken
into account. The rules of this section shall
be applied irrespective of the physical or
electronic or other medium used to effectuate a transfer of a computer program.
(3) To the public—(i) In general. For
purposes of paragraph (c)(2)(i) of this section, a transferee of a computer program
shall not be considered to have the right to
distribute copies of the program to the
public if it is permitted to distribute copies
of the software to only either a related person, or to identified persons who may be
identified by either name or by legal relationship to the original transferee. For
purposes of this subparagraph, a related
person is a person who bears a relationship to the transferee specified in section
267(b)(3), (10), (11), or (12), or section
707(b)(1)(B). In applying section 267(b),
267(f), 707(b)(1)(B), or 1563(a), “10 percent” shall be substituted for “50 percent.”

October 19, 1998

(ii) Use by individuals. The number of
employees of a transferee of a computer
program who are permitted to use the program in connection with their employment is not relevant for purposes of this
paragraph (g)(3). In addition, the number
of individuals with a contractual agreement to provide services to the transferee
of a computer program who are permitted
to use the program in connection with the
performance of those services is not relevant for purposes of this paragraph (g)(3).
(h) Examples. The provisions of this
section may be illustrated by the following examples:
Example 1. (i) Facts. Corp A, a U.S. corporation, owns the copyright in a computer program,
Program X. It copies Program X onto disks. The
disks are placed in boxes covered with a wrapper on
which is printed what is generally referred to as a
shrink-wrap license. The license is stated to be perpetual. Under the license no reverse engineering,
decompilation, or disassembly of the computer program is permitted. The transferee receives, first, the
right to use the program on two of its own computers (for example, a laptop and a desktop) provided
that only one copy is in use at any one time, and,
second, the right to make one copy of the program
on each machine as an essential step in the utilization of the program. The transferee is permitted by
the shrink-wrap license to sell the copy so long as it
destroys any other copies it has made and imposes
the same terms and conditions of the license on the
purchaser of its copy. These disks are made available for sale to the general public in Country Z. In
return for valuable consideration, P, a Country Z resident, receives one such disk.
(ii) Analysis. (A) Under paragraph (g)(1) of this
section, the label license is not determinative. None
of the copyright rights described in paragraph (c)(2)
of this section have been transferred in this transaction. P has received a copy of the program, however,
and, therefore, under paragraph (c)(1)(ii) of this section, P has acquired solely a copyrighted article.
(B) Taking into account all of the facts and circumstances, P is properly treated as the owner of a
copyrighted article. Therefore, under paragraph
(f)(2) of this section, there has been a sale of a copyrighted article rather than the grant of a lease.
Example 2. (i) Facts. The facts are the same as
those in Example 1, except that instead of selling
disks, Corp A, the U.S. corporation, decides to make
Program X available, for a fee, on a World Wide
Web home page on the Internet. P, the Country Z
resident, in return for payment made to Corp A,
downloads Program X (via modem) onto the hard
drive of his computer. As part of the electronic communication, P signifies his assent to a license agreement with terms identical to those in Example 1, except that in this case P may make a back-up copy of
the program on to a disk.
(ii) Analysis. (A) None of the copyright rights
described in paragraph (c)(2) of this section have
passed to P. Although P did not buy a physical copy
of the disk with the program on it, paragraph (g)(2)
of this section provides that the means of transfer-

14

ring the program is irrelevant. Therefore, P has acquired a copyrighted article.
(B) As in Example 1, P is properly treated as the
owner of a copyrighted article. Therefore, under
paragraph (f)(2) of this section, there has been a sale
of a copyrighted article rather than the grant of a
lease.
Example 3. (i) Facts. The facts are the same as
those in Example 1, except that Corp A only allows
P, the Country Z resident, to use Program X for one
week. At the end of that week, P must return the
disk with Program X on it to Corp A. P must also
destroy any copies made of Program X. If P wishes
to use Program X for a further period he must enter
into a new agreement to use the program for an additional charge.
(ii) Analysis. (A) Under paragraph (c)(2) of this
section, P has received no copyright rights. Because
P has received a copy of the program under paragraph (c)(1)(ii) of this section, he has, therefore, received a copyrighted article.
(B) Taking into account all of the facts and circumstances, P is not properly treated as the owner of
a copyrighted article. Therefore, under paragraph
(f)(2) of this section, there has been a lease of a
copyrighted article rather than a sale. Taking into
account the special characteristics of computer programs as provided in paragraph (f)(3) of this section,
the result would be the same if P were required to
destroy the disk at the end of the one week period instead of returning it since Corp A can make additional copies of the program at minimal cost.
Example 4. (i) Facts. The facts are the same as
those in Example 2, where P, the Country Z resident,
receives Program X from Corp A’s home page on the
Internet, except that P may only use Program X for a
period of one week at the end of which an electronic
lock is activated and the program can no longer be
accessed. Thereafter, if P wishes to use Program X,
it must return to the home page and pay Corp A to
send an electronic key to reactivate the program for
another week.
(ii) Analysis. (A) As in Example 3, under paragraph (c)(2) of this section, P has not received any
copyright rights. P has received a copy of the program, and under paragraph (g)(2) of this section, the
means of transmission is irrelevant. P has, therefore,
under paragraph (c)(1)(ii) of this section, received a
copyrighted article.
(B) As in Example 3, P is not properly treated as
the owner of a copyrighted article. Therefore, under
paragraph (f)(2) of this section, there has been a
lease of a copyrighted article rather than a sale.
While P does retain Program X on its computer at
the end of the one week period, as a legal matter P
no longer has the right to use the program (without
further payment) and, indeed, cannot use the program without the electronic key. Functionally, Program X is no longer on the hard drive of P’s computer. Instead, the hard drive contains only a series
of numbers which no longer perform the function of
Program X. Although in Example 3, P was required
to physically return the disk, taking into account the
special characteristics of computer programs as provided in paragraph (f)(3) of this section, the result in
this Example 4 is the same as in Example 3.
Example 5. (i) Facts. Corp A, a U.S. corporation, transfers a disk containing Program X to Corp
B, a Country Z corporation, and grants Corp B an
exclusive license for the remaining term of the copy-

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right to copy and distribute an unlimited number of
copies of Program X in the geographic area of
Country Z, prepare derivative works based upon
Program X, make public performances of Program
X, and publicly display Program X. Corp B will pay
Corp A a royalty of $y a year for three years, which
is the expected period during which Program X will
have commercially exploitable value.
(ii) Analysis. (A) Although Corp A has transferred a disk with a copy of Program X on it to Corp
B, under paragraph (c)(1)(i) of this section because
this transfer is accompanied by a copyright right
identified in paragraph (c)(2)(i) of this section, this
transaction is a transfer solely of copyright rights,
not of copyrighted articles. For purposes of paragraph (b)(2) of this section, the disk containing a
copy of Program X is a de minimis component of
the transaction.
(B) Applying the all substantial rights test under
paragraph (f)(1) of this section, Corp A will be
treated as having sold copyright rights to Corp B.
Corp B has acquired all of the copyright rights in
Program X, has received the right to use them exclusively within Country Z, and has received the rights
for the remaining life of the copyright in Program X.
The fact the payments cease before the copyright
term expires is not controlling. Under paragraph
(g)(1) of this section, the fact that the agreement is
labelled a license is not controlling (nor is the fact
that Corp A receives a sum labelled a royalty). (The
result in this case would be the same if the copy of
Program X to be used for the purposes of reproduction were transmitted electronically to Corp B, as a
result of the application of the rule of paragraph
(g)(2) of this section.)
Example 6. (i) Facts. Corp A, a U.S. corporation, transfers a disk containing Program X to Corp
B, a Country Z corporation, and grants Corp B the
non exclusive right to reproduce (either directly or
by contracting with either Corp A or another person
to do so) and distribute for sale to the public an unlimited number of disks at its factory in Country Z in
return for a payment related to the number of disks
copied and sold. The term of the agreement is two
years, which is less than the remaining life of the
copyright.
(ii) Analysis. (A) As in Example 5, the transfer of
the disk containing the copy of the program does not
constitute the transfer of a copyrighted article under
paragraph (c)(1) of this section because Corp B has
also acquired a copyright right under paragraph
(c)(2)(i) of this section, the right to reproduce and distribute to the public. For purposes of paragraph (b)(2)
of this section, the disk containing Program X is a de
minimis component of the transaction.
(B) Taking into account all of the facts and circumstances, there has been a license of Program X
to Corp B, and the payments made by Corp B are
royalties. Under paragraph (f)(1) of this section,
there has not been a transfer of all substantial rights
in the copyright to Program X because Corp A has
the right to enter into other licenses with respect to
the copyright of Program X, including licenses in
Country Z (or even to sell that copyright, subject to
Corp B’s interest). Corp B has acquired no right itself to license the copyright rights in Program X. Finally, the term of the license is for less than the remaining life of the copyright in Program X.
Example 7. (i) Facts. Corp C, a distributor in
Country Z, enters into an agreement with Corp A, a

1998–42 I.R.B.

U.S. corporation, to purchase as many copies of Program X on disk as it may from time-to-time request.
Corp C will then sell these disks to retailers. The
disks are shipped in boxes covered by shrink-wrap
licenses (identical to the license described in Example 1).
(ii) Analysis. (A) Corp C has not acquired any
copyright rights under paragraph (c)(2) of this section with respect to Program X. It has acquired individual copies of Program X, which it may sell to
others. The use of the term license is not dispositive
under paragraph (g)(1) of this section. Under paragraph (c)(1)(ii) of this section, Corp C has acquired
copyrighted articles.
(B) Taking into account all of the facts and circumstances, Corp C is properly treated as the owner
of copyrighted articles. Therefore, under paragraph
(f)(2) of this section, there has been a sale of copyrighted articles.
Example 8. (i) Facts. Corp A, a U.S. corporation, transfers a disk containing Program X to Corp
D, a foreign corporation engaged in the manufacture
and sale of personal computers in Country Z. Corp
A grants Corp D the non-exclusive right to copy
Program X onto the hard drive of an unlimited number of computers, which Corp D manufactures, and
to distribute those copies (on the hard drive) to the
public. The term of the agreement is two years,
which is less than the remaining life of the copyright
in Program X. Corp D pays Corp A an amount
based on the number of copies of Program X it loads
on to computers.
(ii) Analysis. The analysis is the same as in Example 6. Under paragraph (c)(2)(i) of this section,
Corp D has acquired a copyright right enabling it to
exploit Program X by copying it on to the hard drives of the computers that it manufactures and then
sells. For purposes of paragraph (b)(2) of this section, the disk containing Program X is a de minimis
component of the transaction. Taking into account
all of the facts and circumstances, Corp D has not,
however, acquired all substantial rights in the copyright to Program X (for example, the term of the
agreement is less than the remaining life of the
copyright). Under paragraph (f)(1) of this section,
this transaction is, therefore, a license of Program X
to Corp D rather than a sale and the payments made
by Corp D are royalties. (The result would be the
same if Corp D included with the computers it sells
an archival copy of Program X on a floppy disk.)
Example 9. (i) Facts. The facts are the same as
in Example 8, except that Corp D, the Country Z
corporation, receives physical disks. The disks are
shipped in boxes covered by shrink-wrap licenses
(identical to the licenses described in Example 1).
The terms of these licenses do not permit Corp D to
make additional copies of Program X. Corp D uses
each individual disk only once to load a single copy
of Program X onto each separate computer. Corp D
transfers the disk with the computer when it is sold.
(ii) Analysis. (A) As in Example 7 (unlike Example 8) no copyright right identified in paragraph
(c)(2) of this section has been transferred. Corp D
acquires the disks without the right to reproduce and
distribute publicly further copies of Program X.
This is therefore the transfer of copyrighted articles
under paragraph (c)(1)(ii) of this section.
(B) Taking into account all of the facts and circumstances, Corp D is properly treated as the owner
of copyrighted articles. Therefore, under paragraph

15

(f)(2) of this section, the transaction is classified as
the sale of a copyrighted article. (The result would
be the same if Corp D used a single physical disk to
copy Program X onto each computer, and transferred an unopened box containing Program X with
each computer, if Corp D were not permitted to copy
Program X onto more computers than the number of
individual copies purchased.)
Example 10. (i) Facts. Corp A, a U.S. corporation, transfers a disk containing Program X to Corp E,
a Country Z corporation, and grants Corp E the right
to load Program X onto 50 individual workstations
for use only by Corp E employees at one location in
return for a one-time per-user fee (generally referred
to as a site license or enterprise license). If additional
workstations are subsequently introduced, Program X
may be loaded onto those machines for additional
one-time per-user fees. The license which grants the
rights to operate Program X on 50 workstations also
prohibits Corp E from selling the disk (or any of the
50 copies) or reverse engineering the program. The
term of the license is stated to be perpetual.
(ii) Analysis. (A) The grant of a right to copy,
unaccompanied by the right to distribute those
copies to the public, is not the transfer of a copyright
right under paragraph (c)(2) of this section. Therefore, under paragraph (c)(1)(ii) of this section, this
transaction is a transfer of copyrighted articles (50
copies of Program X).
(B) Taking into account all of the facts and circumstances, P is properly treated as the owner of
copyrighted articles. Therefore, under paragraph
(f)(2) of this section, there has been a sale of copyrighted articles rather than the grant of a lease.
Notwithstanding the restriction on sale, other factors
such as, for example, the risk of loss and the right to
use the copies in perpetuity outweigh, in this case,
the restrictions placed on the right of alienation.
(C) The result would be the same if Corp E were
permitted to copy Program X onto an unlimited
number of workstations used by employees of either
Corp E or corporations that had a relationship to
Corp E specified in paragraph (g)(3) of this section.
Example 11. (i) Facts. The facts are the same as
in Example 10, except that Corp E, the Country Z
corporation, acquires the right to make Program X
available to workstation users who are Corp E employees by way of a local area network (LAN). The
number of users that can use Program X on the LAN
at any one time is limited to 50. Corp E pays a onetime fee for the right to have up to 50 employees use
the program at the same time.
(ii) Analysis. Under paragraph (g)(2) of this section the mode of utilization is irrelevant. Therefore,
as in Example 10, under paragraph (c)(2) of this section, no copyright right has been transferred, and,
thus, under paragraph (c)(1)(ii) of this section, this
transaction will be classified as the transfer of a
copyrighted article. Under the benefits and burdens
test of paragraph (f)(2) of this section, this transaction is a sale of copyrighted articles. The result
would be the same if an unlimited number of Corp E
employees were permitted to use Program X on the
LAN or if Corp E were permitted to copy Program
X onto LANs maintained by corporations that had a
relationship to Corp E specified in paragraph (g)(3)
of this section.
Example 12. (i) Facts. The facts are the same as
in Example 11, except that Corp E pays a monthly
fee to Corp A, the U.S. corporation, calculated with

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reference to the permitted maximum number of
users (which can be changed) and the computing
power of Corp E’s server. In return for this monthly
fee, Corp E receives the right to receive upgrades of
Program X when they become available. The agreement may be terminated by either party at the end of
any month. When the disk containing the upgrade is
received, Corp E must return the disk containing the
earlier version of Program X to Corp A. If the contract is terminated, Corp E must delete (or otherwise
destroy) all copies made of the current version of
Program X. The agreement also requires Corp A to
provide technical support to Corp E but the agreement does not allocate the monthly fee between the
right to receive upgrades of Program X and the technical support services. The amount of technical support that Corp A will provide to Corp E is not foreseeable at the time the contract is entered into but is
expected to be de minimis. The agreement specifically provides that Corp E has not thereby been
granted an option to purchase Program X.
(ii) Analysis. (A) Corp E has received no copyright rights under paragraph (c)(2) of this section.
Corp A has not provided any services described in
paragraph (d) of this section. Based on all the facts
and circumstances of the transaction, Corp A has
provided de minimis technical services to Corp E.
Therefore, under paragraph (c)(1)(ii) of this section,
the transaction is a transfer of a copyrighted article.
(B) Taking into account all facts and circumstances, under the benefits and burdens test Corp E is
not properly treated as the owner of the copyrighted
article. Corp E does not receive the right to use Program X in perpetuity, but only for so long as it continues to make payments. Corp E does not have the
right to purchase Program X on advantageous (or, indeed, any) terms once a certain amount of money has
been paid to Corp A or a certain period of time has
elapsed (which might indicate a sale). Once the
agreement is terminated, Corp E will no longer possess any copies of Program X, current or superseded.
Therefore under paragraph (f)(2) of this section there
has been a lease of a copyrighted article.
Example 13. (i) Facts. The facts are the same as
in Example 12, except that, while Corp E must return copies of Program X as new upgrades are received, if the agreement terminates, Corp E may
keep the latest version of Program X (although Corp
E is still prohibited from selling or otherwise transferring any copy of Program X).
(ii) Analysis. For the reasons stated in Example
10, paragraph (ii)(B), the transfer of the program
will be treated as a sale of a copyrighted article
rather than as a lease.
Example 14. (i) Facts. Corp G, a Country Z
corporation, enters into a contract with Corp A, a
U.S. corporation, for Corp A to modify Program X
so that it can be used at Corp G’s facility in Country
Z. Under the contract, Corp G is to acquire one
copy of the program on a disk and the right to use
the program on 5,000 workstations. The contract requires Corp A to rewrite elements of Program X so
that it will conform to Country Z accounting standards and states that Corp A retains all copyright
rights in the modified Program X. The agreement
between Corp A and Corp G is otherwise identical as
to rights and payment terms as the agreement described in Example 10.
(ii) Analysis. (A) As in Example 10, no copyright rights are being transferred under paragraph

October 19, 1998

(c)(2) of this section. In addition, since no copyright
rights are being transferred to Corp G, this transaction does not involve the provision of services by
Corp A under paragraph (d) of this section. This
transaction will be classified, therefore, as a transfer
of copyrighted articles under paragraph (c)(1)(ii) of
this section.
(B) Taking into account all facts and circumstances, Corp G is properly treated as the owner of
copyrighted articles. Therefore, under paragraph
(f)(2) of this section, there has been the sale of a
copyrighted article rather than the grant of a lease.
Example 15. (i) Facts. Corp H, a Country Z corporation, enters into a license agreement for a new
computer program. Program Q is to be written by
Corp A, a U.S. corporation. Corp A and Corp H
agree that Corp A is writing Program Q for Corp H
and that, when Program Q is completed, the copyright in Program Q will belong to Corp H. Corp H
gives instructions to Corp A programmers regarding
program specifications. Corp H agrees to pay Corp
A a fixed monthly sum during development of the
program. If Corp H is dissatisfied with the development of the program, it may cancel the contract at the
end of any month. In the event of termination, Corp
A will retain all payments, while any procedures,
techniques or copyrightable interests will be the
property of Corp H. All of the payments are labelled
royalties. There is no provision in the agreement for
any continuing relationship between Corp A and
Corp H, such as the furnishing of updates of the program, after completion of the modification work.
(ii) Analysis. Taking into account all of the facts
and circumstances, Corp A is treated as providing
services to Corp H. Under paragraph (d) of this section, Corp A is treated as providing services to Corp
H because Corp H bears all of the risks of loss associated with the development of Program Q and is the
owner of all copyright rights in Program Q. Under
paragraph (g)(1) of this section, the fact that the
agreement is labelled a license is not controlling
(nor is the fact that Corp A receives a sum labelled a
royalty).
Example 16. (i) Facts. Corp A, a U.S. corporation, and Corp I, a Country Z corporation, agree that
a development engineer employed by Corp A will
travel to Country Z to provide know-how relating to
certain techniques not generally known to computer
programmers, which will enable Corp I to more efficiently create computer programs. These techniques
represent the product of experience gained by Corp
A from working on many computer programming
projects, and are furnished to Corp I under nondisclosure conditions. Such information is property
subject to trade secret protection.
(ii) Analysis. This transaction contains the elements of know-how specified in paragraph (e) of
this section. Therefore, this transaction will be
treated as the provision of know-how.
Example 17 (i) Facts. Corp A, a U.S. corporation, transfers a disk containing Program Y to Corp
E, a Country Z corporation, in exchange for a single
fixed payment. Program Y is a computer program
development program, which is used to create other
computer programs, consisting of several components, including libraries of reusable software components that serve as general building blocks in new
software applications. No element of these libraries
is a significant component of any overall new program. Because a computer program created with the

16

use of Program Y will not operate unless the libraries are also present, the license agreement between Corp A and Corp E grants Corp E the right to
distribute copies of the libraries with any program
developed using Program Y. The license agreement
is otherwise identical to the license agreement in Example 1.
(ii) Analysis. (A) No non-de minimis copyright
rights described in paragraph (c)(2) of this section
have passed to Corp E. For purposes of paragraph
(b)(2) of this section, the right to distribute the libraries in conjunction with the programs created
using Program Y is a de minimis component of the
transaction. Because Corp E has received a copy of
the program under paragraph (c)(1)(ii) of this section, it has received a copyrighted article.
(B) Taking into account all the facts and circumstances, Corp E is properly treated as the owner of a
copyrighted article. Therefore, under paragraph
(f)(2) of this section, there has been the sale of a
copyrighted article rather than the grant of a lease.
Example 18 (i) Facts. (A) Corp A, a U.S. corporation, transfers a disk containing Program X to
Corp E, a country Z Corporation. The disk contains
both the object code and the source code to Program
X and the license agreement grants Corp E the right
to—
(1) Modify the source code in order to correct
minor errors and make minor adaptations to Program X so it will function on Corp E’s computer;
and
(2) Recompile the modified source code.
(B) The license does not grant Corp E the right
to distribute the modified Program X to the public.
The license is otherwise identical to the license
agreement in Example 1.
(ii) Analysis. (A) No non-de minimis copyright
rights described in paragraph (c)(2) of this section
have passed to Corp E. For purposes of paragraph
(b)(2) of this section, the right to modify the source
code and recompile the source code in order to create new code to correct minor errors and make
minor adaptations is a de minimis component of the
transaction. Because Corp E has received a copy of
the program under paragraph (c)(1)(ii) of this section, it has received a copyrighted article.
(B) Taking into account all the facts and circumstances, Corp E is properly treated as the owner of a
copyrighted article. Therefore, under paragraph
(f)(2) of this section, there has been the sale of a
copyrighted article rather than the grant of a lease.

(i) Effective date—(1) General. This
section applies to transactions occurring
pursuant to contracts entered into on or
after December 1, 1998.
(2) Elective transition rules—(i) Contracts entered into in taxable years ending
on or after October 2, 1998. A taxpayer
may elect to apply this section to transactions occurring pursuant to contracts entered into in taxable years ending on or
after October 2, 1998. A taxpayer that
makes an election under this paragraph
(i)(2)(i) must apply this section to all contracts entered into in taxable years ending
on or after October 2, 1998.

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(ii) Contracts entered into before October 2, 1998. A taxpayer may elect to
apply this section to transactions occurring in taxable years ending on or after
October 2, 1998, pursuant to contracts entered into before October 2, 1998, provided the taxpayer would not be required
under this section to change its method of
accounting as a result of such election, or
the taxpayer would be required to change
its method of accounting but the resulting
section 481(a) adjustment would be zero.
A taxpayer that makes an election under
this paragraph (i)(2)(ii) must apply this
section to all transactions occurring in
taxable years ending on or after October
2, 1998, pursuant to contracts entered into
before October 2, 1998.
(3) Manner of making election. Taxpayers may elect, under paragraph
(i)(2)(i) or (i)(2)(ii) of this section, to
apply this section, by treating the transactions in accordance with these regulations
on their original tax return.
(4) Examples. The following examples illustrate application of the transition
rule of paragraph (i)(2)(ii) of this section:
Example 1. Corp A develops computer programs for sale to third parties. Corp A uses an overall accrual method of accounting and files its tax return on a calendar-year basis. In year 1, Corp A
enters into a contract to deliver a computer program
in that year, and to provide updates for each of the
following four years. Under the contract, the computer program and the updates are priced separately,
and Corp A is entitled to receive payments for the
computer program and each of the updates upon delivery. Assume Corp A properly accounts for the
contract as a contract for the provision of services.
Corp A properly includes the payments under the
contract in gross income in the taxable year the payments are received and the computer program or updates are delivered. Corp A properly deducts the
cost of developing the computer program and updates when the costs are incurred. Year 3 includes
October 2, 1998. Assume under the rules of this section, the provision of updates would properly be accounted for as the transfer of copyrighted articles. If
Corp A made an election under paragraph (i)(2)(ii)
of this section, Corp A would not be required to
change its method of accounting for income under
the contract as a result of the election. Corp A would
also not be required to change its method of accounting for the cost of developing the computer
program and the updates under the contract as a result of the election. Therefore, under paragraph
(i)(2)(ii) of this section, Corp A may elect to apply
the provisions of this section to the updates provided
in years 3, 4, and 5, because Corp A is not required
to change from its accrual method of accounting for
the contract as a result of the election.
Example 2. Corp A develops computer programs
for sale to third parties. Corp A uses an overall accrual method of accounting and files its tax return on

1998–42 I.R.B.

a calendar-year basis. In year 1, Corp A enters into a
contract to deliver a computer program and to provide one update the following year. Under the contract, the computer program and the update are
priced separately, and Corp A is entitled to receive
payment for the computer program and the update
upon delivery of the computer program. Assume
Corp A properly accounts for the contract as a contract for the provision of services. Corp A properly
includes the portion of the payment relating to the
computer program in gross income in year 1, the
taxable year the payment is received and the program delivered. Corp A properly includes the portion of the payment relating to the update in gross
income in year 2, the taxable year the update is provided, under Rev. Proc. 71–21, 1971–2 CB 549 (see
§601.601 (d)(2) of this chapter). Corp A properly
deducts the cost of developing the computer program and update when the costs are incurred. Year 2
includes October 2, 1998. Assume under the rules
of this section, provision of the update would properly be accounted for as the transfer of a copyrighted
article. If Corp A made an election under paragraph
(i)(2)(ii) of this section, Corp A would be required to
change its method of accounting for deferring income under its contract as a result of the election.
However, the section 481(a) adjustment would be
zero because the portion of the payment relating to
the update would be includible in gross income in
year 2, the taxable year the update is provided, under
both Rev. Proc. 71–21 and §1.451–5. Corp A would
not be required to change its method of accounting
for the cost of developing the computer program and
the update under the contract as a result of the election. Therefore, under paragraph (i)(2)(ii) of this
section, Corp A may elect to apply the provisions of
this section to the update in year 2, because the section 481(a) adjustment resulting from the change in
method of accounting for deferring advance payments under the contract is zero, and because Corp
A is not required to change from its accrual method
of accounting for the cost of developing the computer program and updates under the contract as a
result of the election.
Example 3. Assume the same facts as in Example
1 except that Corp A is entitled to receive payments
for the computer program and each of the updates 30
days after delivery. Corp A properly includes the
amounts due under the contract in gross income in
the taxable year the computer program or updates
are provided. Assume that Corp A properly uses the
nonaccrual-experience method described in section
448(d)(5) and §1.448–2T to account for income on
its contracts. If Corp A made an election under paragraph (i)(2)(ii) of this section, Corp A would be required to change from the nonaccrual-experience
method for income as a result of the election, because the method is only available with respect to
amounts to be received for the performance of services. Therefore, Corp A may not elect to apply the
provisions of this section to the updates provided in
years 3, 4, and 5, under paragraph (i)(2)(ii) of this
section, because Corp A would be required to
change from the nonaccrual-experience method of
accounting for income on the contract as a result of
the election.

(j) Change in method of accounting required by this section—(1) Consent. A
taxpayer is granted consent to change its

17

method of accounting for contracts involving computer programs, to conform
with the classification prescribed in this
section. The consent is granted for contracts entered into on or after December 1,
1998, or in the case of a taxpayer making
an election under paragraph (i)(2)(i) of
this section, the consent is granted for
contracts entered into in taxable years
ending on or after October 2, 1998. In addition, a taxpayer that makes an election
under paragraph (i)(2)(ii) of this section is
granted consent to change its method of
accounting for any contract with transactions subject to the election, if the taxpayer is required to change its method of
accounting as a result of the election.
(2) Year of change. The year of change
is the taxable year that includes December
1, 1998, or in the case of a taxpayer making an election under paragraph (i)(2)(i)
or (i)(2)(ii) of this section, the taxable
year that includes October 2, 1998.
(k) Time and manner of making change
in method of accounting—(1) General.
A taxpayer changing its method of accounting in accordance with this section
must file a Form 3115, Application for
Change in Method of Accounting, in duplicate. The taxpayer must type or print
the following statement at the top of page
1 of the Form 3115: “FILED UNDER
TREASURY REGULATION §1.861–
18.” The original Form 3115 must be attached to the taxpayers original return for
the year of change. A copy of the Form
3115 must be filed with the National Office no later than when the original Form
3115 is filed for the year of change.
(2) Copy of Form 3115. The copy required by this paragraph (k)(l) to be sent
to the national office should be sent to the
Commissioner of Internal Revenue, Attention: CC:DOM:IT&A, P.O. Box 7604,
Benjamin Franklin Station, Washington,
DC 20044 (or in the case of a designated
private delivery service: Commissioner
of Internal Revenue, Attention: CC:
DOM:IT&A, 1111 Constitution Avenue,
NW, Washington, DC 20224).
(3) Effect of consent and Internal Revenue Service review. A change in method
of accounting granted under this section is
subject to review by the district director
and the national office and may be modified or revoked in accordance with the
provisions of Rev. Proc. 97–37 (1997–33
IRB 18) (or its successors) (see
§601.601(d)(2) of this chapter).

October 19, 1998

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10/14/98 11:03 AM

Page 18

PART 602—OMB CONTROL
NUMBERS UNDER THE
PAPERWORK REDUCTION ACT
Par. 3. The authority citation for part
602 continues to read as follows:
Authority: 26 U.S.C. 7805.
Par. 4. In §602.101, paragraph (c) is
amended by adding an entry to the table
in numerical order to read as follows:
§602.101 OMB Control numbers.
* * * * *
(c) * * *

October 19, 1998

CFR part or section
where identified and
described

Current OMB
control No.

* * * * *
1.861–18 . . . . . . . . . . . . . . . . 1545–1594
* * * * *

Approved April 1, 1998.
Donald C. Lubick,
Deputy Assistant Secretary of
the Treasury.
(Filed by the Office of the Federal Register on
September 30, 1998, 8:45 a.m., and published in the
issue of the Federal Register for October 2, 1998, 63
F.R. 52971)

Michael P. Dolan,
Deputy Commissioner of
Internal Revenue.

18

1998–42 I.R.B.

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10/14/98 11:03 AM

Page 19

Part IV. Items of General Interest
Notice of Proposed Rulemaking
Substantiation of Business
Expenses—Use of Mileage Rates
to Substantiate Automobile
Expenses
REG–122488–97
AGENCY: Internal Revenue Service
(IRS), Treasury.
ACTION: Notice of proposed rulemaking.
SUMMARY: This document contains
proposed regulations relating to the use
of mileage rates to substantiate automobile business expenses. The regulations
affect taxpayers who deduct expenses,
and payors who make payments and employees who receive payments under reimbursement or other expense allowance
arrangements, for the business use of an
automobile.
DATES: Written or electronically generated comments and requests for a public
hearing must be received by December
30, 1998.
FOR FURTHER INFORMATION CONTACT: Concerning the regulations, contact Edwin B. Cleverdon or Donna M.
Crisalli, (202) 622-4920 (not a toll-free
number).
ADDRESSES: Send submissions to
CC:DOM:CORP:R (REG–122488–97),
room 5228, Internal Revenue Service,
P.O. Box 7604, Ben Franklin Station,
Washington, DC 20044. In the alternative, submissions may be hand delivered
between the hours of 8 a.m. and 5 p.m. to
CC:DOM:CORP:R (REG–122488–97),
Courier’s Desk, Internal Revenue Service, 1111 Constitution Avenue, NW,
Washington, DC.
Additionally, taxpayers may submit
comments electronically via INTERNET
by selecting the “Tax Regs” option on the
IRS INTERNET site at: http://www.irs.
ustreas.gov/prod/tax_regs/comments.html.
SUPPLEMENTARY INFORMATION
Background and Explanation of
Provisions
Section 274(d) provides that a taxpayer

1998–42 I.R.B.

is not allowed a deduction or credit for
certain expenses unless the expense is
substantiated. These substantiation requirements apply to the expenses of use
of any listed property (defined in section
280F(d)(4)), which includes any passenger automobile and any other property
used as a means of transportation. The
Secretary may issue regulations that provide that some or all of the substantiation
requirements will not apply to expenses
that do not exceed a prescribed amount.
Section 1.274–5T(b)(6) sets forth the
elements of an expenditure or use, i.e., the
amount, time, and business purpose, that
are required to be substantiated with
respect to listed property. Section
1.274(d)–1 provides, in part, that the
Commissioner may prescribe rules under
which mileage allowances reimbursing
ordinary and necessary expenses of local
travel and transportation while traveling
away from home will satisfy the substantiation requirements of §1.274–5T(c), and
the requirements of an adequate accounting to the employer for purposes of
§1.274–5T(f)(4). However, §1.274(d)–
1(a)(3) provides that such mileage allowances are available only to the owner
of a vehicle.
Proposed §1.274–5(g) applies these
substantiation rules to mileage allowances
for business use of an automobile without
the limitation in §1.274(d)–1(a)(3) that a
mileage allowance is available only to the
owner of a vehicle. Proposed §1.274–
5(j)(1) continues to authorize the Commissioner to establish a method for computing meal expenses while traveling
away from home (see current §1.274–
5T(j)), while §1.274–5(j)(2) authorizes
the Commissioner to establish a method
under which a taxpayer may use mileage
rates to determine the amount of the ordinary and necessary business expenses of
using an automobile for local transportation and transportation to, from, and at the
destination while traveling away from
home in lieu of substantiating the actual
costs. The mileage rate method may include appropriate limitations and conditions in order to reflect more accurately
automobile expenses over the entire period of usage. The taxpayer would not,
however, be relieved of substantiating the
amount of each business use (i.e., the

19

business mileage) and the time and business purpose of each use. See Rev. Proc.
97–59 (1997–52 I.R.B. 24), for rules for
using the mileage rate method. This proposed §1.274–5(g), (j), and (m) supplement §1.274–5(c) and (f) as proposed on
March 25, 1997, in the Federal Register
(62 F.R. 14051). Conforming changes to
§1.62–2 are also proposed.
Special Analyses
It has been determined that this notice
of proposed rulemaking is not a significant regulatory action as defined in EO
12866. Therefore, a regulatory assessment is not required. It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C.
chapter 5) does not apply to these regulations, and, because the regulations do not
impose a collection of information on
small entities, the Regulatory Flexibility
Act (5 U.S.C. chapter 6) does not apply.
Pursuant to section 7805(f) of the Internal
Revenue Code, this notice of proposed
rulemaking will be submitted to the Chief
Counsel for Advocacy of the Small Business Administration for comment on its
impact on small business.
Comments and Requests for a Public
Hearing
Before adopting these proposed regulations as final regulations, consideration
will be given to any comments that are
submitted timely (and in the manner described in the ADDRESSES portion of
this preamble) to the IRS. All comments
will be available for public inspection and
copying. A public hearing will be scheduled and held upon request by any person
who submits comments on the proposed
rules. Notice of the time and place for the
hearing will be published in the Federal
Register.
Drafting Information
The principal authors of these proposed
regulations are Edwin B. Cleverdon and
Donna M. Crisalli, Office of the Assistant
Chief Counsel (Income Tax and Accounting). However, personnel from other offices of the IRS and Treasury Department
participated in their development.

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Page 20

*****
Proposed Amendments to the Regulations
Accordingly, 26 CFR part 1 is proposed to be amended as follows:
PART 1—INCOME TAXES
Paragraph 1. The authority citation for
part 1 continues to read in part as follows:
Authority: 26 U.S.C. 7805 * * *
Par. 2. In §1.62–2, paragraph (e)(2) is
revised to read as follows:
§1.62–2 Reimbursement and other
expense allowance arrangements.
* * * * *
(e) * * *
(2) Expenses governed by section
274(d). An arrangement that reimburses
travel, entertainment, use of a passenger
automobile or other listed property, or
other business expenses governed by section 274(d) meets the requirements of this
paragraph (e)(2) if information sufficient
to satisfy the substantiation requirements
of section 274(d) and the regulations
thereunder is submitted to the payor. See
§1.274–5T. Under section 274(d), information sufficient to substantiate the requisite elements of each expenditure or use
must be submitted to the payor. For example, with respect to travel away from
home, §1.274–5T(b)(2) requires that information sufficient to substantiate the
amount, time, place, and business purpose
of the expense must be submitted to the
payor. Similarly, with respect to use of a
passenger automobile or other listed property, §1.274–5T(b)(6) requires that information sufficient to substantiate the
amount, time, use, and business purpose
of the expense must be submitted to the
payor. See §1.274–5(g), however, which
grants the Commissioner authority to prescribe rules permitting the amount of certain expenses to be deemed substantiated
to the payor (in lieu of substantiating the
actual amount of such expenses) by
means of per diem or mileage rates for
travel away from home or transportation
expenses. See also §1.274–5(j)(1), which
grants the Commissioner the authority to
establish a method under which a taxpayer may use a specified amount for
meals while traveling away from home in
lieu of substantiating the actual cost of

October 19, 1998

meals, and §1.274–5(j)(2), which grants
the Commissioner the authority to establish a method under which a taxpayer may
use mileage rates to determine the amount
of the ordinary and necessary expenses of
using an automobile for local transportation and transportation to, from, and at the
destination while traveling away from
home in lieu of substantiating the actual
costs. Substantiation of the amount of a
business expense in accordance with rules
prescribed pursuant to the authority
granted by §1.274–5(g) or (j) will be
treated as substantiation of the amount of
such expense for purposes of this section.
* * * * *
§1.62–2T [Removed]
Par. 3. Section 1.62–2T is removed.
Par. 4. Section 1.274–5 is added to
read as follows:
§1.274–5 Substantiation requirements.
(a) through (f) [Reserved]. For further
guidance, see §1.274–5T(a) through (f).
(g) Substantiation by reimbursement
arrangements or per diem, mileage, and
other traveling allowances—(1) In general. The Commissioner may, in his or her
discretion, prescribe rules in pronouncements of general applicability under which
allowances for expenses described in paragraph (g)(2) of this section will, if in accordance with reasonable business practice,
be regarded as equivalent to substantiation
by adequate records or other sufficient evidence for purposes of §1.274–5T(c) of the
amount of such expenses and as satisfying,
with respect to the amount of such expenses, the requirements of an adequate
accounting to the employer for purposes of
§1.274– 5T(f)(4). If the total allowance received exceeds the deductible expenses
paid or incurred by the employee, such excess must be reported as income on the
employee’s return. See paragraph (j)(1) of
this section relating to the substantiation of
meal expenses while traveling away from
home, and paragraph (j)(2) of this section
relating to the substantiation of expenses
for the business use of an automobile.
(2) Allowances for expenses described.
An allowance for expenses is described in
this paragraph (g)(2) if it is a—
(i) Reimbursement arrangement covering ordinary and necessary expenses of

20

traveling away from home (exclusive of
transportation expenses to and from destination);
(ii) Per diem allowance providing for
ordinary and necessary expenses of traveling away from home (exclusive of
transportation costs to and from destination); or
(iii) Mileage allowance providing for
ordinary and necessary expenses of local
transportation and transportation to, from,
and at the destination while traveling
away from home.
(3) Limitation. For expenses paid or
incurred on or before December 31, 1997,
a mileage allowance described in paragraph (g)(2)(iii) of this section is available only to the owner of a vehicle.
(h) and (i) [Reserved]. For further
guidance, see §1.274- 5T(h) and (i).
(j) Authority for optional methods of
computing certain expenses—(1) Meal
expenses while traveling away from
home. The Commissioner may establish a
method under which a taxpayer may use a
specified amount or amounts for meals
while traveling away from home in lieu of
substantiating the actual cost of meals.
The taxpayer would not be relieved of the
requirement to substantiate the actual cost
of other travel expenses as well as the
time, place, and business purpose of the
travel. See §1.274–5T(b)(2) and (c).
(2) Use of mileage rates for automobile expenses. The Commissioner may
establish a method under which a taxpayer may use mileage rates to determine
the amount of the ordinary and necessary
expenses of using an automobile for local
transportation and transportation to, from,
and at the destination while traveling
away from home

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Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/agency%3Airs%3A848c0aa790c2cb54. Public record. Not legal advice.