Classification of Certain Transactions Involving Computer Programs

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Parts 1 and 602

[TD 8785]

RIN 1545-AU70

Classification of Certain Transactions Involving Computer

Programs

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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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

The collection of information in this 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 Sec. 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 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] were

published in the Federal Register (61 FR 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 thisTreasury 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 bothU.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 CapitalProtection of Literary and Artistic Works, 25

U.S.T. 1341 (ParisText, July 24, 1971). Copyright law grants certain

exclusive rights to a copyright owner. The regulations classify a

transaction as the transfer of a copyright right if the transferee

acquires one or more of the copyright rights identified in Sec. 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 Sec. 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.

[[Page 52972]]

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 commentators 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 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.

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, Sec. 1.482-3(f).

c. Source of Income

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 Sec. 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

[[Page 52973]]

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 Sec. 1.861-7(c), the parties in many cases

can agree on where title passes for sales of inventory property

generally. Consistent with the overall policy of the regulations,

income from electronic transfers of computer programs that constitute

inventory property, classified as sales of copyrighted articles, will

be sourced under similar principles.

2. Relevance of Foreign Law

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 Sec. 1.901-2(e)(5) that substantive and

procedural provisions of foreign law (including applicable tax

treaties) determine the taxpayer's liability 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 Sec. 1.904-6(a)(1).

3. Copyright Rights

The proposed regulations, in Sec. 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 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 transaction 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

[[Page 52974]]

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 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 Sec. 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.

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 Sec. 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 Sec. 1.861-18(c)(3)

of the final regulations.

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

[[Page 52975]]

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.

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.

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

a. Lease Character for Copyrighted Articles

The proposed regulations treat a non-sale 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 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.

7. Related Parties

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.

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 Code sections. Thus, the relevance of the distinction between

services and know-how 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. Know-how 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 know-how described in these regulations.

9. Mixed Transactions

The proposed regulations state that if a transaction in a computer

program consists of transactions in more than one category listed in

Sec. 1.861-18(b)(1), the transactions, unless de minimis, will

[[Page 52976]]

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

required 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 recommended 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, Sec. 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.

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 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

[[Page 52977]]

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.

However, 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

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 Associate Chief Counsel (International), IRS. However, other

personnel from the IRS and Treasury Department participated in their

development.

List of Subjects

26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

26 CFR Part 602

Reporting and recordkeeping requirements.

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:

Sec. 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, 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.

[[Page 52978]]

(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 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.

(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.

(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

[[Page 52979]]

section 267(b), 267(f), 707(b)(1)(B), or 1563(a), ``10 percent'' shall

be substituted for ``50 percent.''

(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

transferring 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

copyright 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

[[Page 52980]]

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 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 (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 one-time 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 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

[[Page 52981]]

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 (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 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.

(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

[[Page 52982]]

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 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 Sec. 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

Sec. 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 Sec. 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 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 Sec. 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 Sec. 601.601(d)(2) of this chapter).

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 Sec. 602.101, paragraph (c) is amended by adding an

entry to the table in numerical order to read as follows:

Sec. 602.101 OMB Control numbers.

* * * * *

(c) * * *

[[Page 52983]]

------------------------------------------------------------------------

Current OMB

CFR part or section where identified and described control No.

------------------------------------------------------------------------

* * * *

* * *

1.861-18................................................... 1545-1594

* * * *

* * *

------------------------------------------------------------------------

Michael P. Dolan,

Deputy Commissioner of Internal Revenue.

Approved: April 1, 1998.

Donald C. Lubick,

Assistant Secretary of the Treasury.

[FR Doc. 98-26475 Filed 9-30-98; 8:45 am]

BILLING CODE 4830-01-U