Back-to-Back Computer Licensing Arrangements Narrowly Carved Out of the Ambit of Sec. 901(l)(1)

In Notice 2005-90, the IRS and Treasury provided an exception to Sec. 901(l)(1)s general rule that denies a foreign tax credit (FTC) for withholding taxes imposed on an item of income (other than dividends) or gain, when the underlying property generating the income or gain is held for a relatively short period. This narrow exception applies to foreign withholding taxes imposed on payments in certain back-to-back computer licensing arrangements. This item provides (1) a brief overview of the FTC; (2) a brief discussion of Sec. 901(k) and (l), and the types of transactions that have led to their enactment; and (3) a discussion of Notice 2005-90.

FTCs

The FTC can be extremely valuable in minimizing a taxpayers global tax liability, and in managing a U.S. multinational groups effective tax rate. Generally, it provides a dollar-for-dollar offset against a U.S. taxpayers gross Federal tax liability. It may be available for foreign income taxes imposed directly on a taxpayer (e.g., on the net income of the taxpayers foreign branch or foreign disregarded entity) or, in the case of a domestic corporation, indirectly on a taxpayer. If certain conditions are satisfied (including owning 10% or more of the foreign corporations voting stock), a domestic corporation receiving a dividend from a foreign corporation may claim an indirect FTC under Sec. 902; see also Sec. 960. Further, foreign withholding taxes may be imposed on certain income items, such as dividends, interest, rents and royalties, and they may be eligible for an FTC. However, the FTC has limits and restrictions, which can reduce its availability and potentially expose a U.S. taxpayer to double taxation.

IRS Challenges

Given the FTCs significance and its ability to drive down a U.S. multinationals effective tax rate, U.S. taxpayers have entered into certain arrangements designed to generate FTCs. The IRS and Congress have closely scrutinized such arrangements because of their perceived lack of economic substance outside of generating FTCs, especially when a taxpayer claims an FTC on withholding taxes on dividend income, but holds the underlying stock on which the dividend is paid for a relatively short period. For example, the IRS hotly contested two cases on the ground that the taxpayers underlying transaction had no economic substance or business purpose other than reducing taxes; see Compaq Computer Corp., 113 TC 214 (1999), revd, 277 F3d 778 (5th Cir. 2001), and IES Industries Inc., 253 F3d 350 (8th Cir. 2001).

In Compaq and IES, U.S. taxpayers claimed FTCs for foreign withholding taxes on dividends from a foreign corporation. In both cases, they had a brief investment in the foreign corporation evidenced by American Depository Receipts (ADRs). To offset a pre-existing capital gain, they purchased the ADRs and immediately sold them back to the seller, ex-dividend, resulting in capital losses. Both taxpayers in-curred a transaction fee from the ADR investment and received a dividend net of the applicable foreign withholding tax. They earned a pre-tax profit, claimed an FTC for the withholding taxes paid on the dividend and reported an after-tax profit.

The IRS challenged the transactions economic substance. In each case, the circuit court held for the taxpayer, determining that the taxpayer had a real (although small) economic risk, and that the transaction had economic substance. This was the case even though the taxpayer in Compaq did not perform a thorough risk investigation.

Curbing FTC Abuses

Congress responded to the perceived abuses concerning brief stockholding periods by enacting Sec. 901(k). Subject to certain exceptions and special rules, Sec. 901(k)(1) generally prevents taxpayers from claiming an FTC relating to a foreign withholding tax on a dividend, unless they hold the stock for more than 15 days during a 31-day period beginning on the date which is 15 days before the date on which such share becomes ex-dividend with respect to such dividend. Also, no FTC is allowed to the extent the taxpayer is under an obligation (whether pursuant to a short sale or otherwise) to make related payments on positions in substantially similar or related property. Sec. 901(k)(2) applies a rule similar to Sec. 901(k)(1) when taxes are deemed paid under Sec. 853, 902 or 960; Sec. 901(k)(3) applies special holding period rules to claim an FTC in the case of certain stock that has a preference with respect to dividends. However, the restrictions on claiming FTCs under Sec. 901(k) are limited to taxes associated with dividend income and technically do not address withholding taxes on other types of income or gain.

To address FTC abuses outside the dividend arena, Congress, as part of the American Jobs Creation Act of 2004, enacted Sec. 901(l) as the counterpart to Sec. 901(k). Sec. 901(l) contains many of the same features as Sec. 901(k) and is designed to prevent FTC manipulation in situations not specifically addressed by its counterpart. As with Sec. 901(k), Sec. 901(l) prevents taxpayers from purchasing FTCs by acquiring short-term ownership of property that generates income (other than dividends) or gain subject to a gross-basis foreign withholding tax.

Sec. 901(l)(1) provides the general rule that FTCs cannot be claimed for foreign withholding taxes imposed on any item of income (other than dividends) or gain with respect to any property if the recipient holds the property for 15 days or less during the 31-day period beginning 15 days before the right to receive payment arises, exclusive of periods during which the recipient is protected from risk of loss or is under an obligation (whether pursuant to a short sale or otherwise) to make related payments on positions in substantially similar or related property. Subject to a dealer exception in Sec. 901(l)(2), taxpayers generally cannot claim an FTC if Sec. 901(l)(1) applies.

However, Congress did recognize that legitimate business transactions that are not structured to manipulate the FTC, nevertheless, could get caught within the rules ambit. Thus, it added Sec. 901(l)(3), which gives the IRS authority to issue regulations providing that Sec. 901(l)(1) does not apply to property when such application is not necessary for Sec. 901(l) purposes. Recognizing that some transactions should be carved out of Sec. 901(l)(1)s general rule, the IRS and Treasury expressed their intent to exercise this authority over a very specific type of transaction by issuing Notice 2005-90.

Notice 2005-90

In the notice, the IRS and Treasury concluded that the application of Sec. 901(l) to foreign withholding taxes on payments in a back-to-back computer program licensing arrangement in the ordinary course of the licensors and licensees respective trades or businesses, is not necessary for Sec. 901(l) purposes, and they expect to issue regulations to that effect. This exception is effective for amounts paid or accrued after Nov. 21, 2004 (Sec. 901(l)s effective date).

Definitions: However, the term back-to-back computer program li-censing arrangement is defined narrowly as a transaction or series of transactions in which (1) a domestic corporation (the master licensor) transfers a copyright right in a computer program or a copy of the computer program (as defined in Regs. Sec. 1.861-18(c) and (f)) to a domestic corporation (the head li-censee); and (2) the head licensee transfers a copyright right in the computer program or a copy of the computer program to one or more of its affiliates, as permitted under the terms and conditions of the master license agreement, for use in computers and similar and related equipment manufactured and marketed by the affiliate (in the case of a transfer of a copyright right) or for the affiliates own use (in the case of a transfer of a copy of the computer program). The term affiliate for this purpose is any member of the head licensees affiliated group as defined in Sec. 1504(a), except that foreign corporations and Sec. 936 corporations meeting Sec. 1504(a)s ownership requirements also are included in the affiliated group.

Additionally, Notice 2005-90 provides guidance on the requirement that the back-to-back computer program licensing arrangement be in the ordinary course of the licensors and licensees respective trades or businesses. This requirement will be met if (1) the arrangement is consistent with normal business practices of the master licensor, independent of tax considerations, such as maintaining a centralized customer relationship with its licensee and minimizing administrative burdens and commercial risks; (2) the master licensor or one or more members of its affiliated group (as defined in Sec. 1504(a)) is regularly engaged in the business of selling, leasing or licensing computer programs; and (3) in the case of each transfer of a copyright right in the computer program or a copy of the computer program to an affiliate of the head licensee, when the payments with respect to such transfer are subject to foreign withholding taxes, the affiliate uses the copyright rights or the copy of the computer program in a trade or business within the meaning of Temp. Regs. Sec. 1.367(a)-2T(b)(2) and (5).

The following example from Notice 2005-90 illustrates the type of arrangement that would apparently qualify for the exception to Sec. 901(l)(1).

Example: Domestic corporation X licenses rights to a computer program (the master license agreement) to domestic corporation Y for use in computers and similar and related equipment that Y employs in connection with its business or that it manufactures and markets to customers. Y conducts its business operations through various domestic and foreign subsidiaries, sublicensing rights to Xs computer program to the subsidiaries as permitted under the terms of the master license agreement. X licenses the computer program to Y, rather than directly to each of Ys subsidiaries, because it wishes to (1) centralize its customer relationship with Y and minimize administrative burdens, (2) minimize its exposure to the credit risk and local risk of Ys foreign subsidiaries and (3) protect its rights in the computer program.

Pursuant to the master license agreement, Y makes payments to X when (1) Y or its subsidiaries reproduce the licensed computer program on computers and other equipment used by Y or its subsidiaries or (2) Y or its subsidiaries reproduce and distribute Xs computer program on computers and other equipment manufactured and marketed to customers by Y or its subsidiaries. Pursuant to the sublicense agreements, Ys subsidiaries make payments to Y when they reproduce Xs computer program on computers and other equipment that they use or when they reproduce and distribute Xs computer program on computers and other equipment that they manufacture and market to customers. Foreign gross-basis withholding taxes are imposed on the payments by Ys foreign subsidiaries to Y.

Conclusion

Although Notice 2005-90 provides relief to a specific factual scenario, it does not consider many other similar transactions not structured to manipulate the FTC. For instance, suppose a master licensor or head licensee is a foreign corporation instead of a domestic corporation, or the transaction involves one or more entities that are not corporations (e.g., partnerships). Should Sec. 901(l)(1) automatically apply to disallow the FTCs? Licensing arrangements, as well as other types of arrangements in which foreign withholding taxes may be paid, can be structured with many different types of entities in many different waysmany of which may not be the type of transaction to which Sec. 901(l)(1) should apply. Nevertheless, they technically would be outside the purview of Notice 2005-90s relief.

Recognizing that additional guidance may be necessary, the IRS and Treasury have requested comments on these types of issues, as well as on additional transactions that should be exempted from Sec. 901(l)(1) via Sec. 901(l)(3). Moreover, they have requested comments on certain terminology used in Sec. 901(k) and (l) (e.g., the terms related payments and positions in substantially similar or related property) and on how the regulations should address the effect of hedging transactions on the holding period and related payment rules of Sec. 901(k) and (l). Hopefully, additional guidance will be forthcoming, exempting other legitimate transactions not designed to manipulate the FTC.

From Joseph Calianno, MBA, J.D., LL.M., CPA, and Bill Zink, CPA, Washington, DC