Software Royalty Source and Withholding

In Field Service Advice (FSA) 200222011, the IRS concluded that royalties were entirely U.S. source and subject to withholding when paid by a domestic corporation that modified software in the U.S., then sublicensed it to a related manufacturer. Although the manufacturer sold products incorporating the modified software both within and outside of the U.S., the royalty was U.S. source, because the payor had used the software in the U.S. The IRS further concluded that even if the use rule did not apply, the royalties would be U.S. source, because it could not audit the taxpayers unreasonable allocation method.

Facts

Corp. B, a domestic corporation, and Corp. X, a foreign corporation, were the largest shareholders in Corp. Y, a foreign corporation. Y, which owned all of the shares of Corp. A, a domestic corporation, created computer-operating software in its home country and licensed to A exclusive worldwide rights (excluding Ys home-country rights) to sell, use, copy, manufacture or sublicense it. A immediately sublicensed its rights to B, a computer manufacturer. Both the license and sublicense agreements were for a one-year term, automatically renewable annually unless terminated by mutual agreement.

In the U.S., As employees modified the software to make it usable in U.S.-manufactured computers. Ys employees assisted, and A reimbursed Y. In addition, A may also have reproduced the modified software in the U.S. and transferred copies to B, but that was unclear.

B installed the sublicensed software into some of the computers it manufactured, which it then sold to third parties both within and outside of the U.S. When a customer purchased a computer with the software installed (pursuant to licensing and sublicensing agreements), B paid A a royalty; in turn, A paid one to Y.

The taxpayer sourced the royalties paid to Y based on Bs accounting of the number of sales in the U.S. and other jurisdictions.

Analysis

The IRS first concluded that A used (within the meaning of Sec. 861(a)(4)) the rights it had licensed solely within the U.S., because all of As activities as to the licensed software (e.g., modification, sublicense and possibly reproduction) occurred there.

It focused on the modification and reproduction activities, rather than on the location of the end-user of the copyrighted product, which apparently contradicts other published guidance in this area. For example, under Rev. Rul. 68-443, a royalty paid by a manufacturer of trademarked products sold to foreign customers was entirely foreign source, although manufacturing of the product incorporating the trademark took place in the U.S. In Rev. Rul. 72-232, a royalty paid for a copyright of a book sold exclusively in a foreign country, but printed in the U.S., was foreign source; in Rev. Rul. 84-78, amounts were foreign source when paid under both an exclusive and a nonexclusive license agreement, for the right to broadcast live in a foreign country a prize fight taking place in the U.S.

Further, because the location where the software was modified and similar activities took place was within the taxpayers control, FSA 200222011 may provide some basis for taxpayers to avoid U.S. withholding tax (and, possibly, to make similar arguments for purposes of the subpart F same-country exception).

Secondly, the IRS concluded that even if the royalties had to be sourced to the place of use, the taxpayer failed to establish a reasonable connection between Bs computer sales and the place of use of As software rights. It was unable to determine whether Bs list of sales locations was based on the customers situs, the place of sale or the location of the computers ultimate use; thus, it could not audit the allocation method.

The Service cited a number of older cases requiring taxpayers to establish an amount paid for the privilege of using a right in a foreign country, and not merely to show the percentage of the sales in the U.S. and abroad; see, e.g., Molnar, 156 F2d 924 (2d Cir. 1946); Rohmer, 153 F2d 61 (2d Cir. 1946); and Est. of Marton, 47 BTA 184 (1942). While these cases are still good law, their reach is not clear. A literal application of the principle they enunciate may put impossible burdens on taxpayers in todays economy. Thus, they should document (to the extent possible) the location of the softwares end-use.

From Lisa Askenazy Felix, J.D., LL.M., Washington, DC