IRS ISSUES FINAL REGS CLASSIFYING TRANSFERS OF COMPUTER PROGRAMS.

The Service has issued final regulations (T.D. 8785) that provide rules for classifying transactions involving computer programs. T.D. 8785 adopts, with modifications, the proposed regulations (REG-251520-96) published on November 13, 1996. (For a summary of REG-251520-96, see TaxPracitce, Nov. 18, 1996, p. 237.)

In response to comments, the final regs 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. Similarly, the regs also provide that income derived from the sale or exchange of a copyright right will be sourced under sections 865(a), 865(c), 865(d), 865(e), or 865(h), as appropriate, while 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.

The final regs provide 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. The regs also provide that distribution to the public does not include distribution to a related person. To reflect that change, the regs' examples were amended to clarify that the number of permitted users, including employees of the transferee, within the group of related persons isn't taken into account in determining whether the transferee has the right to distribute copies of the program to the public.

The examples in the final regs don't assume that the parties are unrelated. Rather, the Service notes, the regs are intended to apply to related and unrelated parties in the same manner.

The final regs no longer provide that know-how can't be copyrightable in order to be treated as know-how. Instead, the regs specify that they will treat the provision of information as the provision of know-how 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.

The final regs now indicate in Example 1 that the term "shrink wrap license" is merely illustrative and was not intended to create an inference that the regs apply only to mass-marketed software. The regs also specify how taxpayers can obtain automatic consent to a change in accounting method whenever they elect the regs' transition rules. Finally, the regs incorporate several changes suggested by commentators into their examples.

The Service notes that the final regs do not incorporate several suggestions offered by commentators. Rejected suggestions include expanding the regs' scope; treating transactions in copyright rights as transactions in intangibles and transactions in copyrighted articles as transactions in tangible property; clarifying that the regs don't affect determinations of whether a foreign tax imposed on transactions in computer programs is a compulsory payment eligible for a foreign tax credit; not treating the transfer of the right to prepare a derivative program as the transfer of a copyright right unless it is coupled with the right to distribute the derivative program to the public; specifying that the right to perform publicly 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 adopting a flexible definition for the term computer.

T.D. 8785 is effective October 2, 1998, and applies to transactions occurring under contracts entered into on or after December 1, 1998. Taxpayers may elect, however, to apply the regs to transactions occurring under contracts entered into in tax years ending on or after October 2, 1998. Taxpayers may also elect to apply the regs to transactions occurring in tax years ending on or after October 2, 1998, under contracts entered into before October 2, 1998, provided (1) the regs would not require them to change their method of accounting or (2) any required change in their accounting method would result in a section 481 adjustment of zero.

FULL TEXT: T.D. 8785; Doc 98-29281 (50 pages)