Software Coalition Recommends Withdrawal of Foreign Tax Credit Regs

February 9, 2021

CC:PA:LPD:PR (REG–101657-20)
Room 5203
Internal Revenue Service
P.O. Box 7604
Ben Franklin Station
Washington, DC 20044

Re: Guidance Related to the Foreign Tax Credit REG-101657-20

Dear Sirs/Madams:

We are writing on behalf of the Software Coalition¹ to address certain aspects of the proposed regulations relating to the creditability of foreign taxes under sections 901 and 903 of the Code² (the “Proposed FTC Regulations”).³ In the preamble to the Proposed Regulations (the “Preamble”), Treasury and the Internal Revenue Service (the “IRS”) requested comments on all aspects of the Proposed FTC Regulations, including on specific aspects of Prop. Treas. Reg. §§ 1.901-2 and 1.903-1 (relating to the creditability of foreign taxes under sections 901 and 903).

We recognize and appreciate the considerable thought that underlies the Proposed FTC Regulations. Our comments address the extent to which the new jurisdictional nexus requirement (the “Jurisdictional Nexus Requirement”) may impact the treatment of common foreign taxes other than the recent unusual unilateral measures such as digital services taxes (“DSTs”), and on alternative approaches Treasury and the IRS may consider to achieve the policy objectives described in the Preamble to oppose the introduction of unilateral measures intended to discriminate against U.S. taxpayers.

The Software Coalition appreciates the opportunity to provide input on these important issues.

Executive Summary

The Jurisdictional Nexus Requirement as proposed will result in significant double taxation for many U.S. companies as many traditional, historically creditable taxes may fail to meet the new requirements for creditability, even though the motivation for the proposed change is to address certain more recent unilateral measures. This double taxation primarily occurs when foreign countries levy withholding taxes based on typical source rules based on location of payor, while the proposed rules would limit creditability based on unusual U.S. source rules, such as location of title transfer and place of performance of services. We sympathize with Treasury's policy goal to oppose the novel unilateral and extraterritorial taxes that have emerged since the conclusion of the BEPS project. The proposed rules, however, not only limit the creditability of the novel unilateral measures, but they would significantly curtail the ability of U.S. taxpayers to benefit from traditional, historically creditable, foreign taxes. Moreover, we believe that preventing U.S. taxpayers from obtaining double tax relief through the Jurisdictional Nexus Requirement will not motivate any foreign government to withdraw those new unilateral measures.

Accordingly, we suggest that the Proposed FTC Regulations should be withdrawn, or at least reproposed without the Jurisdictional Nexus Requirement. Treasury instead should actively advocate in all bilateral and multilateral forums to remove the novel unilateral and extraterritorial taxes which are the policy target of these Proposed FTC Regulations. If our main recommendation is not adopted, Treasury and the IRS should consider modifying the Jurisdictional Nexus Requirement in Prop. Treas. Reg. § 1.901-2(c) to acknowledge the long standing policies of many countries which impose withholding taxes on payments for services and digital goods and continue to allow credits for such taxes. We believe this alternative would also achieve Treasury's policy goals without inappropriately precluding double tax relief for many common taxes on cross-border transactions.

Discussion

1. Congress' Adoption of a Credit System in Sections 901 and 903

Starting in 1918 with the enactment of the Revenue Act of 1918, U.S. persons were allowed to credit foreign “income, war profits, and excess profits taxes” instead of deducting such taxes. This early statute became what is now section 901. The Revenue Act of 1942 expanded the foreign tax credit to include foreign taxes “paid in lieu of a tax upon income, war profits, or excess profits otherwise generally imposed” thus creating what is now section 903. Congress adopted the original versions of section 901 in 1918 and section 903 in 1942 to alleviate double taxation.

Treasury should allow the credit system to function as intended to relieve the burden of double taxation on U.S. companies by allowing a credit for those foreign income and in lieu of taxes which are common features of the international tax system.

Nothing in the statutory text of sections 901 and 903 nor in the legislative history underlying these sections provides a basis for the Jurisdictional Nexus Requirement as drafted in Prop. Treas. Reg. § 1.901-2(c). Section 901 simply states that a credit “shall be allowed [for] the amount of any income, war profits, and excess profits taxes paid or accrued during the taxable year to any foreign country” subject to the limitations of section 904.⁵ Section 903 is similarly straightforward and provides that “the term 'income, war profits, and excess profits taxes' shall include a tax paid in lieu of a tax on income, war profits, or excess profits otherwise generally imposed by any foreign country.” In cases where Congress wishes to exclude a particular type of tax from the scope of section 901, it has done so explicitly, such as in the case of the economic interest requirement in section 901(f). Sections 901 and 903 contain no language that supports the imposition of a jurisdictional nexus requirement on otherwise creditable foreign taxes.⁶

As discussed in further detail below, we believe the Jurisdictional Nexus Requirement would have the effect of frustrating Congress' intent to relieve double taxation by precluding credits for certain taxes that have been historically eligible for foreign tax credits. Accordingly, we believe that that the Jurisdictional Nexus Requirement does not represent a reasonable interpretation of the statute.

2. Principles Reflected in the Code Do Not Necessarily Represent Traditional International Tax Norms

The Preamble states that Treasury and the IRS “have determined that it is necessary and appropriate to require that a foreign tax conform to traditional international norms of taxing jurisdiction as reflected in the [Code] in order to qualify as an income tax in the U.S. sense, or as a tax in lieu of an income tax.”⁷ We do not believe that principles reflected in the Code uniquely represent “traditional international norms of taxing jurisdiction.” In fact, the United States' source rules are not aligned with a number of countries around the world. In particular, the U.S. source rule for payments for the purchase of services is unusual. Taxation at source based on the location of the payor has been a feature of the tax law of many countries for many years. Indeed, we believe that the long-standing existence of withholding taxes on services and royalties based on the location of the payor in many countries around the world indicate that such taxes are firmly within the boundaries of international tax norms.

3. Software Industry and Foreign Withholding Taxes

The software industry makes a substantial contribution to the United States economy. Software companies based in the United States employ a meaningful percentage of the country's technology workforce, which is one of the country's largest and fastest-growing workforces. The software industry accounts for a meaningful percentage of the United States' gross domestic product (“GDP”), by some accounts more than 10%.⁸ The software industry is also one of the United States' largest and most important exporters of goods and services around the world.

The software industry generally, and the Software Coalition specifically, has persistently advocated over more than 30 years with foreign tax administrations to resist calls to implement withholding tax regimes on payments for software and digital services. This advocacy has included participating in rulemaking processes, submitting comment letters in response to proposed legislation, and actively engaging in discussions with tax administrations about pro-growth tax policies that encourage and promote global investment by U.S. software companies.

Treasury and the IRS have opposed the spread of withholding tax regimes aimed at software transactions through the promulgation of the “Software Regulations” in Treas. Reg. § 1.861-18 and involvement with the OECD to revise the commentary to Article 12 (concerning the taxation of royalties) of the OECD Model Tax Convention on Income and on Capital to generally treat sales of software copies as business profits rather than royalties.

Despite these efforts, a significant number of jurisdictions around the world continue to impose withholding tax on cross-border payments for software and digital services supplied by U.S. companies. In some cases, this is because the jurisdiction imposes withholding tax on services. In other cases, it is because the jurisdiction characterizes payments for software as royalties, and imposes its royalty withholding tax on payments which would be characterized as payments for the sale of inventory property under U.S. law.

We expect that the incidence of such withholding taxes may increase, as the global economy continues to migrate towards a service economy, particularly in the case of software. As a consequence, long standing source-based taxes on cross-border payments for services and royalties are being applied to increasing volumes of export revenue earned by U.S. software companies. In most cases, these taxes have existed in the laws of the foreign countries for many years. U.S. software exporters have paid these taxes for many years where they have not been eliminated under a relevant tax treaty and generally have been eligible for a foreign tax credit.

In contrast, since the conclusion of the BEPS project, some countries have introduced unilateral measures which in most cases have been designed to tax revenue or profits of nonresidents which could not be taxed under the currently applicable rules of nexus and source. As such, these unilateral measures are normally designed with a view towards avoiding being covered by tax treaty rules on nexus and source. Additionally, via carefully designed scope definitions many of these taxes are designed to target U.S. exporters. The principal example of these unilateral measures is the DST.

We recognize and appreciate Treasury's continued efforts to oppose DSTs and other unilateral, extraterritorial measures intended to target U.S. companies. We support Treasury's opposition to these types of taxes through its continued involvement in various forums, including the OECD/Inclusive Framework (“IF”) project.

4. Comments on the Extent to which the Proposed FTC Regulations may Impact the Treatment of Longstanding Foreign Taxes on Services and Royalties

4.1 Impact on Exports of Digital Services by U.S. Software Companies

Digital services make up an important and growing subsector of the technology industry. An increasing amount of revenue flows for U.S. software companies is characterized as services, as confirmed by the proposed regulations relating to the classification of cloud transactions (the “Proposed Cloud Regulations”) which Treasury published on August 14, 2019. The COVID-19 crisis and its impact “reinforced cloud adoption to be the 'new normal'” and the extent to which spending on technology is expected to shift to cloud services in the near future is significant.⁹ The Proposed FTC Regulations will impede this growth of U.S. exports of cloud services.

The Proposed FTC Regulations will create unrelieved double taxation in essentially all cases where a U.S. exporter of digital services provides its services to a customer located in a country which imposes a withholding tax on payments for services to a nonresident. Where such a withholding tax applies, the Jurisdictional Nexus Requirement in Prop. Treas. Reg. § 1.901-2(c)(1)(ii) would deny a foreign tax credit for the U.S. digital services supplier because the foreign country would levy tax based on the location of the services recipient (i.e., the location of the foreign counterparty) while the proposed U.S. rules would grant a credit only if the foreign source rule was based on the place of performance of the services (i.e., the location of the U.S. supplier).

To show the extent of the double taxation which the Proposed FTC Regulations will create, we have noted just a few representative examples of transactions which are characterized as services and which are commonly provided by U.S. suppliers into foreign markets. Many of these examples are based on the Proposed Cloud Regulations. When Treasury eventually promulgates regulations providing guidance on the source of income for cloud transactions, we expect that those regulations would not source cloud services income to the service recipient.¹⁰ For purposes of each of the examples, unless otherwise indicated, Corp A is a domestic corporation and Corp B is a foreign corporation.

While our comments focus on the transaction types which are common for software and digital service providers, the issues we discuss in this letter are common to all providers of cross-border services.

In each of the transactions described below, the Proposed FTC Regulations will create unrelieved double taxation whenever the payments are subject to withholding tax under longstanding foreign law.

(a) Computing Capacity

In a typical computing capacity transaction, Corp A, which operates data centers on its premises in various locations, provides Corp B computing capacity on Corp A's servers in exchange for a monthly fee based on the amount of computing power utilized by Corp B.¹¹

(b) Access to Software Development Platform and Website Hosting

In a typical transaction for the provision of a software platform, Corp A provides Corp B a software platform that Corp B uses to develop and deploy websites with a range of features, including blogs, message boards, and other collaborative knowledge bases. The platform and the finished websites are hosted on servers owned by Corp A. Corp B pays Corp A a monthly fee for the platform and website hosting services.¹²

(c) Access to Online Software via an Application

In a typical transaction for the provision of a suite of online software accessed via a web browser or an application, Corp A provides Corp B word processing, spreadsheet, and presentation software and employees of Corp B access the software over the internet through a web browser or an application (“app”). To access the full functionality of the app, the device must be connected to the internet. Corp B pays a monthly fee based on the number of employees with access to the software.¹³

(d) Streaming Digital Content Using Third-Party Servers

In a typical transaction for the provision of online content, Corp A streams digital content in the form of videos and music to end-users from servers located in data centers owned and operated by a third party. Each end-user makes a payment of a monthly fee to Corp A for access to unlimited streaming video and music.¹⁴

(e) SaaS Reseller

In a SaaS reseller transaction, Corp A hosts a software application on its hardware platform and appoints Corp B as its foreign reseller. Customers of Corp B are able to access the software application through a web browser without downloading the applications. The Customers make a payment to Corp B in exchange for their access to the software application and Corp B pays Corp A for each contract it sells to its customers to access Corp A's software.

(f) Online Video Game Functionality

In a representative video game transaction, Corp A is the developer of online games and operates a platform that hosts the games. End-users purchase a monthly (or annual) subscription fee to access online multiplayer functionality of applicable games.

4.2 Disparate Impact due to Choice of Delivery Method for Software

In the software industry, software can be delivered in a number of ways, including on tangible media, via digital download, as a perpetual license, as a limited duration license, through a hosted environment, or licensed for market exploitation. These different delivery methods give rise to different revenue characterizations: sale or lease of inventory property; sale or license of intangible property; or the provision of services.

Despite the fact that these transactions are simply alternative approaches to commercializing the supplier's software the Proposed FTC Regulations would give rise to disparate results across these various delivery methods due to the nuances and peculiarities of the U.S. source rules as applied to those different categories of transactions. To illustrate the disparate impact that the Proposed FTC Regulations would have on these transactions, we have compared various transactions below.

(a) SaaS Delivery v. Lease/License

As discussed above in Section 4.1(c), a typical SaaS transaction would be classified as a provision of services under Prop. Treas. Reg. § 1.861-19(c)(1). If a foreign jurisdiction were to impose withholding tax on this SaaS transaction, the tax would apparently not be eligible for a foreign tax credit under the Proposed FTC Regulations because the foreign country's imposition of withholding tax on the payment for services would be sourced to the location of the services recipient (i.e., the location of non-U.S. users) instead of the place of performance of the services (i.e., the location of the domestic SaaS provider).¹⁵

In contrast, a withholding tax imposed on payments for a limited duration license would be creditable under the Proposed FTC Regulations, because under U.S. law that income item is sourced to the location of the property, even though the limited duration license and the SaaS subscription gave access to software with similar functionality.

To demonstrate this comparison, assume Corp A (a US company) grants a limited duration license to enterprise software to Corp B, which is located outside the United States. Under U.S. source rules, the source of income from limited duration licenses is determined based on the location of the property. For copies of the software that users download outside the United States, Corp A's income should have a foreign source. Accordingly, in any case where the payment by Corp B to Corp A (a U.S. resident) is subject to withholding tax, the foreign tax law's source rule matches the Code's source rule and the tax would be eligible for a foreign tax credit under the Proposed FTC Regulations.

Therefore, under the Proposed FTC Regulations, a typical SaaS transaction and a typical limited duration license transaction give rise to different treatments only because the software supplier uses different commercialization methods. These are two different ways to deliver software functionality to users, but the U.S. source rules are diametrically opposite. The Proposed FTC Regulations would apply differently to these two types of transactions without any policy justification for such disparate treatment.

Indeed, this disparate treatment creates disincentives for U.S. companies considering adopting the more efficient SaaS delivery method. U.S. companies are required to choose between a more economically efficient SaaS distribution method or a lower tax cost.

(b) Software Production Activities Inside the United States v. Outside the United States

The Proposed FTC Regulations combined with section 863(b) may uniquely disadvantage software companies that produce their software products in the United States. In particular, section 863(b) generally provides that the source of income derived from the sale of inventory property is determined with reference solely to the location of production activities, without regard to where title passage occurs. Therefore, U.S. software companies that produce software entirely within the United States and that sell copies of that software outside the United States will have only U.S.-source income. In this scenario, if the sales are made into any of the number of countries that impose withholding tax on software transactions which would be characterized as sales of inventory property under U.S. law (e.g., Argentina, Brazil, Greece, India, Thailand, among many others), that withholding tax may not be creditable under Prop. Treas. Reg. § 1.901-2(c)(1)(ii) because the sourcing rules of the foreign tax law may not be “reasonably similar” to the sourcing rules that apply for US Federal income tax purposes. Accordingly, Prop. Treas. Reg. § 1.901-2(c)(1)(ii) apparently will create substantial double taxation for U.S. software exporters which produce their software in the United States.

Again, the effect of the Jurisdictional Nexus Requirement is to disincentivize a U.S. company from maintaining their production servers in the U.S. U.S. companies are required to choose between investing in U.S.-based production and U.S. jobs or a lower tax cost.

(c) Anomalies Based on Delivery Models via Tangible Media or Digital Download

The Proposed FTC Regulations also may create different results for certain sales of software copies delivered on tangible media compared to copies delivered via digital download, even though these transactions both deliver exactly the same object code copy to the user. If the software is not produced in the United States under section 863(b), then the “title passage” rule of Treas. Reg. § 1.861-7(c) applies to determine the source of income.

For sales of software copies delivered on physical media, the title passage rule normally would be applied by reference to the location of passage of risk of loss of the physical medium on which the software program is carried. If risk of loss passes in the United States, then the income is U.S. source. If title passes outside the United States, then the income is foreign source. Accordingly, if the sales revenue is subject to foreign withholding tax, whether the tax would be creditable apparently would depend on whether risk of loss of the physical medium passes inside or outside the United States. As a practical matter, there is little commercial significance in the software industry as to where title to the medium passes. There is no good policy reason to make that distinction determine whether a foreign withholding tax is creditable.

Further unwarranted distinctions may arise between deliveries on tangible media and digital deliveries. If Prop. Treas. Reg. § 1.861-18(f)(2)(ii) is finalized as proposed, the sale of a copyrighted article transferred through an electronic medium is deemed to have occurred at the location of download or installation, while sales of copies on tangible media would continue to be governed by the title passage rule. Accordingly, if there is withholding tax on such transactions, there would be a match between the U.S. source rules and the foreign source rules for all digital downloads (i.e., income from the transaction would likely be considered foreign source income under both U.S. and foreign source rules). In contrast, deliveries on tangible media may or may not result in a similar source result depending on whether risk of loss to the tangible media passes inside or outside the U.S.

If Prop. Treas. Reg. § 1.861-18(f)(2)(ii) is not implemented and the title-passage rule continues to apply to digital deliveries, then different treatments may arise according to whether the software provider makes copies available from a U.S. or a foreign server. Under the title-passage rule as applied to digital deliveries, under typical commercial practice title would be deemed to pass at the location where the U.S. software company makes the software copy available for download by the user. If the software copy is hosted on servers located in the United States, digital downloads of the software copies by foreign customers may give rise to U.S. source income, but downloads of copies hosted on foreign servers would give rise to foreign source income. Accordingly, there would be a mismatch between the U.S. source rules and the source rules in a number of jurisdictions around the world for downloads from U.S. servers but not for downloads from foreign servers. This distinction should not be the basis for causing the U.S. exporter to be ineligible for foreign tax credits.

5. Alternative Approaches to Address the Challenges of Unilateral Measures

Despite our concerns with the effect of the Proposed FTC Regulations on software transactions, we completely agree with the stated purpose to address the challenges of proliferating unilateral measures that target U.S. companies. We believe that these new taxes are unfair, unreasonable and discriminate against U.S. companies, including members of the Software Coalition. That said, we do not think that the most appropriate approach to opposing those taxes is to condition creditability on whether the source and nexus rules of foreign law mirror the Code. As drafted, the Proposed FTC Regulations are more likely to impose double taxation on U.S. taxpayers than they are to deter foreign governments from moving forward with adopting these unilateral, extraterritorial taxes. Additionally, the Proposed FTC Regulations provide U.S. companies tax incentives to postpone adopting modern delivery methods and incentivize the movement of production services and facilities offshore.

For this reason, we recommend that the Proposed FTC Regulations should be withdrawn, or at least the Jurisdictional Nexus Requirement should be removed. Treasury instead should continue to advocate in bilateral and multilateral forums to remove these taxes. If Treasury does not withdraw the proposed regulations entirely, Treasury and the IRS should consider modifying the Jurisdictional Nexus Requirement in Prop. Treas. Reg. § 1.901-2(c) to acknowledge the long standing policies in many countries to impose withholding taxes on payments for services and digital goods.

5.1 Focus Advocacy in Appropriate Forums

We firmly support Treasury continuing to be a vocal leader in the OECD/IF negotiations with the goal of achieving a fair result for U.S. taxpayers and convincing countries to withdraw all relevant unilateral measures. Treasury also should play an active role in other multilateral organizations such as the UN Committee of Experts to oppose the introduction of taxes that are focused principally on U.S. companies (e.g., proposed Article 12B of the UN Model Tax Convention, which would allow withholding tax on all payments for digital services).

Treasury also should act to oppose these taxes in all relevant bilateral contexts. Treasury should prioritize its review and negotiation of new or updated tax treaties with foreign countries that have imposed unilateral measures. The U.S. government also should prioritize these issues through trade negotiations. For example, the U.S. has opportunities to consider the withdrawal of unilateral measures in negotiations with the U.K. for a post-Brexit trade agreement and with Kenya in the upcoming free trade agreement negotiations.¹⁶

Denying a foreign credit to U.S. taxpayers on payments for exported services and digital goods is not likely to dissuade foreign governments from adopting the “novel extraterritorial foreign taxes” referred to in the Preamble. Although the Software Coalition fully agrees that these “novel extraterritorial foreign taxes” are poor tax policy choices and will disproportionately affect U.S. taxpayers, we believe Treasury's principal focus should be on actively pursuing those actions via bilateral relationships or in multilateral organizations which might realistically lead to the removal or mitigation of these novel foreign taxes.

We believe that the United States' foreign tax credit system in sections 901 and 903 should apply neutrally and equitably to all taxpayers to achieve the intended purpose of relief from double taxation for U.S. taxpayers. At the time that Congress adopted these sections, it had the choice to adopt either an exemption or credit system. Congress chose a credit system. Once Congress chose a credit system, Treasury should allow the system to work as intended to relieve double taxation for all foreign taxes normally and historically recognized as income taxes or withholding taxes. The foreign tax credit rules should recognize that capital importing and less economically developed countries may follow a different set of tax policy goals than the United States, which differences are frequently reflected in a greater reliance on source-based taxation. Those differences in tax policy goals are very much part of historical tax norms.

5.2 Changes to the Jurisdictional Nexus Requirement

If the Jurisdictional Nexus Requirement is not ultimately removed, we recommend that it should be revised to take into account the current, and long-standing, laws in many countries which impose withholding taxes on payments for digital services and goods.

(a) Foreign Taxes Imposed on Payments for Services Should be Excluded from the Jurisdictional Nexus Requirement

As discussed above, a number of countries impose withholding taxes on payments made by residents in exchange for certain (or all) services. These taxes have existed in the international framework for many years, and are clearly creditable taxes under the current regulations. The Proposed FTC Regulations would completely reverse the creditability of these taxes, despite the longevity of the current regulations.

Example 3 of Treas. Reg. § 1.903-1(b)(3) acknowledges that these taxes are a normal part of the international tax system and expressly allows a credit for these taxes. Specifically, Example 3 describes a case in which country X imposes a tax on realized net income that is generally imposed on residents. Nonresidents are subject to a gross income tax that is collected through withholding and which applies to payments for technical services performed outside country X. This Example concludes this transaction is eligible for a foreign tax credit even though the services are not performed in the payor country.¹⁷ It appears that the result of Example 3 will be reversed by the proposed regulations. Reversing the result of Example 3 will cause unrelieved double taxation on a variety of exported services.

As discussed above, the global economy's shift toward a service economy is bringing to the fore the importance of cross-border services, particularly those provided by U.S. companies. Software Coalition members and other U.S. taxpayers from many sectors are subject to withholding taxes in a number of countries on payments for services. These withholding taxes are imposed separately from DSTs and other unilateral measures.

Accordingly, at a minimum we suggest that the Jurisdictional Nexus Requirement should be revised to exclude payments characterized as services from the requirements of Prop. Treas.Reg. § 1.903-1(c)(2)(iii). Taxes imposed on service fees would remain subject to all other eligibility criteria.

The concept underlying the Jurisdictional Nexus Requirement is that the source and nexus rules of foreign law should mirror the Code. The U.S. source and nexus rules do not, however, follow the majority approach around the world in certain respects.

The U.S. rule for determining nexus for gross-based withholding taxes on services cannot be regarded as the typical rule internationally. Many countries impose withholding taxes on payments for services. The UN Model Tax Convention continues to allow for withholding taxes on a variety of service fees,¹⁸ and it should not be Treasury's policy to deny eligibility for foreign tax credits on taxes that are explicitly provided in the model tax conventions upon which many bilateral tax treaties are based.

Governments which enact these taxes justify the tax on the basis of addressing base erosion through fees which extract profits from the market. For decades, this has been regarded as an acceptable tax nexus policy, even though OECD countries have endeavored to remove withholding taxes on transactions among themselves for economic efficiency purposes. For the most part, withholding taxes on software transactions and digital services transactions are not new taxes; they are old taxes that now apply to a larger volume of cross-border transactions.

Destination based principles present elsewhere in U.S. Federal income tax law support the point that source rules which impose tax by reference to the location of the service recipient are consistent with accepted international tax norms. For instance, Treas. Reg. § 1.250(b)-4(d)(1)(ii)(D) provides that a sale of general property that primarily contains digital content is for a foreign use if the end user downloads, installs, receives, or accesses the purchased digital content on the end user's device outside the United States. As discussed in other contexts above, Prop. Treas. Reg. § 1.861-18(f)(2)(ii) provides that when a copyrighted article is sold and transferred through an electronic medium, the sale is deemed to have occurred at the location of download or installation onto the end-user's device used to access the digital content for purposes of Treas. Reg. § 1.861-7(c), and in the absence of information about the location of download or installation onto the end-user's device, the sale will be deemed to have occurred at the location of the customer. These rules reflect a conclusion under U.S. law that for at least some purposes, the income may arise at the customer's location. That same conclusion is the policy basis of foreign withholding taxes on service revenue.

Accordingly, to prevent the Proposed FTC Regulations from an overbroad application, Treasury and the IRS should acknowledge that the domestic laws of a number of countries include these types of taxes, and that these types of taxes are consistent with traditional norms of international taxing jurisdiction. One possible solution to implement this point would be to exclude payments for services from the application of the source requirement in Prop. Treas. Reg. § 1.903-1(c)(2)(iii).

(b) Foreign Taxes Imposed on Payments for Digital Goods Should be Excluded from the Jurisdictional Nexus Requirement

In addition to our recommendation above relating to the treatment of foreign withholding taxes on payments for services, the Coalition recommends that the Proposed FTC Regulations exclude payments classified as transfers of copyrighted articles under Treas. Reg. § 1.861-18(c)(3) from the requirements of Prop. Treas. Reg. § 1.903-1(c)(2)(iii).

Sales of software copies for perpetual use constitute a sale of copyrighted articles as defined in Treas. Reg. § 1.861-18(c)(3). It is not the case that the tax laws of all countries conform to or apply the classification principles of the Software Regulations. In many cases, foreign law would classify as royalties payments made by residents to nonresident providers of software or other digital content. As discussed above in Section 4.1, the current U.S. source rules would classify many payments to U.S. software companies for purchases of copyrighted articles as giving rise to U.S. source income. In other words, there is likely to be a mismatch in many cases between the foreign tax law and U.S. tax law source rules for sales of copyrighted articles. This is an unusual circumstance arising due to the difference between U.S. and foreign law in classification principles relating to digital goods. To address this anomaly, and to ensure that U.S. software suppliers are able to avoid unrelieved double taxation due to these withholding taxes, we suggest that payments for purchases of digital content as defined in Prop. Treas. Reg. § 1.861-18(a)(3) not be subject to the source requirement of Prop. Treas. Reg. § 1.903-1(c)(2)(iii).

6. OECD/IF Involvement

As noted above, the Coalition fully supports Treasury's involvement in the Pillar 1 and 2 project. We encourage Treasury to continue its strong leadership in the upcoming discussions to ensure the removal of all relevant unilateral measures. We also endorse the statement in the Preamble that if an agreement is reached that includes the United States as part of the OECD/IF project, Treasury will amend the regulations under sections 901 and 903 as necessary. We believe that any taxing right allowed under the IF project should be considered eligible for foreign tax credits under U.S. law.

* * *

We would be pleased to answer any questions you may have regarding the topics raised in this letter. The Software Coalition is grateful for the opportunity to provide comments on the Proposed FTC Regulations, and we hope that the above comments will be taken into account in further consideration of the Proposed FTC Regulations.

In addition, the Coalition requests the opportunity to testify at the public hearing regarding the Proposed FTC Regulations (REG-101657-20). The statements at the hearing will relate to the comments submitted in this letter, and other topics pertinent to the proposed regulations.

Sincerely,

Gary D. Sprague
Partner
(650) 856-5510

Rafic H. Barrage
Partner
(202) 452-7090

Steven Smith
Associate
(415) 984-3818

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Appendix A

Software Coalition Members

Adobe Inc.
Amazon.com, Inc.
Autodesk, Inc.
BMC Software, Inc.
Broadcom Inc.
Cisco Systems, Inc.
Electronic Arts Inc.
Dell/EMC
Facebook, Inc.
GE Digital
Mentor Graphics Corporation
Microsoft Corporation
NortonLifeLock, Inc.
Nuance Communications, Inc.
Oracle Corporation
Palo Alto Networks, Inc.
Parametric Technology Corporation
Pivotal Software, Inc.
ResMed Inc.
Salesforce.com, Inc.
SAP America, Inc.
Synopsys, Inc.
VMware, Inc.