Classifying Computer Programs Under Reg. § 1.861-18

U.S. Treasury Regulation § 1.861-18 provides a framework for classifying transactions involving digital content for international tax purposes. The characterization of the income dictates how it is treated under various provisions of the Internal Revenue Code. The primary consequence of this classification is determining the source of the income, whether it is from U.S. or foreign sources. This distinction affects a company’s foreign tax credit limitations and potential withholding tax obligations on payments to foreign entities. The regulation ensures that the substance of a transaction, rather than its label, governs its tax treatment.

The Four Transaction Categories

The regulation establishes four categories for classifying transactions involving digital content like computer programs, books, and movies. This framework looks past labels that parties assign to a transaction, such as “license” or “sale,” and instead focuses on the economic substance of the exchange. Proper classification is the first step in determining the income’s character and source.

Transfer of a Copyright Right

A transaction is classified as a transfer of a copyright right when one or more rights protected by copyright law are transferred. These rights are separate from the ownership of a copy of the content. The recipient must acquire the ability to exploit the digital content in a way reserved for the owner. For example, a developer could sell all rights to an application to a tech firm, giving that firm the power to reproduce, modify, and distribute the program.

Transfer of a Copyrighted Article

This category represents the transfer of a copy of digital content where the recipient does not gain any underlying copyright rights. The buyer obtains the right to use the content for its intended purpose but cannot commercially exploit it. This covers most digital sales to end-users, such as an individual buying a movie or a company acquiring software licenses for its employees. The user can operate the program but cannot make copies for public sale or create new versions.

Provision of Services

A transaction is the provision of services when one party is paid for work in developing, modifying, or maintaining digital content for a client. The client owns the resulting copyright rights, and the developer acts as a contractor. For example, if a company hires programmers to build a custom system, the programmers are paid for their labor. The finished product and all copyright rights belong to the company.

Provision of Know-How

This category applies to transactions transferring information related to programming techniques or other processes considered trade secrets. The information must not be publicly known, must be furnished under conditions that prevent unauthorized disclosure, and must be protected as a trade secret. An example is a software architect licensing a proprietary algorithm to another company under a non-disclosure agreement. The value is in the secret, specialized knowledge being shared, not a finished product.

Distinguishing a Copyright Right from a Copyrighted Article

The distinction between the transfer of a copyright right and a copyrighted article depends on which specific rights a transferee receives. This classification is important because it dictates whether the resulting income is treated as a royalty or as proceeds from a sale. The substance of the rights transferred governs the outcome, not the terminology used by the parties in their agreement.

A transfer of a copyright right occurs if the recipient gains one or more specific abilities defined under copyright law. A primary right is the ability to make copies of the digital content for public distribution by sale, rental, lease, or lending. Another is the authority to prepare derivative works, which means the transferee can modify or adapt the original work to create a new version. The rights to make a public performance or to publicly display the content are also copyright rights.

If a transaction does not transfer any of these specific rights, it is classified as the transfer of a copyrighted article, which is a limited license for use. For instance, a business purchasing a 500-user software license is acquiring 500 copyrighted articles. The business can use the software internally but cannot sell copies, create modified versions for resale, or publicly perform its functions.

For example, a U.S. company granting a foreign distributor the right to modify a user interface and sell unlimited copies transfers a copyright right. The distributor acquired the right to prepare derivative works and make copies for public distribution. If that same foreign company purchased 1,000 standard copies to resell without modification, it would be a transfer of copyrighted articles.

Classifying Mixed and Cloud-Based Transactions

Modern transactions often bundle various elements or deliver functionality through the cloud. The regulation provides principles to address these complex scenarios.

Cloud Computing and SaaS

Software-as-a-Service (SaaS) and other cloud computing models are classified as the provision of a service. A customer obtains on-demand network access to a provider’s software but does not download or control the underlying program. The transaction is a service because the customer pays for a result—the use of a functioning application—rather than for possession or control of the software itself. Factors supporting this include the provider maintaining the software and the customer’s access being contingent on a subscription.

Bundled Transactions

Transactions often bundle digital content with elements like technical support or training. For these mixed transactions, a “predominant character” rule applies. If the other elements are of minor value compared to the digital content, the entire transaction is classified based on the primary component. For example, a $50,000 software license that includes support valued at $1,000 is treated entirely as the transfer of a copyrighted article.

If the other components are not insignificant, the transaction must be unbundled and each part classified separately. For instance, a company might pay $200,000 for a new enterprise resource planning (ERP) system. This fee could cover a $120,000 perpetual software license (a copyrighted article), $50,000 for on-site implementation services (a service), and a $30,000 fee for ongoing support (also a service). In this case, the income must be allocated among the different classifications.

Source of Income Rules

After a transaction is classified, the corresponding source of income rule is applied. This determines whether income is U.S. or foreign source, which is an important distinction for calculating foreign tax credits and withholding taxes. Each classification has a specific rule for sourcing the income.

Income from a Copyright Right or Know-How (Royalties)

Income from the transfer of a copyright right or the provision of know-how is characterized as a royalty. The source of royalty income is determined by the location where the licensee uses the intangible property. For example, if a U.S. company grants a German company the right to use its software in Germany, the royalty payments are foreign-source income.

Income from a Copyrighted Article (Sales)

Income from transferring a copyrighted article is treated as income from the sale of inventory. For electronically transferred articles, the income source is determined by the purchaser’s billing address. If a U.S. developer sells a program electronically to a customer in Canada, the income is foreign-source.

Income from Services

For transactions classified as providing services, the income source is determined by the location where the services are performed. If a U.S. company hires developers in India to create an app, payments to them are foreign-source income. For cloud transactions, the income source is determined by a multi-factor approach. This analysis considers the location of the provider’s intangible property, personnel, and tangible property.