Classification of Certain Transactions Involving Computer Programs

DEPARTMENT OF THE TREASURY
Internal Revenue Service 26 CFR Parts 1 and 602 [TD 8785] RIN 1545-
AU70

TITLE: Classification of Certain Transactions Involving Computer
Programs

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

SUMMARY: This document contains regulations relating to the tax
treatment of certain transactions involving the transfer of computer
programs. The regulations provide rules for classifying such
transactions as sales or licenses of copyright rights, sales or
leases of copyrighted articles, or the provision of services, or of
know-how, under certain provisions of the Internal Revenue Code and
tax treaties. These regulations are necessary to give taxpayers
guidance on the taxation of computer program transactions. These
regulations affect taxpayers engaging in certain transactions
involving computer programs.

DATES: Effective date. These regulations are effective October 2,
1998.

Applicability date. These regulations apply to transactions
occurring pursuant to contracts entered into on or after December 1,
1998. Taxpayers may elect to apply this section to transactions
occurring pursuant to contracts entered into in taxable years ending
on or after October 2, 1998. Taxpayers may also elect to apply this
section to transactions occurring in taxable years ending on or
after October 2, 1998, pursuant to contracts entered into before
October 2, 1998, provided the taxpayer would not be required under
this section to change its method of accounting, or the taxpayer
would be required to change its method of accounting but the
resulting section 481 adjustment would be zero.

FOR FURTHER INFORMATION CONTACT: Anne Shelburne, (202) 874-1305 (not
a toll-free number).

SUPPLEMENTARY INFORMATION:

Paperwork Reduction Act

The collection of information in this final rule has been reviewed
and, pending receipt and evaluation of public comments, approved by
the Office of Management and Budget (OMB) under the Paperwork
Reduction Act (44 U.S.C. 3507) and assigned control number
1545-1594. An agency may not conduct or sponsor, and a person is not
required to respond to, a collection of information unless the
collection of information displays a valid control number assigned
by OMB.

The collection of information in this regulation is in §1.861-18(k)
of the regulations. This information is required to permit taxpayers
to obtain an automatic change in method of accounting. This
information will be used to enable the IRS to determine if taxpayers
were entitled to an automatic change in method of accounting. The
likely respondents are organizations.

Comments concerning the collection of information should be directed
to OMB, Attention: Desk Officer for the Department of the Treasury,
Office of Information and Regulatory Affairs, Washington, DC 20503,
with copies to the Internal Revenue Service, Attn: IRS Reports
Clearance Officer, OP:FS:FP, Washington, DC 20224. Any such comments
should be submitted not later than December 1, 1998. Comments are
specifically requested concerning:

Whether the collection of information is necessary for the proper
performance of the functions of the IRS, including whether the
information will have practical utility;

The accuracy of the estimated burden associated with the collection
of information (see below);

How to enhance the quality, utility, and clarity of the information
collected;

How to minimize the burden of complying with the collection of
information, including the application of automated collection
techniques or other forms of information technology; and Estimates
of capital or start-up costs and costs of operation, maintenance,
and purchase of services to provide information.

The burden per respondent is reflected in the burden of Form 3115.

Books or records relating to this collection of information must be
retained as long as their contents may become material in the
administration of any internal revenue law. Generally, tax returns
and tax return information are confidential, as required by 26
U.S.C. 6103.

Background

This document contains final regulations to be added to the Income
Tax Regulations (26 CFR part 1) under section 861 of the Internal
Revenue Code (Code). These regulations clarify the treatment under
certain provisions of the Code and tax treaties of income from
transactions involving computer programs.

On November 13, 1996, proposed regulations [REG-251520-96] were
published in the Federal Register (61 FR 58152). The IRS received
written comments on the proposed regulations and held a public
hearing on March 19, 1997. Having considered the comments and the
statements made at the hearing, the IRS and Treasury Department
adopt the proposed regulations as modified by this Treasury
decision. The comments and revisions are discussed below.

I. The Proposed Regulations

The proposed regulations clarify certain rules for classifying
transactions involving computer programs. The regulations generally
require that a transaction involving a computer program be treated
as being within one of four possible categories: (1) transfer of
copyright rights, (2) transfer of a copyrighted article, (3)
provision of services relating to development or modification of a
computer program, or (4) provision of know-how relating to computer
programming techniques.

The regulations distinguish between transfers of copyright rights
and transfers of copyrighted articles based on the type of rights
transferred to the transferee. They recognize that computer programs
are subject to copyright protection under both U.S. and foreign
copyright law. See the Copyright Act of 1976, as amended (17 U.S.C.
101 et. seq.); see also, EC Directive on Legal Protection of
Computer Programs, Council Directive 91-250, 1991 J.O. (L 122), and
the Berne Convention for the Capital Protection of Literary and
Artistic Works, 25 U.S.T. 1341 (Paris Text, July 24, 1971).
Copyright law grants certain exclusive rights to a copyright owner.
The regulations classify a transaction as the transfer of a
copyright right if the transferee acquires one or more of the
copyright rights identified in §1.861-18(c)(2) of the proposed
regulations. If the transferee acquires a copy of a computer program
but does not acquire any of the rights identified in §1.861-18(c)
(2), the regulations classify the transaction as the transfer of a
copyrighted article.

The proposed regulations further classify transfers of copyright
rights as either a sale or a license of copyright rights. The
proposed regulations require that this classification be made by
examining whether, taking into account all facts and circumstances,
all substantial rights in the copyright have passed to the
transferee. The proposed regulations also require that transfers of
copyrighted articles be further classified as either a sale or a
lease of a copyrighted article. This classification is made by
examining whether the benefits and burdens of ownership of the
copyrighted article have passed to the transferee. The specific
rules of the proposed regulations are based on certain key
principles: that the special features of computer programs should be
recognized and that functionally equivalent transactions should be
treated similarly. The regulations are also based on the principle
that copyright law should be a factor in classifying transactions
for tax purposes, but should not be determinative.

Finally, the proposed regulations contain 18 examples illustrating
the rules.

II. Comments and Final Regulations.

1. Scope and Application of the Regulations.

a. General Scope.

The proposed regulations classify transactions in computer programs
for certain international provisions of the Code. A number of
comments addressed two types of issues involving the scope of the
regulations: the treatment of computer programs under other tax
provisions of the Code and the application of the principles of the
proposed regulations to products other than computer programs.

As to the treatment of computer programs under other Code sections,
comments were mixed. Several commentators requested that Treasury
expand the scope of the final regulations to apply the regulations'
principles for all U.S. tax purposes. Other commentators, however,
urged caution, stating that issues raised under other Code sections
should be resolved only by legislation or by revising the
regulations under those other sections. Most commentators
recommended applying the regulations for tax accounting purposes.

Some commentators requested that Treasury specifically address the
relevance of the regulations in a specific context.

For example, some commentators requested that the regulations
clarify how the principles apply in determining the consequences of
computer program transactions under tax treaties.

After consideration of these comments, the final regulations retain
the scope of the proposed regulations. However, Treasury and the IRS
are considering whether the principles of these regulations should
apply to other tax provisions of the Code.

These regulations are intended to apply for purposes of applying and
interpreting U.S. tax treaties. United States tax treaties provide
that terms not defined in the treaty are defined by reference to
domestic law. See e.g., U.S. Model Income Tax Convention of
September 20, 1996, Article 3(2).

The second group of comments generally addressed expanding the scope
of the regulations to apply to transactions in other types of
digitized information. The proposed regulations are limited to
classifying transactions in computer programs.

Section 1.861-18(a)(3) of the proposed regulations defines a
computer program as "...a set of statements or instructions to be
used directly or indirectly in a computer in order to bring about a
certain result." The definition includes any data base or similar
item only "...if the data base or similar item is incidental to the
operation of the computer program." Commentators expressed differing
views as to how to define computer programs. Several commentators
recommended that the definition be expanded to include data bases
and content provided as part of the transaction. They note that
advances in technology now permit significant amounts of content,
that are not merely incidental, to be included in even inexpensive
mass-marketed programs. Some commentators recommended that the
definition be expanded to include data bases or similar items even
if not incidental, while some stated that data base products
containing only a de minimis amount of software programming to
facilitate access to the data should be excluded from the
definition.

Several commentators requested that Treasury expand the regulations
more generally, by applying the same or analogous principles in
determining the tax consequences of transactions involving copyright
rights and copyrighted articles to entertainment products, or to
other digitized information.

The suggestions to expand the scope of the regulations, either by
expanding the definition of computer programs or by applying the
regulations to other types of digitized information, were not
adopted. Instead, the final regulations generally retain the
definition of computer programs found in the proposed regulations.
It is intended that a computer program includes any media, user
manuals or documentation, or similar items (in addition to data
bases) if incidental to and routinely transferred along with the
computer program. Treasury and the IRS are not aware of specific
instances where the failure to expand the definition of computer
program would result in inappropriate consequences to taxpayers for
the portion of the transaction not governed by these regulations.
Treasury and the IRS invite comments on this point.

The regulations also continue to apply only to cross-border
transactions involving computer programs because Treasury and the
IRS believe that such transactions raise the most pressing need for
guidance. Treasury and the IRS may consider whether to apply the
principles of these regulations to all transactions in digitized
information as part of a separate guidance project.

b. Relationship with Section 482.

Numerous commentators requested clarification regarding the
application of the regulations for purposes of section 482,
requesting that transactions in copyright rights be treated as
transactions in intangibles and transactions in copyrighted articles
be treated as transactions in tangible property, even if delivered
electronically.

This suggestion has not been adopted. Treasury and the IRS intend to
further consider this issue and may provide additional guidance in
the future. See generally, §1.482-3(f).

c. Source of Income.

Several commentators requested that Treasury provide explicit
guidance in final regulations on how to source income arising from
transactions in computer programs. Generally, under the current
rules, the source of income from sales of property depends to
varying extents upon both the type of property and, for inventory
property, the place of sale, with the place of sale generally
determined by the place where title to the property passes. See
§1.861-7(c). Several commentators requested clarification of which
source rule applies to various transactions in computer programs.
The commentators also pointed out that the place of sale can be
problematic when dealing with sales of computer programs, in part
because typical license agreements do not refer to a transfer of
property, and in part because an electronic transfer is generally
not accompanied by the usual indicia of the transfer of title.
Several commentators suggested that the place of sale should be
deemed to be the location of the customer, or the place where the
customer first obtains the opportunity to install the program onto
its computer.

In response to comments, the final regulations provide specific
source rules. The regulations 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. 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. 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. As to
the issue of determining the place of sale under the title passage
rule of §1.861-7(c), the parties in many cases can agree on where
title passes for sales of inventory property generally.

Consistent with the overall policy of the regulations, income from
electronic transfers of computer programs that constitute inventory
property, classified as sales of copyrighted articles, will be
sourced under similar principles.

2. Relevance of Foreign Law.

Several commentators requested that Treasury clarify that
classification of a transaction involving computer programs for U.S.
tax purposes does not depend on foreign copyright law. In addition,
one commentator requested that the regulations explicitly state that
the terms used in the regulations, although taken from copyright
law, will be interpreted in a manner consistent with the purposes of
the regulations and Internal Revenue Code. In certain cases, terms
taken from copyright law are specifically defined in the regulations
so as to properly implement the regulations' underlying policy.
Unless specifically defined in the regulations, legal standards
taken from copyright law are intended to be given the same
interpretation as under U.S. copyright law. Factual predicates for
application of those standards, however, may be provided by
referring to foreign copyright law. For example, if it were
necessary to determine whether the transferee had acquired the right
to create a derivative work based on a computer program protected
under French copyright law, the facts of the case, i.e.

the rights that the transferee may exercise, are determined under
French law and the agreement between the parties. However, whether
or not the transferee's rights constitute the right to create a
derivative work for purposes of this regulation is determined by
comparing those rights created under French law and the agreement
between the parties to the U.S. law definition of the right to
create a derivative work.

In addition, commentators requested clarification that the
determination of whether a foreign tax imposed on transactions in
computer programs is a compulsory payment, eligible for a foreign
tax credit, is not affected by these regulations. Treasury believes
clarification is unnecessary. These regulations do not in any way
modify the requirement of §1.901-2(e)(5) that substantive and
procedural provisions of foreign law (including applicable tax
treaties) determine the taxpayer's liability under foreign law for
tax and thus whether an amount paid is a compulsory payment.
Moreover, the regulations under section 904 recognize that a
creditable foreign tax may be imposed on an item of income that is
taxed at a different time or in a different manner in a foreign
country than in the United States. See §1.904-6(a)(1).

3. Copyright Rights.

The proposed regulations, in §1.861-18(c)(2), describe four
copyright rights: (i) the right to make copies for distribution to
the public, (ii) the right to prepare derivative programs, (iii) the
right to make a public performance of the program, and (iv) the
right to publicly display the program. If a transfer of a computer
program results in a transferee acquiring any one or more of the
four listed rights, the regulations classify the transaction as a
transfer of a copyright right. Although the commentators agreed that
the right to make copies for distribution to the public is properly
included, they made a number of comments regarding the three other
copyright rights.

a. Derivative Programs.

Commentators stated that final regulations should clarify the right
to prepare derivative programs. They recommended that the
regulations more specifically describe the circumstances resulting
in the transfer of such a copyright right.

Some commentators recommended that a transfer of the right to
prepare a derivative program should not be treated as the transfer
of a copyright right unless it is coupled with the right to
distribute the derivative program to the public. That change, they
say, would make the right more consistent with the right to
reproduce copies, which results in the transfer of a copyright right
only if it is coupled with the right to distribute to the public.

The final regulations do not adopt this recommendation.

Although the final regulations disregard the de minimis right to
make a derivative work, a substantial right to make a derivative
work is appropriately treated as the transfer of a copyright right,
regardless of whether it is coupled with the right to distribute to
the public. The regulations generally follow copyright law in this
respect. Although the right to make copies constitutes the transfer
of a copyright right only if coupled with the right to distribute to
the public, the regulations treat the right to make copies
differently from the other copyright rights because of the unique
characteristics of computer programs, including the ease by which
computer programs can be copied.

Another set of comments requests clarification of the effect of the
transfer of programs that permit the user to distribute certain
ancillary programs in conjunction with works created using the
underlying program, or to incorporate certain program elements into
new programs created using the underlying program.

For example, certain programs, such as software development tools,
permit the transferee to distribute certain ancillary programs or
include certain segments of computer code in new programs created by
the transferee using the development program.

Similarly, transferees of computer programs are sometimes granted
access to the program's source code in order to permit the
transferee to correct minor errors or incompatibilities in the
program.

Under the proposed regulations, the transfer of a software
development tool or the grant of the right to correct minor errors
by modifying the source code might constitute the right to create a
derivative computer program, resulting in the transfer of a
copyright right. Commentators argued, however, that in both cases,
the overall character of the transaction was analogous to the
transfer of a copyrighted article. Several commentators recommended
that where limited portions of a development tool are included in an
application program, the inclusion should be considered de minimis,
and the resulting application program not treated as a derivative
program of the program development tool.

In addition, several commentators recommended that where no
independent value attaches to exploitation of the right to prepare
derivative computer programs, such right should be treated as de
minimis, and not considered in classifying the transaction.

In response to these comments, the final regulations provide in
paragraph (c)(1)(ii) 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. Example 17 clarifies that the right to use software
development tools to create an insubstantial component of a new
program constitutes such a de minimis copyright right.

Example 18 clarifies that the right to modify the source code to
correct minor errors and make minor adaptations to a computer
program also constitutes a de minimis copyright right.

However, the final regulations do not provide that where no
independent value attaches to the exploitation of the right to
prepare derivative computer programs, such right must be treated as
de minimis. Treasury and the IRS believe that in most cases where no
independent value attaches to the grant of the right to prepare
derivative computer programs, the right is de minimis. However, this
may not be true in all cases and, therefore, this comment has not
been adopted.

b. Public Performance and Display.

Several commentators urged Treasury to reserve in final regulations
on two of the copyright rights, the right to make a public
performance and the right to public display of the copyrighted work.
Several commentators recommended that, if Treasury elects not to
reserve, a transaction involving either right should result in
treatment as a transfer of a copyright right only if the transfer is
for commercial exploitation rather than for internal use.

Commentators also requested clarification of these rights in the
entertainment area. They recommended the regulations state that the
right to publicly perform 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 does not permit the public display of the entire article.

These suggestions have not been adopted. However, Treasury and the
IRS recognize that the definition of these rights in the context of
computer programs is still developing, and in the future it may be
necessary to revisit this issue. At the present time, Treasury and
the IRS believe it is appropriate to continue to follow copyright
law as to these rights. In many cases, however, the transfer of a
right for public display or performance of a computer program, such
as marketing or advertising the program, to the extent it
constitutes the transfer of a copyright right, would be considered a
de minimis grant of a copyright right under §1.861-18(c)(1)(ii) of
the final regulations, so that the transaction would not result in
the transfer of a copyright right.

c. Definition of to the Public.

The proposed regulations list the right to make copies for
distribution to the public as one of the four copyright rights.

Commentators recommended that the regulations clarify the meaning of
"to the public." They recommended the definition exclude
distribution to a related party, with related party defined to
ensure that transfers to a non-controlled joint venture would not be
considered distribution to the public. They also recommended that
distribution to identified distributees not be considered
distribution to the public.

Commentators also recommended the regulations state that
distribution to the public does not mean distribution to employees.
In addition, they urge Treasury to make explicit that internal
distribution includes distribution to many employees, including
employees of affiliates, at multiple locations.

In light of these comments, the final regulations provide in new
paragraph (g)(3) that distribution to the public does not include
distribution to a related person, which is defined for purposes of
the regulation as a person who bears a relationship to the
transferee specified in section 267(b)(3), (10), (11), or (12), or
section 707(b)(1)(B), with "10 percent" substituted for " 50
percent." The term also excludes distribution to certain identified
persons or to those with a legal relationship to the original
transferee. The number of employees or independent contractors who
are permitted to use the program in performance of services for the
transferee is not relevant. The examples have also been amended to
clarify that the number of permitted users, which includes employees
of the transferee, within the group of related persons is not taken
into account in determining whether the transferee has the right to
distribute copies of the program to the public. See e.g., paragraph
(h), Example 11.

4. Definition of Copyrighted Article.

The comments on this issue fell into two categories. One group of
comments recommended that final regulations clarify the consequences
of transferring a de minimis copyright right along with the transfer
of a copyrighted article. The proposed regulations state in
§1.861-18(c)(1)(ii) that if a person acquires a copy of a computer
program but does not acquire any of the four copyright rights, the
transfer is classified as a transfer of a copyrighted article.
Several commentators requested that the regulations clarify the
statement to say that if the transfer includes only a de minimis
copyright right, the transfer is classified as a transfer of a
copyrighted article.

As discussed above, in response, the final regulations provide that
if the transfer includes only a de minimis copyright right, the
transfer is classified as a transfer of a copyrighted article. The
second category of comments concerned the definition of a
copyrighted article. Section 1.861-18(c)(3) defines a copyrighted
article as a copy of a computer program from which the work can be
perceived, reproduced, or otherwise communicated, either directly or
with the aid of a machine or device. Several commentators
recommended the regulations be modified to say that the copy of the
program need not be fixed in a tangible medium, and thus
electronically transferred copies also constitute copyrighted
articles.

Treasury and the IRS believe that the regulations clearly indicate
that electronically transferred copies also constitute the transfer
of a copyrighted article. Section 1.861-18(g)(2) of the final
regulations continues to provide that the physical or electronic
medium used to effectuate a transfer of a computer program shall not
be taken into account. Also, the examples contained in the
regulations, including paragraph (h), Examples 2, 3, and 4,
specifically conclude that the electronic transfer of software can
constitute the transfer of copyrighted articles.

One commentator suggested that the words "carrier medium" should be
substituted for the words "the magnetic medium of a floppy disk"
because computer programs may be distributed on a non-magnetic
medium, such as a CD-ROM. This comment has been adopted in
§1.861-18(c)(3) of the final regulations.

5. Further classification of a copyright right as a sale or license

In classifying a copyright right as a sale or license, the proposed
regulations look to whether, considering all the facts and
circumstances, all substantial rights in a copyright right are
transferred. Commentators raised a number of issues regarding the
all substantial rights test, commenting on the effect of
exclusivity, term of transfer, geographic area, and time and manner
of payment.

Several commentators stated that exclusivity is the most important
factor in determining whether all substantial rights have been
transferred. They pointed out that two examples, Examples 5 and 6,
discuss other factors, the term of the transfer and a transfer in a
limited geographic area, in addition to exclusivity, and requested
that the regulations explicitly state that exclusivity is the most
important factor. One commentator suggested that the term of the
transfer may not be relevant since the useful life of the program
may be shorter than originally believed due to technological
advances.

The final regulations do not incorporate these comments.

The regulations were not intended to change the generally applicable
"all substantial rights" test used in determining whether a transfer
of an intangible, including copyright rights, is a sale of the
intangible or a license of the intangible.

Another fact mentioned in the examples is the manner of payment.
Several commentators stated that the term over which payments are
made should be irrelevant in characterizing the transaction, and
requested that this be made explicit. Although the regulations are
not intended to depart from what is the generally applicable rule on
this issue, this comment has been reflected in paragraph (h),
Example 5 of the final regulations, thus clarifying that the payment
term is irrelevant on the facts of this example.

Several commentators pointed out that, in determining whether all
substantial rights are transferred, the regulations state the
principles of section 1222 and section 1235 shall apply. They seek
clarification that section 1222, not section 1235, applies to
transfers of copyrights, with section 1235 only applying to
qualifying transfers of patents.

Although section 1235 by its terms only applies to patent transfers,
the proposed regulations state that "the principles of sections 1222
and 1235" (emphasis added) shall apply. Treasury and the IRS believe
that the all substantial rights test in the regulations under
section 1235, although a safe harbor under that section,
nevertheless reflects the all substantial rights test arising from
case law generally, and is, therefore, an appropriate standard that
may be applied. However, in applying the all substantial rights test
to transactions in computer programs under these regulations,
relevant case law, other than that specifically addressing section
1235 or section 1222, may also be applied, and the final regulations
clarify this point.

6. Further Classification of a Copyrighted Article as a Sale or
Lease.

a. Lease Character for Copyrighted Articles.

The proposed regulations treat a non-sale transfer of a copy of a
computer program as a lease. Some commentators urged Treasury to
reconsider its decision to adopt lease characterization for
transactions that traditionally have been characterized as licenses.
They submitted that the change creates confusion, is inconsistent
with established commercial practice, and implies that all lease
transactions involve tangible property. One commentator asked the
IRS to clarify that the regulation is not intended to produce any
differences in income tax consequences by treating a transfer of a
program as a lease instead of a license.

These comments have not been adopted. Treasury and the IRS continue
to believe that lease characterization is correct for non-sale
transfers of copies of computer programs. Any income tax
consequences from such characterization under these regulations will
result from application of generally applicable tax law to the
leasing transaction.

b. Benefits and Burdens Test.

In determining whether the transfer of a copyrighted article results
in a sale, or instead as a lease generating rental income, the
proposed regulations look to whether, based on the facts and
circumstances, the benefits and burdens of ownership are
transferred. One commentator stated that this test is not helpful
here, and proposed an economic substance test instead, focusing on
the right to use a computer program as the economically valuable
right. Under that standard, a copyrighted article would be
considered sold if transferred with the right to use it
indefinitely. Other commentators, however, believed that the
existing authorities applying the benefits and burdens test provide
the correct analytical approach for distinguishing a sale from a
lease of a copyrighted article.

The final regulations preserve the benefits and burdens test, and
are not intended to change the generally applicable benefits and
burdens test.

7. Related Parties.

The examples to the proposed regulations state that they assume the
parties are unrelated. Several commentators requested that final
regulations clarify the treatment of related parties under the
regulations. They state that the regulations should apply to related
and unrelated parties in the same way, and that Treasury should
specify any particular concerns.

In response to these comments, the examples to the final regulations
do not contain an assumption that the parties are unrelated. The
regulations are intended to apply to related and unrelated parties
in the same manner. The relationship between the parties does not
affect the character of the transaction, with the exception of
special rules regarding definition of the term "distribution to the
public." Of course, if the parties are related for purposes of
section 482, that section may apply to determine the proper amount
of consideration for the transfer.

8. Services and Know-how.

Some commentators suggested that final regulations clarify the
relevancy of the distinction between the provision of services and
the provision of know-how. This suggestion has not been incorporated
in the final regulations. The purpose of the regulations is only to
characterize transactions involving computer programs. Once the
character of the transaction is determined under the regulations,
the taxation of the income arising from the transaction is
determined under other Code sections. Thus, the relevance of the
distinction between services and know-how must be determined under
other Code sections. Compare sections 861(a)(3) and 862(a)(3),
looking to place of performance in sourcing income from services,
with sections 861(a)(4) and 862(a)(4), sourcing income derived from
the transfer of certain know-how based on where the know-how is
used. The distinction between services and know-how may also be
relevant under income tax treaties. Compare Convention Between the
United States of America and Japan for the Avoidance of Double
Taxation and the Prevention of Fiscal Evasion with Respect to Taxes
on Income, Article 8 (Business Profits) and Article 14 (Royalties).

Some commentators suggested the final regulations eliminate the
requirement in paragraph (e) of the proposed regulations, requiring
that know-how not be copyrightable as a prerequisite to being
treated as know-how for purposes of this section. This comment has
been adopted to eliminate any inference that only orally transmitted
information could be classified as know-how.

The final regulations, however, add two other requirements.

Know-how is of the type covered by these regulations only if the
information is information relating to computer programming
techniques, is furnished under conditions preventing unauthorized
disclosure, specifically contracted for between the parties, and is
considered property subject to trade secret protection. Know-how is
considered a property interest under applicable law, and only if the
know-how is specifically contracted for between the parties. These
additional requirements should help clarify the definition of know-
how described in these regulations.

9. Mixed Transactions.

The proposed regulations state that if a transaction in a computer
program consists of transactions in more than one category listed in
§1.861-18(b)(1), the transactions, unless de minimis, will be
treated as separate transactions, with the rules applied separately
to each. Several commentators requested further guidance on how to
treat transactions that include payments for updates, support,
consulting, education, and training. They pointed out that in many
cases, the extent to which such transactions or services will be
required by the transferee are unknown at the time of the initial
contract. They asked that regulations clarify the factors that will
sustain an allocation where these various options are made
available, or that Treasury consider bundling rules.

These comments have not been adopted. These regulations are limited
to characterizing transactions relating to computer programs, and
are not intended to provide rules for allocating income arising from
mixed transactions. Mixed transactions occur in many circumstances
outside of transactions involving computer programs. Whether income
arising from a mixed transaction, involving computer programs or
otherwise, must be allocated to its separate components under
generally applicable principles of taxation, and the method by which
such income is allocated to the transaction's components, must be
determined under other Code sections.

10. Shrink Wrap License.

Several commentators stated that the reference to the term shrink
wrap license in the proposed regulations should be deleted, because
the reference can be misinterpreted as ascribing some legal
significance to the term. They suggested a more general reference to
a user agreement or a user license. In response to these comments,
the final regulations now indicate in Example 1 that the term
shrink-wrap license is merely illustrative. The regulations'
analysis is based on the terms of the agreement between the parties,
and on the nature and extent of the rights transferred, not the
means of packaging or distributing the computer program. In
particular, the use of the term shrink-wrap license in the proposed
regulations was not intended to create an inference that the
regulations apply only to mass-marketed software.

11. Pre-Effective Date Transactions.

The proposed regulations draw no inference for transactions prior to
the regulations' effective date. One commentator recommended that
the regulations permit taxpayers to elect retroactive application of
the regulations. Another commentator requested a statement that a
taxpayer's prior treatment of a transaction would be respected as
long as it is reasonably supportable. Another commentator
recommended the IRS remedy double tax problems for transactions
prior to the effective date.

The final regulations apply to transactions occurring pursuant to
contracts entered into on or after the effective date of the
regulations. A special transition rule permits taxpayers to elect to
apply the regulations to transactions occurring pursuant to
contracts entered into in taxable years ending on or after the date
of publication of this document in the Federal Register. Taxpayers
may also elect to apply this section to transactions occurring in
taxable years ending on or after the date of publication of this
document in the Federal Register, for contracts entered into before
the date of publication of this document in the Federal Register,
provided the taxpayer would not be required under this section to
change its method of accounting, or the taxpayer would be required
to change its method of accounting but the resulting section 481
adjustment would be zero.

With regard to double taxation, taxpayers who believe they are
subject to double taxation may pursue competent authority relief.

12. Accounting Method Changes.

Commentators suggested that the IRS issue, simultaneously with the
issuance of the final regulations, a revenue procedure permitting an
automatic change of accounting to allow taxpayers to apply the
principles of these regulations for purposes of accounting for
prepaid income under software maintenance agreements. Different
rules apply depending on whether the income from such agreements is
considered to be derived from the sale of goods or the performance
of services. Compare, §1.451-5 (sale of goods) and Rev. Proc. 71-21
(1971-2 CB 549) (performance of services).

In response to comments, the final regulations grant taxpayers
consent to change their method of accounting if necessary to conform
the classification of transactions with these regulations, where the
taxpayer elects one of the transtion rules in paragraph (i)(2) of
the regulations. To obtain automatic consent to change a method of
accounting, the regulations direct taxpayers to file Form 3115 with
their returns and send a copy to the national office.

13. Reverse Engineering and Decompilation.

One commentator stated that the right to reverse engineer (or
decompile) a computer program (i.e., the right to reconstruct the
source code from the object code) should be irrelevant in
classifying transactions in computer programs, and that references
to that right should be eliminated from the examples.

This comment has not been adopted. The decompilation of a computer
program can result in the creation of a derivative work.

Under the regulations, the right to create a derivative work is a
copyright right. Therefore, whether the transferee is prohibited
from reverse engineering a computer program could be relevant in
determining if a copyrighted article has been transferred.

14. Effect of Practices Used to Control Piracy.

One commentator suggested that certain practices used to control
software piracy, such as a requirement that the transferee annually
contact the transferor and pay an annual fee, be disregarded in
determining whether a transaction results in a sale or lease of a
computer program.

This comment has not been adopted. Such a transaction must be
analyzed under the benefits and burdens test, taking into account
all the facts and circumstances. Under that test, the requirement
that the transferee contact the transferor and pay an annual fee
might not result in lease characterization, if other significant
benefits and burdens of ownership pass to the transferee.

15. Definition of Computer.

One commentator urged Treasury to adopt a flexible definition of the
term computer. However, the final regulations do not define
computer. The definition of software used in the regulations is
based on the definition in the Copyright Act. The Copyright Act does
not define the term computer.

16. Comments (not otherwise addressed above) Regarding Specific
Examples.

a. Paragraph (h), Examples 6 and 7.

Commentators requested that, given the ease of reproduction, the
distinction between paragraph (h), Examples 6 and 7 should be
removed.

This comment has not been adopted. Although computer programs can be
easily reproduced, a fact which the regulations recognize, there is
still an important commercial and legal distinction between persons
who are granted the right to make copies of a program for
distribution and persons who do not have that right.

b. Example 6.

In response to comments, the final regulations make clear that the
party exercising reproduction rights can exercise that right
indirectly by contracting out the reproduction function.

c. Example 8.

In response to a comment, Example 8 has been clarified to indicate
that the right to make back-up copies of the program, or the fact
that a back-up copy of the program is transferred on a disk, is
irrelevant to classification.

d. Example 9.

In response to a comment, paragraph (h), Example 9 is clarified to
indicate that the mechanics of copying a computer program are
irrelevant.

e. Example 10.

Some commentators suggested that in the case of so-called enterprise
licenses, the fact the transferee can use the program at multiple
locations should not affect the character of the transaction as the
sale of copyrighted articles. This comment has been adopted, and
paragraph (h), Example 10(ii)(C) of the final regulations has been
amended accordingly. f.

Examples 12 and 13.

Some commentators suggested adding examples to illustrate so-called
software maintenance or subscription agreements.

Paragraph (h), Examples 12 and 13 of the proposed regulations,
however, were intended to illustrate such agreements, and, in
response to comments, these examples have been modified in the final
regulations. Generally, the provision of an updated program pursuant
to a maintenance agreement is intended to be treated as the transfer
of a copyrighted article. However, this may not always be the case,
and maintenance agreements must be analyzed in the same way as other
transactions under the regulations.

g. Example 15.

A commentator suggested that the example's use of a derivative
computer program adds complexity, and recommends the example be
redrafted to purely illustrate services. This comment has been
adopted and the example has been revised accordingly.

h. Additional Examples.

Commentators suggested additional examples. The final regulations
add additional examples where clarification was believed necessary.

Special Analyses

It has been determined that this Treasury decision is not a
significant regulatory action as defined in EO 12866. Therefore, a
regulatory assessment is not required. It is hereby certified that
the collection of information contained in these regulations will
not have a significant economic impact on a substantial number of
small entities. This certification is based on the fact that the
rules of this section impact taxpayers who engage in international
transactions in computer programs, and therefore the rules will
impact very few small entities. Moreover, in those few instances
where the rules of this section impact small entities, the economic
impact of the collection of information on such small entities is
not likely to be significant because it merely requires a copy of
the Form 3115 to be filed with the National Office. Accordingly, a
regulatory flexibility analysis is not required under the Regulatory
Flexibility Act (5 U.S.C. chapter 6).

Pursuant to section 7805(f) of the Internal Revenue Code, the notice
of proposed rulemaking preceding these regulations was submitted to
the Chief Counsel for Advocacy of the Small Business Administration
for comment on its impact on small business.

Drafting Information

The principal author of these regulations is Anne Shelburne, of the
Office of Associate Chief Counsel (International), IRS.

However, other personnel from the IRS and Treasury Department
participated in their development.

List of Subjects

26 CFR Part 1 Income taxes, Reporting and recordkeeping
requirements.

26 CFR Part 602 Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations Accordingly, 26 CFR parts
1 and 602 are amended as follows:

PART 1--INCOME TAXES

Paragraph 1. The authority citation for part 1 continues to read in
part as follows:

Authority: 26 U.S.C. 7805 * * *

Par. 2. Section 1.861-18 is added to read as follows:

§1.861-18 Classification of transactions involving computer
programs.

(a) General--(1) Scope. This section provides rules for classifying
transactions relating to computer programs for purposes of
subchapter N of chapter 1 of the Internal Revenue Code, sections
367, 404A, 482, 551, 679, 1059A, chapter 3, chapter 5, sections 842
and 845 (to the extent involving a foreign person), and transfers to
foreign trusts not covered by section 679.

(2) Categories of transactions. This section generally requires that
such transactions be treated as being solely within one of four
categories (described in paragraph (b)(1) of this section) and
provides certain rules for categorizing such transactions. In the
case of a transfer of a copyright right, this section provides rules
for determining whether the transaction should be classified as
either a sale or exchange, or a license generating royalty income.
In the case of a transfer of a copyrighted article, this section
provides rules for determining whether the transaction should be
classified as either a sale or exchange, or a lease generating
rental income.

(3) Computer program. For purposes of this section, a computer
program is a set of statements or instructions to be used directly
or indirectly in a computer in order to bring about a certain
result. For purposes of this paragraph (a)(3), a computer program
includes any media, user manuals, documentation, data base or
similar item if the media, user manuals, documentation, data base or
similar item is incidental to the operation of the computer program.

(b) Categories of transactions--(1) General. Except as provided in
paragraph (b)(2) of this section, a transaction involving the
transfer of a computer program, or the provision of services or of
know-how with respect to a computer program (collectively, a
transfer of a computer program) is treated as being solely one of
the following--

(i) A transfer of a copyright right in the computer program;

(ii) A transfer of a copy of the computer program (a copyrighted
article);

(iii) The provision of services for the development or modification
of the computer program; or

(iv) The provision of know-how relating to computer programming
techniques.

(2) Transactions consisting of more than one category. Any
transaction involving computer programs which consists of more than
one of the transactions described in paragraph (b)(1) of this
section shall be treated as separate transactions, with the
appropriate provisions of this section being applied to each such
transaction. However, any transaction that is de minimis, taking
into account the overall transaction and the surrounding facts and
circumstances, shall not be treated as a separate transaction, but
as part of another transaction.

(c) Transfers involving copyright rights and copyrighted
articles--(1) Classification--(i) Transfers treated as transfers of
copyright rights. A transfer of a computer program is classified as
a transfer of a copyright right if, as a result of the transaction,
a person acquires any one or more of the rights described in
paragraphs (c)(2)(i) through (iv) of this section. Whether the
transaction is treated as being solely the transfer of a copyright
right or is treated as separate transactions is determined pursuant
to paragraph (b)(1) and (b)(2) of this section. For example, if a
person receives a disk containing a copy of a computer program which
enables it to exercise, in relation to that program, a non-de
minimis right described in paragraphs (c)(2)(i) through (iv) of this
section (and the transaction does not involve, or involves only a de
minimis provision of services as described in paragraph (d) of this
section or of know-how as described in paragraph (e) of this
section), then, under paragraph (b)(2) of this section, the transfer
is classified solely as a transfer of a copyright right.

(ii) Transfers treated solely as transfers of copyrighted articles.
If a person acquires a copy of a computer program but does not
acquire any of the rights described in paragraphs (c)(2)(i) through
(iv) of this section (or only acquires a de minimis grant of such
rights), and the transaction does not involve, or involves only a de
minimis, provision of services as described in paragraph (d) of this
section or of know-how as described in paragraph (e) of this
section, the transfer of the copy of the computer program is
classified solely as a transfer of a copyrighted article.

(2) Copyright rights. The copyright rights referred to in paragraph
(c)(1) of this section are as follows--

(i) The right to make copies of the computer program for purposes of
distribution to the public by sale or other transfer of ownership,
or by rental, lease or lending;

(ii) The right to prepare derivative computer programs based upon
the copyrighted computer program;

(iii) The right to make a public performance of the computer
program; or

(iv) The right to publicly display the computer program.

(3) Copyrighted article. A copyrighted article includes a copy of a
computer program from which the work can be perceived, reproduced,
or otherwise communicated, either directly or with the aid of a
machine or device. The copy of the program may be fixed in the
magnetic medium of a floppy disk, or in the main memory or hard
drive of a computer, or in any other medium.

(d) Provision of services. The determination of whether a
transaction involving a newly developed or modified computer program
is treated as either the provision of services or another
transaction described in paragraph (b)(1) of this section is based
on all the facts and circumstances of the transaction, including, as
appropriate, the intent of the parties (as evidenced by their
agreement and conduct) as to which party is to own the copyright
rights in the computer program and how the risks of loss are
allocated between the parties.

(e) Provision of know-how. The provision of information with respect
to a computer program will be treated as the provision of know-how
for purposes of this section 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.

(f) Further classification of transfers involving copyright rights
and copyrighted articles--(1) Transfers of copyright rights. The
determination of whether a transfer of a copyright right is a sale
or exchange of property is made on the basis of whether, taking into
account all facts and circumstances, there has been a transfer of
all substantial rights in the copyright.

A transaction that does not constitute a sale or exchange because
not all substantial rights have been transferred will be classified
as a license generating royalty income. For this purpose, the
principles of sections 1222 and 1235 may be applied.

Income derived from the sale or exchange of a copyright right will
be sourced under section 865(a), (c), (d), (e), or (h), as
appropriate. Income derived from the licensing of a copyright right
will be sourced under section 861(a)(4) or 862(a)(4), as
appropriate.

(2) Transfers of copyrighted articles. The determination of whether
a transfer of a copyrighted article is a sale or exchange is made on
the basis of whether, taking into account all facts and
circumstances, the benefits and burdens of ownership have been
transferred. A transaction that does not constitute a sale or
exchange because insufficient benefits and burdens of ownership of
the copyrighted article have been transferred, such that a person
other than the transferee is properly treated as the owner of the
copyrighted article, will be classified as a lease generating rental
income. 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), (b), (c), or (e), as appropriate.
Income derived from the leasing of a copyrighted article will be
sourced under section 861(a)(4) or section 862(a)(4), as
appropriate.

(3) Special circumstances of computer programs. In connection with
determinations under this paragraph (f), consideration must be given
as appropriate to the special characteristics of computer programs
in transactions that take advantage of these characteristics (such
as the ability to make perfect copies at minimal cost). For example,
a transaction in which a person acquires a copy of a computer
program on disk subject to a requirement that the disk be destroyed
after a specified period is generally the equivalent of a
transaction subject to a requirement that the disk be returned after
such period. Similarly, a transaction in which the program
deactivates itself after a specified period is generally the
equivalent of returning the copy.

(g) Rules of operation--(1) Term applied to transaction by parties.
Neither the form adopted by the parties to a transaction, nor the
classification of the transaction under copyright law, shall be
determinative. Therefore, for example, if there is a transfer of a
computer program on a single disk for a one-time payment with
restrictions on transfer and reverse engineering, which the parties
characterize as a license (including, but not limited to, agreements
commonly referred to as shrink-wrap licenses), application of the
rules of paragraphs (c) and (f) of this section may nevertheless
result in the transaction being classified as the sale of a
copyrighted article.

(2) Means of transfer not to be taken into account. The rules of
this section shall be applied irrespective of the physical or
electronic or other medium used to effectuate a transfer of a
computer program.

(3) To the public--(i) In general. For purposes of paragraph (c)(2)
(i) of this section, a transferee of a computer program shall not be
considered to have the right to distribute copies of the program to
the public if it is permitted to distribute copies of the software
to only either a related person, or to identified persons who may be
identified by either name or by legal relationship to the original
transferee. For purposes of this subparagraph, a related person is a
person who bears a relationship to the transferee specified in
section 267(b)(3), (10), (11), or (12), or section 707(b)(1)(B). In
applying section 267(b), 267(f), 707(b)(1)(B), or 1563(a), "10
percent" shall be substituted for "50 percent."

(ii) Use by individuals. The number of employees of a transferee of
a computer program who are permitted to use the program in
connection with their employment is not relevant for purposes of
this paragraph (g)(3). In addition, the number of individuals with a
contractual agreement to provide services to the transferee of a
computer program who are permitted to use the program in connection
with the performance of those services is not relevant for purposes
of this paragraph (g)(3).

(h) Examples. The provisions of this section may be illustrated by
the following examples:

Example 1. (i) Facts. Corp A, a U.S. corporation, owns the copyright
in a computer program, Program X. It copies Program X onto disks.
The disks are placed in boxes covered with a wrapper on which is
printed what is generally referred to as a shrink-wrap license. The
license is stated to be perpetual.

Under the license no reverse engineering, decompilation, or
disassembly of the computer program is permitted. The transferee
receives, first, the right to use the program on two of its own
computers (for example, a laptop and a desktop) provided that only
one copy is in use at any one time, and, second, the right to make
one copy of the program on each machine as an essential step in the
utilization of the program. The transferee is permitted by the
shrink-wrap license to sell the copy so long as it destroys any
other copies it has made and imposes the same terms and conditions
of the license on the purchaser of its copy.

These disks are made available for sale to the general public in
Country Z. In return for valuable consideration, P, a Country Z
resident, receives one such disk.

(ii) Analysis. (A) Under paragraph (g)(1) of this section, the label
license is not determinative. None of the copyright rights described
in paragraph (c)(2) of this section have been transferred in this
transaction. P has received a copy of the program, however, and,
therefore, under paragraph (c)(1)(ii) of this section, P has
acquired solely a copyrighted article.

(B) Taking into account all of the facts and circumstances, P is
properly treated as the owner of a copyrighted article.

Therefore, under paragraph (f)(2) of this section, there has been a
sale of a copyrighted article rather than the grant of a lease.

Example 2. (i) Facts. The facts are the same as those in Example 1,
except that instead of selling disks, Corp A, the U.S.

corporation, decides to make Program X available, for a fee, on a
World Wide Web home page on the Internet. P, the Country Z resident,
in return for payment made to Corp A, downloads Program X (via
modem) onto the hard drive of his computer. As part of the
electronic communication, P signifies his assent to a license
agreement with terms identical to those in Example 1, except that in
this case P may make a back-up copy of the program on to a disk.

(ii) Analysis. (A) None of the copyright rights described in
paragraph (c)(2) of this section have passed to P. Although P did
not buy a physical copy of the disk with the program on it,
paragraph (g)(2) of this section provides that the means of
transferring the program is irrelevant. Therefore, P has acquired a
copyrighted article.

(B) As in Example 1, P is properly treated as the owner of a
copyrighted article. Therefore, under paragraph (f)(2) of this
section, there has been a sale of a copyrighted article rather than
the grant of a lease.

Example 3. (i) Facts. The facts are the same as those in Example 1,
except that Corp A only allows P, the Country Z resident, to use
Program X for one week. At the end of that week, P must return the
disk with Program X on it to Corp A. P must also destroy any copies
made of Program X. If P wishes to use Program X for a further period
he must enter into a new agreement to use the program for an
additional charge.

(ii) Analysis. (A) Under paragraph (c)(2) of this section, P has
received no copyright rights. Because P has received a copy of the
program under paragraph (c)(1)(ii) of this section, he has,
therefore, received a copyrighted article.

(B) Taking into account all of the facts and circumstances, P is not
properly treated as the owner of a copyrighted article.

Therefore, under paragraph (f)(2) of this section, there has been a
lease of a copyrighted article rather than a sale. Taking into
account the special characteristics of computer programs as provided
in paragraph (f)(3) of this section, the result would be the same if
P were required to destroy the disk at the end of the one week
period instead of returning it since Corp A can make additional
copies of the program at minimal cost.

Example 4. (i) Facts. The facts are the same as those in Example 2,
where P, the Country Z resident, receives Program X from Corp A's
home page on the Internet, except that P may only use Program X for
a period of one week at the end of which an electronic lock is
activated and the program can no longer be accessed. Thereafter, if
P wishes to use Program X, it must return to the home page and pay
Corp A to send an electronic key to reactivate the program for
another week.

(ii) Analysis. (A) As in Example 3, under paragraph (c)(2) of this
section, P has not received any copyright rights.

P has received a copy of the program, and under paragraph (g)(2) of
this section, the means of transmission is irrelevant. P has,
therefore, under paragraph (c)(1)(ii) of this section, received a
copyrighted article.

(B) As in Example 3, P is not properly treated as the owner of a
copyrighted article. Therefore, under paragraph (f)(2) of this
section, there has been a lease of a copyrighted article rather than
a sale. While P does retain Program X on its computer at the end of
the one week period, as a legal matter P no longer has the right to
use the program (without further payment) and, indeed, cannot use
the program without the electronic key. Functionally, Program X is
no longer on the hard drive of P's computer. Instead, the hard drive
contains only a series of numbers which no longer perform the
function of Program X. Although in Example 3, P was required to
physically return the disk, taking into account the special
characteristics of computer programs as provided in paragraph (f)(3)
of this section, the result in this Example 4 is the same as in
Example 3.

Example 5. (i) Facts. Corp A, a U.S. corporation, transfers a disk
containing Program X to Corp B, a Country Z corporation, and grants
Corp B an exclusive license for the remaining term of the copyright
to copy and distribute an unlimited number of copies of Program X in
the geographic area of Country Z, prepare derivative works based
upon Program X, make public performances of Program X, and publicly
display Program X.

Corp B will pay Corp A a royalty of $y a year for three years, which
is the expected period during which Program X will have commercially
exploitable value.

(ii) Analysis. (A) Although Corp A has transferred a disk with a
copy of Program X on it to Corp B, under paragraph (c)(1)(i) of this
section because this transfer is accompanied by a copyright right
identified in paragraph (c)(2)(i) of this section, this transaction
is a transfer solely of copyright rights, not of copyrighted
articles. For purposes of paragraph (b)(2) of this section, the disk
containing a copy of Program X is a de minimis component of the
transaction.

(B) Applying the all substantial rights test under paragraph (f)(1)
of this section, Corp A will be treated as having sold copyright
rights to Corp B. Corp B has acquired all of the copyright rights in
Program X, has received the right to use them exclusively within
Country Z, and has received the rights for the remaining life of the
copyright in Program X. The fact the payments cease before the
copyright term expires is not controlling. Under paragraph (g)(1) of
this section, the fact that the agreement is labelled a license is
not controlling (nor is the fact that Corp A receives a sum labelled
a royalty). (The result in this case would be the same if the copy
of Program X to be used for the purposes of reproduction were
transmitted electronically to Corp B, as a result of the application
of the rule of paragraph (g)(2) of this section.)

Example 6. (i) Facts. Corp A, a U.S. corporation, transfers a disk
containing Program X to Corp B, a Country Z corporation, and grants
Corp B the non exclusive right to reproduce (either directly or by
contracting with either Corp A or another person to do so) and
distribute for sale to the public an unlimited number of disks at
its factory in Country Z in return for a payment related to the
number of disks copied and sold. The term of the agreement is two
years, which is less than the remaining life of the copyright.

(ii) Analysis. (A) As in Example 5, the transfer of the disk
containing the copy of the program does not constitute the transfer
of a copyrighted article under paragraph (c)(1) of this section
because Corp B has also acquired a copyright right under paragraph
(c)(2)(i) of this section, the right to reproduce and distribute to
the public. For purposes of paragraph (b)(2) of this section, the
disk containing Program X is a de minimis component of the
transaction.

(B) Taking into account all of the facts and circumstances, there
has been a license of Program X to Corp B, and the payments made by
Corp B are royalties. Under paragraph (f)(1) of this section, there
has not been a transfer of all substantial rights in the copyright
to Program X because Corp A has the right to enter into other
licenses with respect to the copyright of Program X, including
licenses in Country Z (or even to sell that copyright, subject to
Corp B's interest). Corp B has acquired no right itself to license
the copyright rights in Program X.

Finally, the term of the license is for less than the remaining life
of the copyright in Program X.

Example 7. (i) Facts. Corp C, a distributor in Country Z, enters
into an agreement with Corp A, a U.S. corporation, to purchase as
many copies of Program X on disk as it may from time-to- time
request. Corp C will then sell these disks to retailers.

The disks are shipped in boxes covered by shrink-wrap licenses
(identical to the license described in Example 1).

(ii) Analysis. (A) Corp C has not acquired any copyright rights
under paragraph (c)(2) of this section with respect to Program X. It
has acquired individual copies of Program X, which it may sell to
others. The use of the term license is not dispositive under
paragraph (g)(1) of this section. Under paragraph (c)(1)(ii) of this
section, Corp C has acquired copyrighted articles.

(B) Taking into account all of the facts and circumstances, Corp C
is properly treated as the owner of copyrighted articles.

Therefore, under paragraph (f)(2) of this section, there has been a
sale of copyrighted articles.

Example 8. (i) Facts. Corp A, a U.S. corporation, transfers a disk
containing Program X to Corp D, a foreign corporation engaged in the
manufacture and sale of personal computers in Country Z. Corp A
grants Corp D the non-exclusive right to copy Program X onto the
hard drive of an unlimited number of computers, which Corp D
manufactures, and to distribute those copies (on the hard drive) to
the public. The term of the agreement is two years, which is less
than the remaining life of the copyright in Program X. Corp D pays
Corp A an amount based on the number of copies of Program X it loads
on to computers.

(ii) Analysis. The analysis is the same as in Example 6.

Under paragraph (c)(2)(i) of this section, Corp D has acquired a
copyright right enabling it to exploit Program X by copying it on to
the hard drives of the computers that it manufactures and then
sells. For purposes of paragraph (b)(2) of this section, the disk
containing Program X is a de minimis component of the transaction.
Taking into account all of the facts and circumstances, Corp D has
not, however, acquired all substantial rights in the copyright to
Program X (for example, the term of the agreement is less than the
remaining life of the copyright).

Under paragraph (f)(1) of this section, this transaction is,
therefore, a license of Program X to Corp D rather than a sale and
the payments made by Corp D are royalties. (The result would be the
same if Corp D included with the computers it sells an archival copy
of Program X on a floppy disk.) Example 9. (i) Facts. The facts are
the same as in Example 8, except that Corp D, the Country Z
corporation, receives physical disks. The disks are shipped in boxes
covered by shrink-wrap licenses (identical to the licenses described
in Example 1). The terms of these licenses do not permit Corp D to
make additional copies of Program X. Corp D uses each individual
disk only once to load a single copy of Program X onto each separate
computer. Corp D transfers the disk with the computer when it is
sold.

(ii) Analysis. (A) As in Example 7 (unlike Example 8) no copyright
right identified in paragraph (c)(2) of this section has been
transferred. Corp D acquires the disks without the right to
reproduce and distribute publicly further copies of Program X. This
is therefore the transfer of copyrighted articles under paragraph
(c)(1)(ii) of this section.

(B) Taking into account all of the facts and circumstances, Corp D
is properly treated as the owner of copyrighted articles.

Therefore, under paragraph (f)(2) of this section, the transaction
is classified as the sale of a copyrighted article.

(The result would be the same if Corp D used a single physical disk
to copy Program X onto each computer, and transferred an unopened
box containing Program X with each computer, if Corp D were not
permitted to copy Program X onto more computers than the number of
individual copies purchased.)

Example 10. (i) Facts. Corp A, a U.S. corporation, transfers a disk
containing Program X to Corp E, a Country Z corporation, and grants
Corp E the right to load Program X onto 50 individual workstations
for use only by Corp E employees at one location in return for a
one-time per-user fee (generally referred to as a site license or
enterprise license). If additional workstations are subsequently
introduced, Program X may be loaded onto those machines for
additional one-time per-user fees. The license which grants the
rights to operate Program X on 50 workstations also prohibits Corp E
from selling the disk (or any of the 50 copies) or reverse
engineering the program. The term of the license is stated to be
perpetual.

(ii) Analysis. (A) The grant of a right to copy, unaccompanied by
the right to distribute those copies to the public, is not the
transfer of a copyright right under paragraph (c)(2) of this
section. Therefore, under paragraph (c)(1)(ii) of this section, this
transaction is a transfer of copyrighted articles (50 copies of
Program X).

(B) Taking into account all of the facts and circumstances, P is
properly treated as the owner of copyrighted articles.

Therefore, under paragraph (f)(2) of this section, there has been a
sale of copyrighted articles rather than the grant of a lease.

Notwithstanding the restriction on sale, other factors such as, for
example, the risk of loss and the right to use the copies in
perpetuity outweigh, in this case, the restrictions placed on the
right of alienation.

(C) The result would be the same if Corp E were permitted to copy
Program X onto an unlimited number of workstations used by employees
of either Corp E or corporations that had a relationship to Corp E
specified in paragraph (g)(3) of this section.

Example 11. (i) Facts. The facts are the same as in Example 10,
except that Corp E, the Country Z corporation, acquires the right to
make Program X available to workstation users who are Corp E
employees by way of a local area network (LAN). The number of users
that can use Program X on the LAN at any one time is limited to 50.
Corp E pays a one-time fee for the right to have up to 50 employees
use the program at the same time.

(ii) Analysis. Under paragraph (g)(2) of this section the mode of
utilization is irrelevant. Therefore, as in Example 10, under
paragraph (c)(2) of this section, no copyright right has been
transferred, and, thus, under paragraph (c)(1)(ii) of this section,
this transaction will be classified as the transfer of a copyrighted
article. Under the benefits and burdens test of paragraph (f)(2) of
this section, this transaction is a sale of copyrighted articles.
The result would be the same if an unlimited number of Corp E
employees were permitted to use Program X on the LAN or if Corp E
were permitted to copy Program X onto LANs maintained by
corporations that had a relationship to Corp E specified in
paragraph (g)(3) of this section.

Example 12. (i) Facts. The facts are the same as in Example 11,
except that Corp E pays a monthly fee to Corp A, the U.S.
corporation, calculated with reference to the permitted maximum
number of users (which can be changed) and the computing power of
Corp E's server. In return for this monthly fee, Corp E receives the
right to receive upgrades of Program X when they become available.
The agreement may be terminated by either party at the end of any
month. When the disk containing the upgrade is received, Corp E must
return the disk containing the earlier version of Program X to Corp
A. If the contract is terminated, Corp E must delete (or otherwise
destroy) all copies made of the current version of Program X. The
agreement also requires Corp A to provide technical support to Corp
E but the agreement does not allocate the monthly fee between the
right to receive upgrades of Program X and the technical support
services.

The amount of technical support that Corp A will provide to Corp E
is not foreseeable at the time the contract is entered into but is
expected to be de minimis. The agreement specifically provides that
Corp E has not thereby been granted an option to purchase Program X.

(ii) Analysis. (A) Corp E has received no copyright rights under
paragraph (c)(2) of this section. Corp A has not provided any
services described in paragraph (d) of this section.

Based on all the facts and circumstances of the transaction, Corp A
has provided de minimis technical services to Corp E.

Therefore, under paragraph (c)(1)(ii) of this section, the
transaction is a transfer of a copyrighted article.

(B) Taking into account all facts and circumstances, under the
benefits and burdens test Corp E is not properly treated as the
owner of the copyrighted article. Corp E does not receive the right
to use Program X in perpetuity, but only for so long as it continues
to make payments. Corp E does not have the right to purchase Program
X on advantageous (or, indeed, any) terms once a certain amount of
money has been paid to Corp A or a certain period of time has
elapsed (which might indicate a sale). Once the agreement is
terminated, Corp E will no longer possess any copies of Program X,
current or superseded. Therefore under paragraph (f)(2) of this
section there has been a lease of a copyrighted article.

Example 13. (i) Facts. The facts are the same as in Example 12,
except that, while Corp E must return copies of Program X as new
upgrades are received, if the agreement terminates, Corp E may keep
the latest version of Program X (although Corp E is still prohibited
from selling or otherwise transferring any copy of Program X).

(ii) Analysis. For the reasons stated in Example 10, paragraph (ii)
(B), the transfer of the program will be treated as a sale of a
copyrighted article rather than as a lease.

Example 14. (i) Facts. Corp G, a Country Z corporation, enters into
a contract with Corp A, a U.S. corporation, for Corp A to modify
Program X so that it can be used at Corp G's facility in Country Z.
Under the contract, Corp G is to acquire one copy of the program on
a disk and the right to use the program on 5,000 workstations. The
contract requires Corp A to rewrite elements of Program X so that it
will conform to Country Z accounting standards and states that Corp
A retains all copyright rights in the modified Program X. The
agreement between Corp A and Corp G is otherwise identical as to
rights and payment terms as the agreement described in Example 10. (
ii) Analysis. (A) As in Example 10, no copyright rights are being
transferred under paragraph (c)(2) of this section. In addition,
since no copyright rights are being transferred to Corp G, this
transaction does not involve the provision of services by Corp A
under paragraph (d) of this section. This transaction will be
classified, therefore, as a transfer of copyrighted articles under
paragraph (c)(1)(ii) of this section.

(B) Taking into account all facts and circumstances, Corp G is
properly treated as the owner of copyrighted articles.

Therefore, under paragraph (f)(2) of this section, there has been
the sale of a copyrighted article rather than the grant of a lease.

Example 15. (i) Facts. Corp H, a Country Z corporation, enters into
a license agreement for a new computer program.

Program Q is to be written by Corp A, a U.S. corporation. Corp A and
Corp H agree that Corp A is writing Program Q for Corp H and that,
when Program Q is completed, the copyright in Program Q will belong
to Corp H. Corp H gives instructions to Corp A programmers regarding
program specifications. Corp H agrees to pay Corp A a fixed monthly
sum during development of the program.

If Corp H is dissatisfied with the development of the program, it
may cancel the contract at the end of any month. In the event of
termination, Corp A will retain all payments, while any procedures,
techniques or copyrightable interests will be the property of Corp
H. All of the payments are labelled royalties.

There is no provision in the agreement for any continuing
relationship between Corp A and Corp H, such as the furnishing of
updates of the program, after completion of the modification work.

(ii) Analysis. Taking into account all of the facts and
circumstances, Corp A is treated as providing services to Corp H.

Under paragraph (d) of this section, Corp A is treated as providing
services to Corp H because Corp H bears all of the risks of loss
associated with the development of Program Q and is the owner of all
copyright rights in Program Q. Under paragraph (g)(1) of this
section, the fact that the agreement is labelled a license is not
controlling (nor is the fact that Corp A receives a sum labelled a
royalty).

Example 16. (i) Facts. Corp A, a U.S. corporation, and Corp I, a
Country Z corporation, agree that a development engineer employed by
Corp A will travel to Country Z to provide know-how relating to
certain techniques not generally known to computer programmers,
which will enable Corp I to more efficiently create computer
programs. These techniques represent the product of experience
gained by Corp A from working on many computer programming projects,
and are furnished to Corp I under nondisclosure conditions. Such
information is property subject to trade secret protection.

(ii) Analysis. This transaction contains the elements of know-how
specified in paragraph (e) of this section. Therefore, this
transaction will be treated as the provision of know-how.

Example 17 (i) Facts. Corp A, a U.S. corporation, transfers a disk
containing Program Y to Corp E, a Country Z corporation, in exchange
for a single fixed payment. Program Y is a computer program
development program, which is used to create other computer
programs, consisting of several components, including libraries of
reusable software components that serve as general building blocks
in new software applications. No element of these libraries is a
significant component of any overall new program. Because a computer
program created with the use of Program Y will not operate unless
the libraries are also present, the license agreement between Corp A
and Corp E grants Corp E the right to distribute copies of the
libraries with any program developed using Program Y. The license
agreement is otherwise identical to the license agreement in Example
1.

(ii) Analysis. (A) No non-de minimis copyright rights described in
paragraph (c)(2) of this section have passed to Corp E. For purposes
of paragraph (b)(2) of this section, the right to distribute the
libraries in conjunction with the programs created using Program Y
is a de minimis component of the transaction. Because Corp E has
received a copy of the program under paragraph (c)(1)(ii) of this
section, it has received a copyrighted article.

(B) Taking into account all the facts and circumstances, Corp E is
properly treated as the owner of a copyrighted article.

Therefore, under paragraph (f)(2) of this section, there has been
the sale of a copyrighted article rather than the grant of a lease.

Example 18 (i) Facts. (A) Corp A, a U.S. corporation, transfers a
disk containing Program X to Corp E, a country Z Corporation. The
disk contains both the object code and the source code to Program X
and the license agreement grants Corp E the right to--

(1) Modify the source code in order to correct minor errors and make
minor adaptations to Program X so it will function on Corp E's
computer; and

(2) Recompile the modified source code.

(B) The license does not grant Corp E the right to distribute the
modified Program X to the public. The license is otherwise identical
to the license agreement in Example 1.

(ii) Analysis. (A) No non-de minimis copyright rights described in
paragraph (c)(2) of this section have passed to Corp E. For purposes
of paragraph (b)(2) of this section, the right to modify the source
code and recompile the source code in order to create new code to
correct minor errors and make minor adaptations is a de minimis
component of the transaction.

Because Corp E has received a copy of the program under paragraph
(c)(1)(ii) of this section, it has received a copyrighted article.

(B) Taking into account all the facts and circumstances, Corp E is
properly treated as the owner of a copyrighted article.

Therefore, under paragraph (f)(2) of this section, there has been
the sale of a copyrighted article rather than the grant of a lease.

(i) Effective date--(1) General. This section applies to
transactions occurring pursuant to contracts entered into on or
after December 1, 1998.

(2) Elective transition rules

B-(i) Contracts entered into in taxable years ending on or after
October 2, 1998. A taxpayer may elect to apply this section to
transactions occurring pursuant to contracts entered into in taxable
years ending on or after October 2, 1998. A taxpayer that makes an
election under this paragraph (i)(2)(i) must apply this section to
all contracts entered into in taxable years ending on or after
October 2, 1998.

(ii) Contracts entered into before October 2, 1998. A taxpayer may
elect to apply this section to transactions occurring in taxable
years ending on or after October 2, 1998, pursuant to contracts
entered into before October 2, 1998, provided the taxpayer would not
be required under this section to change its method of accounting as
a result of such election, or the taxpayer would be required to
change its method of accounting but the resulting section 481(a)
adjustment would be zero. A taxpayer that makes an election under
this paragraph (i)(2)(ii) must apply this section to all
transactions occurring in taxable years ending on or after October
2, 1998, pursuant to contracts entered into before October 2, 1998.

(3) Manner of making election. Taxpayers may elect, under paragraph
(i)(2)(i) or (i)(2)(ii) of this section, to apply this section, by
treating the transactions in accordance with these regulations on
their original tax return.

(4) Examples. The following examples illustrate application of the
transition rule of paragraph (i)(2)(ii) of this section:

Example 1. Corp A develops computer programs for sale to third
parties. Corp A uses an overall accrual method of accounting and
files its tax return on a calendar-year basis. In year 1, Corp A
enters into a contract to deliver a computer program in that year,
and to provide updates for each of the following four years. Under
the contract, the computer program and the updates are priced
separately, and Corp A is entitled to receive payments for the
computer program and each of the updates upon delivery. Assume Corp
A properly accounts for the contract as a contract for the provision
of services. Corp A properly includes the payments under the
contract in gross income in the taxable year the payments are
received and the computer program or updates are delivered. Corp A
properly deducts the cost of developing the computer program and
updates when the costs are incurred. Year 3 includes October 2,
1998. Assume under the rules of this section, the provision of
updates would properly be accounted for as the transfer of
copyrighted articles. If Corp A made an election under paragraph (i)
(2)(ii) of this section, Corp A would not be required to change its
method of accounting for income under the contract as a result of
the election. Corp A would also not be required to change its method
of accounting for the cost of developing the computer program and
the updates under the contract as a result of the election.
Therefore, under paragraph (i)(2)(ii) of this section, Corp A may
elect to apply the provisions of this section to the updates
provided in years 3, 4, and 5, because Corp A is not required to
change from its accrual method of accounting for the contract as a
result of the election.

Example 2.

Corp A develops computer programs for sale to third parties. Corp A
uses an overall accrual method of accounting and files its tax
return on a calendar-year basis. In year 1, Corp A enters into a
contract to deliver a computer program and to provide one update the
following year. Under the contract, the computer program and the
update are priced separately, and Corp A is entitled to receive
payment for the computer program and the update upon delivery of the
computer program. Assume Corp A properly accounts for the contract
as a contract for the provision of services. Corp A properly
includes the portion of the payment relating to the computer program
in gross income in year 1, the taxable year the payment is received
and the program delivered. Corp A properly includes the portion of
the payment relating to the update in gross income in year 2, the
taxable year the update is provided, under Rev. Proc. 71-21, 1971-2
CB 549 (see §601.601 (d)(2) of this chapter). Corp A properly
deducts the cost of developing the computer program and update when
the costs are incurred. Year 2 includes October 2, 1998. Assume
under the rules of this section, provision of the update would
properly be accounted for as the transfer of a copyrighted article.
If Corp A made an election under paragraph (i)(2)(ii) of this
section, Corp A would be required to change its method of accounting
for deferring income under its contract as a result of the election.
However, the section 481(a) adjustment would be zero because the
portion of the payment relating to the update would be includible in
gross income in year 2, the taxable year the update is provided,
under both Rev.

Proc. 71-21 and §1.451-5. Corp A would not be required to change its
method of accounting for the cost of developing the computer program
and the update under the contract as a result of the election.
Therefore, under paragraph (i)(2)(ii) of this section, Corp A may
elect to apply the provisions of this section to the update in year
2, because the section 481(a) adjustment resulting from the change
in method of accounting for deferring advance payments under the
contract is zero, and because Corp A is not required to change from
its accrual method of accounting for the cost of developing the
computer program and updates under the contract as a result of the
election.

Example 3. Assume the same facts as in Example 1 except that Corp A
is entitled to receive payments for the computer program and each of
the updates 30 days after delivery. Corp A properly includes the
amounts due under the contract in gross income in the taxable year
the computer program or updates are provided. Assume that Corp A
properly uses the nonaccrual-experience method described in section
448(d)(5) and §1.448-2T to account for income on its contracts. If
Corp A made an election under paragraph (i)(2)(ii) of this section,
Corp A would be required to change from the nonaccrual-experience
method for income as a result of the election, because the method is
only available with respect to amounts to be received for the
performance of services. Therefore, Corp A may not elect to apply
the provisions of this section to the updates provided in years 3,
4, and 5, under paragraph (i)(2)(ii) of this section, because Corp A
would be required to change from the nonaccrual-experience method of
accounting for income on the contract as a result of the election.

(j) Change in method of accounting required by this section--

(1) Consent. A taxpayer is granted consent to change its method of
accounting for contracts involving computer programs, to conform
with the classification prescribed in this section. The consent is
granted for contracts entered into on or after December 1, 1998, or
in the case of a taxpayer making an election under paragraph (i)(2)
(i) of this section, the consent is granted for contracts entered
into in taxable years ending on or after October 2, 1998. In
addition, a taxpayer that makes an election under paragraph (i)(2)
(ii) of this section is granted consent to change its method of
accounting for any contract with transactions subject to the
election, if the taxpayer is required to change its method of
accounting as a result of the election.

(2) Year of change. The year of change is the taxable year that
includes December 1, 1998, or in the case of a taxpayer making an
election under paragraph (i)(2)(i) or (i)(2)(ii) of this section,
the taxable year that includes October 2, 1998.

(k) Time and manner of making change in method of accounting

B-(1) General. A taxpayer changing its method of accounting in
accordance with this section must file a Form 3115, Application for
Change in Method of Accounting, in duplicate.

The taxpayer must type or print the following statement at the top
of page 1 of the Form 3115:

A FILED UNDER TREASURY REGULATION § 1.861-18.

@ The original Form 3115 must be attached to the taxpayers original
return for the year of change. A copy of the Form 3115 must be filed
with the National Office no later than when the original Form 3115
is filed for the year of change.

(2) Copy of Form 3115. The copy required by this paragraph (k)(l) to
be sent to the national office should be sent to the Commissioner of
Internal Revenue, Attention: CC:DOM:IT&A, P.O.

Box 7604, Benjamin Franklin Station, Washington DC 20044 (or in the
case of a designated private delivery service: Commissioner of
Internal Revenue, Attention: CC:DOM:IT&A, 1111 Constitution Avenue,
NW., Washington, DC 20224).

(3) Effect of consent and Internal Revenue Service review.

A change in method of accounting granted under this section is
subject to review by the district director and the national office
and may be modified or revoked in accordance with the provisions of
Rev. Proc. 97-37 (1997-33 IRB 18) (or its successors) (see
§601.601(d)(2) of this chapter).

PART 602--OMB CONTROL NUMBERS UNDER THE PAPERWORK REDUCTION ACT

Par. 3. The authority citation for part 602 continues to read as
follows:

Authority: 26 U.S.C. 7805.

Par. 4. In §602.101, paragraph (c) is amended by adding an entry to
the table in numerical order to read as follows:

§602.101 OMB Control numbers.

* * * * *

(c) * * *

CFR part or section where Current OMB identified and described
control No.

* * * * *

1.861-18...............................................1545-1594

* * * * *

Deputy Commissioner of Internal Revenue
Approved:
Deputy Assistant Secretary of the Treasury

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