U.S. Character and Sourcing of Software Sales

Written by Gregory A. Fallon on Tuesday, 14 July 2015.

U.S. Character and Sourcing of Software Sales

When U.S. companies are involved in international transactions they need to understand where their income will be sourced and how it will be characterized before they can develop effective tax strategies.  These two factors will also be important when taxpayers take advantage of the Foreign Tax Credit.  This article will be focusing on sourcing and character of international and US software sales for “shrink wrap” software.  When classifying software transactions it is important to first determine what rights have been transferred.  The character of software sales is not based on the form adopted by the sellers and buyers or controlled by copyright law it is determined by IRS regulations.  Treas. Reg. 1.861-18(g) focuses on the rights that are acquired by the buyer in determining the type of income.

Shrink Wrapped Software Sales

The sale of most software involves the sale of a physical CD combined with a “shrink wrap’ license that restricts the buyer from selling or making the software public.  This “shrink wrap” license is commonly used in the sale of copyrighted articles.  Software sold with a “shrink wrap” license are sales of a copyrighted article and characterized as the sale of inventory.  Software sold and downloaded over the internet with “shrink wrap” licenses are characterized the same way as sales of physical CDs.  Treas. Reg. 1.861-18(g)(2) holds that the method of delivery will have no impact on the character of the sale.  Now that we have determined that the software sale is the sale of a copyrighted article we can determine how to source the sale.

Income from the sale of inventory is sourced based on where title of the goods passes under IRC 861(a)(6). When software is sold title usually passes when the buyer takes possession of it.  A taxpayer that purchases a software CD from a store will take title of the CD at the register.  In most cases,  If the taxpayer purchases the software by downloading it from the internet they will take possession of it once it is downloaded to their PC.  Some may argue that title passes on the server where it is made available to the buyer but in the event that a buyer is unable to download the software they can almost always get a refund which would imply that the title does not passed until it reaches the buyers computer. Sales of shrink wrapped software will be characterized as income from the sale of inventory and they will be sourced to where title passes as a general rule.  There is an exception to the sourcing of these sales if certain factors are true.  In example, a US or foreign company that manufactures its software (develops and produces it) in one country and sells it to another country may allocate its sales 50/50 to the place of production and the place of sale. However, in order to take advantage of the provision the item being sold must not have an uncontrolled comparable price (the item cannot be something like paper or oil). Using this exception to your advantage can result in substantial tax savings.

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About the Author

Gregory A. Fallon

Gregory A. Fallon

Gregory Fallon is an Enrolled Agent (EA) and as such is admitted by the Treasury Department to practice (represent clients) before the IRS. Gregory has a Master's of Science in Taxation (MST) from Golden Gate University and a B.S. in Business Administration from Northeastern University in Boston, MA.  Gregory is also a Certified Public Accountant (CPA) in Massachusetts and a member of the AICPA.

Gregory began his career in public accounting as an auditor and tax analyst for a regional CPA firm in Boston, MA. In early 2006 he moved to Santa Monica, CA to pursue an opportunity with a national defense contractor.Gregory's knowledge of various federal and state tax laws  has allowed him to create and implement  customized tax strategies for clients.  Currently, Gregory focuses on international tax planning and preparation for individuals and small to mid size firms.