Title 26—Internal Revenue--Volume 1
PART 1—INCOME TAXES
§ 1.861-14T   Special rules for allocating and apportioning certain expenses (other than interest expense) of an affiliated group of corporations (temporary).
(a) In general. Section 1.861-11T provides special rules for allocating and apportioning interest expense of an affiliated group of corporations. The rules of this § 1.861-14T also relate to affiliated groups of corporations and implement section 864(e)(6), which requires affiliated group allocation and apportionment of expenses other than interest which are not directly allocable and apportionable to any specific income producing activity or property. In general, the rules of this section apply to taxable years beginning after December 31, 1986. Paragraph (b) of this section describes the scope of the application of the rule for the allocation and apportionment of such expenses of affiliated groups of corporations. Such rule is then set forth in paragraph (c) of this section. Paragraph (d) of this section contains the definition of the term “affiliated group” for purposes of this section. Paragraph (e) of this section describes the expenses subject to allocation and apportionment under the rules of this section. Paragraph (f) of this section provides rules concerning the affiliated group allocation and apportionment of such expenses in computing the combined taxable income of a FSC or DISC and its related supplier. Paragraph (g) of this section describes the treatment of losses caused by apportionment of such expenses in the case of an affiliated group that does not file a consolidated return. Paragraph (h) of this section provides rules concerning the treatment of the reserve expenses of a life insurance company. Paragraph (j) of this section provides examples illustrating the application of this section.
(b) Scope —(1) Application of section 864(e)(6). Section 864(e)(6) and this section apply to the computation of taxable income for purposes of computing separate limitations on the foreign tax credit under section 904. Section 864(e)(6) and this section also apply in connection with section 907 to determine reductions in the amount allowed as a foreign tax credit under section 901. Section 864(e)(6) and this section also apply to the computation of the combined taxable income of the related supplier and a foreign sales corporation (FSC) (under sections 921 through 927) as well as the combined taxable income of the related supplier and a domestic international sales corporation (DISC) (under sections 991 through 997).
(2) Nonapplication of section 864(e)(6). Section 864(e)(6) and this section do not apply to the computation of subpart F income of controlled foreign corporations (under sections 951 through 964) or the computation of effectively connected taxable income of foreign corporations.
(3) Application of section 864(e)(6) to the computation of combined taxable income of a possessions corporation and its affiliates. [Reserved]
(c) General rule for affiliated corporations —(1) General rule. (i) Except as otherwise provided in paragraph (c)(2) of this section, the taxable income of each member of an affiliated group within each statutory grouping shall be determined by allocating and apportioning the expenses described in paragraph (e) of this section of each member according to apportionment fractions which are computed as if all members of such group were a single corporation. For purposes of determining these apportionment fractions, any interaffiliate transactions or property that are duplicative with respect to the measure of apportionment chosen shall be eliminated. For example, in the application of an asset method of apportionment, stock in affiliated corporations shall not be taken into account, and loans between members of an affiliated group shall be treated in accordance with the rules of § 1.861-11T(e). Similarly, in the application of a gross income method of apportionment, interaffiliate dividends and interest, gross income from sales or services, and other interaffiliate gross income shall be eliminated. Likewise, in the application of a method of apportionment based on units sold or sales receipts, interaffiliate sales shall be eliminated.
(ii) Except as otherwise provided in this section, the rules of § 1.861-8T apply to the allocation and apportionment of the expenses described in paragraph (e) of this section. Thus, allocation under this paragraph (c) is accomplished by determining, with respect to each expense described in paragraph (e), the class of gross income to which the expense is definitely related and then allocating the deduction to such class of gross income. For this purpose, the gross income of all members of the affiliated group must be taken in account. Then, the expense is apportioned by attributing the expense to gross income (within the class to which the expense has been allocated) which is in the statutory grouping and to gross income (within the class) which is in the residual grouping. Section 1.861-8T(c)(1) identifies a number of factors upon which apportionment may be based, such as comparison of units sold, gross sales or receipts, assets used, or gross income. The apportionment method chosen must be applied consistently by each member of the affiliated group in apportioning the expense when more than one member incurred the expense or when members incurred separate portions of the expense. The apportionment fraction must take into account the apportionment factors contributed by all members of the affiliated group. In the case of an affiliated group of corporations that files a consolidated return, consolidated foreign tax credit limitations are computed for the group in accordance with the rules of § 1.1502-4. For purposes of this section the term “taxpayer” refers to the affiliated group (regardless of whether the group files a consolidated return), rather than to the separate members thereof.
(2) Expenses relating to fewer than all members. An expense relates to fewer than all members of an affiliated group if the expense is allocable under paragraph (e)(1) of this section to gross income of at least one member other than the member that incurred the expense but fewer than all members of the affiliated group. The taxable income of the member that incurred the expense shall be determined by apportioning that expense under the rules of paragraph (c)(1) of this section as if the members of the affiliated group that derive gross income to which such expense is allocable under paragraph (e)(1) were treated as a single corporation.
(3) Prior application of section 482. The rules of this section do not supersede the application of section 482 and the regulations thereunder. Section 482 may be applied effectively to deny a deduction for an expense to one member of an affiliated group and to allow a deduction for that expense to another member of the affiliated group. In cases to which section 482 is applied, expenses shall be reallocated and reapportioned under section 864(e)(6) and this section after taking into account the application of section 482.
(d)(1)-(2) [Reserved]. For further guidance, see § 1.861-14(d)(1) and (2).
(e) Expenses to be allocated and apportioned under this section. (1) Expenses not directly traceable to specific income producing activities or property. (i) For further guidance, see § 1.861-14(e)(1)(i).
(ii) An item of expense is not considered to be directly allocable to specific income producing activities or property solely of the member incurring the expense if, were all members of the affiliated group treated as a single corporation, the expense would not be considered definitely related, within the meaning of § 1.861-8T(b)(2), only to a class of gross income derived solely by the member which actually incurred the expense. Furthermore, the expense is presumed not to be definitely related only to a class of gross income derived solely by the member incurring the expense (and is, therefore, presumed not to be directly allocable to specific income producing activities or property of that member) unless the taxpayer is able affirmatively to establish otherwise. As provided in paragraph (c)(1) of this section, expenses described in this paragraph (e)(1) generally shall be apportioned by the member incurring the expense according to apportionment fractions computed as if all members of the affiliated group were a single corporation. Under paragraph (c)(2) of this section, however, an expense shall be apportioned according to apportionment fractions computed as if only some (but fewer than all) members of the affiliated group were a single corporation, if the expense is considered allocable to gross income of at least one member other than the member incurring the expense but fewer than all members of the affiliated group. An item of expense shall be considered to be allocable to gross income of fewer than all members of the group if, were all members of the affiliated group treated as a single corporation, the expense would not be considered definitely related within the meaning of § 1.861-8T(b)(2) to gross income derived by all members of the group. In such case, the expense shall be considered allocable, for purposes of paragraph (c)(2) of this section, to gross income of those members of the group that generated (or could reasonably be expected to generate) the gross income to which the expense would be considered definitely related if the group were treated as a single corporation.
(2) Research and experimental expenses. (i) For further guidance, see § 1.861-14(e)(2)(i) and (ii).
(ii) [Reserved]
(3) Expenses related to supportive functions. Expenses which are supportive in nature (such as overhead, general and administrative, supervisory expenses, advertising, marketing, and other sales expenses) are to be allocated and apportioned in accordance with the rules of § 1.861-8T(b)(3). To the extent that such expenses are not directly allocable under paragraph (e)(1)(ii) of this section to specific income producing activities or property of the member of the affiliated group that incurred the expense, such expenses must be allocated and apportioned as if all members of the affiliated group were a single corporation in accordance with the rules of paragraph (c) of this section. Specifically, such expenses must be allocated to a class of gross income that take into account gross income that is generated, has been generated, or could reasonably have been expected to have been generated by the members of the affiliated group. If the expenses relate to the gross income of fewer than all members of the affiliated group as determined under paragraph (c)(2) of this section, then those expenses must be apportioned under the rules of paragraph (c)(2) of this section, as if those fewer members were a single corporation. See Example (3) of paragraph (j) of this section. Such expenses must be apportioned between statutory and residual groupings of income within the appropriate class of gross income by reference to the apportionment factors contributed by the members of the affiliated group that are treated as a single corporation.
(4) Section 250 deduction. For further guidance, see § 1.861-14(e)(4).
(5) Legal and accounting fees and expenses; damages awards, prejudgment interest, and settlement payments. For further guidance, see § 1.861-14(e)(5).
(f) Computation of FSC or DISC combined taxable income. In the computation under the pricing rules of sections 925 and 994 of the combined taxable income of any FSC or DISC and its related supplier which are members of an affiliated group, the combined taxable income of such FSC or DISC and its related supplier shall be reduced by the portion of the expenses of the affiliated group described in paragraph (e) of this section that is incurred in connection with export sales involving that FSC or DISC. In order to determine the portion of the expenses of the affiliated group that is incurred in connection with export sales by or through a FSC or DISC, the portion of the total of the apportionment factor chosen that relates to the generation of that export income must be determined. Thus, if gross income is the apportionment factor chosen, the portion of total gross income of the affiliated group that consists of combined gross income derived from transactions involving the FSC or DISC and related supplier must be determined. Similarly, if units sold or sales receipts is the apportionment factor chosen, the portion of total units sold or sales receipts that generated export income of the FSC or DISC and related supplier must be determined. The amount of the expense shall then be multiplied by a fraction, the numerator of which is the export related apportionment factor as determined above, and the denominator of which is the total apportionment factor. Thus, if gross income is the apportionment factor chosen, apportionment is based on a fraction, the numerator of which is export related combined gross income of the FSC or DISC and related supplier and the denominator of which is the total gross income of the affiliated group. Similarly, if units sold or sales receipts is the apportionment factor chosen, the fraction is the units sold or sales receipts that generated export income of the FSC or DISC and related supplier over the total units sold or sales receipts of the affiliated group. Under this rule, expenses of other group members may be attributed to the combined gross income of a FSC of DISC and its related supplier without affecting the amount of expenses (other than any commission payable by the related supplier to the FSC or DISC) otherwise deductible by the FSC or DISC, the related supplier, or other members of the affiliated group. The FSC or DISC must calculate combined taxable income, taking into account any reduction by expenses attributed from other members of the affiliated group to determine the commission derived by the FSC or DISC or the transfer price of qualifying export property sold to the FSC or DISC.
(g) Losses created through apportionment. In the case of an affiliated group that does not file a consolidated return, the taxable income in any separate limitation category must be adjusted under this paragraph (g) for purposes of computing the separate foreign tax credit limitations under section 904(d). As a consequence of the affiliated group allocation and apportionment of expenses required by section 864(e)(6) and this section, expenses of a group member may be apportioned for section 904 purposes to a limitation category with a consequent loss in that limitation category. For purposes of this paragraph, the term “limitation category” includes domestic source income, as well as the types of income described in section 904(d)(1) (A) through (I). A loss of one affiliate in a limitation category will reduce the income of another member in the same limitation category if a consolidated return is filed. ( See § 1.1502-4.) If a consolidated return is not filed, this netting does not occur. Accordingly, in such a case, the following adjustments among members are required, in order to give effect to the group allocation of expense:
(1) Losses created through group apportionment of expense in one or more limitation categories within a given member must be eliminated; and
(2) A corresponding amount of income of other members in the same limitation category must be recharacterized.
(h) Special rule for allocation of reserve expenses of life insurance companies. For further guidance, see § 1.861-14(h).
(i) [Reserved]
(j) Examples. The rules of this section may be illustrated by the following examples. All of these examples assume that section 482 has not been applied by the Commissioner.
1 Examples 1 and 4 of this paragraph (j) apply to taxable years beginning before January 1, 2018.
(ii) P, X and Y are affiliated corporations within the meaning of section 864(e)(5) and this section. The research expenses incurred by X are allocable to all income connected with the relevant broad category listed in § 1.861-8T(e)(3)(i). Both X and Y have gross income includible within the class of gross income related to that product category. Accordingly, the research and experimental expenses incurred by X are to be allocated and apportioned as if X and Y were a single corporation. The apportionment for 1988 is as follows:
(ii) Analysis. P, X and Y are an affiliated group of corporations within the meaning of section 864(e)(5). The training expenses incurred by P are not definitely related solely to specific income producing activities or property of P. The employees of X and Y also participate in the training program. Thus, this expense relates to gross income generated by P, X and Y. This expense is definitely related and allocable to all of the gross income from foreign and domestic sources of P, X and Y. It is assumed that apportionment on the basis of gross income is reasonable. The apportionment of the expense is as follows:
(ii) Analysis. Because only the employees of P and X participate in the training program and they perform no services for Y, the expense relates only to gross income generated by P and X. Accordingly, the $100,000 expense must be allocated and apportioned as if P and X were a single corporation. The apportionment of the $100,000 expense is as follows:
(ii) Analysis. The stewardship expenses incurred by P are not directly allocable to specific income producing activities or property of P. The expense is definitely related and allocable to dividends received or to be received by X. Accordingly, the expense of P is allocated and apportioned as if P and X were a single corporation. The expense is definitely related to dividends received or to be received by X from Y, a foreign corporation. Such dividends are foreign source general limitation income. Thus, the entire amount of the expense must be allocated to foreign source dividend income.
(ii) Analysis. The legal expenses incurred by P are not definitely related solely to specific income producing activities or property of P. The expense is definitely related and allocable to the class of gross income which includes only gross income generated by Y. Accordingly, the expense of P is allocated and apportioned as if Y were the only member of the affiliated group, as follows:
(ii) Analysis. P and R are an affiliated group of corporations within the meaning of section 864(e)(5) and this section. The expense incurred by P for marketing studies regarding the worldwide market for product A is an expense that is not directly related solely to the activities of P, but also to the activities of R. This expense must be allocated and apportioned under the rules of paragraph (c)(1) of this section, as if P and R were a single corporation. The expense is allocable to the class of gross income that includes all gross income generated by sales of product A. Apportionment on the basis of gross receipts is reasonable under these facts. F, a foreign corporation, is not a member of the affiliated group. However, for purposes of determining F's commission on its sales, the combined gross income of F and R must be reduced by the portion of the marketing studies expense of P that is incurred in connection with export sales involving F under the rules of paragraph (f) of this section. The computation of the combined taxable income of R and F is as follows:
(k) Effective/applicability date. The rules of this section apply for taxable years beginning after December 31, 1986.
§ 1.861-15   Income from certain aircraft or vessels first leased on or before December 28, 1980.
(a) General rule. A taxpayer who owns an aircraft or vessel described in paragraph (b) of this section and who leases the aircraft or vessel to a United States person (other than a member of the same controlled group of corporations (as defined in section 1563) as the taxpayer) may elect under paragraph (f) of this section to treat all amounts includible in gross income with respect to the aircraft or vessel as income from sources within the United States for any taxable year ending after the commencement of the lease. This paragraph (a) applies only with respect to taxable years ending after August 15, 1971, and only with respect to leases entered into after that date of aircraft or vessels first leased by the taxpayer on or before December 28, 1980. An election once made applies to the taxable year for which made and to all subsequent taxable years unless it is revoked or terminated in accordance with paragraph (g) of this section. A taxpayer need not be a United States person to be eligible to make the election under this section, unless otherwise required by a provision of law not contained in the Internal Revenue Code of 1954. In addition, the taxpayer need not be a bank or other financial institution to be eligible to make this election. The term “United States person” as used in this section has the meaning assigned to it by section 7701(a)(30).
(b) Property to which the election applies —(1) Section 38 property. An election made under this section may be made only if the aircraft or vessel is section 38 property, or property which would be section 38 property but for section 48(a)(5) (relating to property used by governmental units), at the time the election is made and for all taxable years to which the election applies. The aircraft or vessel must be property which qualifies for the investment credit under section 38 unless the property does not qualify because it is described in section 48(a)(5). If an aircraft is used predominantly outside the United States (determined under § 1.48-1(g)(1)), it must qualify under the provisions of section 48(a)(2)(B)(i) and § 1.48-1(g)(2)(i). If a vessel is used predominantly outside the United States, it must qualify under the provisions of section 48(a)(2)(B)(iii) and § 1.48-1(g)(2)(iii). The aircraft or vessel may not be suspension or termination period property described in section 48(h) or section 49(a) (as in effect before the enactment of the Revenue Act of 1978). See paragraph (g) (3) and (4) of this section for rules which apply if the property ceases to be section 38 property.
(2) United States manufacture or construction. An election under this section may be made only if the aircraft or vessel is manufactured or constructed in the United States. The aircraft or vessel will be considered to be manufactured or constructed in the United States if 50 percent or more of the basis of the aircraft or vessel is attributable to value added within the United States.
(3) Exclusion of certain property used outside the United States. The term “aircraft or vessel” as used in this paragraph (b) does not include any property which is used predominantly outside the United States and which qualifies as section 38 property under—
(i) Section 48(a)(2)(B)(v), relating to containers used in the transportation of property to and from the United States,
(ii) Section 48(a)(2)(B)(vi), relating to certain property used for the purpose of exploring for, developing, removing, or transporting resources from the Outer Continental Shelf, or
(iii) Section 48(a)(2)(B)(x), relating to certain property used in international or territorial waters.
(c) Leases or subleases to which the election applies. At the time the election under this section is made and for all taxable years for which the election applies, the lessee of the aircraft or vessel must be a United States person. In addition, the aircraft or vessel may not be subleased to a person who is not a United States person unless the sublease is a short-term sublease. For purposes of this section, a short-term sublease is a sublease for a period of time (including any period for which the sublease may be renewed or extended) which is less than 30 percent of the asset guideline period of the aircraft or vessel leased (determined under section 167(m)). See paragraphs (g) (3) and (4) of this section for rules which apply if the requirements of this paragraph (c) are not met.
(d) Income to which the election applies. An election under this section applies to all amounts derived by the taxpayer with respect to the aircraft or vessel which is subject to the election. The election applies to all amounts which are includible in the taxpayer's gross income whether or not includible during or after the period of a lease to which the election applies. Amounts derived by the taxpayer with respect to the aircraft or vessel include any gain from the sale, exchange, or other disposition of the aircraft or vessel. If by reason of the allowance of expenses and other deductions, there is a loss with respect to an aircraft or vessel, the election applies to treat the loss as having a source within the United States. Similarly, if the sale, exchange or other disposition of the aircraft or vessel which is subject to an election results in a loss, it is treated as having a source within the United States. See paragraph (e)(2) of this section for the application of an election under this section to the income of certain transferees or distributees.
(e) Effect of election —(1) In general. An election under this section applies to the taxable year for which it is made and to all subsequent taxable years for which amounts in respect of the aircraft or vessel to which the election relates are includible in gross income. However, the election may be revoked under paragraph (g) (1) or (2) of this section or terminated under paragraph (g)(3) of this section.
(2) Certain transfers involving carryover of basis. (i) If an electing taxpayer transfers or distributes an aircraft or vessel which is subject to the election under this section, the transferee or distributee will be treated as having made an election under this section with respect to the aircraft or vessel if the basis of the aircraft or vessel in the hands of the transferee or distributee is determined by reference to its basis in the hands of the transferor or distributor. This paragraph (e)(2)(i) applies even though the transferor or distributor recognizes an amount of gain which increases basis in the hands of the transferee or distributee and even though the transferee of distributee is a nonresident alien individual or foreign corporation. For example, if a corporation distributes a vessel which is subject to an election under this section to its parent corporation in a complete liquidation described in section 332(b), the parent corporation will be required to treat all amounts includible in its gross income with respect to the vessel as income from source within the United States if, unless the election is revoked or terminated under paragraph (g) of this section, the basis of the property in the hands of the parent is determined under section 334(b)(1) (relating to the general rule on carryover of basis). In further illustration, if a corporation distributes a vessel (subject to an election) in a distribution to which section 301(a) applies, the distributee will be treated as having made the election with respect to the vessel if its basis is determined under section 301(d)(2) (relating to basis of corporate distributees) even though the basis is the fair market value of the vessel under section 301(d)(2)(A).
(ii) If a member of an affiliated group which files a consolidated return transfers an aircraft or vessel subject to an election to another member of that group, the transferee will be treated as having made the election with respect to the aircraft or vessel. In addition, if a partnership distributes an aircraft or vessel subject to an election to a partner, the partner will be treated as having made the election with respect to the aircraft or vessel.
(iii) If paragraph (e)(2) (i) and (ii) of this section do not apply, the election under this section with respect to an aircraft or vessel will not be considered as made by a transferee or distributee.
(f) Election —(1) Time for making the election. The election under this section must be made before the expiration of the period prescribed by section 6511(a) (or section 6511(c) if the period is extended by agreement) for making a claim for credit or refund of the tax imposed by chapter 1 for the first taxable year for which the election is to apply. The period for that first taxable year is determined without regard to the special periods prescribed by section 6511(d).
(2) Manner of making the election. An election under this section must be made by filing with the income tax return (or an amended return) for the first taxable year for which the election is to apply a statement, signed by the taxpayer, to the effect that the election under section 861(e) is being made. The statement must—
(i) Set forth sufficient facts to identify the aircraft or vessel which is the subject of the election,
(ii) State that the aircraft or vessel was manufactured or constructed in the United States,
(iii) State that the aircraft or vessel is section 38 property described in § 1.861-9(b) which was leased to a United States person (as defined in section 7701(a)(30) of the Code) pursuant to a lease entered into after August 15, 1971,
(iv) State that the electing taxpayer is the owner of the aircraft or vessel,
(v) State the lessee of the aircraft or vessel is not a member of a controlled group of corporations (as defined in section 1563) of which the taxpayer is a member,
(vi) Give the name and taxpayer identification number of the lessee of the aircraft or vessel, and
(vii) State that the aircraft or vessel is not subject to a sublease (other than a short-term sublease) to any person who is not a United States person.
(3) Election by partnership. Any election under this section with respect to an aircraft or vessel owned by a partnership shall be made by the partnership. Any partnership election is applicable to each partner's partnership interest in the aircraft or vessel. However, an election made by a partner before August 8, 1979 will be recognized where the partnership made no election and the election can no longer be revoked without the consent of the Commissioner under paragraph (g)(1) of this section.
(g) Termination of election —(1) Revocation without consent. A taxpayer may revoke an election within the time prescribed in paragraph (f)(1) of this section without the consent of the Commissioner. In such a case, the taxpayer must file an amended income tax return for any taxable year to which the election applied.
(2) Revocation with consent. Except as provided in paragraph (g) (1) or (3) of this section, an election made under this section is binding unless consent to revoke is obtained from the Commissioner. A request to revoke the election must be made in writing and addressed to the Assistant Commissioner of Internal Revenue (Technical), Attention: T:C:C:3, Washington, DC 20224. The request must include the name and address of the taxpayer and be signed by the taxpayer or his duly authorized representative. It must specify the taxable year or years for which the revocation is to be effective and must be filed at least 90 days prior to the time (not including extensions) prescribed by law for filing the income tax return for the first taxable year for which the revocation of the election is to be effective or by November 6, 1979 whichever is later. The request must specify the grounds which are considered to justify the revocation. The Commissioner may require such additional information as may be necessary in order to determine whether the proposed revocation will be permitted. Consent will generally not be given to revoke an election where the revocation would result in treating gross income with respect to the aircraft or vessel (including any gain from the sale, exchange, or other disposition of such aircraft or vessel) as income from sources without the United States where, during the period the election was in effect, there were losses from sources within the United States. A copy of the consent of the Commissioner to revoke must be attached to the taxpayer's income tax return (or amended return) for each taxable year affected by the revocation.
(3) Automatic termination. If an aircraft or vessel subject to an election under section 861(e) ceases to be section 38 property, ceases to be leased by its owner directly to a United States person, or is subleased (other than a short-term sublease) to a person who is not a United States person, within the period set forth in section 6511(a) (or section 6511(c) if the period is extended by agreement) for making a claim for credit or refund of the tax imposed by chapter 1 for the first taxable year for which the election applied, then the election with respect to such aircraft or vessel will automatically terminate. If the election terminates, the taxpayer who made the election must file an amended tax return or claim for credit or refund, as the case may be, for any taxable year to which the election applied.
(4) Factors not causing revocation or termination. The fact that an aircraft or vessel ceases to be section 38 property, ceases to be leased by its owner directly to a United States person, or is leased or subleased for any period of time to a person who is not a United States person, after expiration of the period set forth in section 6511(a) (or section 6511(c) if the period is extended by agreement) for making a claim for credit or refund of the tax imposed by chapter 1 for the first taxable year for which the election applied, will not cause a termination of the election made under this section with respect to the aircraft or vessel. For example, the electing taxpayer is not relieved from any of the consequences of making the election merely because the aircraft or vessel is subleased to a person who is not a United States person for a period in excess of that allowed for short-term subleases under paragraph (c) of this section after expiration of the later of 3 years from the time the return was filed for the first taxable year to which the election applied or 2 years from the time the tax was paid for that year where the period set forth in section 6511(a) has not been extended by agreement.
(5) Effect of revocation or termination. If an election is revoked or terminated under this paragraph (g), the taxpayer is required to recompute the tax for the appropriate taxable years without reference to section 861(e)(1).
(6) Revocation or termination after December 28, 1980. The rules in paragraph (g)(1) through (g)(5) continue to apply with respect to any election made pursuant to this section even though the revocation or termination may occur after December 28, 1980.
§ 1.861-16   Income from certain craft first leased after December 28, 1980.
(a) General rule. If a taxpayer—
(1) Owns a qualified craft (as defined in paragraph (b) of this section).
(2) Leases such qualified craft after December 28, 1980, to a United States person that is not a member of the same controlled group of corporations as the taxpayer, and
(3) The lease is the taxpayer's first lease of the craft and the taxpayer is not considered to have made an election with respect to the craft under § 1.861-9(e)(2),
(b) Qualified craft —(1) In general. A qualified craft is a vessel, aircraft, or spacecraft that—
(i) Is section 38 property (or would be section 38 property but for section 48(a)(5), relating to use by governmental units), and
(ii) Is manufactured or constructed in the United States.
(2) Vessel. The term “vessel” includes every type of watercraft capable of being used as a means of transportation on water, and any items of property that are affixed in a permanent fashion or are integral to the vessel. A vessel that is used predominately outside the United States must be described in section 48(a)(2)(B)(iii) and § 1.48-1(g)(2)(iii), relating to vessels documented for use in the foreign or domestic commerce of the United States, to be a qualified craft.
(3) Aircraft. An aircraft used predominantly outside the United States must be described in section 48(a)(2)(B)(i) and § 1.48-1(g)(2)(i), relating to aircraft registered by the Administrator of the Federal Aviation Agency, and operated to and from the United States or operated under contract with the United States, to be a qualified craft.
(4) Spacecraft. A spacecraft must be described in section 48(a)(2)(B)(viii) and § 1.48-1(g)(2)(viii), relating to communications satellites, or any interest therein, of a United States person, to be a qualified craft.
(5) United States manufacture or construction. A craft will be considered to be manufactured or constructed in the United States if 50 percent or more of the basis of the craft on the date of the lease to a United States person is attributable to value added within the United States.
(c) United States person. For purposes of this section, the term “United States person” includes those persons described in section 7701(a)(30) and individuals with respect to whom an election under section 6013 (g) or (h) (relating to nonresident alien individuals married to United States citizens or residents) is in effect.
(d) Controlled group. For purposes of paragraph (a)(2) of this section, whether a taxpayer and a United States person are members of the same controlled group of corporations is determined under section 1563. Solely for purposes of this section, if at least 80% of the capital interest, or the profits interest, in a partnership is owned, directly or indirectly, by a member or members of a controlled group of corporations, then the partnership shall be considered a member of that controlled group of corporations. In addition, if at least 80% of the capital interest, or the profits interest, in a partnership is owned, directly or indirectly, by a corporation, then the partnership and that corporation shall be considered members of a controlled group of corporations.
(e) Certain transfers and distributions —(1) Transfers and distributions involving carryover of basis. If—
(i) The income with respect to a craft is subject to this section,
(ii) The taxpayer transfers or distributes such craft, and
(iii) The basis of such craft in the hands of the transferee or distributee is determined by reference to its basis in the hands of the transferor or distributor,
(2) Partnerships. If a partnership satisfies the requirements of paragraph (a)(1), (2), and (3) of this section, each partner shall treat all amounts includible in gross income with respect to the craft as income from sources within the United States for any taxable year of the partnership ending after commencement of the lease. In addition, if a partnership distributes a craft the income of which is subject to this section, to a partner, the partner will be treated as if he or she satisfied the requirements of paragraph (a) of this section with respect to such craft.
(3) Affiliated groups. If a member of a group of corporations that files a consolidated return transfers a craft, the income of which is subject to this section, to another member of that same group, the transferee will be treated as if it satisfied the requirements of paragraph (a) of this section with respect to the craft.
§ 1.861-17   Allocation and apportionment of research and experimental expenditures.
(a) Scope. This section provides rules for the allocation and apportionment of research and experimental expenditures that a taxpayer deducts, or amortizes and deducts, in a taxable year under section 174 or section 59(e) (applicable to expenditures that are allowable as a deduction under section 174(a)) ( R&E expenditures ). R&E expenditures do not include any expenditures that are not deductible expenses by reason of the second sentence under § 1.482-7(j)(3)(i) (relating to CST Payments (as defined in § 1.482-7(b)(1)) owed to a controlled participant in a cost sharing arrangement).
(b) Allocation —(1) In general. The method of allocation and apportionment of R&E expenditures set forth in this section recognizes that research and experimentation is an inherently speculative activity, that findings may contribute unexpected benefits, and that the gross income derived from successful research and experimentation must bear the cost of unsuccessful research and experimentation. In addition, the method set forth in this section recognizes that successful R&E expenditures ultimately result in the creation of intangible property that will be used to generate income. Therefore, R&E expenditures ordinarily are considered deductions that are definitely related to gross intangible income (as defined in paragraph (b)(2) of this section) reasonably connected with the relevant SIC code category (or categories) of the taxpayer and therefore allocable to gross intangible income as a class related to the SIC code category (or categories) and apportioned under the rules in this section. For purposes of the allocation under this paragraph (b)(1), a taxpayer's SIC code category (or categories) are determined in accordance with the provisions of paragraph (b)(3) of this section. For purposes of this section, the term intangible property means intangible property (as defined in section 367(d)(4)), including intangible property either created or acquired by the taxpayer, that is derived from R&E expenditures.
(2) Definition of gross intangible income. The term gross intangible income means all gross income earned by a taxpayer that is attributable to a sale or license of intangible property (including income from platform contribution transactions described in § 1.482-7(b)(1)(ii), royalty income from the licensing of intangible property, or amounts taken into account under section 367(d) by reason of a transfer of intangible property), and the full amount of gross income from sales or leases of products or services if the income is derived directly or indirectly (in whole or in part) from intangible property. Gross intangible income also includes a distributive share of any amounts described in the previous sentence, but does not include dividends or any amounts included in income under section 951, 951A, or 1293. See § 1.904-4(f)(2)(vi) for rules addressing the assignment of gross income, including gross intangible income, to a separate category by reason of certain disregarded payments to or from a taxpayer's foreign branch.
(3) SIC code categories —(i) Allocation based on SIC code categories. Ordinarily, a taxpayer's R&E expenditures are incurred to produce gross intangible income that is reasonably connected with one or more relevant SIC code categories. Except as provided in paragraph (b)(3)(iv) of this section, where research and experimentation is conducted with respect to more than one SIC code category, the taxpayer may aggregate the categories for purposes of allocation and apportionment, provided the categories are in the same Major Group. However, the taxpayer may not subdivide any categories. Where research and experimentation is not clearly related to any SIC code category (or categories), it will be considered conducted with respect to all of the taxpayer's SIC code categories.
(ii) Use of three digit standard industrial classification codes. A taxpayer determines the relevant Major Groups and SIC code categories by reference to the two digit and three digit classification, respectively, of the Standard Industrial Classification Manual (SIC code). The SIC Manual is available at https://www.osha.gov/pls/imis/sic_manual.html.
(iii) Consistency. Once a taxpayer selects a SIC code category or Major Group for the first taxable year for which this section applies to the taxpayer, it must continue to use that category in following years unless the taxpayer establishes to the satisfaction of the Commissioner that, due to changes in the relevant facts, a change in the category is appropriate. Therefore, once a taxpayer elects a permissible aggregation of three digit SIC code categories into a two digit Major Group, it must continue to use that two digit category in following years unless the taxpayer establishes to the satisfaction of the Commissioner that, due to changes in the relevant facts, a change is appropriate.
(iv) Wholesale trade and retail trade categories. A taxpayer must use a SIC code category within the divisions of “wholesale trade” or “retail trade” if it is engaged solely in sales-related activities with respect to a particular category of products. In the case of a taxpayer that conducts material non-sales-related activities with respect to a particular category of products, all R&E expenditures related to sales of the products must be allocated and apportioned as if the expenditures were reasonably connected to the most closely related three digit SIC code category other than those within the wholesale and retail trade divisions. For example, if a taxpayer engages in both the manufacturing and assembling of cars and trucks (SIC code 371) and in a wholesaling activity related to motor vehicles and motor vehicle parts and supplies (SIC code 501), the taxpayer must allocate and apportion all R&E expenditures related to both activities as if they relate solely to the manufacturing SIC code 371. By contrast, if the taxpayer engages only in the wholesaling activity related to motor vehicles and motor vehicle parts and supplies, the taxpayer must allocate and apportion all R&E expenditures to the wholesaling SIC code 501.
(c) Exclusive apportionment. Solely for purposes of applying this section to section 904 as the operative section, an amount equal to fifty percent of a taxpayer's R&E expenditures in a SIC code category (or categories) is apportioned exclusively to the residual grouping of U.S. source gross intangible income if research and experimentation that accounts for at least fifty percent of such R&E expenditures was performed in the United States. Similarly, an amount equal to fifty percent of a taxpayer's R&E expenditures in a SIC code category (or categories) is apportioned exclusively to the statutory grouping (or groupings) of foreign source gross intangible income in that SIC code category if research and experimentation that accounts for more than fifty percent of such R&E expenditures was performed outside the United States. If there are multiple separate categories with foreign source gross intangible income in the SIC code category, the fifty percent of R&E expenditures apportioned under the previous sentence is apportioned ratably to foreign source gross intangible income based on the relative amounts of gross receipts from gross intangible income in the SIC code category in each separate category, as determined under paragraph (d) of this section. Solely for purposes of determining whether fifty percent or more of R&E expenditures in a year are performed within or without the United States under this paragraph (c), a taxpayer's R&E expenditures with respect to a taxable year are determined by taking into account only the R&E expenditures incurred in such taxable year (without regard to whether such expenditures are capitalized under section 59(e) or any other provision in the Code), and do not include amounts that were capitalized in a prior taxable year and are deducted in such taxable year.
(d) Apportionment based on gross receipts from sales of products or services —(1) In general. A taxpayer's R&E expenditures not apportioned under paragraph (c) of this section are apportioned between the statutory grouping (or among the statutory groupings) within the class of gross intangible income and the residual grouping within such class according to the rules in paragraphs (d)(1)(i) through (iv) of this section. See paragraph (b) of this section for defining the class of gross intangible income in relation to SIC code categories.
(i) A taxpayer's R&E expenditures not apportioned under paragraph (c) of this section are apportioned in the same proportions that:
(A) The amounts of the taxpayer's gross receipts from sales and leases of products (as measured by gross receipts without regard to cost of goods sold) or services that are related to gross intangible income within the statutory grouping (or statutory groupings) and in the residual grouping bear, respectively; to
(B) The total amount of such gross receipts in the class.
(ii) For purposes of this paragraph (d), gross receipts from sales and leases of products are related to gross intangible income if intangible property is embedded or used in connection with the manufacture or sale of such products, and gross income from services is related to gross intangible income if intangible property is incorporated in or directly or indirectly benefits such services. See paragraph (g)(7) of this section ( Example 7 ). The amount of the gross receipts used to apportion R&E expenditures also includes gross receipts from sales and leases of products or services of any controlled or uncontrolled party to the extent described in paragraphs (d)(3) and (4) of this section. A royalty or other amount paid to the taxpayer for intangible property constitutes gross intangible income, but is not considered part of gross receipts arising from the sale or lease of a product or service, and so is not taken into account in apportioning the taxpayer's R&E expenditures to its gross intangible income.
(iii) The statutory grouping (or groupings) or residual grouping to which the gross receipts are assigned is the grouping to which the gross intangible income related to the sale, lease, or service is assigned. In cases where the gross intangible income of the taxpayer is income not described in paragraph (d)(3) or (4) of this section, the grouping to which the taxpayer's gross receipts and the gross intangible income are assigned is the same. In cases where the taxpayer's gross intangible income is related to sales, leases, or services described in paragraph (d)(3) or (4) of this section, the gross receipts that will be used for purposes of this paragraph (d) are the gross receipts of the controlled and uncontrolled parties that are taken into account under paragraphs (d)(3) and (4) of this section. The grouping to which the controlled or uncontrolled parties' gross receipts are assigned is determined based on the grouping of the taxpayer's gross intangible income attributable to the license, sale, or other transfer of intangible property to such controlled or uncontrolled party as described in paragraph (d)(3)(i) or (d)(4)(i) of this section, and not the grouping to which the gross receipts would be assigned if the assignment were based on the income earned by the controlled or uncontrolled party. See paragraph (g)(1) of this section ( Example 1 ). For purposes of applying this paragraph (d)(1)(iii) to section 250 or section 904 as the operative section, the assignment of gross receipts to the general and foreign branch categories is made after taking into account the assignment of gross intangible income to those categories as adjusted by reason of disregarded payments under the rules of § 1.904-4(f)(2)(vi), and by making similar adjustments to gross receipts under the principles of § 1.904-4(f)(2)(vi).
(iv) For purposes of applying this section to section 904 as the operative section, because a United States person's gross intangible income cannot include income assigned to the section 951A category, no R&E expenditures of a United States person are apportioned to foreign source income in the section 951A category.
(2) Apportionment in excess of gross income. Amounts apportioned under this section may exceed the amount of gross income related to the SIC code category within the statutory or residual grouping. In such case, the excess is applied against other gross income within the statutory or residual grouping. See § 1.861-8(d)(1) for applicable rules where the apportionment results in an excess of deductions over gross income within the statutory or residual grouping.
(3) Sales or services of uncontrolled parties —(i) In general. For purposes of the apportionment within a class under paragraph (d)(1) of this section, if a taxpayer reasonably expects an uncontrolled party to (through a license, purchase, or transfer): Acquire intangible property that would arise from the taxpayer's current R&E expenditures; acquire products in which such intangible property is embedded or used in connection with the manufacture or sale of such products; or receive services that incorporate or directly or indirectly benefit from such intangible property, then the gross receipts of the uncontrolled party from sales, licenses, leases, or services of the particular products or services in which the taxpayer's intangible property is embedded or incorporated or which the taxpayer's intangible property directly or indirectly benefitted are taken into account. If the taxpayer has previously licensed, sold, or transferred intangible property related to a SIC code category to an uncontrolled party, the taxpayer is presumed to expect to license, sell, or transfer to that uncontrolled party all future intangible property related to the same SIC code category. The presumption described in the preceding sentence may be rebutted by the taxpayer with facts that demonstrate that the taxpayer reasonably expects not to license, sell, or transfer future intangible property to the uncontrolled party.
(ii) Definition of uncontrolled party. For purposes of this paragraph (d)(3), the term uncontrolled party means a person that is not a controlled party as defined in paragraph (d)(4)(ii) of this section.
(iii) Sales of components. In the case of a sale or lease of a product by an uncontrolled party that is derived from the taxpayer's intangible property but is incorporated as a component of a larger product (for example, where the product incorporating the intangible property is a component of a large machine), only the portion of the gross receipts from the larger product that are attributable to the component derived from the intangible property is included. For purposes of the preceding sentence, a reasonable estimate based on the principles of section 482 must be made. See paragraph (g)(4)(ii)(B)( 3 ) of this section ( Example 4 ).
(iv) Reasonable estimates of gross receipts. If the amount of gross receipts of an uncontrolled party is unknown, a reasonable estimate of gross receipts must be made annually. Appropriate economic analyses, based on the principles of section 482, must be used to estimate gross receipts. See paragraph (g)(5)(ii)(B)( 3 )( ii ) of this section ( Example 5 ).
(4) Sales or services of controlled parties —(i) In general. For purposes of the apportionment within a class under paragraph (d)(1) of this section, if the controlled party is reasonably expected to (through a license, sale, or transfer): Acquire intangible property that would arise from the taxpayer's current R&E expenditures; acquire products in which such intangible property is embedded or used in connection with the manufacture or sale of such products; or receive services that incorporate or directly or indirectly benefit from such intangible property, then the gross receipts of the controlled party from all of its sales, licenses, leases, or services are taken into account. Except to the extent provided in paragraph (d)(4)(iv) of this section, if the taxpayer has previously licensed, sold, or transferred intangible property related to a SIC code category to a controlled party, the taxpayer is presumed to expect to license, sell, or transfer to that controlled party all future intangible property related to the same SIC code category. The presumption described in the preceding sentence may be rebutted by the taxpayer with facts that demonstrate that the taxpayer will not license, sell, or transfer future intangible property to the controlled party.
(ii) Definition of a controlled party. For purposes of this paragraph (d)(4), the term controlled party means any person that has a relationship to the taxpayer specified in section 267(b) or 707(b), or is a member of a controlled group of corporations (within the meaning of section 267(f)) to which the taxpayer belongs. Because an affiliated group is treated as a single taxpayer, a member of an affiliated group is not a controlled party. See paragraph (e) of this section.
(iii) Gross receipts not to be taken into account more than once. Sales, licenses, leases, or services among the taxpayer, controlled parties, and uncontrolled parties are not taken into account more than once; in such a situation, the amount of gross receipts of the selling person must be subtracted from the gross receipts of the buying person. Therefore, the gross receipts taken into account under paragraph (d)(4)(i) of this section generally reflect the gross receipts from sales made to end users.
(iv) Effect of cost sharing arrangements. If the controlled party has entered into a cost sharing arrangement, in accordance with the provisions of § 1.482-7, with the taxpayer for the purpose of developing intangible property, then ordinarily the controlled party is not reasonably expected to acquire rights in intangible property that would arise from the taxpayer's share of the R&E expenditures with respect to the cost shared intangibles as defined in § 1.482-7(j)(1)(i); acquire products in which such intangible property is embedded or used in connection with the manufacture or sale of such products; or receive services that incorporate or directly or indirectly benefit from such intangible property. Therefore, solely for purposes of apportioning a taxpayer's R&E expenditures (which do not include the amount of CST Payments received by the taxpayer; see paragraph (a) of this section) that are intangible development costs (as defined in § 1.482-7(d)) with respect to a cost sharing arrangement, the controlled party's gross receipts are not taken into account for purposes of paragraphs (d)(1) and (d)(4)(i) of this section. However, the rule in this paragraph (d)(4)(iv) does not apply, and the controlled party's sales are taken into account, to the extent the taxpayer licenses, or has licensed, to the controlled party intangible property resulting from a cost sharing arrangement with the controlled party.
(5) Application of section 864(e)(3). Section 864(e)(3) and § 1.861-8(d)(2) do not apply for purposes of this section.
(e) Affiliated groups. See § 1.861-14(e)(2) for rules on allocating and apportioning R&E expenditures of an affiliated group (as defined in § 1.861-14(d)).
(f) Special rules for partnerships —(1) R&E expenditures. For purposes of applying this section, if R&E expenditures are incurred by a partnership in which the taxpayer is a partner, the taxpayer's R&E expenditures include the taxpayer's distributive share of the partnership's R&E expenditures.
(2) Purpose and location of expenditures. In applying exclusive apportionment under paragraph (c) of this section, a partner's distributive share of R&E expenditures incurred by a partnership is treated as incurred by the partner for the same purpose and in the same location as incurred by the partnership.
(3) Apportionment based on gross receipts. In applying the remaining apportionment under paragraph (d) of this section, if a taxpayer is a partner in a partnership that incurs R&E expenditures described in paragraph (f)(1) of this section and the taxpayer is not reasonably expected to license, sell, or transfer to the partnership (directly or indirectly) intangible property that would arise from the taxpayer's current R&E expenditures, in the manner described in paragraph (d)(3)(i) or (d)(4)(i) of this section, then the taxpayer's gross receipts in a SIC code category include only the taxpayer's share of any gross receipts in the SIC code category of the partnership. For purposes of the preceding sentence, the taxpayer's share of gross receipts is proportionate to the taxpayer's distributive share of the partnership's gross income in the product category. However, if the taxpayer is reasonably expected to license, sell, or transfer to the partnership (directly or indirectly) intangible property that would arise from the taxpayer current R&E expenditures, in the manner described in paragraph (d)(3)(i) or (d)(4)(i) of this section, then the taxpayer's gross receipts in a SIC code category include the full amount of any gross receipts in the SIC code category of the partnership as provided in paragraph (d)(3)(i) or (d)(4)(i) of this section.
(g) Examples. The following examples illustrate the application of the rules in this section.
(1) Example 1: Controlled party and single product —(i) Facts. X, a domestic corporation, is a manufacturer and distributor of small gasoline engines for lawnmowers. Gasoline engines are a product within the category, Engines and Turbines (SIC Industry Group 351). Y, a wholly owned foreign subsidiary of X, also manufactures and sells these engines abroad. X owns no other foreign subsidiaries. During Year 1, X incurred R&E expenditures of $60,000x, which it deducts under section 174 as a current expense, to invent and patent a new and improved gasoline engine. All of the research and experimentation was performed in the United States. Also in Year 1, the domestic gross receipts of X from sales of gasoline engines total $500,000x and foreign gross receipts of Y from sales of gasoline engines total $300,000x. X provides technology for the manufacture of engines to Y through a license that requires the payment of an arm's length royalty. Because X has licensed its intangible property to Y related to the SIC code, it is presumed to reasonably expect to license the intangible property that would be developed from the current research and experimentation. In Year 1, X's gross income is $210,000x, of which $140,000x is U.S. source income from domestic sales of gasoline engines, $40,000x is income included under section 951A, all of which relates to Y's foreign source income from sales of gasoline engines, $20,000x is foreign source royalties from Y, and $10,000x is U.S. source interest income. None of the foreign source royalties are allocable to passive category income of Y, and therefore, under §§ 1.904-4(d) and 1.904-5(c)(3), the foreign source royalties are general category income to X.
(ii) Analysis —(A) Allocation. The R&E expenditures were incurred in connection with developing intangible property related to small gasoline engines and they are definitely related to X's items of gross intangible income related to the SIC code category 351, namely gross income from the sale of small gasoline engines in the United States and royalties received from subsidiary Y, a foreign manufacturer of gasoline engines. Accordingly, under paragraph (b) of this section, the R&E expenditures are allocable to the class of gross intangible income related to SIC code category 351, all of which is general category income of X. X's U.S. source interest income and income included under section 951A are not within this class of gross intangible income and, therefore, no portion of the R&E expenditures are allocated to the U.S. source interest income or foreign source income in the section 951A category.
(B) Apportionment —( 1 ) In general. For purposes of applying this section to section 904 as the operative section, the statutory grouping of gross intangible income is foreign source general category income and the residual grouping of gross intangible income is U.S. source income.
( 2 ) Exclusive apportionment. Under paragraph (c) of this section, because at least 50% of X's research and experimental activity was performed in the United States, 50% of the R&E expenditures, or $30,000x ($60,000x × 50%), is apportioned exclusively to the residual grouping of U.S. source gross intangible income. The remaining 50% of the R&E expenditures is then apportioned between the statutory and residual groupings on the basis of the relative amounts of gross receipts from sales of small gasoline engines by X and Y that are related to the U.S. source sales income and foreign source royalty income, respectively.
( 3 ) Apportionment based on gross receipts. After taking into account exclusive apportionment, X has $30,000x ($60,000x−$30,000x) of R&E expenditures that must be apportioned between the statutory and residual groupings. Under paragraph (d)(4) of this section, Y's gross receipts within the SIC code are taken into account in apportioning X's R&E expenditures. Although X has gross intangible income of $140,000x from domestic sales and $20,000x in royalties from Y, X's R&E expenditures are apportioned to that gross intangible income on the basis of the relative amounts of gross receipts arising from the sale of products by X and Y (and not the relative amounts of X's gross intangible income) in the statutory and residual groupings. Therefore, under paragraphs (d)(1) and (4) of this section $11,250x ($30,000x × $300,000x/($500,000x + $300,000x)) is apportioned to the statutory grouping of X's gross intangible income attributable to its license of intangible property to Y, or foreign source general category income. No portion of the gross receipts by X or Y are disregarded under section 864(e)(3), regardless of whether the income related to those sales is eligible for a deduction under section 250(a)(1)(A). The remaining $18,750x ($30,000x × $500,000x/($500,000x + $300,000x)) is apportioned to the residual grouping of gross intangible income, or U.S. source income.
( 4 ) Summary. Accordingly, for purposes of the foreign tax credit limitation, $11,250x of X's R&E expenditures are apportioned to foreign source general category income, and $48,750x ($30,000x + $18,750x) of X's R&E expenditures are apportioned to U.S. source income.
(2) Example 2: Controlled party and two products in same SIC code category —(i) Facts. The facts are the same as in paragraph (g)(1)(i) of this section (the facts in Example 1 ), except that X also spends $30,000x in Year 1 for research on steam turbines, all of which is performed in the United States, and X has steam turbine gross receipts in the United States of $400,000x. X's foreign subsidiary Y neither manufactures nor sells steam turbines. The steam turbine research is in addition to the $60,000x in R&E expenditures incurred by X on gasoline engines for lawnmowers. X thus has $90,000x of R&E expenditures. X's gross income is $260,000x, of which $140,000x is U.S. source income from domestic sales of gasoline engines, $50,000x is U.S. source income from domestic sales of steam turbines, $40,000x is income included under section 951A all of which relates to foreign source income derived from Y's sales of gasoline engines, $20,000x is foreign source royalties from Y, and $10,000x is U.S. source interest income.
(ii) Analysis —(A) Allocation. X's R&E expenditures generate gross intangible income from sales of small gasoline engines and steam turbines. Both of these products are in the same three digit SIC code category, Engines and Turbines (SIC Industry Group 351). Therefore, under paragraph (a) of this section, X's R&E expenditures are definitely related to all items of gross intangible income attributable to SIC code category 351. These items of X's gross intangible income are gross income from the sale of small gasoline engines and steam turbines in the United States and royalties from foreign subsidiary Y, a foreign manufacturer and seller of small gasoline engines. X's U.S. source interest income and income included under section 951A is not within this class of gross intangible income and, therefore, no portion of X's R&E expenditures are allocated to the U.S. source interest income or income in the section 951A category.
(B) Apportionment —( 1 ) In general. For purposes of applying this section to section 904 as the operative section, the statutory grouping of gross intangible income is foreign source general category income and the residual grouping of gross intangible income is U.S. source income.
( 2 ) Exclusive apportionment. Under paragraph (c) of this section, because at least 50% of X's research and experimental activity was performed in the United States, 50% of the R&E expenditures, or $45,000x ($90,000x × 50%), are apportioned exclusively to the residual grouping of U.S. source gross intangible income. The remaining 50% of the R&E expenditures is then apportioned between the statutory and residual groupings on the basis of the relative amounts of gross receipts of small gasoline engines and steam turbines by X and Y with respect to which gross intangible income is foreign source general category income and U.S. source income.
( 3 ) Apportionment based on gross receipts. After taking into account exclusive apportionment, X has $45,000x ($90,000x−$45,000x) of R&E expenditures that must be apportioned between the statutory and residual groupings. Although X has gross intangible income of $190,000x from domestic sales and $20,000x in royalties from Y, X's R&E expenditures are apportioned to that gross intangible income on the basis of the relative amounts of gross receipts arising from the sale of products by X and Y (and not the relative amounts of X's gross intangible income) in the statutory and residual groupings. Even though a portion of the R&E expenditures that must be apportioned are attributable to research performed with respect to steam turbines, and Y does not sell steam turbines, because Y is reasonably expected to license all intangible property related to SIC code category 351 from X, including intangible property related to steam turbines, under paragraphs (d)(1) and (4) of this section $11,250x ($45,000x × $300,000x/($500,000x + $400,000x + $300,000x)) is apportioned to the statutory grouping of gross intangible income, or foreign source general category income attributable to the royalty income to which the gross receipts of Y are related. The remaining $33,750x ($45,000x × ($500,000x + $400,000x)/($500,000x + $400,000x + $300,000x)) is apportioned to the residual grouping of gross intangible income, or U.S. source gross income.
( 4 ) Summary. Accordingly, for purposes of the foreign tax credit limitation, $11,250x of X's R&E expenditures are apportioned to foreign source general category income and $78,750x ($45,000x + $33,750x) of X's R&E expenditures are apportioned to U.S. source income.
(3) Example 3: Cost sharing arrangement —(i) Facts —(A) Acquisitions and transfers by X. The facts are the same as in paragraph (g)(1)(i) of this section (the facts in Example 1 ) except that, in Year 2, X and Y terminate the license for the manufacture of engines that was in place in Year 1 and enter into a cost sharing arrangement, in accordance with the provisions of § 1.482-7, to share the costs and risks of developing the intangible property related to the engines. Pursuant to the cost sharing arrangement, X has the exclusive rights to exploit the cost shared intangibles within the United States, and Y has the exclusive rights to exploit the cost shared intangibles outside the United States. X's and Y's shares of the reasonably anticipated benefits from the cost shared intangibles are 70% and 30%, respectively. In Year 2, Y makes a PCT Payment (as defined in § 1.482-7(b)(1)(ii)) of $50,000x that is characterized and sourced as a royalty for a license of small gasoline engine technology.
(B) Gross receipts and R&E expenditures. In Year 2, X and Y continue to sell gasoline engines, with gross receipts of $600,000x in the United States by X and $400,000x abroad by Y. X incurs intangible development costs associated with the cost shared intangibles of $100,000x in Year 2, which consist exclusively of research activities conducted in the United States. Y also makes a $30,000x CST Payment (as defined in § 1.482-7(b)(1)(i)) under the cost sharing arrangement. X is entitled to deduct $70,000x of its intangible development costs ($100,000x less the $30,000x CST Payment by Y) by reason of the second sentence under § 1.482-7(j)(3)(i) (relating to CST Payments).
(C) Gross income of X. In Year 2, X's gross income is $360,000x, of which $200,000x is U.S. source income from domestic sales of small gasoline engines, $50,000x is foreign source general category income attributable to the PCT Payment, $100,000x is income included under section 951A (all of which relates to foreign source income derived from engine sales by Y), and $10,000x is U.S. source interest income.
(ii) Analysis —(A) Allocation. The $70,000x of R&E expenditures incurred in Year 2 by X in connection with small gasoline engines are definitely related to the items of gross intangible income related to the SIC code category, namely gross income from the sale of small gasoline engines in the United States and PCT Payments from Y. Accordingly, under paragraph (a) of this section, the R&E expenditures are allocable to this class of gross intangible income. X's U.S. source interest income and income included under section 951A are not within this class of gross intangible income and, therefore, no portion of X's R&E expenditures is allocated to X's U.S. source interest income or section 951A category income.
(B) Apportionment —( 1 ) In general. For purposes of applying this section to section 904 as the operative section, the statutory grouping of gross intangible income is foreign source general category income, and the residual grouping of gross intangible income is U.S. source income.
( 2 ) Exclusive apportionment. Under paragraph (c) of this section, because at least 50% of X's research and experimentation in Year 2 was performed in the United States, 50% of the R&E expenditures, or $35,000x ($70,000x × 50%), is apportioned exclusively to the residual grouping of gross intangible income, U.S. source income.
( 3 ) Apportionment based on gross receipts. Although X has gross intangible income of $200,000x from domestic sales and $50,000x as a PCT Payment from Y, X's R&E expenditures are apportioned to its gross intangible income on the basis of the relative amounts of gross receipts arising from the sale of products by X (and not the relative amounts of X's gross intangible income) in the statutory and residual groupings. Under paragraph (d)(4)(iv) of this section, because of the cost sharing arrangement, Y's gross receipts from sales are not taken into account in apportioning X's R&E expenditures that are intangible development costs with respect to the cost sharing arrangement. Because all of the gross receipts from sales that are taken into account under paragraph (d)(1) of this section relate to gross intangible income that is included in the residual grouping, $35,000x is apportioned to the residual grouping of gross intangible income, or U.S. source income.
( 4 ) Summary. Accordingly, for purposes of the foreign tax credit limitation, $70,000x of X's R&E expenditures are apportioned to U.S. source income.
(4) Example 4: Uncontrolled party —(i) Facts —(A) X's R&E expenditures. X, a domestic corporation, is engaged in continuous research and experimentation to improve the quality of the products that it manufactures and sells, which are floodlights, flashlights, fuse boxes, and solderless connectors. All of these products are in the same three digit SIC code category, Electric Lighting and Wiring Equipment (SIC Industry Group 364). X incurs $100,000x of R&E expenditures in Year 1 that is performed exclusively in the United States. As a result of this research activity, X acquires patents that it uses in its own manufacturing activity.
(B) License to Y and Z. In Year 1, X licenses its floodlight patent to Y and Z, uncontrolled parties, for use in their own territories, Countries Y and Z, respectively. Y pays X a royalty of $3,000x plus $0.20x for each unit sold. Gross receipts from sales of floodlights by Y for the taxable year are $135,000x (30,000 units at $4.50x per unit), and the royalty is $9,000x ($3,000x + $0.20x/unit × 30,000 units). Y has sales of other products of $500,000x. Z pays X a royalty of $3,000x plus $0.30x for each unit sold. Z manufactures 30,000 floodlights in the taxable year, and the royalty is $12,000x ($3,000x + $0.30x/unit × 30,000 units). The dollar value of Z's gross receipts from floodlight sales is not known to X because, in this case, the floodlights are not sold separately by Z but are instead used as a component in Z's manufacture of lighting equipment for theaters. However, a reasonable estimate of Z's gross receipts attributable to the floodlights, based on the principles of section 482, is $120,000x. The gross receipts from sales of all Z's products, including the lighting equipment for theaters, are $1,000,000x. Because X has licensed its intangible property to Y and Z related to the SIC code, it is presumed to reasonably expect to license the intangible property that would be developed from the current research and experimentation.
(C) X's gross receipts and gross income. X's gross receipts from sales of floodlights for the taxable year are $500,000x and its sales of its other products (flashlights, fuse boxes, and solderless connectors) are $400,000x. X has gross income of $500,000x, consisting of U.S. source gross income from domestic sales of floodlights, flashlights, fuse boxes, and solderless connectors of $479,000x, and foreign source gross income from royalties of $9,000x and $12,000x from foreign corporations Y and Z, respectively. The royalty income is general category income to X under § 1.904-4(b)(2)(ii).
(ii) Analysis —(A) Allocation. X's R&E expenditures are definitely related to all of the gross intangible income from the products that it produces, which are floodlights, flashlights, fuse boxes, and solderless connectors. All of these products are in SIC code category 364. Therefore, under paragraph (b) of this section, X's R&E expenditures are definitely related to the class of gross intangible income related to SIC code category 364 and to all items of gross intangible income attributable to the class. These items of X's gross intangible income are gross income from the sale of floodlights, flashlights, fuse boxes, and solderless connectors in the United States and royalties from Corporations Y and Z.
(B) Apportionment —( 1 ) In general. For purposes of applying this section to section 904 as the operative section, the statutory grouping of gross intangible income is foreign source general category income, and the residual grouping of gross intangible income is U.S. source income.
( 2 ) Exclusive apportionment. Under paragraph (c) of this section, because at least 50% of X's research and experimentation was performed in the United States, 50% of the R&E expenditures, or $50,000x ($100,000x × 50%), is apportioned exclusively to the residual grouping of U.S. source gross intangible income.
( 3 ) Apportionment based on gross receipts. After taking into account exclusive apportionment, X has $50,000x ($100,000x−$50,000x) of R&E expenditures that must be apportioned between the statutory and residual groupings. Under paragraph (d)(3)(i) of this section, gross receipts from sales of Y and Z are taken into account in apportioning X's R&E expenditures. Although X has gross intangible income of $479,000x from domestic sales and $21,000x in royalties from Y and Z, X's R&E expenditures are apportioned to its gross intangible income on the basis of the relative amounts of gross receipts arising from the sale of products by X, Y and Z (and not the relative amounts of X's gross intangible income) in the statutory and residual groupings. In addition, under paragraph (d)(3)(iii) of this section only the portion of Z's gross receipts that are attributable to the floodlights that incorporate the intangible property licensed from X, rather than Z's total gross receipts, are used for purposes of apportionment. All of X's gross receipts from sales in the entire SIC code category are included for purposes of apportionment on the basis of gross intangible income attributable to those sales. Under paragraph (d)(1) of this section, $11,039x ($50,000x × ($135,000x + $120,000x)/($900,000x + $135,000x + $120,000x)) is apportioned to the statutory grouping of gross intangible income, or foreign source general category income. The remaining $38,961x ($50,000x × $900,000x/($900,000x + $135,000x + $120,000x)) is apportioned to the residual grouping of gross intangible income, or U.S. source income.
( 4 ) Summary. Accordingly, for purposes of the foreign tax credit limitation, $11,039x of X's R&E expenditures are apportioned to foreign source general category income and $88,961x ($50,000x + $38,961x) of X's R&E expenditures are apportioned to U.S. source income.
(5) Example 5: Uncontrolled party and sublicense —(i) Facts. X, a domestic corporation, is a cloud storage service provider. Cloud storage services are a service within the category, Computer Programming, Data Processing, and other Computer Related Services (SIC Industry Group 737). During Year 1, X incurs R&E expenditures of $50,000x to invent and copyright new storage monitoring and management software. All of the research and experimentation is performed in the United States. X uses this software in its own business to provide services to customers. X also licenses a version of the software that can be used by other businesses that provide cloud storage services. X licenses the software to uncontrolled party U, which sub-licenses the software to other businesses that provide cloud storage services to customers. U does not use the software except to sublicense it. As a part of the licensing agreement with U, U and its sub-licensees are only permitted to use the software in certain countries outside of the United States. Under the contract with U, U pays X a royalty of 50% on the amount it receives from its sub-licensees that use the software to provide services to customers. Because X has licensed its intangible property to U related to the SIC code and U has sublicensed it to other businesses, it is presumed that X is reasonably expected to license the intangible property that would be developed from its current research and experimentation to U and that U would sublicense it to other businesses. In Year 1, X earns $300,000x of gross receipts from providing cloud storage services within the United States. Further, in Year 1 U receives $10,000x of royalty income from its sub-licensees and pays a royalty of $5,000x to X. Thus, X earns $300,000x of U.S. source general category gross income and also earns $5,000x of foreign source general category royalty income from licensing its software to U for use outside of the United States.
(ii) Analysis —(A) Allocation. The R&E expenditures were incurred in connection with the development of cloud computing software and they are definitely related to the items of gross intangible income related to the SIC Code category, namely gross income from the storage monitoring and management software in the United States and royalties received from U. Accordingly, under paragraph (b) of this section, the R&E expenditures are allocable to this class of gross intangible income.
(B) Apportionment —( 1 ) In general. For purposes of applying this section to section 904 as the operative section, the statutory grouping of gross intangible income is foreign source general category income, and the residual grouping of gross intangible income is U.S. source income.
( 2 ) Exclusive apportionment. Under paragraph (c) of this section, because at least 50% of X's research and experimental activity was performed in the United States, 50% of the R&E expenditures, or $25,000x ($50,000x × 50%), is apportioned exclusively to the residual grouping of U.S. source gross intangible income.
( 3 ) Apportionment based on gross receipts —( i ) In general. After taking into account exclusive apportionment, X has $25,000x ($50,000x−$25,000x) of R&E expenditures that must be apportioned between the statutory and residual groupings. Because X has licensed its intangible property related to the SIC code to U and U has licensed it to the sub-licensees, under paragraph (d)(3)(i) of this section, gross receipts from sales of U's sublicensees are taken into account in apportioning X's R&E expenditures. Although X has gross intangible income of $300,000x from domestic sales of services and $5,000x in royalties from U, X's R&E expenditures are apportioned to its gross intangible income on the basis of the relative amounts of gross receipts arising from the sale of services by X and U's sub-licensees (and not the relative amounts of X's gross intangible income) in the statutory and residual groupings.
( ii ) Determination of U's sub-licensee's gross receipts. Under paragraph (d)(3)(iv) of this section, X can make a reasonable estimate of the gross receipts of U's sub-licensees from services incorporating the intangible property licensed by X by estimating, after an appropriate economic analysis, that U would charge a royalty of 5% of the sub-licensee's sales. U received a royalty of $10,000x from the sub-licensees. X then determines U's sub-licensees' foreign sales by dividing the total royalty payments received by U by the royalty estimated rate ($10,000x/.05 = $200,000x).
( iii ) Results of apportionment based on gross receipts. Therefore, under paragraphs (d)(1) and (3) of this section, $10,000x ($25,000x × $200,000x/($300,000x + $200,000x)) is apportioned to the statutory grouping of gross intangible income, or foreign source general category income. The remaining $15,000x ($25,000x × $300,000x/($300,000x + $200,000x)) is apportioned to the residual grouping of gross intangible income, or U.S. source income.
( 4 ) Summary. Accordingly, for purposes of the foreign tax credit limitation, $10,000x of X's R&E expenditures are apportioned to foreign source general category income and $40,000x ($25,000x + $15,000x) of X's R&E expenditures are apportioned to U.S. source income.
(6) Example 6: Foreign branch —(i) Facts —(A) Overview for X. X, a domestic corporation, owns FDE, a disregarded entity that is a foreign branch within the meaning of § 1.904-4(f)(3)(vii). FDE conducts activities solely in Country Y. FDE's functional currency is the U.S. dollar. X is a manufacturer and distributor of small gasoline engines for lawnmowers in the United States. Gasoline engines are a product within the category, Engines and Turbines (SIC Industry Group 351). FDE also manufactures and distributes small gasoline engines but only in Country Y. During Year 1, X incurred R&E expenditures of $60,000x, which it deducts under section 174 as a current expense, to invent and patent a new and improved gasoline engine. All of the research and experimentation was performed in the United States. Also in Year 1, the domestic gross receipts of X from gasoline engines total $500,000x. X provides technology for the manufacture of engines to FDE through a license. FDE compensates X for the technology with an arm's length royalty payment of $10,000x, which is disregarded for Federal income tax purposes.
(B) Overview for FDE. FDE accrues and records on its books and records $100,000x of gross income from sales of gasoline engines to unrelated persons. FDE's gross income is non-passive category income and is foreign source income. In Year 1, the foreign gross receipts of FDE from sales of gasoline engines total $300,000x. The disregarded royalty payment from FDE to X is not recorded on FDE's separate books and records (as adjusted to conform to Federal income tax principles) within the meaning of paragraph § 1.904-4(f)(2)(i) because it is disregarded for Federal income tax purposes. However, the $10,000x disregarded royalty payment would be allocable to foreign source gross income attributable to FDE under § 1.904-4(f)(2)(vi)(B)( 1 )( ii ). Therefore, under § 1.904-4(f)(2)(vi)(A) the amount of foreign source gross income attributable to FDE is adjusted downwards and the amount of foreign source gross income attributable to X is adjusted upward to take the $10,000x disregarded royalty payment into account.
(C) Assignment of X's gross income to separate categories. In Year 1, X has U.S. source general category gross income of $140,000x from domestic sales of gasoline engines. After application of § 1.904-4(f)(2)(vi)(A) to the disregarded payment made by FDE, X has $10,000x of foreign source general category gross income and X also has $90,000x of foreign source foreign branch category gross income.
(ii) Analysis —(A) Allocation. The R&E expenditures were incurred in connection with developing intangible property related to small gasoline engines and are definitely related to the items of gross intangible income related to the SIC code category 351, namely gross income from the sale of small gasoline engines in both the United States and Country Y.
(B) Apportionment —( 1 ) In general. For purposes of applying this section to section 904 as the operative section, the statutory groupings of gross intangible income are foreign source general category income and foreign source foreign branch category income, and the residual grouping of gross intangible income is U.S. source income.
( 2 ) Exclusive apportionment. Under paragraph (c) of this section, because at least 50% of X's research and experimental activity was performed in the United States, 50% of the R&E expenditures, or $30,000 ($60,000x × 50%), is apportioned exclusively to the residual grouping of U.S. source gross intangible income. The remaining 50% of the R&E expenditures is then apportioned between the statutory and residual groupings on the basis of the relative amounts of gross receipts from sales of small gasoline engines that are related to U.S. source income, foreign source general category income, and foreign source foreign branch category income.
( 3 ) Apportionment based on gross receipts. After taking into account exclusive apportionment, X has $30,000x ($60,000x−$30,000x) of R&E expenditures that must be apportioned between the statutory and residual groupings. Because X's gross intangible income is not described in paragraph (d)(3) or (4) of this section (that is, there is no gross intangible income related to sales, leases or services from controlled or uncontrolled parties that are incorporating intangible property that was licensed, sold, or transferred to controlled or uncontrolled parties), the groupings to which the taxpayer's gross receipts and gross intangible income are assigned is the same. However, because the assignment of X's gross income to the foreign branch and general categories is made by taking into account disregarded payments under § 1.904-4(f)(2)(vi), the assignment of gross receipts between the general category and foreign branch category must be determined by making similar adjustments to X's gross receipts under the principles of § 1.904-4(f)(2)(vi). See paragraph (d)(1)(iii) of this section. Foreign gross receipts of FDE from gasoline engines total $300,000x. However, those gross receipts are adjusted under the principles of § 1.904-4(f)(2)(vi) for purposes of apportioning the remaining R&E expenditures by reducing the gross receipts initially assigned to the foreign branch category by an amount equal to the ratio of the royalty income to FDE's gross income that is initially assigned to the foreign branch category. Accordingly, since the disregarded royalty payment of $10,000x caused an adjustment equal to 10% of FDE's initial gross income of $100,000x, 10% of the gross receipts or $30,000x (10% × $300,000x) are similarly assigned to the grouping of foreign source general category income, and the remaining $270,000x of gross receipts are assigned to the grouping of foreign source foreign branch category income. Therefore, under paragraph (d)(1) of this section, $1,125x ($30,000x × $30,000x/($500,000x + $270,000x + $30,000x)) is apportioned to the statutory grouping of X's gross intangible income attributable to foreign source general category income. $10,125x ($30,000x × $270,000x/($500,000x + $270,000x + $30,000x)) is apportioned to the statutory grouping of X's foreign source foreign branch category income. The remaining $18,750x ($30,000x × $500,000x/($500,000x + $270,000x + $30,000x)) is apportioned to the residual grouping of gross intangible income or U.S. source income.
(7) Example 7: Indirectly derived gross intangible income —(i) Facts. P, a domestic corporation, develops and publishes an internet website that persons use (referred to as “users” and collectively referred to as “user base”) without a fee. P incurs R&E expenditures to update software code and write new software code to maintain the website and develop new products that are incorporated into the website. P's activities consist of services that fall within SIC code category 737 (computer programming, data processing, and other computer related services). P sells space on its website for businesses to advertise to its user base in exchange for a fee. P's technology allows it to collect data on users and to use that data to effectively target advertisements. P does not grant rights to the technology or other intangible property to the businesses advertising on its website. In Year 1, P incurs R&E expenditures of $60,000x, which it deducts under section 174. All the research and experimentation is performed in the United States. Also in Year 1, P earns gross receipts of $200,000x from the sale of advertisements, all of which gives rise to U.S. source gross income.
(ii) Analysis —(A) Allocation. The R&E expenditures were incurred in connection with developing intangible property used for P's website. Accordingly, they are definitely related and allocable to gross intangible income derived directly or indirectly (in whole or in part) from that intangible property. Because P's advertising sales are dependent on the users attracted to its website, P's gross income from advertising is indirectly derived from intangible property and is included in gross intangible income. Accordingly, under paragraph (b) of this section, the R&E expenditures are allocable to the class of gross intangible income related to SIC code category 737, which consists of U.S. source income.
(B) Apportionment. Because all gross receipts from services that the intangible property directly or indirectly benefits result in U.S. source income, no apportionment is required.
(h) Applicability date. This section applies to taxable years beginning after December 31, 2019. However, taxpayers may choose to apply this section to taxable years beginning on or after January 1, 2018, and before January 1, 2020, provided they apply this section in its entirety and for any subsequent year beginning before January 1, 2020.
§ 1.861-18   Classification of, and source of gross income from, digital content transactions.
(a) General —(1) Scope. This section provides rules for classifying digital content transactions (as defined in paragraph (b)(1) of this section) for purposes of subchapter N of chapter 1 of the Internal Revenue Code, sections 59A, 245A, 250, 267A, 367, 404A, 482, 679, 1059A, chapters 3 and 4, sections 842 and 845 (to the extent involving a foreign person), and transfers to foreign trusts not covered by section 679.
(2) Digital content —(i) Digital content defined. For purposes of this section, digital content means a computer program or any other content, such as books, movies, and music, in digital format that is—
(A) Protected by copyright law; or
(B) Not protected by copyright law solely—
( 1 ) Due to the passage of time; or
( 2 ) Because the creator dedicated the content to the public domain.
(ii) Computer program defined. 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 and includes any media, user manuals, documentation, data base, or similar item if the media, user manuals, documentation, data base, or other similar item is incidental to the operation of the computer program.
(b) Categories of transactions —(1) General. A transaction that constitutes a transfer of digital content, or the provision of services or of know-how with respect to digital content (each a digital content transaction), is treated as being solely one of the following—
(i) A transfer of a copyright right in the digital content;
(ii) A transfer of a copy of the digital content (a copyrighted article);
(iii) The provision of services for the development or modification of the digital content; or
(iv) The provision of know-how relating to development of digital content.
(2) Transaction with multiple elements. Taking into account the overall transaction and the surrounding facts and circumstances, a transaction that has multiple elements, one or more of which would be a digital content transaction if considered separately, is classified in its entirety as a digital content transaction under one of the categories described in paragraph (b)(1) of this section if the predominant character of the transaction is described in one of the categories in that paragraph.
(3) Determination of predominant character —(i) General rule. For purposes of paragraph (b)(2) of this section and § 1.861-19(c)(2), the predominant character of a transaction is determined by ascertaining the primary benefit or value received by the customer in the transaction.
(ii) Special rule. If the primary benefit or value received by the customer in the transaction is not reasonably ascertainable, the predominant character of a transaction is instead determined by ascertaining the primary benefit or value received by a typical customer in a substantially similar transaction as determined under paragraphs (b)(3)(ii)(A) and (B) of this section.
(A) The primary benefit or value received by a typical customer is determined by data on how a typical customer uses or accesses the digital content. See paragraph (h)(17) of this section ( Example 17 ).
(B) If data described in paragraph (b)(3)(ii)(A) of this section is not available, then the predominant character of a transaction subject to the special rule in paragraph (b)(3)(ii) of this section is determined by examining other factors that are indicative of the primary benefit or value received by a typical customer, including the following—
( 1 ) How the transferor or provider markets the transaction;
( 2 ) The relative development costs to the transferor or provider of each element of the transaction; and
( 3 ) The relative price paid in an uncontrolled transaction for one or more elements compared to the total contract price of the transaction in question.
(iii) Identification and development of data. A transferor or provider must use reasonable efforts to identify the data specified in paragraphs (b)(3)(i) and (ii)(A) of this section, or if necessary, to apply the factors relevant to paragraph (b)(3)(ii)(B) of this section. However, a transferor or provider is not required to develop any of the data specified in those paragraphs that it does not develop in the course of business.
(c) Transfers involving copyright rights and copyrighted articles —(1) Transfers involving transfers of copyright rights. A digital content transaction involves a transfer of a copyright right if, as a result of the transaction, a person acquires one or more of the rights described in paragraphs (c)(2)(i) through (iv) of this section.
(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 digital content 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 digital content based upon the digital content;
(iii) The right to make a public performance of digital content, other than a right to publicly perform digital content for the purpose of advertising the sale of the digital content performed; or
(iv) The right to publicly display digital content, other than a right to publicly display digital content for the purpose of advertising the sale of the digital content displayed.
(3) Copyrighted articles. A copyrighted article includes a copy of digital content 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 digital content may be fixed in any medium.
(d) Provision of services. The determination of whether a transaction involving newly developed or modified digital content involves the provision of services 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 digital content and how the risks of loss are allocated between the parties. See paragraph (h)(15) of this section ( Example 15 ).
(e) Provision of know-how. The provision of information with respect to digital content involves the provision of know-how for purposes of this section only if the information is—
(1) Information relating to the development of digital content;
(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 transfer of a copyright right that does not constitute a sale or exchange because not all substantial rights have been transferred will be classified as a license. For this purpose, the principles of sections 1222 and 1235 apply. 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 —(i) Classification. 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 transfer of a copyrighted article 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.
(ii) Source. Income from transactions that are classified as sales or exchanges of copyrighted articles will be sourced under section 861(a)(6), 862(a)(6), 863, or 865(a), (b), (c), or (e), as appropriate. When a copyrighted article is sold and transferred through an electronic medium, the sale is deemed to have occurred at the location of the billing address of the purchaser for purposes of § 1.861-7(c). However, in any case in which the sales transaction is arranged in a particular manner for a principal purpose of tax avoidance, the foregoing rules will not be applied. In such a case, all of the facts and circumstances relevant to the transaction, such as the place where the copyrighted article will be used, the place where negotiations and the execution of the agreement occurred, and the terms of the agreement, will be considered, and the sale will be treated as having occurred where the substance of the sale occurred. Income derived from leasing a copyrighted article will be sourced under section 861(a)(4) or 862(a)(4), as appropriate.
(3) Special circumstances of digital content. In connection with determinations under this paragraph (f), consideration must be given as appropriate to the special characteristics of digital content 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 digital content on a 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 digital content deactivates itself after a specified period is generally the equivalent of a transaction subject to a requirement that the disk be returned after a specified period.
(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 digital content transaction.
(3) To the public —(i) In general. For purposes of paragraph (c)(2)(i) of this section, a transferee of digital content shall not be considered to have the right to distribute copies of the digital content to the public if it is permitted to distribute copies of the digital content 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 digital content who are permitted to use the digital content 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 digital content who are permitted to use the digital content in connection with the performance of those services is not relevant for purposes of this paragraph (g)(3).
(h) Examples. The examples in this paragraph (h) illustrate the provisions of this section. Unless otherwise specified, assume that Corp A is a domestic corporation, the digital content described in each example does not contain any online functionality, and all facts in each example occur as part of a single transaction.
(1) Example 1: Sale of a computer program on a disk —(i) Facts. Corp A 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 (b)(1) of this section, the transfer of a disk containing a copy of Program X from Corp A to P is a digital content transaction with one element, which is the transfer of a copy of Program X. Therefore, the transaction is treated solely as a transfer of a copyrighted article under paragraph (b)(1)(ii) of this section. Under paragraph (g)(1) of this section, the label license is not determinative.
(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.
(2) Example 2: Sale of a computer program via download from the internet —(i) Facts. The facts are the same as those in paragraph (h)(1) of this section ( Example 1 ), except that instead of selling disks, Corp A 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) Under paragraph (b)(1) of this section, the digital transfer of a copy of Program X from Corp A to P is a digital content transaction with one element, which is the transfer of a copy of Program X. Therefore, the transaction is treated solely as a transfer of a copyrighted article under paragraph (b)(1)(ii) of this section. 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.
(B) As in paragraph (h)(1) of this section ( 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.
(3) Example 3: Lease of a computer program with requirement to return disk —(i) Facts. The facts are the same as those in paragraph (h)(1) of this section ( 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 (b)(1) of this section, the transfer of a disk with a copy of Program X from Corp A to P is a digital content transaction with one element, which is the transfer of a copy of Program X. Therefore, the transaction is treated solely as a transfer of a copyrighted article under paragraph (b)(1)(ii) of this section.
(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 digital content 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.
(4) Example 4: Lease of a computer program with electronic lock —(i) Facts. * * *
(ii) Analysis. (A) Under paragraph (b)(1) of this section, the digital transfer of a copy of Program X from Corp A to P is a digital content transaction with one element, which is the transfer of a copy of Program X. Therefore, the transaction is treated solely as a transfer of a copyrighted article under paragraph (b)(1)(ii) of this section.
(B) As in paragraph (h)(3) of this section ( 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 digital content as provided in paragraph (f)(3) of this section, the result in this paragraph (h)(4) ( Example 4 ) is the same as in Example 3.
(5) Example 5: Sale of copyright rights to a computer program —(i) Facts. Corp A 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 (a period shorter than the copyright term). Corp A has ascertained that the primary benefit or value from the transaction to Corp B is derived from the four legal rights obtained in Program X from Corp A and not from the receipt of a copy of Program X. The transfer of a copy of Program X is merely the means by which Corp A provides Corp B access to Program X in order to exercise its copyright rights.
(ii) Analysis. (A) The transaction between Corp A and Corp B has multiple elements. One element is the transfer of a disk with a copy of Program X, which would be a digital content transaction described under paragraph (b)(1)(ii) of this section (transfer of a copyrighted article) if considered separately. Another element is the grant of the right to make an unlimited number of copies of Program X and distribute those copies to the public, the right to prepare derivative works based upon Program X, the right to make public performances of Program X, and the right to publicly display Program X, which would be described under paragraphs (b)(1)(i) and (c)(2) of this section (transfer of a copyright right) if considered separately.
(B) Because the transaction has multiple elements, one or more of which would be a digital content transaction if considered separately, paragraph (b)(2) of this section provides that the transaction is classified within a single category under paragraph (b)(1) of this section if its predominant character is described in that paragraph. Pursuant to paragraph (b)(3)(i) of this section, the predominant character of the transaction is based on the primary benefit or value of the transaction to the customer, if it is reasonably ascertainable. The predominant character of this transaction is therefore the transfer of copyright rights because the primary benefit or value received by Corp B from the transaction is the ability to exercise the copyright rights described in paragraph (c)(2) of this section. Therefore, this transaction is classified solely as a transfer of copyright rights described in paragraph (b)(1)(i) of this section.
(C) 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.)
(6) Example 6: License of copyright right to make copies of a computer program and distribute to the public —(i) Facts. Corp A transfers a disk containing Program X to Corp B, a Country Z corporation, and grants Corp B the non-exclusive right to reproduce and distribute for sale to the public an unlimited number of disks containing Program X 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. Corp A has ascertained that the primary benefit or value from the transaction to Corp B is derived from the right to reproduce and distribute Program X and not from the receipt of a copy of Program X. The transfer of a copy of Program X is merely the means by which Corp A provides Corp B access to Program X in order to exercise its copyright rights.
(ii) Analysis. (A) The transaction between Corp A and Corp B has multiple elements. One element is the transfer of a disk with a copy of Program X, which would be described under paragraph (b)(1)(ii) of this section (transfer of a copyrighted article) if considered separately. Another element is the grant of the right to reproduce and distribute for sale to the public an unlimited number of disks containing Program X, which would be described under paragraphs (b)(1)(i) and (c)(2)(i) of this section (transfer of a copyright right) if considered separately.
(B) Because the transaction has multiple elements, one or more of which would be a digital content transaction if considered separately, paragraph (b)(2) of this section provides that the transaction is classified within a single category under paragraph (b)(1) of this section if its predominant character is described in that paragraph. Pursuant to paragraph (b)(3) of this section, the predominant character of the transaction is based on the primary benefit or value of the transaction to the customer, if it is reasonably ascertainable. The predominant character of this transaction is therefore the transfer of a copyright right because the primary benefit or value received by Corp B is the right to reproduce and distribute for sale to the public copies of Program X. Therefore, this transaction is classified solely as a transfer of copyright rights described in paragraph (b)(1)(i) of this section.
(C) Taking into account all of the facts and circumstances, there has been a license of Program X to Corp B. 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.
(7) Example 7: Sale of disks containing copies of a computer program to a distributor —(i) Facts. Corp C, a distributor, enters into an agreement with Corp A 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 paragraph (h)(1) of this section ( Example 1 )).
(ii) Analysis. (A) Under paragraph (b)(1) of this section, the transfers of disks with copies of Program X from Corp A to Corp C are digital content transactions with one element, which is the transfer of copies of Program X. Therefore, the transactions are classified solely as the transfer of copyrighted articles under paragraph (b)(1)(ii) of this section. The use of the term license is not dispositive under paragraph (g)(1) of this section.
(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.
(8) Example 8: License to a computer manufacturer of copyright rights to make and load copies of a computer program onto the hard drive of computers —(i) Facts. Corp A 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. Corp A has ascertained that the primary benefit or value from the transaction to Corp D is the ability to copy and distribute Program X onto computers manufactured by Corp D, not from the receipt of a copy of Program X. The transfer of a copy of Program X is merely the means by which Corp A provides Corp D access to Program X in order to exercise its right to make and distribute copies.
(ii) Analysis. (A) The transaction between Corp A and Corp D has multiple elements. One element is the transfer of a disk with a copy of Program X, which would be described in paragraph (b)(1)(ii) of this section (transfer of a copyrighted article) if considered separately. Another element is the grant of the non-exclusive right to copy Program X onto the hard drive of an unlimited number of computers and distribute those copies (on the hard drive) to the public, which would be described in paragraphs (b)(1)(i) and (c)(2)(i) of this section (transfer of a copyright right) if considered separately.
(B) Because the transaction has multiple elements, one or more of which would be a digital content transaction if considered separately, paragraph (b)(2) of this section provides that the transaction is classified within a single category under paragraph (b)(1) of this section if its predominant character is described in that paragraph. Pursuant to paragraph (b)(3) of this section, the predominant character of the transaction is based on the primary benefit or value of the transaction to the customer, if it is reasonably ascertainable. The predominant character of this transaction is therefore the transfer of copyright rights because the primary benefit or value received by Corp D is the right to copy Program X onto the hard drive of an unlimited number of computers and sell those copies (on the hard drive) to the public. Therefore, this transaction is classified solely as a transfer of copyright rights described in paragraph (b)(1)(i) of this section.
(C) Taking into account all of the facts and circumstances, there has been a license of Program X to Corp D. 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 D's interest). Corp D 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. The result would be the same if Corp D included with the computers it sells a copy of Program X on a disk.
(9) Example 9: Sale of disks containing a copy of computer program to a computer manufacturer —(i) Facts. The facts are the same as those in paragraph (h)(8) of this section ( 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 paragraph (h)(1) of this section ( 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) Under paragraph (b)(1) of this section, the transfers of disks with copies of Program X from Corp A to Corp D are digital content transactions with one element, which is the transfer of copies of Program X. Therefore, the transaction is classified solely as the transfer of copyrighted articles under paragraph (b)(1)(ii) of this section. Corp D acquires the disks without the right to reproduce and distribute publicly further copies of Program X.
(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.
(10) Example 10: Sale of a computer program with right to load onto multiple employee workstations —(i) Facts. Corp A transfers a disk containing Program X to Corp E 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) It must be determined whether the transfer from Corp A to Corp E of a disk containing a copy of Program X and the right to load Program X onto 50 individual workstations is a transaction with multiple elements. There is at least one element, which is the transfer of a disk containing a copy of Program X, which either is a digital content transaction under paragraph (b)(1) of this section or would be a digital content transaction if considered separately. If there is no additional element, then the transaction is classified as a transfer of a copyrighted article pursuant to paragraph (b)(1)(ii) of this section. If there is a second element, then paragraph (b)(2) of this section applies and the transaction is classified within a single category under paragraph (b)(1) of this section if its predominant character is described in that paragraph. 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 described in paragraph (c)(2) of this section. Therefore, there is no second element in this transaction and it is classified solely as the transfer of copyrighted articles (50 copies of Program X).
(B) Taking into account all of the facts and circumstances, Corp E 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 other persons that had a relationship to Corp E specified in paragraph (g)(3) of this section.
(11) Example 11: Sale of a computer program with right to make available to multiple employees via local area network —(i) Facts. The facts are the same as those in paragraph (h)(10) of this section ( 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 paragraph (h)(10) of this section ( Example 10 ), this is a digital content transaction with a single element that is classified as the transfer of a copyrighted article pursuant to paragraph (b)(1)(ii) of this section. 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 persons that had a relationship to Corp E specified in paragraph (g)(3) of this section.
(12) Example 12: Lease of a computer program with right to receive upgrades and technical support services —(i) Facts. The facts are the same as in paragraph (h)(11) of this section ( Example 11 ), except that instead of paying a one-time fee, Corp E pays a monthly fee to Corp A 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 in the form of troubleshooting and configuration assistance to Corp E, but the agreement does not allocate the monthly fee between the right to use Program X, 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 when the contract is entered into but is expected to be minimal. Corp A has ascertained that the primary benefit or value to Corp E from the transaction is the right to use Program X on the LAN (without the ability to exercise any of the rights described in paragraphs (c)(2)(i) through (iv) of this section), not the receipt of technical support services with respect to Program X.
(ii) Analysis. (A) The transaction between Corp A and Corp E has multiple elements. One element is the transfer of a disk with a copy of Program X, which would be described in paragraph (b)(1)(ii) of this section (transfer of a copyrighted article) if considered separately. Another element is the provision of technical support services, which are not services for the development or modification of Program X described in paragraph (d) of this section because Corp E has received no copyright rights with respect to Program X. Thus, the technical support services would not be described in any of the categories in paragraph (b)(1) of this section if considered separately.
(B) Because the transaction has multiple elements, one or more of which would be a digital content transaction if considered separately, paragraph (b)(2) of this section provides that the transaction is classified within a single category under paragraph (b)(1) of this section if its predominant character is described in that paragraph. Pursuant to paragraph (b)(3) of this section, the predominant character of the transaction is based on the primary benefit or value of the transaction to the customer. The predominant character of this transaction is therefore the transfer of a copyrighted article because the primary benefit or value received by Corp E is the right to use Program X. Accordingly, this transaction is classified solely as a transfer of a copyrighted article described in paragraph (b)(1)(ii) of this section.
(C) 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 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.
(13) Example 13: Sale of a computer program along with right to receive upgrades —(i) Facts. The facts are the same as those in paragraph (h)(12) of this section ( 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 paragraph (h)(10)(ii)(B) of this section ( Example 10 ), the transfer of the program will be treated as a sale of a copyrighted article rather than as a lease.
(14) Example 14: Sale of a modified computer program —(i) Facts. Corp G enters into a contract with Corp A 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 paragraph (h)(10) of this section ( Example 10 ).
(ii) Analysis. (A) It must be determined whether the transfer of disks with modified copies of Program X from Corp A to Corp G is a transaction with multiple elements. There is at least one element, the transfer of copies of Program X, which either is a digital content transaction under paragraph (b)(1) of this section or would be a digital content transaction if considered separately. If there is no additional element, then the transaction is classified as a transfer of a copyrighted article pursuant to paragraph (b)(1)(ii) of this section. If there is a second element, then paragraph (b)(2) of this section applies and the transaction is classified within a single category under paragraph (b)(1) of this section if its predominant character is described in that paragraph. Pursuant to paragraph (d) of this section, the modifications made by Corp A before transferring Program X to Corp G do not constitute the provision of services for the development or modification of digital content because Corp A retains all copyright rights with respect to the modified software. Therefore, there is no second element in this transaction and it is classified solely as the transfer of copyrighted articles.
(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.
(15) Example 15: Provision of services for development of a computer program —(i) Facts. Corp H enters into a license agreement for a new computer program. Program Q is to be written by Corp A. 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. Under paragraph (b)(1) of this section, the provision of computer program development services by Corp A to Corp H is a digital content transaction with one element, which is the provision of services for the development or modification of digital content. Under paragraph (d) of this section, the transaction between Corp A and Corp H involves the provision of services for the development of a computer program 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. Taking into account all of the facts and circumstances, Corp A is treated as providing services to Corp H described in paragraph (b)(1)(iii) of this section. 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).
(16) Example 16: Provision of know-how by computer programmers —(i) Facts. Corp A 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. The provision of know-how with respect to computer programming techniques by Corp A's development engineer to Corp I is described in paragraph (e) of this section. Therefore, the transaction is a digital content transaction with one element, which is the provision of know-how. The transaction is classified solely as the provision of know-how pursuant to paragraph (b)(1)(iv) of this section.
(17) Example 17: Sale of development program in transaction with multiple elements —(i) Facts. Corp A transfers a disk containing Program Y to Corp E 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. 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 paragraph (h)(1) of this section ( Example 1 ). Corp A cannot reasonably ascertain the primary benefit or value of the transaction to Corp E. A customer like Corp E derives two benefits from this or a substantially similar transaction, the first of which is the ability to use Program Y to develop new software and the second of which is the right to utilize the libraries and reusable software components in Program Y in distributed programs. Corp A possesses data arising from market research and customer surveys indicating that customers utilize Program Y primarily for its computer program development features and do not make significant use of the libraries of reusable software components. The libraries and reusable software components are not significant components of any overall new program created by using Program Y.
(ii) Analysis. (A) The transaction between Corp A and Corp E has multiple elements. One element is the transfer of a disk with a copy of Program Y, which would be described in paragraph (b)(1)(ii) of this section (transfer of a copyrighted article) if considered separately. Another element is the grant of the right to distribute copies of the libraries of reusable software components with any program developed using Program Y, which would be described in paragraphs (b)(1)(i) and (c)(2)(i) of this section (transfer of a copyright right) if considered separately.
(B) Because the transaction has multiple elements, one or more of which would be a digital content transaction if considered separately, paragraph (b)(2) of this section provides that the transaction is classified within a single category under paragraph (b)(1) of this section if its predominant character is described in that paragraph. Pursuant to paragraph (b)(3)(i) of this section, the predominant character of a transaction is generally based on the primary benefit or value of the transaction to the customer. If the primary benefit or value is not reasonably ascertainable, paragraph (b)(3)(ii) of this section provides that the predominant character of a transaction may be determined based on the primary benefit or value to a typical customer of a substantially similar transaction. This primary benefit or value to a typical customer can be identified through actual data about use or access pursuant to paragraph (b)(3)(ii)(A) of this section, or if that data is not available, by other evidence indicative of the primary benefit or value to a typical customer pursuant to paragraph (b)(3)(ii)(B) of this section. Although there are two benefits in this type of transaction, Corp A possesses data indicating that a typical customer primarily uses Program Y because of its computer program development features, rather than the right to distribute reusable components. This is reinforced by the fact that programs created using Program Y do not contain libraries of reusable software components as significant components. These facts indicate that the primary benefit or value to a typical customer arises from the ability to use Program Y, rather than the right to distribute reusable components. Therefore, the predominant character of this transaction is the transfer of a copy of Program Y, and this transaction is thus classified solely as the transfer of a copyrighted article described in paragraph (b)(1)(ii) of this section.
(C) 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.
(18) Example 18: Sale of a computer program with right to make modifications —(i) Facts. Corp A transfers a disk containing Program X to Corp E. The disk contains both the object code and the source code to Program X, and the license agreement grants Corp E the right to modify the source code to correct minor errors and make minor adaptations to Program X so it will function on Corp E's computer; as well as the right to recompile the modified source code. 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 paragraph (h)(1) of this section ( Example 1 ). Corp A has ascertained that the primary benefit or value received by Corp E from the transaction is the core functionality of Program X rather than the limited rights to modify the source code.
(ii) Analysis. (A) The transaction between Corp A and Corp E has multiple elements. One element is the transfer of a disk with a copy of Program X, which would be described in paragraph (b)(1)(ii) of this section (transfer of a copyrighted article) if considered separately. Another element is the grant of the right to modify the source code to Program X and recompile the modified source code to create new code to correct minor errors, and to make minor adaptations to Program X, which would be described in paragraphs (b)(1)(i) and (c)(2)(ii) of this section (transfer of a copyright right) if considered separately.
(B) Because the transaction has multiple elements, one or more of which would be a digital content transaction if considered separately, paragraph (b)(2) of this section provides that the transaction is classified within a single category under the categories described under paragraph (b)(1) of this section if its predominant character is described in that paragraph. Pursuant to paragraph (b)(3) of this section, the predominant character of the transaction is based on the primary benefit or value of the transaction to the customer, if it is reasonably ascertainable. Since the primary benefit or value received by Corp E is the core functionality of Program X, rather than the limited rights to modify the source code, the predominant character of this transaction is the transfer of a copyrighted article. Therefore, this transaction is classified solely as a transfer of a copyrighted article under paragraph (b)(1)(ii) of this section.
(C) 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.
(19) Example 19: License to website operator to make and sell copies of electronic books via download —(i) Facts. Corp A operates a website that offers electronic books for download onto customers' computers or other electronic devices. The books offered are protected by copyright law. In a transaction between Corp A and a content owner, Corp A receives from the content owner a digital master copy of a book, which Corp A downloads onto its server. Corp A receives the non-exclusive right to reproduce an unlimited number of copies of the book for purposes of distribution and sale to the public. Corp A pays the content owner a specified amount for each copy sold to a customer. Corp A may not transfer any of the rights it receives from the content owner. The term of the agreement Corp A has with the content owner is shorter than the remaining life of the copyright. The content owner has ascertained that the primary benefit or value Corp A receives in the transaction is the right to reproduce and distribute an unlimited number of copies of the book and not the transfer of a copy of the book. In a separate transaction, Corp A charges a customer a fixed fee for each book purchased. When purchasing a book from Corp A on Corp A's website, the customer must acknowledge the terms of a license agreement with the content owner that states that the customer may download and view the electronic book in perpetuity but may not reproduce, distribute, or sell copies of it. Once the customer downloads the book from Corp A's server onto a device, the customer may access and view the book from that device, which does not need to be connected to the internet for the customer to view the book. The customer owes no additional payment to Corp A for the ability to view the book in the future.
(ii) Analysis. (A) Notwithstanding the license agreement between each customer and the content owner granting the customer rights to use the book, the relevant transactions are the transfer of a master copy of the book along with the grant from the content owners to Corp A of the right to reproduce and sell to the public copies of the books, and the transfers of copies of the books by Corp A to customers. Although the content owner is identified as a party to the license agreement memorializing the customer's rights with respect to the book, each customer obtains those rights directly from Corp A, not from the content owner. Under paragraph (b)(1) of this section, the download of a copy of a book by a customer is a digital content transaction with one element, which is the transfer of a digital copy of a book. Therefore, the transaction is treated solely as a transfer of a copyrighted article under paragraph (b)(1)(ii) of this section. Under the benefits and burdens test of paragraph (f)(2) of this section, the transaction is classified as a sale and not a lease, because the customer receives the right to view the book in perpetuity on its device.
(B) The transaction between the content owner and Corp A has multiple elements. One element is the transfer of a master copy of the book, which would be described in paragraph (b)(1)(ii) of this section (transfer of a copyrighted article) if considered separately. Another element is the grant of the right to reproduce and sell an unlimited number of copies to customers, which would be described in paragraphs (b)(1)(i) and (c)(2)(i) of this section (transfer of a copyright right) if considered separately. Because the transaction has multiple elements, one or more of which would be a digital content transaction if considered separately, paragraph (b)(2) of this section provides that the transaction is classified within a single category under the categories described under paragraph (b)(1) of this section if its predominant character is described in that paragraph. Pursuant to paragraph (b)(3) of this section, the predominant character of the transaction is based on the primary benefit or value of the transaction to the customer, if it is reasonably ascertainable. Since the primary benefit or value Corp A receives in the transaction is the right to reproduce and distribute an unlimited number of copies, the predominant character of this transaction is the transfer of a copyright right. Therefore, this transaction is classified solely as a transfer of copyright rights described in paragraph (b)(1)(i) of this section.
(C) Taking into account all of the facts and circumstances, there has been a license of books to Corp A. Under paragraph (f)(1) of this section, there has not been a transfer of all substantial rights in the copyright rights to the books because each content owner has the right to enter into other licenses with respect to the copyright of their book. Corp A has acquired no right itself to license the copyrights in the books. Finally, the terms of the licenses are for less than the remaining lives of the copyrights in the books.
(20) Example 20: Internet platform operator as agent for application developers —(i) Facts. Corp A operates a platform on the internet that offers applications for download onto a customer's mobile phone. Under general tax principles, Corp A and an application developer establish an agency relationship whereby Corp A acts as the agent to offer the application for sale to customers on behalf of the application developer. The applications are protected by copyright law. Under the agreement between Corp A and the application developer, Corp A agrees to provide the application developer with platform and agency services to facilitate the sale of the application to customers. Corp A also provides the application developer with hosting services to host the application on Corp A's servers for download by the customers. Corp A receives a digital master copy of the application along with a non-exclusive right to make copies of the application and allow customers to download copies of the application from Corp A's platform. Corp A has ascertained that the primary benefit or value from the transaction received by the application developer is the platform and agency services that Corp A provides. Corp A receives the right to make copies of the application merely to perform its activities as an agent on behalf of the application developer. When purchasing an application on Corp A's platform, the customer must acknowledge the terms of a license agreement with the application developer that states that the customer may use the application but may not reproduce or distribute copies of it. In addition, the agreement provides that the customer may download the application onto only one mobile phone at a time. A customer does not need to be connected to the internet to access the application. The customer owes no additional payment to Corp A or the application developer for the ability to use the application in perpetuity. Corp A retains a fixed percentage of each purchase price of the application and remits the remaining balance to the application developer.
(ii) Analysis. (A) The transaction between Corp A and the application developer has multiple elements. One element is the transfer of a master copy of an application by the application developer to Corp A, which would be described in paragraph (b)(1)(ii) of this section (transfer of a copyrighted article) if considered separately. Another element is the transfer of the right to make and distribute copies of the application by the application developer to Corp A, which would be described in paragraphs (b)(1)(i) and (c)(2) of this section (transfer of a copyright right) if considered separately. A third element is the platform and agency services provided by Corp A to the application developer, which would not be described in this section if considered separately. A fourth element is the hosting services provided by Corp A to the application developer, which would be described in § 1.861-19 if considered separately. Under the facts and circumstances, although Corp A receives a copy of the application and the right to make and distribute copies of the application, Corp A receives this copy and right merely to facilitate the sale of applications on behalf of the application developer.
(B) Because the transaction has multiple elements, one or more of which would be a digital content transaction if considered separately, paragraph (b)(2) of this section provides that the transaction is classified within a single category under the categories described under paragraph (b)(1) of this section if its predominant character is described in that paragraph. Pursuant to paragraph (b)(3) of this section, the predominant character of the transaction is based on the primary benefit or value of the transaction to the customer, if it is reasonably ascertainable. Since the primary benefit or value the application developer receives in the transaction is the platform and agency services, the predominant character of this transaction is the platform and agency services and not a digital content transaction nor a cloud transaction.
(C) The transfer of a copy of an application from the application developer to a customer is a digital content transaction with one element, which is the transfer of a copy of a digital program. Therefore, the transaction is treated solely as a transfer of a copyrighted article under paragraph (b)(1)(ii) of this section. Under the benefits and burdens test of paragraph (f)(2) of this section, this transaction is a sale of a copyrighted article because a customer has the right to use the application in perpetuity.
(21) Example 21: Movies and TV shows available for stream, rent, or purchase —(i) Facts. Corp A offers a catalog of movies and TV shows, all of which are subject to copyright protection. Corp A gives customers several options for viewing the content, each of which has a separate price. A “streaming” option allows a customer to view the video, which is hosted on Corp A's servers, while connected to the internet for as many times as the customer wants during a limited period. A “rent” option allows a customer to download the video to its computer or other electronic device (which does not need to be connected to the internet for viewing) and watch the video as many times as the customer wants for a limited period, after which an electronic lock is activated and the customer may no longer view the content. A “purchase” option allows a customer to download the video and view it as many times as the customer chooses with no end date. Under all three options, the customer may view the video but may not reproduce or distribute copies of it, prepare derivative works based on it, or publicly display it.
(ii) Analysis. (A) With respect to the “rent” option, under paragraph (b)(1) of this section the download of a video by a customer is a digital content transaction with one element, which is the transfer of a copy of the video. Therefore, the transaction is treated solely as the transfer of a copyrighted article under paragraph (b)(1)(ii) of this section. Although a customer will retain a copy of the content at the end of the payment term, the customer cannot access the content after the electronic lock is activated. The activation of the electronic lock is the equivalent of having to return the copy. Therefore, the transaction is classified as a lease of a copyrighted article under paragraph (f)(2) of this section because the customer's right to view the videos is for a limited period.
(B) With respect to the “purchase” option, under paragraph (b)(1) of this section the download of a video by a customer is a digital content transaction with one element, which is the transfer of a copy of the video. Therefore, the transaction is treated solely as the transfer of a copyrighted article under paragraph (b)(1)(ii) of this section. The transaction is classified as a sale of a copyrighted article under paragraph (f)(2) of this section because the customer receives the right to view the videos in perpetuity.
(C) With respect to the “streaming” option, the transaction is Corp A's grant of the right to its customers to view the movies or shows while connected to the internet for a limited period. There is no transfer of any copyright rights described in paragraph (c)(2) of this section. There is also no transfer of a copyrighted article because the content is not downloaded by a customer, but rather, is accessed through an on-demand network. The transaction also does not constitute the provision of services for the development of digital content or the provision of know-how under paragraph (b)(1) of this section. Therefore, the transaction is not a digital content transaction described in paragraph (b)(1) of this section. Instead, the transaction is a cloud transaction that is classified under § 1.861-19. See § 1.861-19(b).
(22) Example 22: Website offering third-party videos via stream —(i) Facts. Corp A operates a website that allows customers to stream videos that third-party content creators upload to Corp A's website. Corp A has advertising contracts with third-party advertisers pursuant to which Corp A earns advertising revenue when a customer views a video. Customers can either stream videos for free with advertisements or can pay a subscription fee to stream videos without advertisements. Under the contract between Corp A and content creators, content creators retain all ownership rights in their videos and must own or have the necessary rights to publish their videos. The contract also states that content creators grant Corp A a non-exclusive license to use, reproduce, distribute, and display their videos in connection with Corp A's website, and grant customers a non-exclusive license to view the videos. These licenses terminate within a commercially reasonable time after a content creator removes or deletes a video from Corp A's website. Content creators have ascertained that the primary benefit or value Corp A receives from transactions with content creators is the right to use, reproduce, distribute, and display their videos. Corp A pays content creators a percentage of advertising revenue generated from the videos and a percentage of subscription fees.
(ii) Analysis. (A) The transaction between Corp A and the content creators has multiple elements. One element is the uploading of a video by a content creator, which would be described in paragraph (b)(1)(ii) of this section (transfer of a copyrighted article) if considered separately. Another element is the grant by content creators to Corp A of the right to use, reproduce, distribute, and display their videos, which would be described in paragraph (b)(1)(i) of this section (transfer of a copyright right) if considered separately. Content creators are not providing content development services to Corp A under paragraph (d) of this section because content creators own the copyright rights in the videos.
(B) Because the transaction has multiple elements, one or more of which would be a digital content transaction if considered separately, paragraph (b)(2) of this section provides that the transaction is classified within a single category under the categories described under paragraph (b)(1) of this section if its predominant character is described in that paragraph. Pursuant to paragraph (b)(3) of this section, the predominant character of the transaction is based on the primary benefit or value of the transaction to the customer. The predominant character of the transaction is therefore the transfer of copyright rights because the primary benefit or value received by Corp A is the right to use, reproduce, distribute, and display videos. Accordingly, this transaction is characterized solely as a transfer of a copyright right as described in paragraphs (b)(1)(i) of this section.
(C) Taking into account all of the facts and circumstances, there has been a license of videos to Corp A. Under paragraph (f)(1) of this section, there has not been a transfer of all substantial rights in the copyright rights to the videos because each content owner has the right to enter into other licenses with respect to the copyright of their videos. Corp A has acquired no right itself to license the copyrights in the videos. Finally, the terms of the licenses are for less than the remaining lives of the copyrights in the videos.
(D) For both the free streaming and subscription streaming transactions between Corp A and customers, there is no transfer of any copyright rights described in paragraph (c)(2) of this section. There is also no transfer of a copyrighted article, because the content is not downloaded by a customer, but rather is accessed through an on-demand network. The transactions also do not constitute the provision of services for the development of digital content or the provision of know-how under paragraph (b)(1) of this section. Therefore, paragraph (b)(1) of this section does not apply to such transactions. Instead, both transactions are cloud transactions that are classified under § 1.861-19. See § 1.861-19(b).
(23) Example 23: Sale of computer programs electronically through a reseller —(i) Facts. Corp A owns the copyright to software (Program S). Corp A hosts Program S on its servers. Corp A grants Corp B, a foreign corporation wholly owned by Corp A, the right to distribute copies of Program S (without the right to reproduce copies of Program S) to Corp B's customers that are located in Corp B's country. Under the agreement between Corp A and Corp B, Corp B pays Corp A a fixed fee for each copy of Program S that Corp A delivers to a customer. In separate transactions, customers pay Corp B for the right to receive digital copies of Program S that they may then use in perpetuity without further payment. Corp B is responsible for managing the purchase/sale interaction with Corp B's customers, including invoicing and collections. Corp A is responsible for creating and delivering the digital copies of Program S to Corp B's customers from Corp A's servers. Corp B does not perform any functions to provide access to Program S.
(ii) Analysis. (A) Although there is a single contract between Corp A and Corp B that grants a legal right to Corp B with respect to Program S, that right (the right to distribute) is not a copyright right described in paragraphs (b)(1)(i) and (c)(2) of this section. Instead, the transactions between Corp A and Corp B and then Corp B and its customers are functionally and economically equivalent to back-to-back transfers of copyrighted articles. The transfers are only superficially different from those described in paragraph (h)(24) of this section ( Example 24 ) where the reseller acquires product keys and sells them on to customers. Therefore, each sale of a copy of Program S by Corp B to a customer should be viewed as a transfer of a copyrighted article from Corp A to Corp B and then from Corp B to the customer.
(B) The transaction between Corp A and Corp B is a digital content transaction with a single element that is classified as a transfer of a copyrighted article described in paragraph (b)(1)(ii) of this section. There are no additional elements because Corp B's receipt of the right to distribute copies of Program S (without the right to make copies) is not a copyright right described in paragraph (c)(2) of this section. Under the benefits and burdens test of paragraph (f)(2) of this section, the transfer is classified as the sale of a copyrighted article.
(C) The transaction between Corp B and a customer is a digital content transaction with a single element that is classified as a transfer of a copyrighted article described in paragraph (b)(1)(ii) of this section. Under the benefits and burdens test of paragraph (f)(2) of this section, this transaction is a sale of a copyrighted article because the customer has the right to use the application in perpetuity.
(24) Example 24: Sale of video games with online and offline functionality through retailers using digital keys —(i) Facts. Corp A owns the copyright in a computer program (Program Y). Corp A creates digital keys that allow for the download of one copy of Program Y from Corp A's website. Corp A sells these digital keys to retailers for a one-time fee per key, and the retailers do not use Program Y, but instead sell them in separate transactions to customers for a one-time fee per key. Corp A ascertains that the primary benefit or value to retailers from the purchase of digital keys from Corp A is the right to further transfer the digital keys to customers. The retailers cannot reasonably ascertain the primary benefit or value that their specific customers derive from Program Y, nor is there data available to the retailers about how their customers typically use Program Y. Program Y is a video game that contains online and offline features, both of which can be played without paying an additional game-specific cost after paying the one-time fee to purchase a key. The offline feature is comprised of a single-player story that does not require any internet connection to play. The online feature is comprised of the ability to play competitive matches against other players that are hosted on servers owned by Corp A. The competitive matches require an ongoing connection to the internet to play. Neither the customers nor the retailer receives any copyright rights described in paragraph (c)(2) of this section with respect to Program Y. Customers can use Program Y in perpetuity. Program Y is primarily marketed as a single-player game in television and online advertising, with only brief mentions of the multiplayer mode in print advertising. The development cost for Program Y was allocated 40% to developing the single-player content, 20% to developing the multiplayer content, and 40% to developing content that is used by both types of content ( e.g., cost of developing the game engine).
(ii) Analysis. (A) The transaction between Corp A and a retailer has multiple elements. One element is the transfer of a key with the right to download a copy of Program Y for use to play the offline story, which would be a digital content transaction described in paragraph (b)(1)(ii) of this section (transfer of a copyrighted article) if considered separately. Another element is the transfer of the same key with a copy of Program Y providing on-demand network access to digital content in the form of competitive multiplayer functionality, which would be a cloud transaction described in § 1.861-19(b) if considered separately.
(B) Because the transaction has multiple elements, one of which would be a digital content transaction if considered separately and one of which would be a cloud transaction if considered separately, paragraph (b)(2) of this section provides that the transaction is classified within a single category under paragraph (b)(1) of this section if its predominant character is described in that paragraph, or the transaction is classified solely as a cloud transaction if its predominant character is a cloud transaction pursuant to § 1.861-19(c)(2). Pursuant to paragraph (b)(3)(i) of this section, the predominant character of the transaction is based on the primary benefit or value of the transaction to the customer, if it is reasonably ascertainable. The predominant character of this transaction is therefore the transfer of copyrighted articles because the primary benefit or value received by a retailer is the right to further transfer the same copyrighted articles to customers in the form of digital keys. The retailers do not have any intent to utilize the cloud functionality of the digital keys, although they do have the right to do so. Therefore, this transaction is classified solely as a transfer of copyrighted articles described in paragraph (b)(1)(ii) of this section.
(C) Under the benefits and burdens test of paragraph (f)(2) of this section, the transfer between Corp A and a retailer is classified as the sale of a copyrighted article because the retailer has the right to use, or sell, Program Y in perpetuity without further payment.
(D) The transfer of a key (with the right to download a copy of Program Y) by a retailer to a customer also contains the same two elements as each transaction between Corp A and a retailer. However, a retailer cannot reasonably ascertain the primary benefit or value derived by a specific customer from Program Y. In such situations, paragraph (b)(3)(ii) of this section provides that the predominant character of a transaction may be determined based on the primary benefit or value to a typical customer of a substantially similar transaction. This primary benefit or value to a typical customer can be identified through actual data about use or access pursuant to paragraph (b)(3)(ii)(A) of this section, or if that data is not available, by using other evidence indicative of the primary benefit or value to a typical customer pursuant to paragraph (b)(3)(ii)(B) of this section. Because the retailers do not have available data about how customers use Program Y, they may use the marketing with respect to Program Y to determine that its predominant character is that of a transfer of a copyrighted article described in paragraph (b)(1)(ii) of this section. The relative development costs of the offline and online components of the game could also be used if they are known to a retailer. Therefore, the transfer between a retailer and a customer of a digital key containing the right to download a copy of Program Y is classified solely as a transfer of a copyrighted article.
(E) Under the benefits and burdens test of paragraph (f)(2) of this section, the transfer between a retailer and a customer is classified as the sale of a copyrighted article because the customer has the right to use Program Y in perpetuity without further payment.
(25) Example 25: Source of income from the sale of a copyrighted article transferred through an electronic medium —(i) Facts. Corp A is the parent company of a world-wide group of affiliated companies. Corp B is a foreign corporation wholly owned by Corp A. In the ordinary course of business, Corp B acts as a procurement hub for Corp A's affiliated companies. In this role, Corp B regularly purchases products that will be distributed amongst Corp A's affiliated companies to be used by them in their respective businesses. Corp B purchases digital copies of a computer program (Program Y) from Corp C, an unrelated company. Corp B may use Program Y in perpetuity without further payment. Corp B receives no copyright rights in Program Y. Corp B does not use Program Y, and instead distributes all of its copies of Program Y to various affiliates. Corp C sources income from the sale of Program Y using sections 861(a)(6) and 862(a)(6).
(ii) Analysis. (A) Under paragraph (b)(1) of this section, the transfer of Program Y from Corp C to Corp B is a digital content transaction with one element, which is the transfer of a copy of Program Y. Therefore, the transaction is treated solely as transfers of a copyrighted articles under paragraph (b)(1)(ii) of this section. Taking into account all of the facts and circumstances, there have been sales of copies of Program Y to Corp B under paragraph (f)(2) of this section.
(B) Income from the sale of Program Y by Corp C is sourced pursuant to sections 861(a)(6) and 862(a)(6) to the place where the sale occurred. Pursuant to paragraph (f)(2)(ii) of this section, a transfer of a copyrighted article through an electronic medium is treated as occurring at the billing address of the purchaser, in this case Corp B, unless the sales transaction is arranged for a principal purpose of tax avoidance. In this case, the sale is treated as occurring at the billing address of Corp B, and Corp C's income is foreign source, even though Corp B will not use Program Y, because Corp B regularly purchases products that will be distributed amongst its affiliates to be used in their respective businesses, and therefore there is no evidence that Corp B was used by Corp A to purchase Program Y with a principal purpose of tax avoidance.
(26) Example 26: Application of anti-abuse rule for sale of a copyrighted article transferred through an electronic medium —(i) Facts. Corp A is the parent company of a world-wide group of affiliated companies. Corp B is a foreign affiliate of Corp A. In the ordinary course of business, Corp B does not act as a procurement hub regularly purchasing products for use by Corp A's affiliated companies. Corp A negotiates an agreement with Corp C, an unrelated company, to purchase digital copies of a computer program (Program Y) for use in Corp A's business. The agreement grants Corp A the right to use Program Y in perpetuity for a one-time payment. Corp C requests that Corp B be the purchaser of the copies of Program Y even though Corp B will not use Program Y and is not otherwise involved in the transaction between Corp A and Corp C for a principal purpose of tax avoidance. Corp A agrees, and Corp B purchases the copies of Program Y and subsequently distributes them to Corp A. Corp C sources income from the sale of Program Y using sections 861(a)(6) and 862(a)(6).
(ii) Analysis. (A) Under paragraph (b)(1) of this section, the transfer of Program Y from Corp C to Corp B is a digital content transaction with one element, which is the transfer of a copy of Program Y. Therefore, the transaction is classified solely as a transfer of a copyrighted article under paragraph (b)(1)(ii) of this section. Taking into account all of the facts and circumstances, there have been sales of copies of Program Y to Corp B under paragraph (f)(2) of this section.
(B) Income from the sale of Program Y by Corp C is sourced pursuant to sections 861(a)(6) and 862(a)(6) to the place where the sale occurred. Pursuant to paragraph (f)(2)(ii) of this section, a transfer of a copyrighted article through an electronic medium is treated as occurring at the billing address of the purchaser, in this case Corp B, unless the sales transaction is arranged for a principal purpose of tax avoidance. In this case, Corp B does not regularly purchase products that will be used by other companies within Corp A's group of affiliated companies, and Corp B was instead used as the purchaser of Program Y on behalf of Corp A with a principal purpose of tax avoidance. Therefore, the place where the sale occurred must be determined based on all relevant facts and circumstances. Corp A negotiated the purchase, and the software will be used by Corp A in its business. As a result, under paragraph (f)(2)(ii) of this section, the sale is treated as occurring at the location of Corp A and the income derived by Corp C from the sale is U.S. source.
(C) The same result would apply if, instead of using Corp B for the purchase, Corp A made the purchase but rented a P.O. Box outside the United States to serve as the billing address for the transaction with a principal purpose of tax avoidance.
(i) Applicability date —(1) In general. This section applies to taxable years beginning on or after January 14, 2025.
(2) Early application. A taxpayer can apply this section to taxable years beginning on or after August 14, 2019 and all subsequent taxable years not described in paragraph (i)(1) of this section (early application years) if—
(i) The taxpayer also applies § 1.861-19 to the early application years;
(ii) This section and § 1.861-19 are applied to the early application years by all persons related to the taxpayer (within the meaning of sections 267(b) and 707(b));
(iii) The period of limitations on assessment for each early application year of the taxpayer and all related parties (within the meaning of sections 267(b) and 707(b)) is open under section 6501; and
(iv) The taxpayer would not be required under this section to change its method of accounting as a result of such election.
(j) Change in method of accounting required by this section. In order to comply with this section, a taxpayer may be required to change its method of accounting. If so required, the taxpayer must secure the consent of the Commissioner in accordance with the requirements of § 1.446-1(e) and the applicable administrative procedures for obtaining the Commissioner's consent under section 446(e) for voluntary changes in methods of accounting.