New Chief Counsel Advisory Rules that Sale of Software Products By a Controlled Foreign Corporation to End-User Customers in the U.S. Did Not Constitute an Investment in the U.S.
The Chief Counsel’s Office just released an advisory, CCA 201106007, which ruled that the sale of software products by a controlled foreign corporation to end-users situated in the United States was not an investment in the U.S. under section 956(c)(1)(D) requiring that the amount so invested be included in the U.S. shareholders’ gross income under section 951(a)(1)(B) based on the underlying facts.
The taxpayer is a U.S. entity involved in the distribution of information technology and services, including the development of software in the U.S. under a cost sharing arrangement with its wholly-owned foreign subsidiary, S (also CFC). Under the cost sharing arrangement, S acquired the rights to market the acquired copyrights in the U.S. When the taxpayer finishes the development of a software product intended for sale to end-user customers, the final version of the software “code” is transferred to a “gold master” disk and delivered to S. The wholly owned subsidiary then reproduces and sells copies of the software to unrelated, end-user customers in the United States.
Background
Under the CFC provisions, a U.S. shareholder is required to include in gross income her pro rata share of the CFC’s subpart F income and the increase in the CFC’s investment in U.S. property See §951(a)(1)(B). The underlying rationale for the investment in U.S. property provision is that such reinvestment is substantially equivalent to a dividend. See Sen. Rep. No. 1881, 87th Cong., 2d Sess., 1962-3 CB 703, 704. The term U.S. property is defined in section 956(c) (1) as a rule of inclusion and section 956(c)(2) as a rule of exclusion. (and excluded from the definition of the term in section 956(c)(2). U.S. property includes tangible property in the U.S., stocks and debt obligations of related domestic corporations, and patents, copyrights and other intangibles acquired or developed for use in the U.S. A CFC’s stock in a U.S. subsidiary is also U.S. property. See Tobin, “Double Taxing Sandwiches”, 39 Tax Mgmt. Int’l 273 (2010).
There are exceptions to U.S. property set forth in section 956(c)(2) which attempt to apply to property held temporarily in the United States as part of a “normal commercial transactions”. A U.S. shareholder claiming the benefit of any exception must file a statement with its return identifying the property covered by the exception. Treas. Reg. § 1.956-2(b)(2). Portfolio investments in stock and debt of unrelated U.S. companies are also excluded from the definition of U.S. property.
In addition to the myriad of rules of inclusion and exclusion contained in section 956(c) and the underlying regulations, property held by a foreign corporation controlled by the CFC is treated as owned by the CFC if avoidance of section 956 is “one of the principal purposes for creating, organizing, or funding (through capital contributions or debt) such other foreign corporation.” The latter rule is intended to prevent taxpayers from circumventing section 956 by using a CFC with no earnings and profits to hold U.S. property that is effectively acquired with the earnings of a related CFC. Treas. Reg. § 1.956-1T(b)(4)(i). See, e.g., The Limited, Inc. v. Comm’r, 113 TC 169, 192 (1999) , rev'd on another issue, 286 F3d 324 (6th Cir. 2002).
Intangibles as U.S. Property
The CCA starts its analysis by noting “United States property” per section 956(a)(1)(D) includes any right to use intangible property in the U.S. that is acquired or developed by a CFC for use in the U.S. The operative word here is “right” to use in the U.S. Whether such right has been acquired or developed for use in the U.S. is based on examining all facts present. Treas. Reg. § 1.956- 2(a)(iv)(d). However, a right actually used principally in the U.S. will generally be considered to have been acquired or developed for use in the U.S. unless affirmative evidence shows the contrary.
Thus, both the statute and regulations to section 956 define U.S. property in relation to whether a CFC develops intangible property intended for use in the U.S. or acquires the right to use intangible property in the U.S.—not whether such right is actually exercised.
Resolution of the Issue in CCA 201106007
Here, S, a CFC, invested in U.S. property per section 956 when it acquired or developed the rights to use copyright rights in the U.S. pursuant to the cost sharing arrangement. However, the actual sales of the computer software copies from S to end-user customers in the U.S. do not in and of themselves constitute an investment in U.S. property within the scope of section 956(c)(1)(D). Furthermore, the actual transfer of copies of the software by S to the end-user U.S. customers does not affect the calculation of the inclusion amount, if any, under section 956 attributable to S’s original investment in U.S. property, because S did not acquire or develop additional rights (or relinquish any rights) to use the software in the U.S. merely as a result of the sale of copies to a U.S. person.
The CCA did find, as mentioned, that S made an investment in U.S. property for purposes of section 956(c)(1)(D) as a result of its acquisition or development of rights to use copyright rights in the U.S. under the cost sharing agreement. Still, the amount invested in the U.S. is based on S’s adjusted basis in the copyright rights. Where S’s costs were properly deducted in computed taxable income, it may have a $0 basis in U.S. property. The CCA then opined that further factual development is needed to determine whether and to what extent other aspects of Sub's activities with respect to the copyright rights constitute an investment in U.S. property within section 956.
CCA Conclusion
The CCA concluded, based on the preceding analysis, that the sale of software products by S (a CFC) to end-user customers in the U.S. did not constitute an investment in U.S. property under section 956(c)(1)(D) so as to require an income inclusion for its U.S. parent corporation. S, however, was viewed in the CCA as having made an investment in U.S. property when it acquired or developed rights to use copyrights in the U.S. under the cost sharing agreement. Still, the actual sales of the computer software copies from S to the U.S. end-user (customers) did not, per se, constitute an investment in the U.S.
