[Federal Register Volume 61, Number 220 (Wednesday, November 13, 1996)]
[Proposed Rules]
[Pages 58152-58158]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 96-29055]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-251520-96]
RIN 1545-AU70


Classification of Certain Transactions Involving Computer 
Programs

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking and notice of public hearing.

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SUMMARY: This document contains proposed regulations relating to the 
tax treatment of certain transactions involving the transfer of 
computer programs. The proposed regulations provide rules for 
classifying such transactions as sales, licenses, leases, or the 
provision of services or of know-how under certain provisions of the 
Internal Revenue Code and tax treaties. This document also provides 
notice of a public hearing on the proposed regulations.

DATES: Comments must be received by February 11, 1997. Requests to 
speak (with outlines of oral comments) at a public hearing scheduled 
for March 19, 1997, at 10 a.m. must be submitted by February 26, 1997.

ADDRESSES: Send submissions to: CC:DOM:CORP:R (REG-251520-96), room 
5228, Internal Revenue Service, POB 7604, Ben Franklin Station, 
Washington, DC 20044. In the alternative, submissions may be hand 
delivered between the hours of 8 a.m. and 5 p.m. to: CC:DOM:CORP:R 
(REG-251520-96), Courier's Desk, Internal Revenue Service, 1111 
Constitution Avenue NW., Washington, DC. Alternately, taxpayers may 
submit comments electronically via the Internet by selecting the ``Tax 
Regs'' option on the IRS Home Page, or by submitting comments directly 
to the IRS Internet site at http:\\www.irs.ustreas. gov\prod\tax__regs\comments.html. The public hearing will be held in 
the NYU Classroom, room 2615, Internal Revenue Building, 1111 
Constitution Avenue NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, William H. 
Morris, (202) 622-3880 or Carol P. Tello, (202) 622-3880; concerning 
submissions and the hearing, Christina Vasquez, (202) 622-7180 (not 
toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background

    These regulations are proposed to clarify the treatment under 
certain provisions of the Internal Revenue Code (Code) and tax treaties 
of income from transactions involving computer programs.

I. Introduction

    Computer programs are generally protected by copyright law. 
Typically the protection afforded by copyright law is a principal 
source of the value of a computer program to the owner of the 
copyright. Conversely, the principal source of the value of a computer 
program to the purchaser of a copy of the program is not the protection 
afforded by copyright law, but the right to use or sell the copy. In 
this regard, computer programs are similar to other copyrighted works 
such as books, records, motion pictures, etc. For example, when a copy 
of a book is purchased, the purchaser does not thereby also acquire any 
copyright rights. Accordingly, the proposed regulations generally 
distinguish between transactions in a copyright and in the subject of 
the copyright.
    In developing regulations addressing the treatment of computer 
programs, the IRS and Treasury generally have been guided by the 
following principles: (i) the rules should take into account the 
special features of computer programs, such as the ability to deliver 
copies electronically as well as physically, and to make perfect copies 
at little or no cost, and (ii) wherever possible, transactions that are 
functionally equivalent should be treated similarly. For example, a 
transaction that involves the transfer for internal use only of fifty 
copies of a computer program should generally be treated the same as a 
transfer of one copy (for internal use) with the right to make forty-
nine other copies all for internal use. Similarly, if the right to use 
a computer program is limited in time, the transaction should generally 
be treated the same irrespective of whether, at the end of the period 
of permitted use, a disk containing the computer program must be 
returned, or the program automatically deactivates itself.

II. Copyright Law Principles

    Distinguishing between transactions in a copyright and in the 
subject of the copyright requires an examination of U.S. and foreign 
copyright law (e.g. EC Directive on Legal Protection of Computer 
Programs, 1991 (91/250/EEC); and the Berne Convention (Paris Text, July 
24, 1971)). An overview of U.S. copyright law as it relates to computer 
programs is set forth below. However, the IRS and the Treasury do not 
purport in these regulations to interpret U.S. copyright law and these 
proposed regulations should not be taken as an expression of the legal 
or policy views of the U.S. Copyright Office.
    The Copyright Act of 1976, as amended (17 U.S.C. 101 et seq.), 
provides protection against infringement of the exclusive rights of the 
owner of a copyright in original works of authorship, fixed in any 
tangible medium of expression, including literary works. (17 U.S.C. 
102.) The term literary works is defined to include: ``* * * numbers, 
or other verbal or numerical symbols or indicia, regardless of the 
nature of the material objects, such as books, periodicals, 
manuscripts, phonorecords, film, tapes, disks, or cards, in which they 
are embodied.'' (17 U.S.C. 101.) Thus, computer programs are literary 
works for purposes of the Copyright Act.
    The Copyright Act grants five exclusive rights to a copyright 
owner. Of these, three are most relevant in the case of computer 
programs: the right to reproduce copies of the copyrighted work (17 
U.S.C. 106(1)); the right to prepare derivative works, which may 
themselves be separately copyrighted, based upon the copyrighted work 
(17 U.S.C. 103 and 106(2)); and the right to distribute copies of the 
copyrighted work to the public by sale or other transfer of ownership, 
or by rental, lease or lending (17 U.S.C. 106(3)). Additionally, in 
certain circumstances, the right to publicly perform the copyrighted 
work (17 U.S.C. 106(4)) and the right to publicly display the 
copyrighted work may also be relevant (17 U.S.C. 106(5)).
    Thus, under U.S. copyright law, the user of a computer program who 
does not possess any of those five rights (or parts of them) has 
obtained only rights to use the copyrighted article it possesses. 
Generally, that user is treated

[[Page 58153]]

only as having received a copy of the copyrighted work. Under U.S. 
copyright law, a copy is a material object in which a work is fixed by 
any method now known or later developed, and from which the work can be 
perceived, reproduced, or otherwise communicated, either directly or 
with the aid of a machine or device (17 U.S.C. 101.). In these proposed 
regulations a copy is also referred to as a ``copyrighted article.'' 
The distinction between copies and copyrights is made most clearly in 
section 202 of the Copyright Act which provides:

    Ownership of a copyright, or of any of the exclusive rights 
under a copyright, is distinct from ownership of any material object 
in which the work is embodied. Transfer of ownership of any material 
object, including the copy or phonorecord in which the work is first 
fixed, does not of itself convey any rights in the copyrighted work 
embodied in the object; nor, in the absence of an agreement, does 
transfer of ownership of a copyright or of any exclusive rights 
under a copyright convey property rights in any material object.

    Certain rights pass to the purchaser of a copy of a computer 
program. The most important of these is the right to sell (but not, 
without permission, to lease, rent, or lend) the copy to another 
person. (17 U.S.C. 109.) Additionally, the owner of a copy of a 
computer program has the right to make a copy of that copy as an 
essential step in the utilization of the program (e.g., copying to the 
memory of the computer) and may also make a copy for archival purposes. 
(17 U.S.C. 117.) If, however, the owner of the copy sells that copy, 
all copies made pursuant to the 17 U.S.C. 117 right must be destroyed.

III. The Proposed Regulations and Copyright Law Principles

    Although the proposed regulations are guided by copyright law 
principles in determining whether a copyright right or copyrighted 
article has been transferred, the regulations depart in some cases from 
a strict reliance on copyright law in order to take into account the 
special nature of computer programs and to treat functionally 
equivalent transactions in the same way. For example, the proposed 
regulations do not treat the transfer of a right to copy as the 
transfer of a copyright right, unless it is accompanied by the right to 
distribute the copies to the public.
    Thus, where a corporation obtains the right, under an agreement, to 
make fifty copies of a program for use by its employees at one location 
(a site license) the transaction is not, for all practical purposes, 
any different from a transaction in which fifty individual disks are 
purchased. Accordingly, the proposed regulations treat the transaction 
as the transfer of a copyrighted article, rather than of a copyright 
right, despite a copyright law requirement that the corporation receive 
a ``license'' to make those fifty copies. Similarly, under the proposed 
regulations, the transfer of a computer program in perpetuity for 
internal use only on a single disk or set of disks in return for a one-
time payment, in a transaction styled as a license of copyright rights 
(a so-called shrink wrap license), is treated as the sale of a 
copyrighted article and not the transfer of a copyright right. 
Therefore, such a transfer is classified solely as the sale of a 
copyrighted article for the purposes of the proposed regulations.

IV. Explanation of Provisions

    Section 1.861-18(a)(1) of the proposed regulations describes the 
scope of the proposed regulations. These proposed regulations provide 
rules for classifying transfers of computer programs for the purposes 
of subchapter N of chapter 1 of the Internal Revenue Code, sections 
367, 404A, 482, 551, 679, 1057, 1059A, chapter 3, chapter 5, sections 
842 and 845 (to the extent involving a foreign person), and transfers 
to foreign trusts not covered by section 679.
    Section 1.861-18(a)(2) describes the categories of transactions 
relating to computer programs. In particular, a transfer of a copyright 
right may be either a sale or license of that right and a transfer of a 
copyrighted article may be either a sale or lease of that copyrighted 
article. Section 1.861-18(a)(3) defines the term computer program.
    Section 1.861-18(b)(1) provides that a transaction involving the 
transfer of a computer program will be classified as either the 
transfer of a copyright right, the transfer of a copyrighted article, 
the provision of services relating to the development of a computer 
program, or the provision of know-how.
    Section 1.861-18(b)(2) provides that a transaction involving 
computer programs which consists of more than one of the categories in 
paragraph (b)(1), is treated as separate transactions. Any resulting 
transaction that is de minimis, however, taking into account all facts 
and circumstances, will not be treated as a separate transaction.
    Section 1.861-18(c)(1)(i) provides that the transfer of a computer 
program will be classified as the transfer of a copyright right if the 
transferee acquires one or more of the rights set forth in paragraph 
(c)(2).
    Section 1.861-18(c)(1)(ii) provides that if such rights are not 
transferred and the transaction does not involve, or involves to only a 
de minimis extent, the provision of services or know-how, then the 
transaction will be classified solely as the transfer of a copyrighted 
article.
    Section 1.861-18(c)(2) identifies those rights that will be treated 
as copyright rights for purposes of the proposed regulations. This list 
differs from the list of rights set out in the Copyright Act to take 
into account the special nature of computer programs. Specifically, the 
copyright law right to copy will only be treated as a copyright right 
for the purposes of the proposed regulations if it is accompanied by 
the right to distribute such copies to the public. The copyright rights 
that apply for purposes of this section are, in addition to the right 
to copy and distribute to the public, the right to prepare derivative 
computer programs, the right to make a public performance of the 
computer program, and the right to publicly display the computer 
program. The list of rights contained in Sec. 1.861-18(c)(2) rather 
than those contained in the Copyright Act will apply for the purposes 
of the proposed regulations.
    Section 1.861-18(c)(3) defines a copyrighted article as a copy of a 
computer program from which the work can be perceived, reproduced or 
otherwise communicated.
    Section 1.861-18(d) of the proposed regulations provides rules for 
determining whether a transaction involving a newly-developed or 
modified computer program will be treated as the provision of services 
or another transaction described in paragraph (b)(1) of this section. 
The determination is based on all facts and circumstances, including 
how risk of loss is allocated and the intent of the parties as to 
ownership of the copyright. See, e.g., Boulez v. Commissioner, 83 T.C. 
584 (1984); Rev. Rul. 74-555 (1974-2 C.B. 202); Rev. Rul. 84-78 (1984-1 
C.B. 173).
    Section 1.861-18(e) provides rules for determining whether a 
transfer of information related to a computer program will be 
considered the provision of know-how. A provision of know-how will not 
be considered to occur unless a party transfers information that (i) 
relates to computer programming techniques, (ii) is not capable of 
being copyrighted, and (iii) is protected by trade secret protection.
    Under Sec. 1.861-18(f)(1), if a transfer involves copyright rights, 
it will be further classified as either a sale or a license of 
copyright rights. This classification will be made by

[[Page 58154]]

examining whether, taking into account all facts and circumstances, all 
substantial rights, under the principles of sections 1222 and 1235, 
have passed to the transferee.
    Under Sec. 1.861-18(f)(2), if a transfer involves a copyrighted 
article, it will be further classified as either a sale or a lease of a 
copyrighted article. This classification will be made by examining 
whether the benefits and burdens of ownership have passed to the 
transferee. See, e.g., Grodt & McKay Realty, Inc. v. Commissioner, 77 
T.C. 1221, 1237-38 (1981); Torres v. Commissioner, 88 T.C. 702, 720-27 
(1987); Estate of Thomas v. Commissioner, 84 T.C. 412, 431-40 (1985).
    Under Sec. 1.861-18(f)(3), the determination of the classification 
of a transfer involving a copyright right or copyrighted article must 
appropriately consider the special nature of computer programs in 
transactions that take advantage of those characteristics. For example, 
a transaction in which a person acquires a copyrighted article on disk 
subject to a requirement that the disk be destroyed after a specified 
period is generally the equivalent of a requirement that the disk be 
returned after such period. Similarly, a transaction in which the 
program deactivates itself after a specified period may also be treated 
as the equivalent of returning the copy.
    Section 1.861-18(g) of the proposed regulations provides certain 
additional rules of operation. Section 1.861-18(g)(1) provides that 
neither the form adopted by the parties to a transaction nor the 
classification of a transaction under copyright law are determinative 
for tax purposes. Therefore, as illustrated in Example 1, a transfer of 
a computer program on a disk subject to a shrink-wrap license will 
generally be a sale of a copyrighted article.
    Section 1.861-18(g)(2) provides that the method of transferring the 
computer program, for example by disk or electronically, shall not be 
relevant in determining whether a copyright right or a copyrighted 
article has been transferred.
    The foregoing rules are illustrated by a number of examples 
contained in Sec. 1.861-18(h).
    Under Sec. 1.861-18(i), these regulations are proposed to apply to 
all transactions occurring on or after the date that is 60 days after 
the date the final regulations are published in the Federal Register. 
No inference should be drawn from the proposed effective date 
concerning the treatment of transactions involving computer programs 
entered into before the regulations are applicable.
    The application of these rules for purposes of the affected 
Internal Revenue Code sections may result in a change in the method of 
accounting for certain transactions involving computer programs by 
certain taxpayers. If the final regulations are adopted, the IRS will 
consider issuing an automatic change revenue procedure to address the 
situation where the taxpayer is required to change its method of 
accounting to comport with the new regulations.

Special Analyses

    It has been determined that this notice of proposed rulemaking is 
not a significant regulatory action as defined in EO 12866. Therefore, 
a regulatory assessment is not required. It also has been determined 
that section 553(b) of the Administrative Procedure Act (5 U.S.C. 
chapter 5) does not apply to these regulations, and because the 
regulations do not impose a collection of information on small 
entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not 
apply. Pursuant to section 7805(f) of the Internal Revenue Code, this 
notice of proposed rulemaking will be submitted to the Chief Counsel 
for Advocacy of the Small Business Administration for comment on its 
impact on small business.

Comments and Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any comments that are submitted timely 
(in the manner described in the ADDRESSES caption) to the IRS. All 
comments will be available for public inspection and copying.
    A public hearing has been scheduled for March 19, 1997, at 10 a.m. 
in the NYU Classroom, room 2615, Internal Revenue Building, 1111 
Constitution Avenue NW., Washington, DC. Because of access 
restrictions, visitors will not be admitted beyond the Internal Revenue 
Building lobby more than 15 minutes before the hearing starts.
    The rules of 26 CFR 601.601(a)(3) apply to the hearing.
    Persons that wish to present oral comments at the hearing must 
submit comments by February 11, 1997 and submit an outline of the 
topics to be discussed and the time to be devoted to each topic (in the 
manner described in the ADDRESSES caption) by February 26, 1997.
    A period of 10 minutes will be allotted to each person for making 
comments.
    An agenda showing the scheduling of the speakers will be prepared 
after the deadline for receiving outlines has passed. Copies of the 
agenda will be available free of charge at the hearing.

Drafting Information

    The principal authors of these regulations are William H. Morris 
and Carol P. Tello, of the Office of Associate Chief Counsel 
(International), IRS. However, other personnel from the IRS and 
Treasury Department participated in their development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

    Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1--INCOME TAXES

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

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

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


Sec. 1.861-18  Classification of transactions involving computer 
programs.

    (a) General--(1) Scope. This section provides rules for classifying 
transactions relating to computer programs for purposes of subchapter N 
of chapter 1 of the Internal Revenue Code, sections 367, 404A, 482, 
551, 679, 1057, 1059A, chapter 3, chapter 5, sections 842 and 845 (to 
the extent involving a foreign person), and transfers to foreign trusts 
not covered by section 679.
    (2) Categories of transactions. This section generally requires 
that such transactions be treated as being solely within one of four 
categories (described in paragraph (b)(1) of this section) and provides 
certain rules for categorizing such transactions. In the case of a 
transfer of a copyright right, this section provides rules for 
determining whether the transaction should be classified as either a 
sale or exchange, or a license generating royalty income. In the case 
of a transfer of a copyrighted article, this section provides rules for 
determining whether the transaction should be classified as either a 
sale or exchange, or a lease generating rental income.
    (3) Computer program. For purposes of this section, a computer 
program is a set of statements or instructions to be used directly or 
indirectly in a computer in order to bring about a certain result. For 
purposes of this paragraph (a)(3), a computer program includes any data 
base or similar item if the data base or similar item is incidental to 
the operation of the computer program.

[[Page 58155]]

    (b) Categories of transactions--(1) General. Except as provided in 
paragraph (b)(2) of this section, a transaction involving the transfer 
of, or the provision of services or of know-how with respect to, a 
computer program (collectively, a transfer of a computer program) is 
treated as being solely one of the following--
    (i) A transfer of a copyright right in the computer program;
    (ii) A transfer of a copy of the computer program (a copyrighted 
article);
    (iii) The provision of services for the development or modification 
of the computer program; or
    (iv) The provision of know-how relating to computer programming 
techniques.
    (2) Transactions consisting of more than one category. Any 
transaction involving computer programs which consists of more than one 
of the transactions described in paragraph (b)(1) of this section shall 
be treated as separate transactions, with the appropriate provisions of 
this section being applied to each such transaction. However, any 
transaction that is de minimis, taking into account the overall 
transaction and the surrounding facts and circumstances, shall not be 
treated as a separate transaction, but as part of another transaction.
    (c) Transfers involving both a copyright right and a copyrighted 
article--(1) Classification--(i) Transfers treated as transfers of 
copyright rights. A transfer of a computer program is classified as a 
transfer of a copyright right if, as a result of the transaction, a 
person acquires any one or more of the rights described in paragraphs 
(c)(2)(i) through (iv) of this section. For example, if a person 
receives a disk containing a copy of a computer program which enables 
it to exercise, in relation to that program, a non-de minimis right 
described in paragraphs (c)(2)(i) through (iv) of this section (and the 
transaction does not involve, or involves only a de minimis provision 
of services as described in paragraph (d) of this section or of know-
how as described in paragraph (e) of this section), then, under 
paragraph (b)(2) of this section, the transfer is classified solely as 
a transfer of a copyright right.
    (ii) Transfers treated solely as transfers of copyrighted articles. 
If a person acquires a copy of a computer program but does not acquire 
any of the rights described in paragraphs (c)(2)(i) through (iv) of 
this section (and the transaction does not involve, or involves only a 
de minimis provision of services as described in paragraph (d) of this 
section or of know-how as described in paragraph (e) of this section), 
the transfer of the copy of the computer program is classified solely 
as a transfer of a copyrighted article.
    (2) Copyright rights. The copyright rights referred to in paragraph 
(c)(1) of this section are as follows--
    (i) The right to make copies of the computer program for purposes 
of distribution to the public by sale or other transfer of ownership, 
or by rental, lease or lending;
    (ii) The right to prepare derivative computer programs based upon 
the copyrighted computer program;
    (iii) The right to make a public performance of the computer 
program; or
    (iv) The right to publicly display the computer program.
    (3) Copyrighted article. A copyrighted article is a copy of a 
computer program from which the work can be perceived, reproduced or 
otherwise communicated, either directly or with the aid of a machine or 
device. The copy of the program may be fixed in the magnetic medium of 
a floppy disk or in the main memory or hard drive of a computer.
    (d) Provision of services. The determination of whether a 
transaction involving a newly developed or modified computer program is 
treated as either the provision of services or another transaction 
described in paragraph (b)(1) of this section is based on all the facts 
and circumstances of the transaction, including, as appropriate, the 
intent of the parties (as evidenced by their agreement and conduct) as 
to which party is to own the copyright rights in the computer program 
and how the risks of loss are allocated between the parties.
    (e) Provision of know-how. The provision of information with 
respect to a computer program will not be treated as the provision of 
know-how for the purposes of this section unless the information is--
    (1) Information relating to computer programming techniques;
    (2) Not capable itself of being copyrighted; and
    (3) Subject to trade secret protection.
    (f) Further classification of transfers involving copyright rights 
and copyrighted articles--(1) Transfers of copyright rights. The 
determination of whether a transfer of a copyright right is a sale or 
exchange of property is made on the basis of whether, taking into 
account all facts and circumstances, there has been a transfer of all 
substantial rights in the copyright. A transaction that does not 
constitute a sale or exchange because not all substantial rights have 
been transferred will be classified as a license generating royalty 
income. For this purpose, the principles of sections 1222 and 1235 
shall apply.
    (2) Transfers of copyrighted articles. The determination of whether 
a transfer of a copyrighted article is a sale or exchange is made on 
the basis of whether, taking into account all facts and circumstances, 
the benefits and burdens of ownership have been transferred. A 
transaction that does not constitute a sale or exchange because 
insufficient benefits and burdens of ownership of the copyrighted 
article have been transferred, such that a person other than the 
transferee is properly treated as the owner of the copyrighted article, 
will be classified as a lease generating rental income.
    (3) Special circumstances of computer programs. In connection with 
determinations under this paragraph (f), consideration must be given as 
appropriate to the special characteristics of computer programs in 
transactions that take advantage of these characteristics (such as the 
ability to make perfect copies at minimal cost). For example, a 
transaction in which a person acquires a copy of a computer program on 
disk subject to a requirement that the disk be destroyed after a 
specified period is generally the equivalent of a transaction subject 
to a requirement that the disk be returned after such period. 
Similarly, a transaction in which the program deactivates itself after 
a specified period is generally the equivalent of returning the copy.
    (g) Rules of operation--(1) Term applied to transaction by parties. 
Neither the form adopted by the parties to a transaction, nor the 
classification of the transaction under copyright law, shall be 
determinative. Therefore, for example, if there is a transfer of a 
computer program on a single disk for a one-time payment with 
restrictions on transfer and reverse engineering, which the parties 
characterize as a license (generally referred to as a shrink-wrap 
license), 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 medium used to effectuate a transfer of a computer program.
    (h) Examples. The provisions of this section may be illustrated by 
the following examples. All of the following examples assume that all 
parties are unrelated to each other:


[[Page 58156]]


    Example 1. (i) Facts. Corp A, a U.S. corporation, owns the 
copyright in a computer program, Program X. It copies Program X on 
to 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 of the computer program is permitted. The 
transferee receives, first, the right to use the program on two of 
its own computers (for example, a laptop and a desktop) provided 
that only one copy is in use at any one time, and, second, the right 
to make one copy of the program on each machine as an essential step 
in the utilization of the program. The transferee is permitted by 
the shrink-wrap license to sell the copy so long as it destroys any 
other copies it has made and imposes the same terms and conditions 
of the license on the purchaser of its copy. These disks are made 
available for sale to the general public in Country Z. In return for 
valuable consideration, P, a Country Z resident, receives one such 
disk.
    (ii) Analysis. (A) Under paragraph (g)(1) of this section, the 
label license is not determinative. None of the copyright rights 
described in paragraph (c)(2) of this section have been transferred 
in this transaction. P has received a copy of the program, however, 
and, therefore, under paragraph (c)(1)(ii) of this section, P has 
acquired solely a copyrighted article.
    (B) Taking into account all of the facts and circumstances, P is 
properly treated as the owner of a copyrighted article. Therefore, 
under paragraph (f)(2) of this section, there has been a sale of a 
copyrighted article rather than the grant of a lease.
    Example 2. (i) Facts. The facts are the same as those in Example 
1, except that instead of selling disks, Corp A, the U.S. 
corporation, decides to make Program X available, for a fee, on a 
World Wide Web home page on the Internet. P, the Country Z resident, 
in return for payment made to Corp A, downloads Program X (via 
modem) onto the hard drive of his computer. As part of the 
electronic communication, P signifies his assent to a license 
agreement with terms identical to those in Example 1, except that in 
this case P may make a back-up copy of the program on to a disk.
    (ii) Analysis. (A) None of the copyright rights described in 
paragraph (c)(2) of this section have passed to P. Although P did 
not buy a physical copy of the disk with the program on it, 
paragraph (g)(2) of this section provides that the means of 
transferring the program is irrelevant. Therefore, P has acquired a 
copyrighted article.
    (B) As in Example 1, P is properly treated as the owner of a 
copyrighted article. Therefore, under paragraph (f)(2) of this 
section, there has been a sale of a copyrighted article rather than 
the grant of a lease.
    Example 3. (i) Facts. The facts are the same as those in Example 
1, except that Corp A only allows P, the Country Z resident, to use 
Program X for one week. At the end of that week, P must return the 
disk with Program X on it to Corp A. P must also destroy any copies 
made of Program X. If P wishes to use Program X for a further period 
he must enter into a new agreement to use the program for an 
additional charge.
    (ii) Analysis. (A) Under paragraph (c)(2) of this section, P has 
received no copyright rights. Because P has received a copy of the 
program under paragraph (c)(1)(ii) of this section, he has, 
therefore, received a copyrighted article.
    (B) Taking into account all of the facts and circumstances, P is 
not properly treated as the owner of a copyrighted article. 
Therefore, under paragraph (f)(2) of this section, there has been a 
lease of a copyrighted article rather than a sale. Taking into 
account the special characteristics of computer programs as provided 
in paragraph (f)(3) of this section, the result would be the same if 
P were required to destroy the disk at the end of the one-week 
period instead of returning it since Corp A can make additional 
copies of the program at minimal cost.
    Example 4. (i) Facts. The facts are the same as those in Example 
2, where P, the Country Z resident, receives Program X from Corp A's 
home page on the Internet, except that P may only use Program X for 
a period of one week at the end of which an electronic lock is 
activated and the program can no longer be accessed. Thereafter, if 
P wishes to use Program X, it must return to the home page and pay 
Corp A to send an electronic key to reactivate the program for 
another week.
    (ii) Analysis. (A) As in Example 3, under paragraph (c)(2) of 
this section, P has not received any copyright rights. P has 
received a copy of the program, and under paragraph (g)(2) of this 
section, the means of transmission is irrelevant, P has, therefore, 
under paragraph (c)(1)(ii) of this section, received a copyrighted 
article.
    (B) As in Example 3, P is not properly treated as the owner of a 
copyrighted article. Therefore, under paragraph (f)(2) of this 
section, there has been a lease of a copyrighted article rather than 
a sale. While P does retain Program X on its computer at the end of 
the one week period, as a legal matter P no longer has the right to 
use the program (without further payment) and, indeed, cannot use 
the program without the electronic key. Functionally, Program X is 
no longer on the hard drive of P's computer. Instead, the hard drive 
contains only a series of numbers which no longer perform the 
function of Program X. Although in Example 3, P was required to 
physically return the disk, taking into account the special 
characteristics of computer programs as provided in paragraph (f)(3) 
of this section, the result in this Example 4 is the same as in 
Example 3.
    Example 5. (i) Facts. Corp A, a U.S. corporation, transfers a 
disk containing Program X to Corp B, a Country Z corporation, and 
grants Corp B an exclusive license for the remaining term of the 
copyright to copy and distribute an unlimited number of copies of 
Program X in the geographic area of Country Z, prepare derivative 
works based upon Program X, make public performances of Program X, 
and publicly display Program X. Corp B will pay Corp A a royalty of 
$y a year for three years, which is the expected period during which 
Program X will have commercially exploitable value.
    (ii) Analysis. (A) Although Corp A has transferred a disk with a 
copy of Program X on it to Corp B, under paragraph (c)(1)(i) of this 
section because this transfer is accompanied by a copyright right 
identified in paragraph (c)(2)(i) of this section, this transaction 
is a transfer solely of copyright rights, not of copyrighted 
articles. For purposes of paragraph (b)(2) of this section, the disk 
containing a copy of Program X is a de minimis component of the 
transaction.
    (B) Applying the all substantial rights test under paragraph 
(f)(1) of this section, Corp A will be treated as having sold 
copyright rights to Corp B. Corp B has acquired all of the copyright 
rights in Program X, has received the right to use them exclusively 
within a geographic area, and has received the rights for the 
remaining life of the copyright in Program X. 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). (This would also be the case if the copy of 
Program X to be used for the purposes of reproduction were 
transmitted electronically to Corp B, as a result of the application 
of the rule of paragraph (g)(2) of this section.)
    Example 6. (i) Facts. Corp A, a U.S. corporation, transfers a 
disk containing Program X to Corp B, a Country Z corporation, and 
grants Corp B the non exclusive right to reproduce and distribute 
for sale to the public an unlimited number of disks at its factory 
in Country Z in return for a payment related to the number of disks 
copied and sold. The term of the agreement is two years, which is 
less than the remaining life of the copyright.
    (ii) Analysis. (A) As in Example 5, the transfer of the disk 
containing the copy of the program does not constitute the transfer 
of a copyrighted article under paragraph (c)(1) of this section 
because Corp B has also acquired a copyright right under paragraph 
(c)(2)(i) of this section. For purposes of paragraph (b)(2) of this 
section, the disk containing Program X is a de minimis component of 
the transaction.
    (B) Taking into account all of the facts and circumstances, 
there has been a license of Program X to Corp B, and the payments 
made by Corp B are royalties. Under paragraph (f)(1) of this 
section, there has not been a transfer of all substantial rights in 
the copyright to Program X because Corp A has the right to enter 
into other licenses with respect to the copyright of Program X, 
including in Country Z (or even to sell that copyright, subject to 
Corp B's interest). Corp B has acquired no right itself to license 
the copyright rights in Program X. Finally, the term of the license 
is for less than the remaining life of the copyright in Program X.
    Example 7. (i) Facts. Corp C, a distributor in Country Z, enters 
into an agreement with Corp A, a U.S. corporation, to purchase as 
many copies of Program X on disk as it may from time-to-time 
request. Corp C will then sell these disks to retailers. The disks 
are shipped in boxes covered by shrink-wrap licenses (identical to 
the license described in Example 1).
    (ii) Analysis. (A) Corp C has not acquired any copyright rights 
under paragraph (c)(2) of this section with respect to Program X. It 
has acquired individual copies of Program X,

[[Page 58157]]

which it may sell to others. The use of the term license is not 
dispositive under paragraph (g)(1) of this section. Under paragraph 
(c)(1)(ii) of this section, Corp C has acquired copyrighted 
articles.
    (B) Taking into account all of the facts and circumstances, Corp 
C is properly treated as the owner of copyrighted articles. 
Therefore, under paragraph (f)(2) of this section, there has been a 
sale of copyrighted articles.
    Example 8. (i) Facts. Corp A, a U.S. corporation, transfers a 
disk containing Program X to Corp D, a foreign corporation engaged 
in the manufacture and sale of personal computers in Country Z. Corp 
A grants Corp D the non-exclusive right to copy Program X onto the 
hard drive of computers which it manufactures, and to distribute 
those copies (on the hard drive) to the public. The term of the 
agreement is two years, which is less than the remaining life of the 
copyright in Program X. Corp D pays Corp A an amount based on the 
number of copies of Program X it loads on to computers.
    (ii) Analysis. The analysis is the same as in Example 6. Under 
paragraph (c)(2)(i) of this section, Corp D has acquired a copyright 
right enabling it to exploit Program X by copying it on to the hard 
drives of the computers that it manufactures and then sells. For 
purposes of paragraph (b)(2) of this section, the disk containing 
Program X is a de minimis component of the transaction. Taking into 
account all of the facts and circumstances, Corp D has not, however, 
acquired all substantial rights in the copyright to Program X (for 
example, the term of the agreement is less than the remaining life 
of the copyright). Under paragraph (f)(1) of this section, this 
transaction is, therefore, a license of Program X to Corp D rather 
than a sale and the payments made by Corp D are royalties.
    Example 9. (i) Facts. The facts are the same as in Example 8, 
except that Corp D, the Country Z corporation, receives physical 
disks. The disks are shipped in boxes covered by shrink-wrap 
licenses (identical to the licenses described in Example 1). Corp D 
uses each individual disk only once to load a single copy of Program 
X onto each separate computer. Corp D transfers the disk with the 
computer when it is sold.
    (ii) Analysis. (A) As in Example 7 (unlike Example 8) no 
copyright right identified in paragraph (c)(2) of this section has 
been transferred. Corp D acquires the disks without the right to 
reproduce and distribute publicly further copies of Program X. This 
is therefore the transfer of copyrighted articles under paragraph 
(c)(1)(ii) of this section.
    (B) Taking into account all of the facts and circumstances, Corp 
D is properly treated as the owner of copyrighted articles. 
Therefore, under paragraph (f)(2) of this section, the transaction 
is classified as the sale of a copyrighted article.
    Example 10. (i) Facts. Corp A, a U.S. corporation, transfers a 
disk containing Program X to Corp E, a Country Z corporation, and 
grants Corp E the right to load Program X onto 50 individual 
workstations for use only by Corp E employees at one location in 
return for a one-time per-user fee (generally referred to as a site 
license). If additional workstations are subsequently introduced, 
Program X may be loaded on to those machines for additional one-time 
per-user fees. The license which grants the rights to operate 
Program X on 50 workstations also prohibits Corp E from selling the 
disk (or any of the 50 copies) or reverse engineering the program. 
The term of the license is stated to be perpetual.
    (ii) Analysis. (A) The grant of a right to copy, unaccompanied 
by the right to distribute those copies to the public, is not the 
transfer of a copyright right under paragraph (c)(2) of this 
section. Therefore, under paragraph (c)(1)(ii) of this section, this 
transaction is a transfer of copyrighted articles (50 copies of 
Program X).
    (B) Taking into account all of the facts and circumstances, P is 
properly treated as the owner of a copyrighted article. 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.
    Example 11. (i) Facts. The facts are the same as in Example 10, 
except that Corp E, the Country Z corporation, acquires the right to 
make Program X available to workstation users who are Corp E 
employees by way of a local area network (LAN). The number of users 
that can use Program X on the LAN at any one time is limited to 50. 
Corp E pays a one-time fee for the right to have up to 50 employees 
use the program at the same time.
    (ii) Analysis. Under paragraph (g)(2) of this section the mode 
of transmission is irrelevant. Therefore, as in Example 10, under 
paragraph (c)(2) of this section, no copyright right has been 
transferred and thus, under paragraph (c)(1)(ii) of this section, 
this transaction will be classified as the transfer of a copyrighted 
article. Under the benefits and burdens test of paragraph (f)(2) of 
this section, this transaction is a sale of copyrighted articles.
    Example 12. (i) Facts. The facts are the same as in Example 11, 
except that Corp E pays a monthly fee to Corp A, the U.S. 
corporation, calculated with reference to the permitted maximum 
number of users (which can be changed) and the computing power of 
Corp E's server. In return for this monthly fee, Corp C 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, or if the 
contract is terminated, Corp E must return the disk containing the 
earlier version of Program X to Corp A, and delete (or otherwise 
destroy) any copies made of the current version of Program X. The 
agreement specifically provides that Corp E has not thereby been 
granted an option to purchase Program X.
    (ii) Analysis. (A) Corp E has received no copyright rights under 
paragraph (c)(2) of this section. Under paragraph (d) of this 
section, based on all the facts and circumstances of the 
transaction, Corp A has not provided services to Corp E. Therefore, 
under paragraph (c)(1)(ii) of this section, the transaction is a 
transfer of a copyrighted article.
    (B) Taking into account all facts and circumstances, under the 
benefits and burdens test Corp E is not properly treated as the 
owner of the copyrighted article. Corp E does not receive the right 
to use Program X in perpetuity, but only for so long as it continues 
to make payments. Corp E does not have the right to purchase Program 
X on advantageous (or, indeed, any) terms once a certain amount of 
money has been paid to Corp A or a certain period of time has 
elapsed (which might indicate a sale). Once the agreement is 
terminated, Corp E will no longer possess any copies of Program X, 
current or superseded. Therefore under paragraph (f)(2) of this 
section there has been a lease of a copyrighted article.
    Example 13. (i) Facts. The facts are the same as in Example 12, 
except that while Corp E must return copies of Program X as new 
upgrades are received, if the agreement terminates, Corp E may keep 
the latest version of Program X (although Corp E is still prohibited 
from selling or otherwise transferring any copy of Program X).
    (ii) Analysis. For the reasons stated in Example 10, the 
transfer of the program will be treated as a sale of a copyrighted 
article rather than as a lease.
    Example 14. (i) Facts. Corp G, a Country Z corporation, enters 
into a contract with Corp A, a U.S. corporation, for Corp A to 
modify Program X so that it can be used at Corp G's facility in 
Country Z. Under the contract, Corp G is to acquire one copy of the 
program on a disk and the right to use the program on 5,000 
workstations. The contract requires Corp A to rewrite elements of 
Program X so that it will conform to Country Z accounting standards. 
The services required to perform this task are de minimis taking 
into account the facts and circumstances of this transaction. The 
agreement between Corp A and Corp G is otherwise identical as to 
rights and payment terms as the agreement described in Example 10.
    (ii) Analysis. (A) As in Example 10, no copyright rights are 
being transferred under paragraph (c)(2) of this section. Under 
paragraph (b)(2) of this section, the services provided are de 
minimis. This transaction will be classified, therefore, as a 
transfer of copyrighted articles under paragraph (c)(1)(ii) of this 
section.
    (B) Taking into account all facts and circumstances, Corp G is 
properly treated as the owner of copyrighted articles. Therefore, 
under paragraph (f)(2) of this section, there has been the sale of a 
copyrighted article rather than the grant of a lease.
    Example 15. (i) Facts. Corp H, a Country Z corporation, enters 
into a license agreement for a modified version of Program X only if 
Corp A, a U.S. corporation, makes substantial modifications to the 
program. Only the core idea of Program X will be used and a 
considerable amount of labor will be expended in rewriting Program 
X, which under applicable copyright law as a derivative work will be 
a separate, new program. Corp A and Corp H agree that Corp A is 
modifying Program X for Corp H and that, when modified Program X is 
completed, the copyright in the modified program will belong to Corp 
H. Corp H gives instructions

[[Page 58158]]

to Corp A programmers regarding program specifications. Corp H 
agrees to pay Corp A a fixed monthly sum during development of the 
program. If Corp H is dissatisfied with the development of the 
program it may cancel the contract at the end of any month. In the 
event of termination, Corp A will retain all payments, while any 
procedures, techniques or copyrightable interests will be the 
property of Corp H. All of the payments are labelled royalties. 
There is no provision in the agreement for any continuing 
relationship between Corp A and Corp H, such as the furnishing of 
updates of the program, after completion of the modification work.
    (ii) Analysis. Taking into account all of the facts and 
circumstances, Corp A is treated as providing services to Corp H. 
Under paragraph (d) of this section, Corp A is treated as providing 
services to Corp H because Corp H bears all of the risks of loss 
associated with the development of modified Program X and is the 
owner of all copyright rights in modified Program X. Under paragraph 
(g)(1) of this section, the fact that the agreement is labelled a 
license is not controlling (nor is the fact that Corp A receives a 
sum labelled a royalty).
    Example 16. (i) Facts. Corp A, a U.S. corporation, and Corp I, a 
Country Z corporation, agree that a development engineer employed by 
Corp A will travel to Country Z to provide know-how relating to 
certain techniques which are 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. Such information is not capable of being 
copyrighted, but it is subject to trade secret protection.
    (ii) Analysis. This transaction contains the elements of know-
how specified in paragraph (e) of this section. Therefore, this 
transaction will be classified as the provision of know-how.

    (i) Effective date. This section applies to transactions occurring 
on or after the date that is sixty days after the date final 
regulations are published in the Federal Register.
Margaret Milner Richardson,
Commissioner of Internal Revenue.
[FR Doc. 96-29055 Filed 11-7-96; 3:11 pm]
BILLING CODE 4830-01-U