Thursday, March 28, 2013

Taxation of Computer Software Sales: Ordinary Income, Capital Gain, or Both?

David C. Blum for Bloomberg BNA writes:   The taxation of computer software is complex, confusing, and in some circumstances, uncertain; although self-created computer software is routinely sold today, especially with the significant increase in the number of “apps” that are created for mobile devices, there is surprisingly little statutory or regulatory guidance on the proper way to tax the sale of such software.
In general, the taxation of software can vary greatly depending upon a multitude of factors, including, for example, whether the software was acquired or developed, and if developed, whether it was developed for internal use or developed for sale in the ordinary course of business, as well as whether the software was sold or licensed. 1 This article focuses on the tax aspects of the sale of computer software and related intellectual property by the person whose personal efforts created such IP rights.

1 For a good overall discussion of the taxation of software, see Postlewaite, Cameron & Kittle-Kamp,Federal Income Taxation of Intellectual Properties and Intangible Assets.
As a first step, the software must be sold and not merely licensed. In order to “sell” software, the transferor must transfer all or “substantially all” rights to the software. This typically occurs when the transferor transfers both the source code and the object code without restriction. 2

2 Note, Treasury regulations under Section 861 also address the sale versus license distinction for software in the context of sourcing of income for cross-border tax purposes.
Because computer software may be protected under various intellectual property rights, several Internal Revenue Code (the Code) 3 provisions are potentially applicable in characterizing the gain or loss recognized on the sale of computer software. However, IP rights, such as copyrights, trademarks, trade secrets, patents and know-how, are all generally subject to different provisions of the Code and common law. As a result, they are all generally taxed differently, and therein lies the problem. Some of these provisions have directly contrasting taxing schemes and the application of these various provisions result in differing federal income tax treatment.

3 All references to the “Code” are to the Internal Revenue Code of 1986, as amended, and any Treasury Regulations promulgated thereunder.
Further, there is little statutory or regulatory guidance to indicate which Code provisions control when an asset such as “software” is capable of being protected under both copyright and patent laws. For example, should copyright tax provisions trump patent tax provisions or vice versa? The answer is unclear.
There is little statutory or regulatory guidance to indicate which Code provisions control when an asset such as “software” is capable of being protected under both copyright and patent laws.
The Tax Court addressed the sale of software more than 20 years ago in Levy v. Commissioner. 4 That case however focused solely on the sale of software as a single asset and did not address each of the IP rights that comprised the software and related IP. Until more guidance is available, practitioners should determine what specific assets were sold (assigned), rather than rely solely on a single case that does not fully address the realities of today.

4 T.C. Memo 1992-471.
What Assets Were Really Sold?
A software purchase agreement may contain language such as, “The Seller/Assignor agrees to sell/assign all of its right, title, and interest throughout the world in and to the Software Products and all intellectual property embodied in the Software Products, including, but not limited to”:
• all patent rights, if any;
• all copyrights;
• all rights of paternity, integrity, disclosure, and withdrawal, referred to as “moral rights”;
• all trademark rights, including all trademarks, service marks, trade names, domain names, logos and trade dress, any common law rights, and goodwill associated therewith;
• all computer code embodied in the software products;
• all trade secrets, know-how, technology, and other confidential business information embodied in the software products;
• all notes, manuals, analysis, compilations, studies, summaries, and other material prepared by or for the seller/assignor to the extent relevant or necessary to those items above; and
• all rights and privileges pertaining to the subject matter of the items above.
The seller/assignor may also typically assign, transfer, sell, and convey to the buyer/assignee “such methods, tools, techniques, logic, and know-how used by Seller/Assignor to create the Software Products.”
Thus, the seller/assignor will generally sell all of its interests in or to various IP rights (to the extent such were in existence) to the buyer/assignee. With respect to the specific assets, one must consider, among other things, whether registered or unregistered copyrights were assigned; whether any patent or patentable rights were assigned; whether any trademarks, service marks, or trade names were assigned, as well as whether there was an assignment of trade secrets, know-how, technology, and other confidential business information embodied in the software products.
Taxation of Intellectual Property
Copyrights
Section 1221(a) of the Code defines a “capital asset,” in relevant part, as all assets other than:
• inventory held primarily for sale to customers in the ordinary course of business;
• property used in a trade or business subject to depreciation provided for in Section 167; and
• a copyright, literary, musical, or artistic composition, or “similar property” held by the person whose personal efforts created such property.
Thus, if a person sells a copyright that he or she created, then it cannot generally qualify as a capital asset, and as a result, cannot be taxed at capital gain tax rates. Instead, it would be taxed at ordinary income tax rates.
The legislative intent behind this exclusion is to prevent the creator of a work protected under copyright laws from converting what would otherwise be compensation for personal services (taxed as ordinary income) into property taxed at capital gain rates. However, as discussed below in the section on patents, the exact opposite is true.
Because computer software is typically protected under copyright law (whether or not registered), Code Section 1221 is generally applicable to the sale of computer software. The Tax Court directly addressed the federal income tax treatment of the sale of computer software code in Levy.
In this case, the taxpayer (a computer programmer) was denied capital gain treatment on the sale of computer software. The court concluded that, because the software was eligible for copyright protection, the exclusion contained in Section 1221(a)(3) applied. Thus, the sale of software was taxable at ordinary income (and not capital gain) tax rates. The fact that the taxpayer did not seek copyright protection was deemed irrelevant.
In Levy, the taxpayer entered into an agreement to sell “all rights and interest in and to the Systems, including without limitation, all source and object code and manuals and all other related documentation and materials therefor and all enhancements now existing or hereafter made thereto.” The Tax Court considered the characterization of the gain recognized on the sale and after examining copyright law and its protection of computer software, the court applied the literal language of the Code and regulations and concluded that the software's eligibility for protection under the copyright law brought it within the exclusion under Section 1221(a)(3).
In Levy, the court concluded that the software's eligibility for protection under the copyright law brought it within the exclusion under
Section 1221(a)(3).
Notably, the taxpayer did not appear to argue, nor did the court address, whether the self-created software could have also been covered by patent, trade secret, know-how, or any other IP protection. Consequently, the decision did not address the applicability of other possible IP being sold along with the unregistered copyrights.
Patents
In direct contrast to copyrights, Section 1235 of the Code provides that the transfer of property consisting of “all substantial rights” to a patent by any holder shall be considered the sale or exchange of a capital asset held for more than one year. Therefore, a holder would generally qualify for long-term capital gain tax rates regardless of the holding period.
A “holder” of a patent is statutorily defined to include “any individual whose efforts created such property.” Under Section 1235, it is not necessary that the patent or the patent application be in existence if the requirements of Section 1235 are otherwise met. 6

6 Treas. Reg. Section 1.1235-2(a).
As a result, if computer software (or some portion thereof) is patentable, an argument exists that the taxpayer may be able to claim the benefits of Section 1235 on the sale of such software. One case, Gilson v. Commissioner, 7 appeared to take such a view.
(David Blum is a partner in the Tax Planning Group at Levenfeld Pearlstein LLC in Chicago. He concentrates his practice on a broad range of transactional, tax planning, and tax litigation matters, with extensive experience in creating and implementing tax-efficient structures for all types of domestic and cross border transactions.)

3 comments:


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