Global Tax Alert | 18 July 2013

CFC income from software leases determined to be foreign personal holding company income

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Executive summary

On 15 July 2013, the Internal Revenue Service (the Service) released Field Attorney Advice 20132702F (the memorandum). The memorandum addresses the US federal income tax treatment of fees earned by a controlled foreign corporation (a CFC) in exchange for providing certain software to unrelated customers outside the CFC's country of organization. The Service analyzed the fees as rental income arising from leases of copyrighted articles under Treas. Reg. Section 1.861-18. On the facts described in the memorandum, the Service determined that the CFC did not operate an organization that was regularly engaged in the business of marketing. Consequently, the CFC did not satisfy the active leasing exception to foreign personal holding company income, and the income was taxable currently to United States shareholders of the CFC as subpart F income.

Detailed discussion


The CFC in the memorandum (which is dated 17 May 2013) was one of a group of related entities in the business of developing and marketing software. An affiliate of the CFC was the legal owner of the software at issue in the memorandum. Pursuant to a cost-sharing arrangement with the affiliate, the CFC had acquired the right to distribute copies of the software to unrelated customers within a specified territory. The CFC was obligated to pay a royalty to the affiliate equal to a percentage of the CFC's profits from distributing the software.1

Each customer paid the CFC a one-time fee with respect to each end-user of the software. The CFC provided the customer with a “key” that allowed it to download the software. Thereafter, the customer was obligated to pay annual “maintenance” and “support” fees (each a percentage of the fees for the end-user licenses that year). After one year, the customer had the option of certifying to the CFC that the customer no longer used the software, in which case the customer would not be obligated to continue paying the maintenance and support fees. The CFC had seven customers during the three-year period at issue in the memorandum. The CFC itself had contracted with only five of those seven customers (one of the five during the years at issue); with respect to the other two, the CFC had assumed pre-existing contracts from an affiliate. All seven of the customers were located and apparently used the software outside of the CFC's country of organization.

During the relevant period, the CFC had three (and later only two) employees.2 The CFC could not provide any details about the amount of time the employees had spent on marketing.3 Their backgrounds were in accounting, financing, or technology. Their job descriptions consisted mainly of administrative and bookkeeping duties.4 They were not compensated (at least in the Service's estimation) as full-time employees, and they were not eligible for bonuses or commissions based on successful marketing efforts. Entities in the group other than the CFC apparently performed marketing functions for the group. Indeed, the Service noted that of all of the press releases on the group's website, the CFC had released “almost none.”


A transaction involving the transfer of a computer program is classified for purposes of the CFC rules solely as one of four types of transactions.5 If the transferee acquires any one of certain rights in the program—such as the right to make copies of the program for distribution to the public and the right to prepare derivative computer programs based upon the copyrighted program—the transfer is classified as a transfer of a “copyright right.”6 In contrast, if a transferee acquires a copy of the program but none of the enumerated rights, the transfer is classified as a transfer of a “copyrighted article.”7 The transfer of a copyrighted article constitutes a sale of the article if, taking into account all facts and circumstances, the benefits and burdens of ownership have been transferred.8 Otherwise, the transfer is a lease that generates rental income.9

In general, United States shareholders of a CFC must include currently in income amounts of foreign personal holding company income (FPHCI) earned by the CFC—whether or not the CFC actually makes a distribution of the income.10 Rental income (in the form of rents or royalties) generally constitutes FPHCI.11 An exception exists for rental income that is derived by a CFC in the active conduct of a trade or business and received from unrelated persons (the active leasing exception).12 Treas. Reg. Section 1.954-1(c)(1)13 specifies the four situations in which a CFC will be deemed to derive rental income in an active trade or business. The focus of the memorandum was the “active marketing exception” (the AME). The AME pertains to rental income derived by a CFC from leasing property as a result of the CFC's performance of marketing functions, provided that the CFC maintains and operates an organization in such country that is both (i) regularly engaged in the business of marketing the leased property, and (ii) “substantial” in relation to the amount of rents derived from the leasing of such property.14 Only the activities of the CFC's own officers and employees are considered for purposes of the AME.15

Analysis and Implications

The Service determined (i) that the transactions at issue were leases of a copyrighted article generating rental income and (ii) that the CFC did not satisfy the AME to FPCHI with respect to that income.

The Service concluded that the transactions were (i) transfers of a copyrighted article (as opposed to a copyright right) and (ii) leases, not sales, almost exclusively based upon its analysis of the terms of the contracts between the CFC and its customers. Moreover, in determining that a customer did not receive the benefits and burdens of ownership of the copyrighted article, the Service placed great weight on the customer's ability to terminate the contract by certifying that it would not use the software.

The Service determined that the CFC did not satisfy the AME based upon the CFC's failure to operate an organization in its country that was regularly engaged in the business of marketing the software. The facts that the Service found relevant in so doing are worth noting: the job descriptions and qualifications of the CFC's employees, their salaries and incentive compensation, the time spent by the employees on marketing activities, documentation (or lack thereof) of those activities, the number of customers (recognizing the distinction between assumed and internally-developed customers), and the number of press releases on the group's website that the CFC had issued. Also noteworthy is the information that the Service apparently lacked or omitted. For example, the memorandum does not describe the marketing activities undertaken by the group as a whole, or the significance of such activities to commercialize the software. It does not state whether any of the CFC's affiliates were primarily engaged in sales activities (which would presumably include some marketing activities).

The memorandum leaves certain issues unaddressed, including:

  • Treas. Reg. Section 1.954-2(c)(1)(i) sets forth the “active developer exception” to FPHCI, excluding rents earned by a CFC from leasing property that it “produced” or “acquired and added substantial value to.”16 Unlike the AME, the active developer exception does not explicitly require that the relevant activities be performed by a CFC's own officers or employees. Because the CFC in the memorandum was a cost-sharing participant with respect to the software, it might be argued that the CFC had developed or “produced” the software. The memorandum simply notes the exceptions for rental income other than the AME are “not at issue here.”
  • While recognizing that a CFC's activities may vary by license, the memorandum does not clarify whether the AME must be satisfied on a license-by-license basis, or whether a CFC that satisfies the AME in a given year with respect to a particular license is treated as satisfying the AME for all licenses that year.

Given the paucity of guidance with respect to the AME (for both rental and royalty income), additional facts or more detailed analysis would have been helpful. Nevertheless, the memorandum provides guidance as to the information that the Service deems relevant for evaluating the application of the AME.


1. Although the memorandum redacts the percentage that the CFC was required to pay to its affiliate, it describes it as a “huge” percentage.

2. The titles of the two employees were Financial Controller (or, sometimes, Accounting Manager) and Software Media Production Assistant. One of the CFC's directors, the Executive Director, seemed to the Service to fulfill the duties of an officer. Accordingly, the Service considered the director to be an employee for purposes of the memorandum.

3. The CFC was only able to provide the Service with a copy of a presentation that it claimed one employee had given to a customer.

4. There was only one mention of marketing services: one of the employees was to “develop[] and assist[] the marketing function” in a particular (redacted) territory and to “work[] with the UK and European marketing executives to promote and assist sales opportunities.”

5. See generally Treas. Reg. Section 1.861-18. The form adopted by the parties to the transaction, the classification of the transaction under copyright law, and the means of transfer (whether by a physical disk or an electronic medium) are not determinative as to the classification of the transaction. Treas. Reg. Section 1.861-18(g)(1) and (2). The four types are: a transfer of a “copyright right” in the computer program; a transfer of a copy of the computer program (a copyrighted article); the provision of services for the development or modification of the computer program; and the provision of know-how relating to computer programming techniques. Treas. Reg. Section 1.861-18(b)(1). Only the first two types of transactions are addressed in the memorandum.

6. Treas. Reg. Section 1.861-18(c)(1)(i) and (c)(2).

7. Treas. Reg. Section 1.861-18(c)(1)(ii) (effectively treating software as tangible property).

8. Treas. Reg. Section 1.861-18(f)(2).

9. Id.

10. See generally Sections 951(a)(1)(A); 952(a)(2); 954(c).

11. Section 954(c)(1)(A).

12. Treas. Reg. Section 1.954-2(b)(6).

13. References to “Treas. Reg. Section” are to that section of the Treasury regulations promulgated under the Internal Revenue Code of 1986, as amended (the Code). References to “section” are to that section of the Code.

14. Treas. Reg. Section 1.954-2(c)(1)(iv). If a CFC acquired a lease from another person, the active marketing exception would nevertheless apply if, following the acquisition, the CFC performs active and substantial management, operational, and remarketing functions with respect to the leased property. Treas. Reg. Section 1.954-2(c)(2)(vi).

15. Treas. Reg. Section 1.954-2(c)(1)(iv).

16. Treas. Reg. Section 1.954-2(c)(1)(i) (also requiring that CFC be regularly engaged in production activities). A similar exception exists for active royalties. See Treas. Reg. Section 1.954-2(d)(1)(i).

For additional information with respect to this Alert, please contact the following:

Ernst & Young LLP, International Tax Services, San Francisco
  • Stephen Bates
    +1 415 894 8190
Ernst & Young LLP, International Tax Services, Washington, DC
  • Allen Stenger
    +1 202 327 6289
  • Awo Archampong Gray
    +1 202 327 8332

EYG no. CM3655