PLR 200843013: C-code licensing income qualified as active software royalties

Plain-English summary

A software developer licensed C-code through two models: semiconductor manufacturers embedded it in chips used by licensed product makers, while other licensees compiled it directly into software or integrated circuits. Licensees paid initial fees and royalties based on units shipped. The company represented that it actively developed, manufactured, or produced the software and satisfied the income, expense, and distribution tests in § 543(d)(3)-(5). The remaining question was whether the payments were received in connection with licensing “computer software.” Using the machine-readable-code definition found in related regulations, the IRS concluded that the C-code was software designed to make a computer or integrated circuit perform functions. Royalties from both products therefore qualified as active business computer software royalties excluded from personal holding company income under § 543(a)(1)(C).

Ruling snapshot

• Question: Were royalties from licensing the C-code products active business computer software royalties under § 543(d)?
• Outcome: Approved. The C-code met the applicable definition of computer software, so its licensing royalties qualified.
• Key authorities: IRC §§ 543(a)(1)(C), 543(d); Treas. Reg. §§ 1.197-2(c)(4)(iv), 1.199-3(j)(3)(i), 1.861-18(a)(3)(i); Rev. Proc. 2000-50

Full text (IRS public release)

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Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 200843013 [Third Party Communication:
Release Date: 10/24/2008 Date of Communication: Month DD, YYYY]
Person To Contact:
Index Number: 543.03-00 ---------------, ID No. -------------
Telephone Number:
---------------------
------------------------- Refer Reply To:
--------------------------- CC:PSI:B05
--------------------------------------------------------------- PLR-113147-08
----------------- Date:
--------------------------- July 14, 2008

                                                 LEGEND

Taxpayer = ---------------------------------------------------------------------------------

Product 1 = -----------------

Product 2 = -----------------------

Dear --------------:

   This is in response to a request for a ruling dated March 12, 2008, and

subsequent correspondence, submitted on behalf of Taxpayer by your authorized
representatives. The ruling concerns whether certain royalties are active business
computer software royalties under §§ 543(a)(1)(C) and 543(d) of the Internal Revenue
Code. The relevant facts as represented in your submission are set forth below.

      Taxpayer develops ------------------------software (Product 1 and Product 2) that

improves basic -------- quality and enables ----------------------in -------------------------, --------
--------------------------------------------------------------------------------------------------------------------,
-----------------, -------------, ---------------------------------------- ----------------, and -------- and ----
---------------. The software enables -------- to be stored efficiently within the limited
storage capacity of a ------- allowing a high --------- quality while saving space on the -----
for other content. Taxpayer’s ------------------------ software takes the form of an algorithm
based blueprint that is translated to C code, which is the source code for most computer
programs. C-code is machine readable code that causes a computer to perform a
desired function or set of functions. Taxpayer’s source code is licensed and delivered
to Taxpayer’s customers. Taxpayer’s customers generally convert Taxpayer’s source
code into object code for use in their own products.
PLR-113147-08 2

     Taxpayer uses two licensing models when licensing its software to licensees.

The first licensing model is a two-tier model whereby Taxpayer’s C-code software is first
provided under license to semiconductor manufacturers who incorporate Taxpayer’s
software in semiconductor chips as integrated circuits (implementation licensees). The
implementation licensees pay an initial fee for the software they choose to license. The
implementation licensees then sell their integrated circuits to pre-approved
manufacturers of ---------------------------------------, which hold licenses to use Taxpayer’s
software (system licensees). The system licensees are separately licensed to make
and sell ------------------------------------------------, such as -----------------, --------------------------

--------------------------, ----------------------------, ----------------------------, and ------------------------
------------------------------ that incorporate integrated circuits purchased from
implementation licensees. Sales of ----------------------------------------incorporating
Taxpayer’s software by system licensees generate royalties for Taxpayer generally
based on the number of the units shipped by the system licensees.

   Under the second licensing model, Taxpayer licenses its software to independent

software vendors and --------------------------------------------that act as combined
implementation and system licensees (dual licensees). Taxpayer’s software is
incorporated into software applications such as ------------------used in desktop or
notebook computers. Dual licensees that manufacture integrated circuits themselves
incorporate Taxpayer’s software into their ---------------------------------------. In these
cases, the implementation and the system licensees are one in the same. Accordingly,
with dual licensees, the software that will be embedded in the ----------------------------------
is compiled directly from Taxpayer’s C-code software. As with the first licensing
model, the dual licensees pay Taxpayer an initial administrative fee for the C-code and
pay royalties to Taxpayer based on the number of units shipped to their customers.

   Taxpayer represents that it is engaged in the active conduct of the trade or

business of developing, manufacturing, or producing computer software. Taxpayer
further represents that it meets the tests provided in §§ 543(d)(3), (4), and (5).

Ruling Requested

   Taxpayer requests a ruling that any royalties received by Taxpayer from the

licensing of Product 1 and Product 2 are active business computer software royalties for
purposes of §§ 543(a)(1)(C) and 543(d).

Law and Analysis

   Section 541 imposes for each taxable year on the undistributed personal holding

company income (as defined in § 545) of every personal holding company (as defined
in § 542), a personal holding company tax equal to 15 percent of the undistributed
personal holding company income. Under § 542(a), a personal holding company
PLR-113147-08 3

means any corporation (other than a corporation described in § 542(c)) if at least 60
percent of its adjusted ordinary gross income (as defined in § 543(b)(2)) for the taxable
year is personal holding company income (as defined in § 543(a)), and at any time
during the last half of the taxable year more than 50 percent in value of its outstanding
stock is owned, directly or indirectly, by or for not more than 5 individuals.

    Under § 543(a)(1), personal holding company income means, in part, the portion

of the adjusted ordinary gross income that consists of royalties (other than mineral, oil,
or gas royalties, or copyright royalties). However, § 543(a)(1)(C) provides an exception
for active business computer software royalties (as defined in § 543(d)).

    Section 543(d)(1) defines the term “active business computer software royalties”

to mean any royalties received by any corporation during the taxable year in connection
with the licensing of computer software, which meet the requirements of § 543(d)(2),
(3), (4), and (5).

    Under § 543(d)(2), the royalties described in § 543(d)(1) must be (A) received by

a corporation engaged in the active conduct of the trade or business of developing,
manufacturing, or producing computer software, and (B) are attributable to computer
software which is developed, manufactured, or produced by such corporation (or its
predecessor) in connection with the trade or business described in § 543(d)(1)(A), or is
directly related to such trade or business.

   Under § 543(d)(3), the active business computer software royalties must

constitute at least 50 percent of the ordinary gross income of the corporation for the
taxable year. Under § 543(d)(4), the sum of the taxpayer’s deductions allowable under
§§ 162, 174, and 195 for the taxable year which are properly allocable to the trade or
business described in § 543(d)(2) must equal or exceed 25 percent of the ordinary
gross income of the corporation for the taxable year. Under § 543(d)(5), the sum of the
dividends paid during the taxable year (determined under § 562) , the dividends
considered to be paid on the last day of the taxable year under § 563(d), and the
consent dividends for the taxable year (as defined under § 565) must equal or exceed
the amount, if any, by which the personal holding company income for the taxable year
exceeds 10 percent of the corporation’s ordinary gross income for the taxable year.

   Under § 543(d)(6)(A), in any case in which the taxpayer receives royalties in

connection with the licensing of computer software and another corporation which is a
member of the same affiliated group as the taxpayer meets the requirements of
§ 543(d)(2), (3), (4), and (5) with respect to such computer software, the taxpayer shall
be treated as having met such requirements. For this purpose, § 543(d)(6)(B) defines
the term “affiliated group” as having the meaning given such term by § 1504(a).

  The sole issue for us to address is whether Taxpayer’s royalties received in

connection with the licensing of Product 1 and Product 2 are “received in connection
PLR-113147-08 4

with the licensing of computer software” under § 543(d)(1). Although § 543(d) does not
define “computer software,” the term is defined for purposes of other sections of the
Code. For example, § 1.197-2(c)(4)(iv) of the Income Tax Regulations defines
computer software as any program or routine (that is, any sequence of machine-
readable code) that is designed to cause a computer to perform a desired function or
set of functions, and the documentation required to describe and maintain that program
or routine It includes all forms and media in which the software is contained, whether
written, magnetic, or otherwise. Computer programs of all classes, for example,
operating systems, executive systems, monitors, compilers and translators, assembly
routines, and utility programs as well as application programs, are included. Computer
software also includes any incidental and ancillary rights that are necessary to effect the
acquisition of the title to, the ownership of, or the right to use the computer software,
and that are used only in connection with that specific computer software.

    Rev. Proc. 2000-50, 2000-2 C.B. 601, which provides guidelines on the treatment

of the costs of computer software uses the definition of computer software under
§ 1.197-2(c)(4)(iv). Section 1.861-18(a)(3)(i) defines a computer program as a set of
statements or instructions to be used directly or indirectly in a computer in order to bring
about a certain result. More recently, § 1.199-3(j)(3)(i) provides a definition of computer
software for determining whether a taxpayer is entitled to the § 199 domestic production
deduction for producing computer software within the United States. The definition of
computer software in § 1.199-3(j)(3)(i), which is derived from the definition of that term
under § 1.197-2(c)(4)(iv), defines computer software as any program or routine or any
sequence of machine-readable code that is designed to cause a computer to perform a
desired function or set of functions, and the documentation required to describe and
maintain that program or routine. Thus, for example, an electronic book available online
or for download is not computer software. Computer software also includes the
machine-readable code for video games and similar programs, for equipment that is an
integral part of other property, and for typewriters, calculators, adding and accounting
machines, copiers, duplicating equipment, and similar equipment, regardless of whether
the code is designed to operate on a computer (as defined in § 168(i)(2)(B)).

     Taxpayer has represented that it is engaged in the active conduct of the trade or

business of developing, manufacturing, or producing computer software and meets the
tests provided in §§ 543(d)(3), (4), and (5). We believe that it is appropriate in this case
to apply the definition of computer software under § 1.199-3(j)(3)(i) to the term
“computer software” in § 543(d)(1). Based upon that definition, Taxpayer’s C-code
software should be considered computer software for purposes of § 543(d)(1) because
it is a program that is designed to cause a computer to perform a desired function or set
of functions even if the computer is an integrated circuit or other equipment.

   Accordingly, based solely on the above, we rule that:

PLR-113147-08 5

   Any royalties received by Taxpayer from the licensing of Product 1 and Product 2

are active business computer software royalties for purposes of §§ 543(a)(1)(C) and
543(d).

  Except as specifically set forth above, no opinion is expressed or implied

concerning the federal income tax consequences of the above described facts under
any other provision of the Code or regulations.

   This ruling is directed only to the taxpayer that requested it. Under section

6110(k)(3) of the Code it may not be used or cited as precedent. In accordance with a
power of attorney filed with the request, a copy of the ruling is being sent to your
authorized representatives.

                                       Sincerely yours,

                                       /Paul Handleman/

                                       Paul F. Handleman
                                       Chief, Branch 5
                                       Office of the Associate Chief Counsel
                                       (Passthroughs & Special Industries)

Enclosures (2)
Copy of this letter
Copy for § 6110 purposes
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