If a U.S. company pays a royalty to a foreign company for the use of a software license, there is an issue regarding whether the royalty payment is considered to be U.S. source income to the foreign licensor. If the royalty is considered to be U.S. source income to the foreign licensor then I.R.C. Section 1442 U.S. nonresident tax withholding generally will apply at a rate of 30%.
The general rule based on several IRS Revenue Rulings is that royalty income from the license of a software copyright should be sourced to the place where the licensee sells the product or provides the service which utilizes the licensed software. For example, if a licensee obtains a right to replicate a computer software program for distribution to the public, the royalty income earned by the licensor should be sourced to the location of the market where the copies of the software program are sold to customers.
However, the IRS took a position in a Field Service Advice that was inconsistent with the prior Revenue Rulings. In the FSA, a U.S. licensee licensed software from a foreign licensor. The U.S. licensee modified the licensed software and sublicensed the modified software to another U.S. company. The sublicensee manufactured computers and installed the modified software on computers that it sold both inside and outside the United States. The IRS determined that the source of the royalties paid by the U.S. licensee to the foreign licensor should be based on the location of the U.S. licensee’s activities. The royalties that the U.S. licensee paid to the foreign licensor were considered to be U.S. source income.
If a software license royalty is considered to be U.S. source income paid by a U.S. licensee to a foreign licensor then the U.S. licensee generally is required to withhold 30% U.S. nonresident tax. The applicable U.S. nonresident tax withholding rate could be reduced by a provision of a U.S. tax treaty with a foreign country. For example, Article 12, paragraph 2(a) on Royalties of the U.S. tax treaty with Italy reduces the applicable U.S. tax on software license royalties to 5% provided that the parties to the transaction otherwise would meet the requirements of the Limitation on Benefits provision in the Protocol to the treaty. Even if a treaty reduces the applicable U.S. nonresident tax withholding rate to zero, the U.S. licensee is still required to file the Forms 1042-S and 1042. The U.S. licensee must obtain the Form W-8BEN from the foreign licensor prior to making the royalty payment. The foreign licensor is required to obtain a U.S. federal tax identification number in order to qualify for a reduced U.S. nonresident tax withholding rate that is reported on the Form 1042-S.
For more information, please contact our international tax advisor at 301.231.6200.