On August 9, 2019, the U.S. Treasury Department (Treasury) and the Internal Revenue Service (IRS) issued proposed regulations (the proposed regulations) that would classify cloud transactions for U.S. federal income tax purposes.1 Specifically, the new rules would help taxpayers determine whether certain transactions (and income derived therefrom) constitute a lease of property or a provision of services when applying various provisions of the Internal Revenue Code of 1986, as amended, including provisions related to the base erosion and anti-abuse tax and Subpart F income. The proposed regulations also include guidance applicable to transfers of "digital content," by expanding on existing regulations that currently govern transactions involving only transfers of computer programs.
Cloud Transactions
The proposed regulations define a cloud transaction as a transaction through which a person obtains non-de minimis, on-demand network access to computer hardware, digital content, or other similar computing resources, using one or more of several models, including Software as a Service (SaaS), Platform as a Service (PaaS), or Infrastructure as a Service (IaaS). Although the proposed regulations acknowledge that this definition includes both transactions involving SaaS, PaaS, and IaaS, as well as transactions involving the streaming of digital content and access to remote servers and information stored in databases, the proposed regulations do not apply to every transaction involving the internet, such as a simple download or other electronic transfer of digital content for use on a personal computer or other electronic device.
The proposed regulations provide that a cloud transaction is classified solely as a lease of property or provision of services. The proposed regulations note all relevant factors must be taken into account in classifying a cloud transaction, and provide a list of non-exhaustive factors that tend to demonstrate that a cloud transaction should be treated as a provision of services, such as whether the provider has the right to determine the specific property used in the cloud transaction and replace such property with comparable property; whether the property is a component of an integrated operation in which the provider has other responsibilities, including ensuring the property is maintained and updated; and whether the provider's fee is primarily based on a measure of work performed or the level of the customer's use rather than the mere passage of time.
The proposed regulations also acknowledge that certain arrangements may consist of multiple transactions, some of which may constitute a cloud transaction and others which may not. In such cases, the rules applicable to cloud transactions would apply only to the transactions that constitute cloud transactions under the proposed regulations.
Transfers of Digital Content
General
Currently, Treasury Regulation § 1.861-18, which was issued in 1998 and is sometimes referred to as the "software regulations," is limited to certain transactions involving transfers of "computer programs." The proposed regulations would extend the application of Treasury Regulation § 1.861-18 to transfers of "digital content," which is defined to include all content in digital format that is either protected by copyright law or is no longer protected by copyright law solely due to the passage of time, whether or not the content is transferred in a physical medium, including books, movies, and music in digital format in addition to computer programs. The IRS and Treasury acknowledged that copyrighted digital content has become a common basis for commercial transactions and that consumption of such digital content has grown in part because electronic devices allow users to more easily obtain and use digital content. In addition, the IRS and Treasury found the rules in Treasury Regulation § 1.861-18 to be instructive for a broad range of transactions involving digital content, rather than those that only involve computer programs.
The proposed regulations also provide for a new exception to the provisions of Treasury Regulation § 1.861-18 regarding "copyright rights". Under this exception, the transfer of the right to publicly perform or display digital content for the purpose of advertising the sale of the digital content is considered by the IRS and Treasury to be insignificant. Accordingly, the proposed regulations exclude such transfers from the rules applicable to the transfer of a copyright right in Treasury Regulation § 1.861-18.
Source of Income
The proposed regulations also provide that income from the sale of electronically transferred digital content subject to copyright is sourced to the location where such content is downloaded or installed onto the end-user's device that is used to access such content or, in the absence of such information, to the location of the customer according to the provider's recorded sales data for business or financial reporting purposes. Under existing law such income is sourced by considering a variety of factors, such as the location where legal title passes. The IRS and Treasury acknowledged that due to advances in technology, source of income is becoming increasingly unclear and is potentially at risk for manipulation.
The proposed regulations would be applicable to taxable years beginning on or after the date of publication of the adopted final regulations.
