The Department of the Treasury and the IRS on January 10, 2025, released final regulations on the classification of digital content and cloud transactions. These regulations -- T.D. 10022 -- generally follow proposed regulations issued in August 2019, with certain modifications to address stakeholder comments received. The regulations are generally effective for tax years beginning on or after January 14, 2025, with the option to elect to apply to tax years beginning on or after August 14, 2019, and all subsequent tax years, subject to certain conditions.
Treasury and the IRS also released proposed regulations to determine how income from cloud transactions is to be sourced for U.S. federal tax purposes, and a notice requesting comment on the potential implications of applying the characterization rules for digital content and cloud transactions to all provisions of the Internal Revenue Code. Comments on both the proposed regulations and the notice are due by April 14, 2025.
Relevance
Today, most businesses’ interactions with customers occur in some form of digital or cloud environment. Until now, there have been no final regulations specifically addressing the treatment of digital content and cloud transactions for federal income tax purposes. Both the characterization and sourcing of income from these transactions are important because they impact the application of various international tax provisions of the Internal Revenue Code, including the determination of U.S. withholding tax and other income tax reporting obligations. These regulations will apply to any taxpayer that engages in digital content and cloud transactions across various industries and in a cross-border context.
A Closer Look
The final regulations modify Reg. §1.861-18 to expand its scope to include the transfer of all manner of digital content so that it is no longer limited to computer programs. Digital content is defined as a computer program or any other content, such as books, movies, and music, in digital format that is protected by copyright law or not protected by copyright law solely due to the passage of time or because the creator dedicated the content to the public domain.
As in the 2019 proposed regulations, Reg. §1.861-18 classifies transfers of digital content into one of four categories:
- A transfer of a copyright right in the digital content;
- A transfer of a copy of the digital content (a copyrighted article);
- The provision of services for the development or modification of the digital content; or
- The provision of know-how relating to development of digital content.
As a result of taxpayer comments, the final regulations replace the de minimis transaction rule with a predominant character rule for the characterization of digital content and cloud transactions. Under the new predominant character rule, a transaction that has multiple elements is classified in its entirety as a digital content or cloud transaction if the predominant character is a digital content or cloud transaction. The predominant character is generally determined by the primary benefit or value received by the customer in the transaction. If that is not reasonably determinable, the predominant character is determined based on the primary benefit or value received by a typical customer in a substantially similar transaction.
If a copyright right is transferred, the transaction would generally be classified as a sale or license of intangible property. If a copyrighted article is transferred, the transaction would generally be classified as a sale or lease of tangible property. New sourcing rules were provided such that when a copyrighted article is sold and transferred through an electronic medium, the sale is deemed to have occurred at the location of the purchasers’ billing address for purposes of Reg. §1.861-7(c). Reg. §1.861-19 provides rules that generally classify all cloud transactions as services income, eliminating a delineation made in the 2019 proposed regulations between lease and services income. A cloud transaction is defined as a transaction through which a person obtains on-demand network access to computer hardware, digital content (as defined in Reg. §1.861-18(a)(2)), or other similar resources. A cloud transaction does not include network access to download digital content for storage and use on a person’s computer or other electronic device.
The addition of numerous examples in Reg. §1.861-18 regarding the classification of digital content transactions in various industries, including online gaming and streaming of other types of content, facilitates understanding of the final regulations. The examples emphasize that providers will need to pay careful attention to contracting with customers, including the method and terms of delivery for digital content to achieve a preferred tax outcome.
One specific example of this concept is the clarification of rules related to the distribution of “software as a service” or “SasS.” Example 10 in Reg. §1.861-19(d) discusses a fact pattern whereby Corp A owns the SaaS IP and provides the service to end customers through its own activities but engages Corp B as a distributor of the SaaS. Corp B will invoice customers, but since all cloud services are provided directly to the end customers by Corp A, the remittance of the required distribution fee to Corp A by Corp B is viewed as a cloud transaction (services income). Reg. §1.861-19, however, would view the distribution transaction as a license or sale of a copyright right by Corp A if Corp B has the copyright right to provide the cloud transactions directly to its customers and exercises such rights through its own activities, in exchange for a distribution fee.
Reg. §§1.861-18 and 1.861-19 continue to apply only with respect to certain enumerated international tax provisions of the Code. However, Notice 2025-6 requests comments regarding issues to consider in deciding whether to apply the characterization rules in Reg. §§1.861-18 and -19 to all provisions of the Code.
Sourcing of Cloud Transactions
The proposed regulations (mostly designated as Reg. §1.861-19(d)) classify cloud transactions (such as software-as-a-service, on-demand platform access) as services and follow Sections 861(a)(3) and 862(a)(3) and some court cases in generally sourcing income to where services are performed. However, the preamble to the proposed regulations recognizes that such general sourcing rules were designed with more traditional operating models in mind. Thus, the proposed regulations attempt to consider the distinctive attributes of cloud transactions. The proposed regulations provide a mechanical formula that is based on the location of intangible assets, employee functions, and tangible property pertaining to the provision of the cloud transaction, and results in a fraction that is applied to the gross income from the cloud transaction to determine source.
The intangible property factor is intended to reflect the contribution of intangible property to the provision of the cloud transaction and is comprised of research and experimental (R&E) expenditures, royalties, and amortization expenses for intangible property used in the cloud service during the taxable year. For this purpose, R&E expenditures are those associated with cloud transactions in the same product line as the cloud transaction performed and the amortization and royalty expense for intangible property that is directly used to provide the cloud transaction. If the same expense could be included in the intangible property factor for more than one cloud transaction during the taxable year, the expense should be allocated among those cloud transactions based on the relative gross income earned from each cloud transaction. The U.S. portion of the intangible property factor is determined based on the extent to which the R&E employees perform services in the same product line in the United States (determined using Industry codes).
The personnel (employee) factor is intended to reflect the contribution of certain employees to the provision of the cloud transaction and includes the compensation of employees that perform or manage technical or operational activities of the cloud service (for example, engineering, operational, and support activities). Any compensation paid to R&E personnel is covered under the intangible property factor and is therefore excluded under the personnel factor. For personnel that directly contribute to multiple cloud transactions, the employee’s compensation is allocated based on the relative amount of time the employee spends contributing to each cloud transaction. If an employee contributes to multiple cloud transactions simultaneously, then that employee’s compensation is allocated based on the gross income earned from each cloud transaction. The U.S.-source portion is determined based on the extent to which the employees perform services in the U.S.
The tangible property factor is intended to reflect the contribution of tangible property to the provision of the cloud transaction and focuses on depreciation expense or rental expense of physical assets (servers, networking equipment) directly involved in the provision of the cloud services. Depreciation expense is to be determined by dividing the adjusted depreciable basis (as defined in Reg. §1.168(b)-1(a)(4)) of the tangible property by the applicable recovery period as though the alternative depreciation system set forth in Reg. §168(g)(2) applied for the entire period the property has been in service. For any depreciation or rental expense that could be included in the tangible property factor for more than one cloud transaction, such expense should be allocated based on the relative gross income earned. The U.S.-source portion is determined by the location of the owned or leased assets.
The denominator of the formula is the sum of the above factors. The numerator is the sum of each factor that is from sources within the U.S. The fraction that results from dividing the numerator over the denominator is multiplied by the gross income of the relevant cloud transaction(s) to determine the U.S. source amount. The remainder is assumed to be foreign-source.
One of the most important aspects of the proposed regulations is that the above factors are applied exclusively on a taxpayer- by-taxpayer basis. Therefore, if the cloud transactions involve multiple related parties, the factors and activities of the related parties are not considered for purposes of the sourcing rules. However, attention should be paid to any related parties acting as agents for the taxpayer, as such factors/attributes presumably may be imputed to the taxpayer.
A taxpayer can aggregate substantially similar cloud transactions and source the gross income from those transactions as if they were one transaction. An anti-abuse rule prohibits aggregating substantially similar cloud transactions if doing so would materially distort the source of gross income from any cloud transaction.
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