Bringing Tax Regulations Into the Digital World with Changes to Income Sourcing

On August 9, 2019, the IRS published proposed US Department of the Treasury (Treasury) regulations in an attempt to clarify that transactions involving digital content and cloud computing should be treated as a sale, lease, license, or provision of services. This classification is important when applying various international provisions of the Internal Revenue Code.

Digital content and cloud computing have existed for more than 20 years. However, the recent development of popular business models that involve both prompted the IRS to provide much-needed guidance to assist taxpayers with the classification and sourcing of digital and cloud-related income.

The proposed regulations—an update to Regulation Section 1.861-18 and the new Proposed Regulation Section 1.861-19—would apply to relevant transactions entered into in tax years beginning on or after the date of publication of the Treasury decision to adopt the regulations as final.

Computer Software and Digital Content

The existing Regulation Section 1.861-18—often referred to as the computer software regulations—were released in 1998. They were intended to help classify transactions related strictly to computer programs and didn’t directly address transactions involving digital format software and media.

The new proposed regulations were drafted in response to subsequent changes in modern computer storage and service technology as well as the increased digitization of today’s economy.

Proposed Regulation Section 1.861-18 builds on the existing regulations by broadening its scope to include digital content, which is defined as any content in digital format that’s either protected by copyright law or unprotected by copyright law solely due to the passage of time. This definition applies whether the medium of transfer is physical, digital, or otherwise.

For example, digital content might include items purchased digitally, such as movies, books, video games, or music.

Cloud Transactions

New Proposed Regulation Section 1.861-19 is intended to assist taxpayers with classifying transactions under modern fundamental service models, such as:

  • Software as a Service
  • Platform as a Service
  • Infrastructure as a Service

The proposed regulation combines these related business models under the term cloud transactions. A cloud transaction is defined as a transaction through which a person obtains on-demand network access to the following:

  • Computer hardware
  • Digital content, as defined above
  • Other similar resources, such as storage, server space, and software

The proposed regulations may also apply to cloud-based transactions that don’t fit into these specific models, such as:

  • Streaming music and video
  • Mobile device applications
  • Data accessed through remotely hosted software

These regulations aren’t intended to apply to simple, everyday content downloads by consumers for use on a personal computer or other electronic device. Those instances are presumed to be covered by the existing regulations.

As a general theme, the proposed regulations provide guidance that most cloud transactions should be classified as either a service or a lease of property. A transaction may have characteristics of both a service and a lease, but the preamble to the proposed regulations states that case-law precedent dictates that in most circumstances, treatment as either a service or a lease should prevail, rather than requiring a single transaction be bifurcated between the two.

All relevant factors must be accounted for when classifying a cloud transaction. A list of nonexclusive factors that should be used to demonstrate the appropriate classification is provided in the proposed regulations:

  • Whether or not the provider has the right to determine the specific property used in the cloud transaction and replace such property with comparable property
  • Whether or not the property is a component of an integrated operation in which the provider has other responsibilities, including maintenance and updates
  • Whether or not 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

Income Sourcing

A primary driver in classifying digital and cloud transactions is the effect of such classification on the foreign tax credit of US taxpayers. As such, the proposed regulations also discuss the sourcing of income related to these transactions.

They state that revenue should be sourced to the location where such content is downloaded or installed onto the end-user’s device. If this information isn’t available, the location of the customer according to the provider’s records will generally suffice for sourcing that revenue.

If finalized, this rule has the potential to alter the treatment of the sourcing of digital and cloud transactions, potentially to the benefit of US taxpayers, as digital content provided by US persons had previously generally been sourced to the location of the provider rather than the location of the customer. The IRS has requested comment with respect to data availability and reliability for purposes of this sourcing rule.

We’re Here to Help

To learn more about how changes to income sourcing regulations will affect your organization, contact your Moss Adams professional.