On August 9, 2019, Treasury and the IRS issued proposed regulations under section 861 of the Code to clarify how transactions involving digital content and cloud computing are classified for tax purposes.  The new rules propose to revise and expand upon Treasury Regulation § 1.861-18 regarding digital content transactions and establish new Treasury Regulation § 1.861-19 regarding cloud computing transactions.  The proposed regulations also propose changes to Treasury Regulation § 1.861-7 regarding the source rules for sales of personal property.  Collectively, the rules are intended to address whether a digital transaction is characterized as a sale, lease, license, or provision of services for purposes applying various provisions of the Code, including the source rules, which are critical for purposes of determining whether withholding is required under Chapter 3 and reporting obligations under sections 6041 and 6050N, and Subpart F.

Proposed Changes to Treasury Regulation § 1.861-18 for Classification of Transactions Involving Digital Content

The final regulations currently in effect under Treasury Regulation § 1.861-18 address the classification of certain digital transactions, but these regulations use antiquated terminology and have not been updated since 1998.  They provide guidance on how to categorize a transaction involving a computer program as either: (i) the transfer of a copyright right in the computer program, (ii) the transfer of a copy of the computer program, (iii) the provision of services for the development or modification of the computer program or (iv) the provision of know-how regarding computer programming techniques.  By changing the term “computer programs” to the more comprehensive term “digital content,” the proposed regulations would extend existing guidance to apply to transactions involving all copyrighted digital content, such as books, movies, and music stored in digital format (including content whose copyright has expired solely due to the passage of time).  In this way, the proposed regulations are generally consistent with how most taxpayers have been thinking of and analyzing digital content transactions.

One clarification in the proposed regulations, however, may come as a surprise to taxpayers.  Typically, income from the sale of inventory is sourced where title passes from seller to buyer.  The proposed regulations clarify this rule for sales of digital content through an electronic medium (e.g., the sale of a music file that can be downloaded and played offline).  Because of uncertainty regarding where title actually passes from seller to buyer in the case of digital content and concerns that contractual terms could depart from economic reality, the proposed regulations provide that income from these sales would be sourced based on the location where the buyer downloaded the file, essentially treating such location as the place where title passes.  The proposed regulations under Treasury Regulation § 1.861-18 also add three examples to the regulations that focus on transactions related to the downloading of electronic books, memberships providing access to a catalog of copyrighted music, and the viewing of video content. Accordingly, foreign corporations and nonresident alien individuals selling digital content to U.S. users may be subject to U.S. tax on such transactions.

Income from leases or licenses of digital content remain subject to the traditional sourcing rule that they are sourced to the location of the property.  Although the regulations do not clarify this point, this would presumably indicate that lease or license of a copyrighted article would be sourced based on the location where it is downloaded or installed on the end user’s computer, similar to the sourcing rule for sales of digital content.  The source rules applicable to leases and licenses of digital content are particularly important for withholding agents given the potential for Chapter 3 withholding liability in the event that such income is U.S. source.

Proposed New Treasury Regulation § 1.861-19 for Classification of Cloud Transactions

The proposed regulations under Treasury Regulation § 1.861-19 also provide guidance for cloud transactions, such as streaming video and remotely-hosted software.  The regulations define a cloud transaction as a transaction in which a person obtains non-de minimis on-demand network access to computer hardware, digital content, or other similar resources.  This includes Software as a Service (“SaaS”), Platform as a Service (“PaaS”), and Infrastructure as a Service (“IaaS”).  Under the proposed regulations, a cloud transaction is classified as either a provision of services or a lease of property, based on the application of a multi-factor test.  The regulations provide a non-exhaustive list of factors that support treatment of a transaction as the provision of services, including the following:

  • the customer is not in physical possession of the property;
  • the customer’s control of the property is limited to network access and use of the property;
  • the provider retains the right to determine the specific property used in the cloud transaction and to replace such property with comparable property;
  • the property is a component of an integrated operation in which the provider has maintenance, updating, and other responsibilities;
  • the customer does not have a significant economic or possessory interest in the property;
  • the provider bears the risk of diminished revenue or increased expense in the case of nonperformance on the contract;
  • the provider uses the property to concurrently provide significant services to persons unrelated to the customer;
  • the provider’s fee is based on work performed or the customer’s use rather than the passage of time; and
  • the contract price substantially exceeds the rental value of the property.

The proposed regulations under Treasury Regulation § 1.861-19 include eleven examples that illustrate the classification of cloud transactions and the distinction between cloud transactions and digital content transactions, including examples regarding access to computing capacity, access to software development and website hosting, access to software and software downloads, access to online and offline software, data storage, streaming digital content using third party servers, downloaded digital content, and access to online databases.  The examples first analyze whether the transaction constitutes a cloud transaction.  If the transaction does not constitute a cloud transaction, the analysis generally turns to the rules under Treasury Regulation § 1.861-18.  If the transaction does constitute a cloud transaction, the analysis turns to whether the transaction is properly treated as one involving the provision of services or a lease of property.

Interestingly, all of the examples conclude that the cloud transactions are service transactions and not the lease of property.  In the preamble, Treasury asks for examples of cloud transactions that should be treated as a lease of property.  Moreover, the proposed regulations fail to address how income from cloud transactions should be sourced.  Generally, income generated from a lease of property is sourced where the property is located, and income generated from the provision of services is sourced where the service is performed.  Given that the examples conclude that the cloud transactions are service transactions, the question of where such a service is performed looms large.  It could conceivably be a number of locations: where the end user accesses the service, where the server is located, or where the company operating the server is located.  Without further guidance, the determination of whether cloud transactions are subject to U.S. withholding tax will remain difficult.