August 2019 in Tax

Proposed Regulations on Tax Treatment of Revenues from Cloud and Digital Content Transactions

The Internal Revenue Service (IRS) and the Department of Treasury (Treasury) recently released proposed regulations regarding the classification of transactions involving cloud computing and the transfer of digital content for purposes of the international provisions of the Internal Revenue Code.

Current regulations address how to classify transactions involving computer programs when applying various provisions of the Internal Revenue Code but fall short when it comes to guidance on transactions involving digital content and cloud computing. Newly proposed regulations would broaden the applicability of the current regulations to include transfers of digital content (i.e., books, movies, music, etc.) as well as add a new provision providing guidance on when a cloud transaction should be classified as a provision of services or a lease of property for taxation purposes.

Clarifying Digital Content

The IRS and Treasury acknowledge 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. As such, the proposed regulations aim to help provide certainty to taxpayers who provide digital content to customers. For purposes of this proposed regulation, digital content will now include all content in digital format that is either protected by copyright law or was previously protected by copyright law, including books, movies, and music as well as computer programs.  The proposed regulations also update the rules on advertising, stating that the transfer of the right to publicly perform or display digital content for the purpose of advertising the sale of the digital content does not by itself constitute a transfer of a copyright right and thus is not taxed as such.

Defining a Cloud Transaction

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 computing resources. Cloud computing transactions typically utilize one or more of the following models, Software as a Service (SaaS), Platform as a Service (PaaS), or Infrastructure as a Service (IaaS), however, as stated above, the definition would also include other on-demand transactions such as streaming digital content and information in certain databases. It is important to note that the proposed regulations do not apply to every transaction involving the Internet. For example, a simple download or other electronic transfer of digital content for use on a personal computer or another electronic device would not be considered a cloud computing transaction.

Classifying Cloud Transactions

The proposed regulations provide that a cloud transaction is classified solely as a lease of property or provision of services and notes that several factors must be considered in classifying a cloud transaction.

Lease of Property

A service contract for a cloud transaction is a lease of property when considering all relevant factors, including whether:

1. the property is in the physical possession of the recipient,
2. the recipient controls the property,
3. there is significant economic or possessory interest in the property by the recipient,
4. the provider does not bear any risk of substantially diminished receipts or substantially increased expenditures if there is nonperformance under the contract,
5. the property is not used concurrently by the provider to provide significant services to entities unrelated to the recipient,
6. the total contract price does not substantially exceed the rental value of the property for the contract period.

Provision of Services

A service contract for a cloud transaction is a provision of services when considering all relevant factors, including whether:

1. the provider has the right to determine the specific property used in the cloud transaction and replace such property with comparable property;
2. the property is a component of an integrated operation in which the provider has other responsibilities, including ensuring the property is maintained and updated;
3. 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.

Note: The proposed regulations state that arrangements involving multiple transactions will require a separate classification of each transaction as some may constitute a cloud transaction while others may not (unless the transaction is de minimis).

Determining the Source of Income

One of the more important aspects of the proposed regulations includes treating the sale of digital content as occurring at the location where the customer downloads the content or installs it on the device used to access it. (In lieu of such information, one would use the physical location of the customer according to the provider’s recorded sales data for business or financial reporting purposes.) This is significant as it could mean that vendors from outside the US who sell to US customers may be subject to US income or withholding tax and, vice-versa, US companies may find that where and how their income is sourced affects their ability to take a foreign tax credit.

What’s Next?

The IRS and Treasury are accepting comments on the proposed regulations until November 12, 2019. The proposed regulations will be applicable to taxable years beginning on or after the date of publication of the final regulations.

For more information, please contact a member of our Tax Practice.

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