Treasury Proposes New International Tax Rules for “Cloud Transactions” and Sales of Digital Content

Miller & Martin PLLC Alerts | October 10, 2019

Author: Joseph Helm

Recently the United States Department of the Treasury and the Internal Revenue Service issued a set of proposed regulations regarding the treatment of “cloud transactions” and transactions involving digital content. These regulations are intended as a much-needed update on the characterization of certain kinds of transactions conducted over the internet, for the purpose of sourcing income. Characterization is critical for determining the jurisdiction (either the U.S. or a foreign country) that has primary income taxing authority over the income. Accordingly, the proposed regulations, once finalized, are likely to be important to U.S. businesses serving customers abroad via the internet, as well as foreign businesses accessing the U.S. markets digitally. Indeed, the newly proposed digital content rule is a radical departure from prior law, and as such, should be monitored closely by foreign businesses selling digital content in the U.S. The notice of proposed rulemaking set a deadline of November 12, 2019 for submission of comments and/or a request for public hearing.

“Cloud Transactions”

Proposed Treas. Reg. § 1.861-19 provides for the classification of a “cloud transaction” as either a provision of services or a lease of property. For many years, practitioners advising companies doing business over the internet (in particular, companies providing products and services in which the internet is an integral part of the offering, as opposed to, for example, retailing tangible goods), were forced to analogize to regulations having to do with computer programs (which had been issued in final form in 1998), in addition to applying general tax principles. See Treas. Reg. § 1.861-18. Although, for the most part, the tax community was able to reach relatively comfortable conclusions about digital transactions, the “old” computer program regulations were an awkward fit with the new digital economy, particularly Saas, PaaS, and IaaS business models.[1]

The proposed regulations define a “cloud transaction” as “a transaction through which a person obtains a non-de minimis on-demand network access to computer hardware, digital content . . . , or other similar resources.” Intended to encompass Saas, PaaS, and IaaS business models, in addition to other transaction types such as streaming of music and video, mobile device applications, and access to data through remotely hosted software, the definition is quite broad in scope.

As noted above, the proposed regulations create a binary choice as to characterization—cloud transactions will either be deemed a provision of services or a lease of property. The determination is based on a set of factors, which, as written, effectively create a presumption that most cloud transactions will be deemed a provision of services:

(i) The customer is not in physical possession of the property;

(ii) The customer does not control the property, beyond the customer’s network access and use of the property;

(iii) The provider has the right to determine the specific property used in the cloud transaction and replace such property with comparable property;

(iv) The property is a component of an integrated operation in which the provider has other responsibilities, including ensuring the property is maintained and updated;

(v) The customer does not have a significant economic or possessory interest in the property;

(vi) The provider bears any risk of substantially diminished receipts or substantially increased expenditures if there is nonperformance under the contract;

(vii) The provider uses the property concurrently to provide significant services to entities unrelated to the customer;

(viii) 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; and

(ix) The total contract price substantially exceeds the rental value of the property for the contract period.

The effective presumption that most cloud transactions should be characterized as a provision of services is generally consistent with the historical treatment to date by the international tax community at large. Accordingly, the majority of businesses with international cloud transaction business models should not be caught off-guard by the clarification.

Interestingly, the proposed regulations are silent as to the sourcing rules implicated by the characterization determination, which amounts to a tacit decision by Treasury to leave in place the default rules regarding services generally (place of performance) and leases generally (place of property). Unfortunately, this does little to create greater clarity as to how place of performance is to be determined when services are being rendered over a digital network by capital and labor that can be spread out over multiple jurisdictions.[2]

To some extent, for U.S. companies entering into cloud transactions with foreign customers either through foreign subsidiaries or directly from the U.S., the basic sourcing rules are less important now under the Global Intangible Low-Taxed Income (“GILTI”) and Foreign-Derived Intangible Income (“FDII”) regimes enacted as part of the Tax Cuts and Jobs Act of 2017 (“TCJA”). Under the FDII rules, which provide a substantial deduction for certain income earned by U.S.-based corporations providing products and services to foreign customers, eligible companies pay an effective rate of 13.125% through 2025 on such income. FDII is fairly agnostic as to place of performance, as it provides for the deduction as long as the underlying transaction is with a foreign customer who is the end user, irrespective of whether the services are deemed performed in the U.S. or abroad.[3]

Sales of Digital Content

Under general U.S. tax rules, income from the sale of inventory, including copyrighted articles such as books and music recordings, is sourced to the jurisdiction where legal title to the product and risk of loss passes from seller to buyer.[4] Pursuant to a proposed change to the I.R.C. § 861 regulations, however, the sourcing rule will change for “digital content.” This proposed change could prove extremely significant for foreign-based companies selling digital content into the U.S. market.

The proposed regulations expand the scope of the existing computer program regulations to apply to all transfers of “digital content,” defined as “any content in digital format and 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[,]” with the purpose of the change to include articles such as books, music, and videos in digital, downloadable formats.

The proposed regulations provide a new sourcing rule for the sale of digital copyrighted articles over the internet. These sales will now be sourced to the location of download or installation on an end-user’s device. If the location of download or installation is unknown, such sales will be deemed to have taken place at the end user’s location, determined by recorded sales data for business or financial reporting purposes.

Importantly, the proposed sourcing rule for digital content is a significant change from existing principles. Foreign businesses which sell copyrighted articles through the internet to U.S. customers should monitor the proposed sourcing rule – should the proposed rule become final as written, such businesses could find themselves generating U.S.-source income from these sales, and thus could be deemed to be conducting a U.S. trade or business with effectively connected income. Foreign businesses selling digital content with marketing subsidiaries and/or personnel in the U.S., but which heretofore have not had U.S.-sourced sales, are advised to review their operating structures and to consider planning for the new regime.

For more information or counsel relating to your transactions, contact Miller & Martin attorney Joe Helm or any other member of our Tax or Mergers & Acquisitions and Private Equity practice.

 

[1] Software-as-a-service (“SaaS”) “allows customers to access applications on a provider’s cloud infrastructure through an interface such as a web browser.” Platform-as-a-service (“PaaS”) “allows customers to deploy applications created by the customer onto a provider’s cloud infrastructure using programming languages, libraries, services, and tools supported by the provider.” Infrastructure-as-a-service (IaaS”) “allows customers to access processing, storage, networks, and other infrastructure resources on a provider’s cloud infrastructure.”

[2] See, e.g., Commissioner v. Piedras Negras Broadcasting Co., 127 F.2d 260 (5th Cir. 1942) (holding that advertising income derived from U.S. customers by a radio station located in Mexico was foreign source, because the services were deemed performed in Mexico; i.e., the ads were broadcast from equipment located in Mexico even though targeted at U.S. listeners).

[3] See generally I.R.C. § 250(b).

[4] If a domestic corporation manufactures inventory in the U.S. and title and risk of loss pass outside the U.S., pre-TCJA provided that 50 percent of the income would be U.S. source and 50 percent would be foreign source. The TCJA modified this rule to provide that 100 percent of the income from the sale of property manufactured by the corporation in the U.S. is U.S. source, irrespective of where title passes. The corollary also holds: if the domestic corporation manufactures the inventory outside the U.S., 100 percent of the income from the sale is foreign source, irrespective of where title passes and regardless of whether the products are sold to U.S. or foreign customers. On the other hand, if domestic corporation purchases the inventory it sells, the sales income would be sourced based on where title and risk of loss pass to the buyer.

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