Recently proposed IRS regulations would significantly affect tax on income from international cloud transactions and electronic transfers of digital content. Accordingly, CFOs should review the structure of agreements involving such transactions and transfers.
Issued on Aug. 9, the proposed regulations represent an attempt by the IRS to catch up with technological advancements, two decades after it issued regulations addressing the U.S. federal income tax treatment of cross-border transfers of computer programs.
The preamble to the proposed regulations states that current industry practice is generally consistent with their underlying principles, and thus the IRS and Treasury Department expect them to have only a small effect on economic activity and compliance costs.
Nonetheless, corporations and other taxpayers engaged in cloud services and online sales, streaming, and licensing should review their existing intercompany and third-party agreements. They also should structure their future agreements taking the proposed regulations into consideration.
Similarly, CFOs and tax departments should review their tax positions and determine whether any adjustments should be made in light of the proposed regulations.
What the Proposed Regulations Cover
With respect to cloud transactions, the proposed regulations cover, for the first time, income from transactions involving on-demand network access to “computing resources” such as software, networks, databases, servers, and other technological resources via software-as-a-service (SaaS), platform-as-a-service (PaaS), and infrastructure-as-a-service (IaaS) platforms.
They also cover income from transactions involving on-demand network access to “technological resources” such as streaming music and videos, mobile development applications, and access to data through remotely hosted software.
With respect to digital content transfers, the proposed regulations expand the scope of the 1998 software regulations. Under the proposal, they would cover income from transactions involving the transfer of any content in digital format (in addition to transfers of computer programs already covered by the 1998 software regulations) that is either protected by copyright law or no longer protected by copyright law solely due to the passage of time.
That applies whether or not the content is transferred in a physical medium.
This includes income from transfers (including mere download) in digital format of books, movies, and music for storage and use on personal electronic devices.
Treatment of Income from Cloud Transactions
Generally, the proposed regulations provide that the IRS views income from cloud transactions solely as either income for services or rental income.
The preamble notes that cloud transactions involve access to property or use of property instead of the sale, exchange, or license of property. Therefore, the IRS does not propose to classify such income as royalties or sales income.
The proposal provides a non-exhaustive list of factors to determine whether a cloud transaction generates service income or rental income. For example, the following factors weigh in favor of service income classification:
- The service recipient does not have physical possession of the property, does controls the property, and/or does not have a significant economic or possessory interest in the property.
- The provider has the right to determine the specific property used in the cloud transaction and replace such property with comparable property.
- The provider has other responsibilities such as maintenance and updates of the property.
- 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.
The preamble notes that the interpretation of factors and their application to cloud transactions must be sensitive to the inherent differences between transactions involving physical access to property and transactions involving on-demand network access.
The proposed regulations generally do not allow for a bifurcation of the classification of income from a cloud transaction. Generally, income from a cloud transaction will either be classified solely as income for services or solely as rental income.
Treatment of Income from Digital Content Transfers
Generally, the proposed regulations provide that, consistent with the 1998 software regulations, the IRS views income from digital content transfers as (i) income from a sale of personal property (e.g., sale of inventory), (ii) rental income, (iii) royalty income, or (iv) income for services.
Importantly, the IRS proposes to base its determination of whether such a transfer is U.S.-source or foreign-source transfer on the location of download or installation onto the device that the end user uses to access the digital content.
In the absence of information about such download or installation, the sale would be deemed to have occurred at the location of the customer based on the taxpayer’s recorded sales data for business or financial reporting purposes.
This is a material change from the current rules that determine the source of income from the sale of inventory property based on where title passes or where the production activities occurred. The IRS believes those rules are not appropriate in the context of sales and transfers of digital content by electronic medium (in particular electronically downloaded software and content).
Importantly, the proposed regulations do not propose to change the sourcing rules that apply to income from cloud transactions or income from digital content transfers that are not classified as a sale and transfer of property. The existing sourcing provisions under the Tax Code would apply to such types of income (whether they are classified as service income, rental income, or license income).
The IRS is requesting comments on administrable rules for sourcing income from cloud transactions in a manner consistent with the existing sourcing rules.
How Companies Would Be Affected
The proposed regulations must go through a rulemaking process, including written comments or hearings, before final binding regulations can be published. However, if finalized as proposed, they are expected to have significant corporate income tax implications. For example, they would affect:
- The determination of whether U.S. withholding tax applies to a payment by a U.S. corporation to a non-U.S. affiliate or a non-U.S. third-party provider of cloud services or digital content to the U.S. corporation
- The determination of whether a payment from a U.S. corporation to its non-U.S. cloud services provider affiliate triggers adverse U.S. federal income tax consequences to the U.S. corporation under the BEAT regime
- The U.S. federal income tax treatment under the “controlled foreign corporation” regime (including the Subpart F and GILTI rules) of cloud transactions or digital content transfers income received by non-U.S. corporations owned by U.S. persons
- The eligibility of U.S. corporations to benefit from the U.S. federal income tax benefits under the Foreign Derived Intangible Income regime with respect to income they derive from online sales, licenses, or services to non-U.S. customers for use outside the United States.
Erez Tucner is a shareholder in the tax practice at the law firm Greenberg Traurig. Pallav Raghuvanshi is an associate in the firm’s tax practice.
This article reflects the opinions of the authors, and not of Greenberg Traurig, LLP. The article is presented for informational purposes only and it is not intended to be construed or used as general legal advice nor as a solicitation of any type.