Are there Silver Linings in the New Cloud Regulations? How Clicks are Taxed

The Department of Treasury and the Internal Revenue Service (“IRS”) recently issued proposed and final regulations for Treasury Regulation Section 1.861-18 and 19. These regulations will significantly change the way computer programs, movies, and music, in digital format, will be taxed in the United States. This article the recent changes the final regulations made to the taxation to digital content and cloud transactions. This article also discusses the changes the 2025 proposed regulation changes to determine the source of income from cloud transactions, based on a taxpayer-by-taxpayer approach that looks to the location of the taxpayer’s employees and assets. Since a significant portion of digital content and cloud transactions involves a cross-border element, we will begin this article with a discussion as to how U.S. and foreign persons are taxed in the United States.

Taxation of U.S. Persons

The basic rule of the U.S. income tax system is that U.S. citizens, resident aliens and corporations are subject to tax on worldwide income regardless of the country from which the income derives, the country in which payment is made or the currency in which the income is received. For U.S. persons, the term “source of income” is typically only relevant for foreign tax credit purposes. The foreign tax credit provisions contained in Internal Revenue Code sections 901 through 909 permit a foreign tax credit to reduce U.S. taxation on foreign source income.

Taxation of Non-Residents by the United States: Effectively Connected and Non-Effectively Connected Income, Gain, or Loss

A non-resident individual or other non-resident entity of the United States (“U.S.”), including a foreign corporation, is subject to U.S. income tax only with respect to U.S. source income it derives from passive investment as well as income or gain effectively connected, or treated as effectively connected with the carrying on of a U.S. trade or business or through a permanent establishment. In contrast with non-U.S. persons, including a foreign corporation, a fundamental axiom of the U.S. tax system is it requires a U.S. citizen or resident, as well as a U.S. (domestic) corporation or partnership, to pay U.S. income tax on his or its worldwide taxable income subject to applicable treaty provisions. A U.S. person includes a domestic corporation, domestic partnership, domestic trust, or domestic estate.

A foreign corporation or other non-U.S. resident carrying on a trade or business in the U.S. is taxed on a net basis, i.e., on effectively connected income or (“ECI”) derived by such U.S. trade or business less allowable deductions. The ECI rules apply U.S. trade or business characterization to income derived by indirect owners of the business through a flow-through entity, such as foreign beneficiaries of a trust or foreign partners in a partnership, for each owner’s pro rata share or deemed allocation of ECI. This outcome is sourced as ECI by Sections 875(1) and 875(2) of the Internal Revenue Code, which provide that a foreign corporation (or nonresident alien individual) is engaged in a U.S. trade or business if the partnership, estate, or trust is engaged in a U.S. trade or business.

U.S. ECI “net-income” is subject to U.S. income tax at regular tax rates. The same outcome applies to a foreign corporation that is a resident of a treaty jurisdiction to the extent its business and associated profits are attributable to a permanent establishment situated in the U.S. For a foreign corporation the current tax rate of U.S. federal income tax is 21 percent.

U.S. Source Income: Foundational Rules

For a foreign corporation not engaged in a trade or business in the U.S., it is subject to a 30 percent flat rate (without deduction or credit) on its U.S. source income that is otherwise not ECI. Section 881(a)(1) of the Internal Revenue Code describes this category of U.S. source income, which is generally passive in nature, as “fixed or determinable or periodical income (“FDAP”). FDAP U.S. source income includes dividends, interest, rents, salaries, wages, premiums, annuities, and compensations. See Treas. Reg. Sections 1.1441-2(b)(1)(i); 1.1441-2(b)(1)(ii). Further, certain species of foreign source income that are attributable to a foreign corporation’s office or fixed place of business in the United States may be deemed to be effectively connected with a U.S. trade or business.

Royalties and License Payments as FDAP

Royalties and payments made by U.S. users for licenses and similar arrangements for the use of intangible property owned by a foreign corporation (or non-U.S. person) are treated as FDAP. This includes payments for the use of patents, copyrights, secret processes and formulas, goodwill, franchises, trademarks, trade names, and brands. Accordingly, royalty payments for the use of intangibles within the U.S. which are not ECI of a U.S. trade or business (or permanent establishment) of a foreign corporation or non-resident licensor, are subject to the flat 30 percent tax and applicable withholding rate subject to treaty modification. The governing standard is for royalty income to be sourced based on the country in which the licensed property is used and not the jurisdiction in which the licensor resides or maintains its principal place of business.

The dividing line between the licensing of intangible property and from gains from the sale of intangible property is not always clear. This has been the subject of tax litigation. This is because gains from the sale of property, including intangible personal property, do not subject a foreign corporation to tax under Section 881(a) unless otherwise provided to a contrary provision of the Internal Revenue Code.

Generally, a sale results where the transfer is made of all substantial rights of ownership. Even where there is a transfer of all or substantially all ownership rights to potentially qualify the transaction as a “sale” of intangible property, gains from such sale to the extent “contingent on the productivity, use or disposition of the property” are treated as FDAP and are taxed at a gross rate of 30 percent. A payment that is indefinite in amount or as to time is generally not treated as “contingent” for purposes of this rule.

Source of Income from Leases, Licenses, and Services Distinguished

The sourcing rules under Sections 861 and 862 instruct whether income from payments of a particular transaction will be treated as U.S. source or foreign source income or partly both based on an allocation provision. See IRC Sections 861(a)(3) and 862(a)(3). Compensation for personal services performed in the United States is U.S. source income, and compensation for personal services performed abroad is foreign-source income. See IRC Sections 861(a)(3) and 862(a)(3). As noted, personal services are sourced under the “place of performance” standard. See IRC Section 861(a)(3). In comparison, royalty and licensing income associated with intangible personal property is sourced according to where the intangibles are used, which is where the legal protection sought by the licensee is sought. See IRC Sections 861(a)(4) and 862(a)(4). For example, a licensee remits fees to the manufacturer of copyrighted software for use in the U.S. The manufacturer or developer of the software is a foreign corporation based in Brazil which does not have, at present, a tax treaty with the United States. The payment is U.S. source income, assuming that the Brazilian corporation does not carry on a trade or business within the United States.

In the Deficit Reduction Act of 1984, Congress enacted Section 7701(e) of the Internal Revenue Code in an effort to distinguish between a lease and a service contract. Six factors are set forth in the statute in making this determination; to wit: 1) the service recipient has physical possession of the property “leased;” 2) the service recipient controls the property; 3) the service recipient has a significant economic or possessory interest in the property; 4) the service provider does not bear economic risk of loss by substantially increased expenditures if there is nonperformance under the contract; 5) the service provider does not use the property concurrently to provide significant services to entities unrelated to the service recipient; and 6) the total contract price does not substantially exceed the rental value of the property for the contract period.

Income from Computer Programs and Cloud Transactions

As mentioned above, income from copyrights, patents, trademarks, or similar intangibles may be treated as “royalties” and therefore FDAP under a “license” arrangement, or, gain from the sale of the property in issue if substantially all rights are transferred, or as services income if the income is principally derived in the form of compensation for the owner’s services in developing the property. Where the foreign person or corporation receives payments but does not have ownership in the intangible property, the transaction is treated as compensation. Where less than substantially all of the foreign person’s or corporation’s rights are transferred, the transaction is characterized, in general, as a license.

Treasury Regulation Section 1.861-18 provides rules for classifying income from computer programs as well as income from services and know-how. There are several rules involving the transfer of a computer program, service, or know-how including: 1) a transfer of a “copyright right” in the program, which is treated as a sale if “all substantial rights” in the copyright as to a particular country are transferred or a license producing royalty income if less than all substantial rights are transferred; 2) a transfer of the program or intangible, which is treated as a sale where “the benefits and burdens” of ownership are transferred and, if not, then the transaction constitutes a lease yielding rental income; 3) a contract for services with respect to the development or modification of the program; or 4) for “know-how relating to computer programming techniques,” which would, in general presumably be treated as licensing income unless the transferee acquires ownership rights with respect to the “know-how.”

Treasury Regulation Section 1.861-18, issued in 1998 (also known as the “Software Rules”), did not seem to provide a complete basis for addressing characterization and sourcing issues related to “cloud computing” transactions, a more recent phenomenon. While computer software technology involved the purchase or lease of license to install and run software on an individual’s or corporation’s computers, cloud computing permits consumers to access the internet or virtual space where the software is located through one or more provider’s servers to run its data on the host company’s software, hardware, and data storage with a developer perhaps serving as an intermediate party between the consumer and the owner of the technology.

Therefore, it was unclear based on the computer Software Rules whether cloud computing income should be characterized as royalty, rental, or services income. Cloud computing transactions may, in general, be described as involving three models: 1) a software as a service (“SaaS”); 2) a platform as a service (“PaaS”); and 3) infrastructure as a service (“IaaS”). SaaS allows customers to access applications on a provider’s cloud infrastructure through an interface such as a web browser. It is generally understood that SaaS transactions are the predominant cloud computing transaction. 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. IaaS allows customers to access processing, storage, networks, and other infrastructure resources on a provider’s cloud infrastructure.

A cloud computing transaction typically does not involve a transfer of a copyright right or copyrighted article or any provision of development services or know-how relating to computer programs or programming. The problem with issuing tax rules on cloud computing is that these transactions occur entirely in the virtual world, i.e., there is little connection between the revenue-generating activity with a particular geographic location. The potential incongruities between the source of revenue and geographic activity can yield no taxation at all or double taxation. There is an associated problem of classification of payment for cloud services.

The Proposed Cloud Computing Regulations

Proposed Regulations, in Prop. Reg. Section 1.861-19, provides specific rules for cloud transactions. The Treasury, in its proposed rulemaking, acknowledged that in general, a cloud transaction involves access to property or use of property, instead of the sale, exchange, or license of property, and therefore should be classified as either a lease of property or the providing of services. The Treasury then looked to Section 7701(e) and relevant case law that delineate the factors to be employed in characterizing a cloud computing transaction as either a lease of property or the rendition of services. In particular, Section 7701(e)(1) instructs that a contract that purports to be a service contract will be treated instead as a lease, if, based on all facts and circumstances: 1) the service recipient is in physical possession of the property, 2) the service recipient controls the property, 3) the service recipient has significant economic or possessory interest in the property, 4) the service provider does not bear any risk of substantially diminished receipts or substantially increased expenditures if there is nonperformance under the contract, 5) the service provider does not use the property concurrently to provide significant services to entities unrelated to the service recipient, and 6) the total contract price does not substantially exceed the rental value of the property for the contract period.

Internal Revenue Code Section 7701(e)(2) provides that the factors in Section 7701(e)(1) apply to determine whether any arrangement, not just contracts which purport to be service contracts, is to be treated as a lease. The list of factors is neither weighted, nor all-inclusive. In general, cloud computing will involve payment for the rendition of services but again, must be examined under the filter of each specific transaction and “all relevant” factors tested.

The Proposed Regulations define a “cloud transaction” to be “a transaction through which a person obtains on-demand network access to computer hardware, digital content (as defined in Section 1.861-18(a)(3)), or other similar resources, other than on-demand network access that is de minimis taking into account the overall arrangement and the surrounding facts and circumstances.” See Prop. Reg. Section 1.861-19(b). The preamble to the Proposed Regulations provides that examples include “streaming music and video, transactions involving mobile device applications, and access to data through remotely hosted software.” See REG-130700-14. However, a cloud transaction does not include “network access to downloaded digital content for storage and use on a person’s computer or other electronic device.” See Prop. Reg. Section 1.861-19(b).

The Proposed Regulations Definition of Digital Content

The Proposed Regulations defined “digital content” 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 (e.g., books, movies, and music in digital format). See Prop. Reg. Section 1.861-18(a)(3). The Proposed Regulations provide that the transfer of the “mere right” to publicly perform or display digital content for the purpose of advertising the sale of the digital content should not constitute the transfer of a copyright right. See Prop. Reg. Section 1.861-18(c)(2)(iii) and (iv). When copyrighted articles are sold and transferred through an electronic medium, the sale is deemed to occur at the location of download or installation onto the end-user’s device used to access the digital content for purposes of Treasury Regulation Section 1.861-7(c). See Prop. Reg. Section 1.861-18(f)(2)(ii). If there is no information on the location of download or installation onto the user’s device, then under the Proposed Regulations, the sale was deemed to have occurred at the location of the customer based on the taxpayer’s recorded sales data for business or financial reporting purposes. See Prop. Reg. Section 1.861-18(f)(2)(ii).

Sourcing Rules Under the Proposed Regulations For Cloud Computing Transactions

The U.S. source rules in general derive from an attempt to identify the geographic locus of the economic activity or financial arrangements that deductions and credits derive from inside or outside the United States. The source rules play a more prominent role in the taxation of foreign persons and corporations, since they effectively define the boundaries of U.S. taxation. Traditionally, services have been performed by individuals located at easily identified physical locations. In today’s internet-driven businesses, internet commerce poses a challenge to the application of the traditional sourcing rules. The Piedras Negras, 127 F.2d at 260-61 case provides useful guidance in determining the source of income for high tech companies. The Piedras Negras case involved a foreign radio station located close to the U.S. border that broadcasted programing targeted primarily at U.S. listeners. The majority of the foreign radio station’s income was derived from U.S. advertisers. The studio and broadcasting plant were located in a foreign country (Mexico) and the employment of capital and labor was outside of the U.S. The Fifth Circuit Court of Appeals stated that the source of income “is the situs of the income-producing service,” that is, the “services required of the taxpayer under the contracts.” Under these facts, the court held that there was no U.S. source income because the principal place of business was outside the U.S. and the labor and activities that produced the income were outside the U.S.

Piedras Negras continues to be relevant to technology companies today because it addresses issues that arise when a foreign corporation provides services in multiple locations. Importantly, the case held that the location of the customer is not relevant in determining the source of income. The Fifth Circuit Court of Appeals in Container Corp. v. Commissioner, No. 10-60515 (5th Cir. May 2, 2011) cited the Piedras Negras case in determining the source of income for guaranty fees and stated “[i]t is clear that the source of payments for services is where the services are performed, not where the benefit is inured.”

The source rules for gross income are organized by categories of income, such as interest, dividends, personal services income, rentals, royalties, and gains from the disposition of property. See IRC Sections 861 and 862. Since the source of income is determined according to the location where the income producing activity occurs (i.e., the location of the services required under the contract), the location of the employees that provide the service and the property used in the service are relevant. If all of a company’s employees and property are located in a foreign country, it normally should be easy to conclude that the source of compensation for services should be outside the U.S. However, additional questions can arise when contributions to the services are provided by third parties. For example, if a dependent agent A dependent agent is a person, whether or not an employee of the foreign enterprise, who is not an independent agent) conducts activities in the U.S. on behalf of the principal, income earned by the principal but which is generated in part by that agent’s activities could be deemed U.S. source income to that extent. Conversely, if a dependent agent is located in a foreign jurisdiction, then the income potentially could be classified as foreign source services income.

The Proposed Regulations propose a formula to determine the “place of performance” for sourcing income received from a cloud transaction which are categorized as the provision of services. The Proposed Regulations adopt a “taxpayer-by-taxpayer” approach for the sourcing with every regarded legal entity treated as an individual taxpayer. These rules focus on the economic contributions between parties and provide mathematical formulas to determine the source of income for purposes of U.S. taxation. Under the proposed regulations, income generated from cloud transactions is considered U.S.-source and therefore subject to U.S. taxation to the extent that non-U.S. business personnel, intangible property, and tangible property that contributed to income received from the transaction was located and/or performed in the United States.

Under Sections 861 through 865, a number of different rules apply to determine the source of income for U.S. tax purposes. Section 861(a)(3) of the Internal Revenue Code, gross income that is U.S. source income includes compensation for labor or personal services performed in the United States. However, Section 862(a)(3) excludes gross income from foreign sources for labor or personal services performed outside the United States. See IRC Sections 861(a)(3) and 862(a)(3). Therefore, if the services are performed in the United States, the income is U.S. sourced income and subject to U.S. federal income tax; if the services are performed outside the United States, then the income is foreign sourced income. If a portion of such taxable income was attributable to sources within the United States and a portion of the income was attributable to sources outside the United States, the portion attributable to sources within the United States could be determined by a formula of general apportionment.

In contrast to rules governing the source of services income, rules governing the source of rental income and royalty income are sourced according to the place in which the property is located or used. See IRC Sections 861(a)(4) and 862(a)(4). Case law and other authorities interpreting this standard as it applies to royalties do not provide a clear framework for the analysis. The gain from the sale of personal property, such as a sale of intangible property, is sourced according to the residence of the seller. See IRC Section 865(a). However, sales of the intangible are sourced in the same fashion as royalties. See IRC Section 865(d). On the other hand, sales of inventory property, such as the sale of a computer program at retail, are sourced where title passes. See IRC Sections 861(a)(6) and 862(a)(6); Treas. Reg. Section 1.861-18(f)(2). Finally, a foreign sourced gain may be recharacterized as a U.S. sourced gain if the sale is attributable to an office or fixed place of business in the United States. See IRC Section 865(e)(2).

The proposed regulations cited Internal Revenue Code Section 861(a)(3) and 862(a)(3) to state that gross income from a cloud transaction should be sourced according to where the services are performed.” To determine where services are performed, the Proposed Regulations adopt a formula that uses three factors: an intangible property factor, a personnel factor, and a tangible property factor and in each case the U.S. source portion thereof. The factors would be specified expense items.

For cloud transactions, the U.S. source portion of gross income would be determined by multiplying the gross income by a fraction known as the “apportionment fraction.” The numerator of which is the sum of the U.S. source portions of each of the three actors and the denominator of which is the sum of the three factors.

Expressed formulaically:

The above three factor test would apply to each cloud computing transaction.

The Intangible Factor

The first factor in the apportionment fraction is the intangible property factor. The intangible property is the sum of the specified research and experimental expenditures discussed in Section 174(b) of the Internal Revenue Code. Under the proposed regulations, the U.S. portion of the research and experimental expenditures must be apportioned in each cloud transaction for gross income allocation. See Prop. Reg. Section 1.861-19(d)(2)(i). The proposed regulations determine the U.S. source portion of the intangible property factor by multiplying the intangible property by a fraction. The numerator of the fraction would be the sum of the total compensation paid to research and experimental expenditures for services performed within the United States under the principles of the time basis rule. The denominator would be the total compensation paid for the research and experimental personnel. See Treas. Reg. Section 1.861-4(b)(2)(ii)(E).

Below, please find the Intangible Factor Test Expressed formulaically:

The Personnel Factor

The second factor in the apportionment fraction is the personnel factor. The personnel factor is the sum of the total compensation paid to all the entities’ employees whose direct service contributed to the cloud transaction. See Prop. Reg. Section 1.861-19(d)(3)(i). Compensation paid for research and expenditures are excluded from this personnel factor allocation. Personnel factor would be considered the direct contribution to the provision of a cloud transaction to the extent the personnel “personally perform technical or operational activities for the provision of the cloud transaction, or to the extent they are managers who directly support or immediately supervise such technical or operational personnel. The Proposed Regulations provides a comprehensive list of activities that would and would not be considered to contribute to a cloud transaction.

Under Proposed Regulation Section 1.861-19(d)(3)(i), activities that directly contribute to a cloud transaction:

1. Conduct of scientific, engineering, or technical activities for the configuration, delivery, or maintenance of the cloud transaction;
2. Provision of monitoring, diagnostic, or incident response with respect to the cloud transaction’s performance, reliability, efficiency, or security;
3. Management of cloud transaction’s infrastructure;
4. Delivery of end-user support with respect to the cloud transaction; and
5. Similar function.

Under Proposed Regulation Section 1.861-19(d)(3)(iv), activities not directly contributing to the provision of a cloud transaction.

1. Business strategy;
2. Leadership;
3. Legal or compliance;
4. Marketing;
5. Communications;
6. Sales;
7. Business development;
8. Finance;
9. Accounting;
10. Clerical;
11. Human resources or administration;
12. Similar function.

Compensation paid to an employee whose primary function is to directly contribute to a cloud transaction must be allocated. The allocation is based on the relative amount of time the employee spends contributing to the cloud transaction instead of the gross income generated by the cloud transaction. The U.S. source portion of the personnel factor is equal to that factor part of the services performed in the United States based on a time basis rule. See Prop. Reg. Section 1.861-19(d)(3)(ii). This means, in the context of a cloud transaction, the personnel factor is determined by multiplying the personal factor by a fraction in which the numerator is the sum of the total compensation paid to personnel services performed within the United States and the denominator being the total sum of compensation paid to such personnel. See Treas. Reg. Section 1.861-4(b)(2)(ii)(E).

If the proposed regulations are finalized by the IRS, the personnel factor rule will necessitate rigorous tracking of employee time. Business will also be required to determine whether and to what extent employees worked on cloud transactions and where that work occurred.

Below, please find the Personal Factor Test Expressed formulaically:

The Tangible Factor

The third factor in the apportionment fraction is the tangible factor. The tangible property factor would equal the sum of (1) the depreciation expense for the taxable year for tangible property and 2) rental expenses for the year the tangible property is leased. 103. Expenses would be included in the tangible property factor to the extent it is directly provided to the cloud transaction. See Prop. Reg. Section 1.861-19(d)(4)(i). Expenses relevant to more than one cloud transaction would be allocated among the cloud transactions based on a relative gross income portion that is received from each cloud transaction. The U.S. source portion of the tangible property factor would equal the part of the factor attributable to the property located within the United States.

Below, please find the Tangible Factor Test Expressed formulaically:

In determining the tangible property factor, the depreciation system described in Section 168(g)(2) would be required to be utilized. See Prop. Reg. Section 1.861-19(d)(4)(iii).

Anti-Abuse Rule

The proposed regulations contain a general anti-abuse rule, which would permit the IRS to adjust the sourcing of an individual’s or entity’s income if transactions are structured with a principal purpose of reducing U.S. tax liability in a manner that is inconsistent with the regulation’s intent.

The Final Cloud Computing Regulations

On January 14, 2025, the IRS and the Department of Treasury finalized the final cloud transactions. The final regulations defined the terms “digital content transaction” and “cloud transaction.” The final regulations defined the terms “digital content transaction” and “cloud transaction” as the transfer of digital content or the provision of modification or development services or of know-how with regard to digital content. The final regulations define a “cloud transaction” as a transaction through which a person obtains on-demand network access to computer hardware, digital content, or other similar resources, other than on-demand network access that is de minimis taking into account the overall arrangement and surrounding facts and circumstances. On-demand access may be distinguished from transactions whose predominant character involves downloading a program to the user’s own computer or transferring rights in the content that extend beyond online use. The final regulations also modify Treasury Regulation Section 1.861-18 to include the transfer of all manner of digital content so that it is no longer limited to computer programs. The final regulations introduced the following changes to the 2019 proposed regulations.

Below are the significant changes that the final regulations made to cloud transactions and digital content.

1. Cloud Transactions as Services.

In a departure from the Proposed Regulations, all cloud transactions will be classified solely as the provision of services. There will be no need to perform an analysis to distinguish between services and a lease to determine how a cloud transaction is taxed.

2. Definition of Digital Content

The final regulations extended the scope of the Proposed Regulations in Treasury Regulation Section 1.861-18 to transactions involving “digital content.” The final regulations do not expand the definition of digital content. However, the final regulations have expanded the scope of “digital content” to include any content in digital format that is either protected by copyright law, no longer protected by copyright law solely due to the passage of time or because the content was dedicated (or passed) to the public domain.

The final regulations define “cloud transactions” as a transaction through which a person obtains on-demand network access to computer hardware, digital content or other similar resources, but does not include network access for the purpose of downloading digital content for storage and use on a person’s computer or other electronic device.

The final regulations have introduced a new predominant character rule. Under the new predominant character rule, a transaction that has multiple elements is classified in its entirety as a digital content or cloud transaction if the predominant character is a digital content or cloud transaction. The predominant character is generally determined by the primary benefit or value received by the customer in the transaction. If that is not reasonably determinable, the predominant character is determined based on the primary benefit or value received by a typical customer in a substantially similar transaction.

The final regulations also include a new change that was not in the proposed regulations. This change is the replacement of the “de minimis” standard with the “predominant character” standard. The prior de minimis standard sets a relatively low floor (i.e., a minimal or insignificant level) above which a component element in a multi-element transaction may need to be treated as a separate transaction in its own right. By contrast, the new predominant character standard seeks to determine the primary benefit or value received by the “customer” in a multi-element transaction between two parties. When ascertained, such primary benefit or value to the customer will be the transaction’s predominant character and, if such predominant character is a digital content or cloud transaction, the transaction “in its entirety” (including all of its elements) will be characterized as such.

3. Distinction Between Temporary Downloads and Streaming

The final regulations provide a distinction between temporary downloads and streaming. This means that temporary downloads that involve a transfer of digital content could be classified as the transfer of a copyrighted article. In other words, a temporary download could result in a rental or lease income. However, when a customer streams digital content, the provider may merely be providing a service. In essence, the distinction between temporary downloads and streaming lies in the actual transfer and possession of the digital content. Temporary downloads will likely be treated like a transfer of copyrighted materials, while streaming will likely be considered a service providing access. The final regulations’ new predominant character rule will classify transactions that will include elements of both temporary downloads and streaming.

4. Sourcing Rules

New sourcing rules were provided by the final regulations such that when a copyrighted article is sold and transferred through an electronic medium, the sale is deemed to have occurred at the location of the purchasers’ billing address for purposes of Treasury Regulation Section 1.861-7(c).

Treasury Regulation Section 1.861-19 provides rules that generally classify all cloud transactions as services income. Eliminating a delineation made in the 2019 proposed regulations between lease and services income. A cloud transaction is defined as a transaction through which a person obtains on-demand network access to computer hardware, digital content (as defined in Treasury Regulation Section 1.861-18(a)(2)), or other similar resources. A cloud transaction does not include network access to download digital content for storage and use on a person’s computer or other electronic device. Income from sales of downloads copyrighted articles will be sourced based on the billing address of the immediate purchaser of the article, rather than on where the ultimate end-user downloads or installs the article.

The Final Regulations Discuss the Application Predominant Character Standard in Cross-Border Digital Transaction

The final regulations amend many of the illustrative examples in Treasury Regulation 1.861-18 and 19 and add several new ones. Example 20 contained in the final regulations discusses the application of predominant character standard in a digital transaction.

Example 20: Internet platform operator as agent for application developers-

(i) Facts. Corp A operates a platform on the internet that offers applications for download onto a customer’s mobile phone. Under general tax principles, Corp A and an application developer establish an agency relationship whereby Corp A acts as the agent to offer the application for sale to customers on behalf of the application developer. The applications are protected by copyright law. Under the agreement between Corp A and the application developer, Corp A agrees to provide the application developer with platform and agency services to facilitate the sale of the application to customers. Corp A also provides the application developer with hosting services to host the application on Corp A’s servers for download by the customers. Corp A receives a digital master copy of the application along with a non-exclusive right to make copies of the application and allow customers to download copies of the application from Corp A’s platform. Corp A has ascertained that the primary benefit or value from the transaction received by the application developer is the platform and agency services that Corp A provides. Corp A receives the right to make copies of the application merely to perform its activities as an agent on behalf of the application developer. When purchasing an application on Corp A’s platform, the customer must acknowledge the terms of a license agreement with the application developer that states that the customer may use the application but may not reproduce or distribute copies of it. In addition, the agreement provides that the customer may download the application onto only one mobile phone at a time. A customer does not need to be connected to the internet to access the application. The customer owes no additional payment to Corp A or the application developer for the ability to use the application in perpetuity. Corp A retains a fixed percentage of each purchase price of the application and remits the remaining balance to the application developer.

(ii) Analysis.

(A) The transaction between Corp A and the application developer has multiple elements. One element is the transfer of a master copy of an application by the application developer to Corp A, which would be described in paragraph (b)(1)(ii) of this Section [1.861-18] (transfer of a copyrighted article) if considered separately. Another element is the transfer of the right to make and distribute copies of the application by the application developer to Corp A, which would be described in paragraphs (b)(1)(i) and (c)(2) of this section (transfer of a copyright right) if considered separately. A fourth element is the hosting services provided by Corp A to the application developer, which would be described in Section 1.861-19 if considered separately. Under the facts and circumstances, although Corp A receives a copy of the application and the right to make and distribute copies of the application, Corp A receives this copy and right merely to facilitate the sale of applications on behalf of the application developer.

(B) Because the transaction has multiple elements, one or more of which would be a digital content transduction if considered separately, paragraph (b)(2) of this section provides that the transaction is classified within a single category under the categories described under paragraph (b)(1) of this section if its predominant character is described in that paragraph. Pursuant to paragraph (b)(3) of this section, the predominant character of the transaction is based on the primary benefit or value of the transaction to the customer [the application developer in this transaction], if it is reasonably ascertainable.

(C) The transfer of a copy of an application from the application developer to a customer [the end-user in this transaction] is a digital content transaction with one element, which is the transfer of a copy of a digital program. Therefore, the transaction is treated solely as a transfer of a copyrighted article under paragraph (b)(1)(ii) of this section. Under the benefits and burdens test of paragraph (f)(2) of this section, this transaction is a sale of a copyrighted article because a customer has the right to use the application in perpetuity.

In Example 20’s analysis, there are only two transactions. The first is the 4-element transaction between the app developer and Corp A, analyzed in clauses (A) and (B). The second is the single-element transaction between the app developer and the end-user, analyzed in clause (C).The following preliminary observations have been made:

1. By finding that the grant of a license by the app developer to Corp A is a transfer of a copyright, within the meaning of Treasury Regulation 1.861-18(b)(1)(i) and (c)(2)(i), Example 20 perhaps reads the definition too narrowly. It fails to take into account that transfers of a copyright right to make and distribute copies are typically for the purpose of allowing the licensee to commercially exploit the license for its own account (i.e., for its own profit). Without this purpose, it should not be possible for such a copyright right to be transferred.

2. With respect to the second transaction in which the app (i.e., copyrighted article) is transferred to the purchaser of the app, Example 20 looks through Corp A due to its agency relationship with the app developer. Example 20 assumes the existence of this relationship under general tax principles without analysis. The final regulations explain that the assumption is made because such an analysis is outside the scope of the final regulations.

3. Under general tax principles, an agent’s activities are generally imputed to its principal. If the agent conducts its activities in the U.S. on behalf of a nonresident principal who otherwise lacks a physical presence in the U.S., the principal may be deemed to be engaged in the conduct of a U.S. trade or business through the agent, provided that the agent’s activities in the U.S. are considerable, continuous, and regular. If a U.S. trade or business is found, the ECI would be subject to U.S. income tax on a net basis at a rate of 21% if the principal is a non-U.S. corporation.

Conclusion

The foregoing is intended to provide the reader with a basic understanding how digital content and cloud transactions are taxed under the newly released final regulations and proposed sourcing regulations to determine the source of income from a cloud transaction. It should be evident from this article that this is a complex area of tax law and that this area of tax law is subject to constantly new developments and changes. Consequently, it is crucial that U.S. and foreign digital content creators should review their particular circumstances with a qualified U.S. international tax attorney.

Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi & Liu, LLP. Anthony has substantial experience advising foreign and domestic technology companies regarding the U.S. tax consequences of digital content and cloud transactions. Anthony has written numerous articles on international tax planning and frequently provides continuing educational programs to other tax professionals.

He has assisted companies with a number of international tax issues, including Subpart F, GILTI, and FDII planning, foreign tax credit planning, and tax-efficient cash repatriation strategies. Anthony also regularly advises foreign individuals on tax efficient mechanisms for doing business in the United States, investing in U.S. real estate, and pre-immigration planning. Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or adiosdi@sftaxcounsel.com.

This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.