Digital Borders and the New Proposed Regulations for the Sourcing Cloud Computing Transactions

The United States taxes U.S. persons on all of their income, from whatever source derived. Therefore, the source of income generally has no effect on the computation of a U.S. person’s taxable income. Sourcing can have a significant effect, however, on the computation of a U.S. person’s foreign tax credit limitation, which equals the portion of the pre-credit U.S. tax that is attributable to foreign source income. The source rules play a more prominent role in the taxation of foreign persons, since they effectively define the boundaries of U.S. taxation. The United States taxes the gross amount of a foreign person’s U.S.-source nonbusiness income at a flat rate of 30%. The United States taxes foreign persons at graduated rates on the net amount of income effectively connected with the conduct of a U.S. trade or business. Thus, the United States generally taxes the U.S.-source income of foreign persons and generally exempts their foreign-source income.

Source Rules for Gross Income

The sourcing 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. The first step in the sourcing process is to determine the applicable category for the item of income at issue. Classification of income is very important for purposes of the sourcing rules. Traditionally, a transaction involving computer programs can be classified as one of the following:

1. A transaction of a copyright right in the computer program;
2. A transfer of a copy of the computer program (a copyrighted article);
3. The provision of services for the development or modification of the computer program; or
4. The provision of know-how relating to computer programming techniques.

For purposes of the sourcing rules, transactions involving mass-marketed software generally are classified as transfers of copyrighted articles, that is, a transfer of inventory. Under the traditional sourcing rules, the source of income derived from the transfer of a copyrighted article is determined under the rules applicable to a sale of tangible personal property if the underlying license is perpetual and a lease of tangible personal property if the use of the copyrighted article is limited in term. The former is sourced under the title passage rule and the latter is sourced under a place of use rule.

Once a determination has been made regarding the appropriate category of income, the next step is to apply the applicable source rule to classify the item of income as either U.S. or foreign source income.

Personal Services Income

Compensation for personal services performed in the United States is U.S.-source income, and compensation for personal services performed outside the United States is foreign-source income. Personal services income includes salaries, wages, fees, and commissions, including any payment that an employer receives as compensation for services performed by employees or other agents.

Sourcing Rules Under the Proposed Regulations For Cloud Computing Transactions

The Proposed Cloud 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.

Conclusion

The proposed cloud regulations governing the sourcing of cloud computing transactions would apply on a taxpayer-by-taxpayer basis. For purposes of sourcing cloud transactions in which sourcing of services, how services are taxed will depend on the three factors discussed above which includes the Intangible Property Factor, Personnel Factor, and the Tangible Property Factor. For purposes of determining the sourcing of services, only the assets and personnel of the entity in question would be considered. The new anti-abuse rules contained in the proposed regulations are designed to prevent manipulation to avoid U.S. taxation or obtain improper U.S. tax benefits. If finalized, the proposed cloud regulations will impose significant record-keeping burdens to substantiate the allocation of services. The proposed regulations may also require U.S. and foreign companies to implement and manage a Know Your Customer (“KYC”) program to verify client identities.

Through the proposed regulations, the IRS has put the cloud industry on notice that the way U.S. taxes cloud computing transactions will dramatically change. The same can be said for the way cloud computing transactions will be disclosed to the IRS. It is important to note that this area is constantly subject to new development and changes, as the IRS entertains new regulations and announcements in the taxation of cloud computing transactions.

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 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.