Potential U.S. Tax Consequences for Foreign App Developers that Utilize U.S. Platforms to Sell Apps to Customers

On January 14, 2025, the Internal Revenue Service (“IRS”) and the Department of Treasury made significant changes to the digital content and cloud regulations. For this purpose, digital content means a computer program or any other content, such as books, movies, and music, in digital format that is protected by copyright law or no longer so protected solely due to the passage of time or because the creator dedicated the content to the public domain. A cloud transaction is a transaction through which a person obtains on-demand network access to computer hardware, digital content, or other similar resources. For the most part, the 2025 final regulations follow 2019 proposed regulations with a few important revisions. This article discusses the key changes the 2025 regulations made to the 2019 proposed regulations governing the taxation of digital content and cloud transactions. This article also discusses the tax consequences to foreign application developers that utilize U.S. platforms to facilitate the sale of apps to customers.

Taxation of U.S. Persons in Connection with Income Received from Digital Content or Cloud Transactions

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. All income worldwide received by a U.S. person from a digital content or cloud transaction is subject to U.S. taxation.

Taxation Non-Residents by the United States in connection with Digital Content or Cloud Transactions is Limited to U.S. Source Income

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. 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.

Income received by nonresidents from U.S. source 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. Income from services performed outside the United States (with exceptions discussed below) are not subject to U.S. taxation.

Historical Rules Governing the Source of Income from Leases, Licenses, and Services

Historically, 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.

Summary of the Software Rules

The “Software Rules” are set forth in Treasury Regulation Section 1.861-18. The Software Rules are limited to transactions involving computer programs. Treasury Regulation Section 1.861-18(a)(3) defines the term “computer program” as “a set of statements or instructions to be used directly or indirectly in a computer in order to bring about a certain result. A computer program includes any media, user manuals, documents, data base or similar item if the media, user manuals, documentation, data base or similar item is incidental to the operation of the computer program.

The Software Rules provides that a transaction is characterized based on its substance, not solely on the description of the transaction in the agreements. The Software Rules provide that it is necessary to determine the substance of the transaction in order to determine the character of a transaction and the income related to such a transaction. See Treas. Reg. Section 1.861-18(g). The 2019 Proposed Regulations extended the application of Treasury Regulation Section 1.861-18 expanded the definition to include certain “digital content” transactions. For purposes of the Proposed 2019 Regulations, the term “digital content” is defined as “a computer program or other content, such as books, movies, and music, in digital format that is either protected by copyright law solely due to the passage of time or because the creator dedicated the content to the public domain.” See Treas. Reg. Section 1.861-18(a)(2). The Final Digital Content Regulations added the reference to digital content not being protected by copyright law solely because the creator dedicated the content to the public domain.

As a general rule, the Software Rules classify any transaction involving the transfer of a computer program as includable in one of the following four categories categories:

1. Transfer of All Substantial Rights in a Copyright Right

Under a transfer of a copyright right, a transfer is treated as a transfer of copyright rights if, as a result of a transaction, a person acquires any of the following: 1) the right to make copies of the computer program for purposes of distribution to the public by sale or other transfer of ownership, or by rental, lease, or lending; 2) the right to prepare derivative computer programs based upon the copyrighted computer program; 3) the right to make a public performance of the computer program; or 4) the right to publicly display the computer program. For the transfer of copyright rights to be characterized as a sale, it must be a transfer of “all substantial rights” which essentially requires the transfer to be exclusive and to be the remainder of the left of the copyright.

According to the regulations promulgated at the time, the following was an example of a transfer of all substantial rights in a copyright right: Corp A owns the copyright in a computer program, Program X and Corp A transfers a disk containing Program X to Corp B, a Country Z corporation, and grants Corp B “an exclusive license for the remaining term of the copyright to copy and distribute an unlimited number of copies of Program X in the geographic area of Country X, prepare derivative works based upon Program X, make public performances of Program X and publicly display Program X. Corp B will pay Corp A royalty of $y a year for three years which is the expected period during which Program X will have commercially exploitable value. The example states that the transfer should be treated as a sale by Corp A because Corp A transferred to Corp B copyright rights and Corp B received the right to use it exclusively in Country Z and for the remaining life of the copyright. As a result, there was a transfer of all substantial rights in the copyright right.

2. Transfer of a Copyright Article

Under a transfer of a copyrighted article, a transfer is treated as a transfer of a “copyrighted article” if a person acquires a copy of a computer program but does not acquire any of the copyright rights and the transfer does not involve, or involves a de minimis, provision of services. See Treas. Reg. Section 1.861-18(c)(1)(ii). To be treated as a sale, there must be a transfer of the benefits and burdens of ownership in the copyrighted article. The regulations provided a detailed example of a transfer of a copyrighted article that should be treated as a sale. According to the example, Corp A owns the copyright in a computer program (“Program X”) and copies Program X onto disks. The disks are placed in boxes covered with a wrapper on which is printed what is generally referred to as a “shrink wrap license.” The license is stated to be perpetual. The transferred receives the right to use the program on two of its own computers, the right to make one copy of the program on each machine as an essential step in using the program, and the right to make one copy of the program on each machine as an essential step in using the program, and the right to resell the copy of the program so long as it destroys any other copies it has made. P, a resident of Country X receives a disk. This example concluded that the label “license” is not determinative and that since none of the copyright rights have been transferred to P, P has acquired a copyrighted article. Consequently, under this example, there was a sale of a copyrighted article and Corp A realized sale income. See Treas. Reg. Section 1.861-18(h), Example 1.

3. The Provision of Services for the Development or Modification of Computer Programs

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. The determination of whether a transaction is treated as either the provision of services of another transaction is based on all the facts and circumstances of the transaction, including appropriate, the intent of the parties (as evidenced by their agreement and conduct) as to which party is to own the copyright rights in the computer program and how the risks of loss are allocated between the parties. See Treas. Reg. Section 1.861-18(d).

The Software Rules provided the following example of a transaction that should be treated as a provision of services: Corp H, a Country Z corporation, enters into a license agreement for a new computer program, Program Q. Program Q is to be written by Corp A and the parties agree that when Program Q is completed, the copyright in Program Q will belong to Corp H. Corp H agrees to pay Corp A a fixed monthly sum during development of the program. All of the payments are labeled royalties. The example concludes that taking into account all of the facts and circumstances, Corp A is treated as providing services to Corp H because Corp H bears all of the risks of loss associated with Program Q and is the owner of all copyright rights in Program Q. See Treas. Reg. Section 1.861-18(h), Example 15.

4. The Provisions of Know-How Relating to Computer Programing Techniques

The provisions of know-how relating to computer programming techniques describe the transfer of specialized, practical knowledge that is not widely known. This can occur through training, demonstration, documentation, or other means. Under Software Rules, a computer program is treated as know-how if it 1) relates to computer programming techniques; 2) is furnished under conditions preventing unauthorized disclosure, specifically contracted for between the parties; and 3) is considered property subject to trade secret protection.

Cloud Computing and Digital Content

The 2019 Proposed Regulations defined a “cloud transaction” to be “a transaction through which a person obtains on-demand network access to computer hardware, digital content, or 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 Proposed Regulations discuss examples of “streaming music and video, transactions involving mobile device applications, and access to data through remotely hosted software.”

The 2019 Proposed Regulations provide that a cloud transaction is classified as either a lease of property or provision of services, taking into account all relevant factors. Under the 2019 Proposed Regulations, if a transaction is composed of multiple cloud computing transactions, then each transaction requires a separate classification unless any transaction is de minimis. The final regulations issued in 2025 classifies all cloud transactions as services. Consequently, there is no longer a need to determine if a cloud transaction should be classified as a lease of property or services.

The New “Predominant Character” Rule

Where a transaction consisted of more than one of the four types of transactions discussed above, the prior regulations required that each transaction should be treated as a separate transaction, unless any transaction was de minimis. In such cases, any such de minimis transaction was required to be treated as part of another transaction. Whether a transaction was de minimis was determined by “taking into account the overall transaction and surrounding facts and circumstances.” See Treas. Reg. Section 1.861-18(b)(2). Prior to January 14, 2025, the regulations generally required taxpayers to bifurcate transactions into their component parts, and to separately apply the regulations to each component part, unless any such part was de minimus. The Treasury and the IRS replaced the bifurcation de minimis approach with a new predominant character rule. The new predominant character rule applies for purposes of the final digital content regulations.

The “predominant character” of a transaction that contains multiple elements, one or more of which would be a digital content transaction or a cloud transaction if considered separately, generally is determined by reference to “the primary benefit or value received by the customer in the transaction” under Treasury Regulation Section 1.861-18(b)(3)(i). If the primary benefit or value to the customer cannot be reasonably ascertained under the general rule, the predominant character rule looks to the primary benefit or value by “a typical customer in a substantially similar transaction.” See Treas. Reg. Section 1.861-18(b)(3)(ii). This is typically done by reviewing data as to how a typical user uses or accesses the digital data. See Treas. Reg. Section 1.861-18(b)(3)(ii)(A). If data is unavailable, other facts should be considered such as the primary benefit or value received by a typical customer under Treasury Regulation Section 1.861-18(b)(3)(ii)(B) which includes: 1) how the transaction is marketed; 2) the relative development costs of each element of the transaction; and 3) the relative price paid in an uncontrolled transaction for one or more elements to the total contract price of the transaction in question.

New Source Rule

The final digital content regulations provide a new source rule for sales of copyrighted articles transferred through an electronic medium. Under the new source rule of Treasury Regulation Section 1.861-18(f)(2)(ii), when a copyrighted article is sold and transferred through an electronic medium, the sale is deemed to have occurred at the location of the billing address of the purchaser as a proxy for title passage for purposes of Treasury Regulation Section 1.861-7(c). The new sourcing rules contain an anti-abuse rule. The new anti-abuse rule provides as follows: if a digital content transaction is arranged in a particular manner for ‘a’ principal purpose of tax avoidance, the purchaser’s billing address for -18 purposes is determined by the “facts and circumstances” of the transaction overall. The “facts and circumstances” test considers where copyrighted articles will be used, the place where negotiations and the execution of the agreement occurred, and the terms of the agreement.

Final Digital Content Regulations Discussing U.S. Platform Operators Acting as An Agent For Foreign Application Developers

The Final Digital Content Regulations have added new Example 20. Example 20 discusses the U.S. tax consequences to foreign application developers when an agency relationship is developed with a U.S. platform operator.

Example 20 provides as follows:

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.

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). We have made the following preliminary observations:

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 (Foreign app developer) 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 (“USTB”) through the agent, provided that the agent’s activities in the U.S. are considerable, continuous, and regular. If a USTB is found, the effectively connected income 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. Many of the cases that have examined whether a U.S. person was an agent of a nonresident principal to create a USTB do not describe the basis for their conclusions. However, some criteria have emerged from other court decisions. Based on common law agency principles, these criteria are: (i) the existence of a contract between the parties; (ii) the agent’s power to bind its principal with third parties; (iii) the existed of fiduciary relationship between the parties; and (iv) the right of the principal to control the agent’s conduct on matters entrusted to it. Of these four criteria, the agent’s power to bind the principal with third parties is the key criterion.

Conclusion

The foregoing is intended to provide the reader with a basic understanding how digital content is taxed under the newly released regulations. The newly released regulations contained Example 20 which involves a platform operator acting as an agent for application developers. The facts provide that “under general tax principles” the platform operator (Corp A) and the app developer establish an agency relationship whereby Corp A acts as an agent to offer the application for sale to customers on behalf of the application developer. In Example 20, whether a U.S. taxpayer is acting as an agency of a foreign app developer is determined under general tax principles. Under general tax principles, this type of agency arrangement can result in the foreign app developer having an unexpected USTB and associated U.S. tax consequences. Foreign app developers utilize U.S. hosting services or are planning to utilize U.S. hosting services should consult with a qualified U.S. tax attorney to determine if such an agency relationship could trigger a U.S. tax consequence.

Anthony Diosdi is an international tax attorney 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.