By Anthony Diosdi
On August 9, 2019, the U.S. Treasury Department and the Internal Revenue Service (“IRS”) released proposed regulations characterizing cloud computing transactions and “transactions involving digital content.” See Prop. Reg. Sections 1.861-18 and 1.861-19. The proposed regulations modify the current “Software Rules” that govern the taxation of computer programs and transfer of digital content. This article will discuss these new proposed regulations and potential cross-border tax planning opportunities available to businesses involved in cloud computing and digital downloads.
An Overview of Current Regulations Promulgated by the Treasury Department and the IRS Regarding the So-Called “Software Rules”
The current Income Tax Regulations enumerated in Treasury Regulation Section 1.861-18 otherwise known as the “Software Rules” govern the taxation of transactions involving computer programs. These Software Rules provide guidance on how to classify and source income from transactions involving “computer programs.” In the past, computer programs were generally protected by copyright law. Consequently, the rules for characterizing computer program transactions were guided by copyright principles found in both U.S. and foreign copyright laws. See T.D. 8785, 1998-2 C.B. 494, 495. Copyright law generally protects computer programs and distinguishes between transactions in a copyright and in the subject of a copyright. Copyright law generally protects computer programs and distinguishes between transactions in a copyright and in the subject of the copyright. Under U.S. copyright law, exclusive rights, such as the right to reproduce copies of the copyrighted works, are granted to the owner of a computer program copyright. In contrast, the purchaser of a copy of a computer program generally possess only the right to sell or use the copy. Under the Treasury Regulation Section 1.861-18(c)(2), a transfer of copyrights will occur if the transferee obtains any of the following:
1. The right to make copies of the computer program to distribute to the public, for sale, or other transfer of ownership, or by rental, lease or lending;
2. The right to prepare derivative computer programs based upon the copyrighted program;
3. The right to make a public performance of the program; or
4. The right to publicly display the program.
If there has been a transfer of a copyright rights, the issue is whether the transfer is a sale, generating gain or loss, or a license, generating royalty income. The transaction will be a taxable sale if, taking into account all of the facts and circumstances, all substantial rights in the copyright have been transferred. The principles under Internal Revenue Code Section 1222 relating to capital gains and losses and Internal Revenue Code Section 1235 relating to the sale or exchange of patents may be applied when determining whether all substantial rights have been transferred. See Treas. Reg. Section 1.861-18(f)(1).
If the transferee acquires a copy of a computer program, but does not acquire any rights listed above, the transaction is characterized as a transfer of a copyrighted article. A copyrighted article is a copy of a computer program from which work can be perceived, reproduced or otherwise communicated. See Treas. Reg. Section 1.861-18(c)(3). Further, the electronic transfer of software can constitute the transfer of copyrighted articles. See Treas. Reg. Section 1.861-18(g)(2). Once it has been determined that there has been a transfer of a copyrighted article, an analysis of the facts and circumstances, including the intent of the parties as evidenced by their agreement and conduct, may lead to the conclusion that the transaction involves the provision of services. See Treas. Reg. Section 1.861-18(f)(2). If a transaction does not constitute a sale because insufficient benefits and burdens of ownership of the copyrighted article have been transferred, it will be classified as a lease generating rental income. See Treas. Reg. Section 1.861-18(f)(2).
The New Proposed Regulations Enacted by the Treasury Department and the IRS Regarding Cloud Computing and Digital Transactions
The current Software Rules governing the taxation of all electronic downloads and transactions were enacted in 1998. At that time, much of the technology used in today’s e-commerce did not exist. This is apparent in the way the Software Rules define the term “computer program” for purposes of an electronic transaction. According to the regulations, a “computer program” includes “a set of statements or instructions to be used directly or indirectly in a computer in order to bring about a certain result.” This includes “any media, user manuals, documentation, data base or similar item if * * * [they are] incidental to the operation of the computer program.” See Treas. Reg. Section 1.861-18(a)(3). Because cloud technology was still in its infancy and commercially undeveloped when the regulations under Section 1.861-18 were promulgated, these regulations do not provide any guidance for cloud based computing.
The new proposed regulations have attempted to keep up with technology. The proposed regulations have provided some clarity for taxing cloud computing transactions and other transactions involving on-demand network access. The proposed regulations also extend the classification rules in the Software Rules to transfers of “digital content” other than computer programs. The proposed regulations define “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. This includes books, movies, and music in digital form. See Prop Reg. Section 1.861-18(a)(3).
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, 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(h). The proposed regulations also provide examples of “cloud transactions” which includes streaming music and video, transactions involving mobile device applications, and access to data through remotely hosted software.
Cloud computing transactions are typically what has been known in the industry as: Software as a Service (“SaaS”), Platform as a Service (“PaaS”) and Infrastructure as a Service (“IaaS”). Computing transactions involving Saas, PaaS, and IaaS do not typically involve the transfer of a copyright. As discussed above, the transfer of a copyright became the basis of the taxation of a download or digital transaction. In order to take into consideration the changes in computing transactions and digital downloads,
the proposed regulations no longer utilizes the transfer of copyright rights test discussed in Treasury Regulation Section 1.861-18(c)(2) to determine if a taxable transfer has taken place.
Instead, the Proposed Regulations provide that a cloud transaction is classified as either a lease of property or the provision of services, taking into account all relevant factors. See Treas. Reg. Section 1.861-19(c). If a transaction is comprised of multi cloud computing transactions, then each transaction requires a separate classification unless any transaction is de minimis. See Prop Reg. Section 1.861-19(c)(3). Proposed Regulation Section 1.861-19 provides that the following factors are relevant for this determination:
1. The customer is not in physical possession of the property;
2. The customer does not control the property, beyond the customer’s network access and use of the property;
3. The provider has the right to determine the specific property used in the cloud transaction and replace such property with comparable property;
4. The property is a component of an integrated operation in which the provider has other responsibilities, including ensuring the property is maintained and updated;
5. The customer does not have a significant economic or possessory interest in the property.
6. The provider bears any risk of substantially diminished receipts or substantially increased expenditures if there is nonperformance under the contract;
7. The provider uses the property concurrently to provide significant services to entities unrelated to the customer;
8. The provider’s fee is primarily based on a measure of work performed or the level of the customer’s use rather than the mere passage of time; and
9. The total contract price substantially exceeds the rental value of the property for the contract price.
Certain cloud transactions that have characteristics of both a lease and services will be classified in their entirety as one or the other and the whole will not be bifurcated into two proportionate transactions. If an arrangement involves a cloud computing transaction and non-cloud computing (e.g., software), the proposed regulations provide that the classification rules apply only to classify the cloud transaction, and any non-cloud transaction will be classified separately under such other section of the Internal Revenue Code, regulations, or under general tax law principles. The uncertainty to this general rule is if a transaction is comprised of multiple cloud computing transactions, then each transaction requires a separate classification.
New Single Source of Income for Downloads of Digital Content
The proposed regulations provide a new source rule for transactions in the cloud involving the sale of digital content. Income earned from the performance of “services” is sourced according to the place of performance. See IRC Sections 861(a)(3) and 862(a)(3). Consequently, 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. Determining where digital services are performed, and thus the source of the income derived in connection with such services, can be difficult. For example, computer equipment that facilitates delivery of the digital product might be located in one country, and employees that maintain and monitor such equipment might be located in another country, and the coders who developed the software might reside in a third country.
Income earned from rents and royalties (the term “royalties” is often referred to as “amounts received for the privilege of using patents, copyrights, trademarks, and franchises) are sourced according to the place in which the property is located or utilized. If a copyrighted article is 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. See Prop. Reg. Section 1.861-18 and Treas. Reg. Section 1.861-7(c). If no information is available on the location of download or installation onto the end user’s device, then the sale is 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. 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. On the other hand, sales of inventory property, such as the sale of a computer program at retail, are sourced where title passes. 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.
Implications of the New Single Source Rule in the Context Cross-Border Cloud Computing Transactions and Digital Downloads
Outbound Tax Planning Considerations
The new sourcing rules will enhance the ability of U.S. companies to utilize the new foreign derived intangible income (“FDII”) planning rules enacted under under the 2017 Tax Cut and Jobs Act. FDII is available to U.S. domestic corporations that are taxed as C corporations. FDII allows U.S. corporations that sell goods and/or provide services to foreign customers to reduce its effective tax rate to 13.125 percent on qualifying income.
The FDII benefit is determined based on a multi-step calculation. First, a domestic corporation’s gross income is determined and then reduced by certain items of income, including amounts included in income under Subpart F, dividends received from controlled foreign corporations (“CFC”), and income earned in foreign branches. This amount is reduced by deductions properly allocable to such income, yielding deduction eligible income.
Second, the foreign portion of such income is determined. This amount includes any income derived from the sale of property to any foreign person for a foreign use. The term “sale” is specifically defined for this purpose to include any lease, license, exchange, or other disposition. “Foreign use” is defined to mean “any use, consumption, or disposition which is not within the United States.” Qualifying foreign income also includes income derived in connection with services provided to any person not located within the United States, or with respect to property that is not located in the United States. The services may be performed within or outside the United States. The gross foreign sales and services income is reduced by expenses properly allocated to such income. The sum of these two amounts yields foreign-derived deductible eligible income.
Third, a domestic corporation’s deemed intangible income is determined. This is the excess (if any) of the corporation’s deduction eligible income over 10 percent of its qualified business asset investment (“QBAI”). A domestic corporation’s QBAI is the average of its adjusted bases (using a quarterly measuring convention) in depreciable tangible property used in the corporation’s trade or business to generate the deduction eligible income. The adjusted bases are determined using straight line depreciation. A domestic corporation’s QBAI does not include land, intangible property, or any other assets that do not produce the deductible eligible income.
The FDII calculation is expressed by the following formula:
Deemed Intangible Income X Foreign-Derived Deduction Eligible Income
Deduction Eligible Income
The FDII computation is a single calculation on a consolidated group. Domestic corporation’s FDII is 37.5 percent deductible in determining its taxable income (subject to a taxable income limitation), which yields a 13.125 percent effective tax rate. If deemed intangible income is zero or less, there is no benefit.
U.S. tax on FDII may be reduced even further with foreign tax credits to the extent the FDII is foreign source income. For purposes of calculating the foreign tax credit limitation, only 62.5 percent of the FDII should be taken into account, but all foreign taxes imposed on FDII should be available for credit.
Inbound Tax Planning Considerations
The taxation of cloud computing and digital downloads in the context of inbound tax planning is based on the concept of “nexus.” In order to understand the concept of “nexus” for purposes of inbound tax planning considerations, we will begin by discussing how foreign persons (individual and corporate) are taxed in the United States. The taxation of foreign persons depends generally on whether income derives from U.S. sources and whether that income derives from conduct of a U.S. trade or business.
The rapid evolution of electronic commerce and the Internet has generated many difficult conceptual issues. Since a foreign person can be found to be conducting a U.S trade or business without having a fixed place of business in the United States, an obvious question is when and how cloud computing and digital downloads from sources outside U.S. can constitute a U.S. trade or business.
Suppose that a foreign corporation regularly and continuously undertakes to effect a substantial quantity of cloud computing transactions and digital download sales to customers in the United States through Internet advertising and sales on a web site that is maintained by an independent Internet service provider in this country. Will these sales be subject to U.S. taxation?
In determining whether and how U.S. income tax should be imposed on the transactions involving digital goods and services by the foreign corporation in the above example, a threshold question is there sufficient nexus between the United States and the foreign corporation. If the foreign corporation, a provider of digital goods and services has sufficient nexus to be taxed in the United States, the foreign corporation will be subject to tax on a net basis and be required to comply with all U.S. reporting requirements. In the United States, a foreign taxpayer is considered to be subject to the tax jurisdiction of the United States if the person is engaged in a trade or business in the United States, and has income effectively connected to the U.S. trade or business.
In order to determine if the foreign corporation has sufficient nexus to be taxed in the United States, it must be first determined if the foreign corporation’s activities constitutes a trade or business conducted within the United States. Historically, the determination of a trade or business has been an annual concept. See Treas. Regs Sections 1.881-1, 1.8643(b), and 1.871-7(d)(2)(iv). A wide range of activities can cause a foreign taxpayer to be deemed engaged in the conduct of a U.S. trade or business.
The term “trade or business within the United States” is not defined in the Internal Revenue Code, although certain statutory prescriptions apply in specific instances dealing with the performance of services. See IRC Section 864(b). As applied to foreign persons, a U.S. trade or business will be found to exist if there are regular, continuous, and considerable business activities in this country. Isolated or sporadic transactions will not usually be construed as the conduct of a trade or business. See Treas. Reg. Section 1.864-2(e).
In the example above, the foreign corporation regularly and continuously undertook a substantial quantity of sales to customers in the United States. Under these facts and circumstances, the foreign corporation’s activities will arise to a U.S. trade or business. Now since we determined that the foreign corporation is engaged in a trade or business within the United States for the taxable year, the next step in the “nexus” analysis is to determine how U.S. (and certain foreign) source income will be taxed for U.S. income tax purposes is testing such income under Internal Revenue Code Section 864(c) to determine whether it is effectively connected income. When there is a question whether such items are effectively connected with the U.S. trade or business, Section 864(c)(2) prescribes some factors for analysis:
1. Did the income, gain or loss derive from assets used in or held for the use in the conduct of the trade or business (the “asset-use test”)?
2. Did the activities of the trade or business constitute a material factor in the realization of the income, gain, or loss (the “business-activity test”)?
In applying these factors, the Internal Revenue Code provides that due regard must be given to whether the income, gain, or loss was accounted for through the trade or business.
The “asset-use test” is employed when the income, gain or loss was derived from assets used in or held for use in the conduct of such trade or business. See Treas. Reg. Section 1.864-4(c)(2)(iv)(b).
The “business-activities test” is used to distinguish whether the activities of such trade or business were a material factor in the realization of income, gain, or loss. See Treas. Reg. Section 1.864-4(c)(3)(i).
For purposes of the foreign corporation selling digital goods to U.S. consumers, other than utilizing a U.S. Internet service provider, the foreign corporation does not have any connections with the United States. Thus, the above “asset-use test” or “business-activities test” will not apply. This does not mean the foreign corporation in our test is “safe” from U.S. taxation. This is because the Internal Revenue Code provides for a third lesser known test. In addition to the above “asset-use test” and “business-activities test,” “due regard must be given to a catch all provision discussed in Internal Revenue Code Section 864. Internal Revenue Code Section 864(c)(3) is a catchall provision, commonly referred to as the “limited force of attraction” principle. Under prior law, if a foreign taxpayer was engaged in a U.S. trade or business, all income was treated as business income and taxed at regular rates, whether or not related to that business.
A vestige of the “limited force of attraction” principle remains in Internal Revenue Code Section 864. Any items of U.S-source income not covered by Section 864(c)(2) will be attributed to the U.S. trade or business even absent an actual connection with the trade or business. See IRC Section 864(c)(3). As a result, for the purposes of the example discussed above, U.S. source income from the sale of digital goods by the foreign corporation will be taxed as effectively connected income even though there is no actual connection with the United States.
The situation could be even worse for a U.S. for tax standpoint. If the foreign corporation discussed in the example above maintained an office or other fixed place of business in the United States, in addition to U.S. source income, certain foreign source income, gain, or loss “attributable” to that office or fixed place of business would be treated as effectively connected income (and thus subject to U.S. federal income tax) provided that (1) such income, gain, or loss would be treated as effectively connected if U.S. source; (2) such office or fixed place of business regularly carries on activities of the type that generated such income and is a material factor in the production of income. Subject to the foregoing limitations, the even foreign source income can be treated as U.S. effectively connected income.
Relief for a Foreign Seller of Digital Goods Through a Bilateral Tax Treaty?
In certain cases, foreign persons with a nexus to the United States can utilize a tax treaty to mitigate its U.S. income tax consequences. The major purpose of an income tax treaty is to mitigate international double taxation through tax reductions on certain types of income derived by residents of one treaty country from sources within the other treaty country. The United States currently has income tax treaties with approximately 60 countries. Whether or not a foreign seller of digital goods may utilize a tax treaty to reduce its U.S. tax depends on the establishment clause of the particular treaty it is attempting to utilize. For example, the foreign seller may be based in a jurisdiction that does not have a U.S. income income tax treaty or such person fails to satisfy the relevant qualified resident test under the applicable US tax treaty with the base jurisdiction.
The rules governing cloud computing and digital transaction are involving. Whether you are a U.S. entity marketing digital goods domestically and/or abroad or you are a foreign person marketing digital services to U.S. persons, global tax planning is extremely important. For U.S. corporations marketing digital goods offshore, the ultimate goal should be to utilize FDII and foreign tax credits to reduce U.S. federal tax. For foreign persons or entities providing digital goods to U.S. consumers, as a general rule, the goal should be to minimize U.S. contacts. In either case, the retention of counsel well versed in the global taxation of digital goods is extremely important.
Anthony Diosdi is a partner and attorney at Diosdi Ching & Liu, LLP, located in San Francisco, California. Diosdi Ching & Liu, LLP also has offices in Pleasanton, California and Fort Lauderdale, Florida. Anthony Diosdi advises clients in tax matters domestically and internationally throughout the United States, Asia, Europe, Australia, Canada, and South America. Anthony Diosdi may be reached at (415) 318-3990 or by email: firstname.lastname@example.org.
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.