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IRS Clarifies Tax Treatment of Digital Content and Cloud Transactions

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The IRS has released new guidance on defining and sourcing income from digital content and cloud transactions for U.S. international tax purposes. The new rules, outlined in final regulations, proposed regulations and a Notice, impact taxpayers earning gross income from cross-border cloud transactions. 

The issue is determining how this income is sourced. Should it be classified as U.S. source income, subject to U.S. taxation? Is it considered foreign source income, taxed in another jurisdiction, potentially allowing the taxpayer to claim a U.S. foreign tax credit? The new guidance expands traditional sourcing rules to address these evolving forms of commerce. 

Final Regulations

A cloud transaction is a transaction when a person obtains on-demand network access to computer hardware, digital content or similar resources. Under the rules, cloud transactions are classified exclusively as service transactions, not lease transactions. If a transaction includes both digital content transfers and cloud services, its classification is based on its “predominant character”—determined by the primary benefit or value the customer receives. 

Digital content is defined as a computer program or any other content, such as books, movies and music, in digital format that is:  

  1. Protected by copyright law; or 
  2. Not protected by copyright law solely due to the passage of time or  because the creator dedicated the content to the public domain. 

Example of Predominant Character Test

A corporation sells video games to a retailer, providing digital keys for both online and offline functionality. The right to download a copy for offline play is considered a digital content transaction. However, if the same key grants access to an online multiplayer platform, it qualifies as a cloud transaction. 

In this case, the transaction is classified as the transfer of copyrighted articles because the retailer’s primary benefit is the ability to distribute these digital keys to customers. 

For sourcing, the final regulations treat sales of copyrighted articles as having occurred at the customer’s location, using the customer’s billing address. The IRS notes that a billing address is “more administrable” than the location where the content is downloaded or installed.   

The final rules do not include sourcing rules for cloud transactions. Instead, the IRS points to its new proposed regulations, which address that issue. 

Sourcing Cloud Transactions in Proposed Regulations

The proposed regulations treat income from cloud transactions as services income and source it on a taxpayer-by-taxpayer basis. The place of performance is established through a formula that relies on three factors: the intangible property factor, the personnel factor and the tangible property factor. These factors are used in a fraction that calculates the portion of worldwide expenses are attributable to sources within the U.S. This fraction is then applied to the income from the cloud transaction to determine where it is taxed.  

Because of the technical nature of a cloud transaction, the place of performance is where the resources and personnel responsible for the development, management and delivery of the service are located. Thus, the rules rely on the location of key activities as opposed to ancillary activities, such as marketing, sales and contracting. 

The proposed rules do not consider the location of the customer or end-user, where the service is consumed. Also, the location where a contract for cloud  services is executed is not considered by the sourcing rules.  

Public Comments

The related IRS notice requests public comments on whether the characterization and sourcing rules relating to transactions involving computer programs should only apply to international Code provisions or include broader topics as well. Some areas of the Code under consideration are the Sec. 179 expensing rules, the Sec. 197 amortization rules, the uniform capitalization rules and the depreciation rules for computer software. Comments are due April 14th.

Conclusion

The new IRS guidance updates international tax rules to better align with current practices in digital content and cloud transactions. Businesses selling downloadable content or on-demand network access now have clearer guidelines on how their transactions will be classified and sourced.   

Companies in these industries should assess their operations for tax planning opportunities. The proposed regulations introduce a three-factor formula for determining the place of performance, meaning decisions on where to locate intangible property, personnel and tangible assets can significantly impact income sourcing and overall tax liability.

Contributors

Lucia Nasuti Smeal headshot

Lucia Nasuti Smeal, Guest Writer

Lucia Nasuti Smeal is a guest author on tax topics for Frazier & Deeter. Smeal is an attorney, an adjunct tax professor with Georgia State University’s J. Mack Robinson College of Business and with Franklin University, and former editor of Tax Notes Today, published by Tax Analysts. In past years, Smeal worked for the Congressional Research Service and is a former member of the U.S. House Periodical Press Corps. She is a frequent speaker and writer on current tax developments.

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