Recently, the I.R.S. released proposed regulations for the classification of cloud computing transactions and proposed amendments to the existing computer software regulations of Treas. Reg. §1.861-18 (the "-18 Regulations").
Until now, when attempting to classify computer-based transactions, taxpayers only had the guidance of the -18 Regulations, which were proposed in 1996 and adopted in 1998 with minimal change. These rules have not kept pace with computer-based transactions, which are an ever-growing and evolving area. To put things in perspective, when the -18 Regulations were adopted, a typical internet connection could download 1GB in approximately 48 hours. Now, it takes less than 15 minutes. Oh, how times have changed.
The -18 Regulations, in their current state, provide rules for classifying transactions that involve "computer programs."1 They apply to transfers of computer programs as well as to services relating to the development or modification of computer programs. As such, this does not have direct application to many of the internet-based transactions in which taxpayers engage daily (e.g., streaming a movie on Netflix or storing data in Dropbox).
The proposed rulemaking addresses three aspects:
- It proposes amendments to the -18 Regulations that will extend the scope of the regulations to apply to transfers of digital content, which goes beyond computer programs.
- It proposes a new source rule for income from certain transactions covered under the -18 Regulations.
- It proposes to add Treas. Reg. §1.861-19 to address the classification of cloud computing transactions.
In the absence of I.R.S. guidance, and since the -18 Regulations did not apply, cloud computing transactions had previously been analyzed based on traditional characterization principles. With no transfer of property rights, cloud computing transactions have generally been treated as service transactions. The proposed regulations are consistent with such practical treatment, and thus, no economic impact is projected.
While the proposed regulations provide clarity as to the classification of cloud computing transactions as service transactions, they do not address the source rule for services in the cloud. Therefore, the existing uncertainty as to where income will be sourced continues. In the context of cloud computing, services can be deemed to take place where servers are located, where company personnel are located, or maybe where customers are located (or any combination of the above). Regrettably, the new proposed rulemaking does not offer clarity on that point.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.