Although the focus of proposed regulations issued by the US Internal Revenue Service (IRS) on August 9, 2019, may have been on "cloud computing," the proposed regulations provide significant new guidance on the taxation of transfers of digital content as well.

From a big picture standpoint, the proposed regulations would ratify the approach many taxpayers have historically taken for digital content. In the absence of specific guidance on transfers of digital content, many companies have been applying, by analogy, Treasury Regulations §1.861-18, the regulations applicable to the characterization and sourcing of computer software. Because the rationale of the computer software regulations in many cases seems equally applicable to digital transactions, it was logical to apply the computer software regulations to digital downloads and other transactions not technically within these regulations' scope.

By broadening the applicability of §1.861-18 from "computer programs" to "digital content," the proposed regulations would provide needed certainty to taxpayers providing digital content to customers in today's mobile world. "Digital content," for purposes of the new proposed rules, would include books, movies and music in digital format, along with software and other computer programs.

Besides broadening the property subject to the rules of the computer software regulations, the proposed regulations would make other changes to §1.861-18.

Source of income

The most significant change relates to determination of the source of income. The source of income is important for a variety of tax reasons. For a non-US company, where its income is sourced can affect whether the company is subject to US income or withholding tax. For a US company, where and how its income is sourced can affect its ability to take a foreign tax credit.

There has always been some uncertainty as to where a sale of software and, by implication, a sale of digital content, has occurred. Current regulations incorporate the generally applicable rules for sourcing income, but those rules were designed with tangible property in mind, especially when it comes to sales of inventory. Those general sourcing rules, which look to whether and where title to the property passes and when and where rights in the property are transferred, are not an obvious fit for transfers of digital content.

As an initial matter, in the absence of explicit language in the terms of use for the digital content, it is difficult for the parties to determine (or prove to the IRS) whether and where "title" passes when digital content is transferred—especially in an agreement that is formally styled as a license. Even if the terms of use specify where title passes for US tax purposes, it is unclear how much weight tax authorities will give such language, given that the term and underlying concepts do not have much significance for other purposes in the transfer of digital content.

The proposed regulations would generally treat the sale of digital content as occurring where the customer downloads the content or installs it on the device used to access it. This new source rule would be a significant change for those vendors who have language in agreements with the customer specifying that title passes at a point prior to complete download of the content. Thus, under the proposed regulations, vendors who are located outside the United States but who sell to US customers may find themselves with significant US-source sales income and may, if the proposed regulations enter into effect, have to determine whether they are engaged in the conduct of a trade or business in the United States and therefore owe US income tax on those sales.

Further, despite the conceptual appeal of sourcing the income from a sale based on the place where the customer is located, the approach in the proposed regulation raises a lot of issues in practice. First, the vendor often will not know the physical location of the customer at the time of download or installation. The proposed regulations would address that common scenario by providing that the location of sale is deemed to be the customer's "recorded sales data for business or financial reporting purposes."

While a default rule based on the residence of the customer is a common way of dealing with the difficulty of determining actual location at the time of download, a lot more clarity and detail will be necessary if the final regulations adopt this sourcing rule. In particular, guidance will be needed to clarify how the sourcing rule applies when a single customer uses the digital content in different locations, and when the purchaser of record may be making the acquisition on behalf of affiliates located in other jurisdictions. In any case, sourcing based on the actual or deemed location of the customer means that the new income tax rules will have to deal with many of the issues that tax authorities have been struggling with in the sales tax and value-added tax context.

Updating the rules for advertising

The proposed regulations would provide taxpayers with greater ability to advertise or display digital content intended for sale without causing that usage to be treated (and taxed) as the acquisition of a license of the digital content. Thus, if the owner of digital content permits a seller of that digital content to perform or display it for the purpose of advertising its sale, the owner is not treated for tax purposes as having transferred a license for tax purposes to the seller.

To illustrate this rule, the preamble to the proposed regulations gives the example of an owner of a video game allowing a video game retailer to display screenshots of the video game on television commercials promoting sales of the game. Unlike the current regulations, under which the owner of the video game and the retailer may be treated as entering into a license, the proposed regulations would provide that the grant of such a limited right to the retailer generally does not constitute the transfer of a copyright right in the video game.

Next steps

The proposed regulations are prospective. They would apply to digital content transactions occurring pursuant to contracts entered into in taxable years beginning on or after the date final regulations are published. Still, affected taxpayers should not delay in analyzing the impact of the proposed regulations on them, both with respect to cloud computing and digital content, because comments are due within 90 days of the date the regulations are published in the Federal Register.

Dentons is the world's first polycentric global law firm. A top 20 firm on the Acritas 2015 Global Elite Brand Index, the Firm is committed to challenging the status quo in delivering consistent and uncompromising quality and value in new and inventive ways. Driven to provide clients a competitive edge, and connected to the communities where its clients want to do business, Dentons knows that understanding local cultures is crucial to successfully completing a deal, resolving a dispute or solving a business challenge. Now the world's largest law firm, Dentons' global team builds agile, tailored solutions to meet the local, national and global needs of private and public clients of any size in more than 125 locations serving 50-plus countries.

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.