Recently the United States Department of the Treasury and the Internal Revenue Service issued a set of proposed regulations regarding the treatment of "cloud transactions" and transactions involving digital content. These regulations are intended as a much-needed update on the characterization of certain kinds of transactions conducted over the internet, for the purpose of sourcing income. Characterization is critical for determining the jurisdiction (either the U.S. or a foreign country) that has primary income taxing authority over the income. Accordingly, the proposed regulations, once finalized, are likely to be important to U.S. businesses serving customers abroad via the internet, as well as foreign businesses accessing the U.S. markets digitally. Indeed, the newly proposed digital content rule is a radical departure from prior law, and as such, should be monitored closely by foreign businesses selling digital content in the U.S.
The proposed regulations define a "cloud transaction" as "a transaction through which a person obtains a non-de minimis on-demand network access to computer hardware, digital content . . . , or other similar resources." Proposed Treas. Reg. § 1.861-19 provides for the classification of a "cloud transaction" as either a provision of services or a lease of property. The determination is based on a set of factors, which, as written, effectively create a presumption that most cloud transactions will be deemed a provision of services:
- The customer is not in physical possession of the property;
- The customer does not control the property, beyond the customer's network access and use of the property;
- The provider has the right to determine the specific property used in the cloud transaction and replace such property with comparable property;
- The property is a component of an integrated operation in which the provider has other responsibilities, including ensuring the property is maintained and updated;
- The customer does not have a significant economic or possessory interest in the property;
- The provider bears any risk of substantially diminished receipts or substantially increased expenditures if there is nonperformance under the contract;
- The provider uses the property concurrently to provide significant services to entities unrelated to the customer;
- 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
- The total contract price substantially exceeds the rental value of the property for the contract period.
The effective presumption that most cloud transactions should be characterized as a provision of services is generally consistent with the historical treatment to date by the international tax community at large. Accordingly, the majority of businesses with international cloud transaction business models should not be caught off-guard by the clarification.
Sales of Digital Content
Under general U.S. tax rules, income from the sale of inventory, including copyrighted articles such as books and music recordings, is sourced to the jurisdiction where legal title to the product and risk of loss passes from seller to buyer. Pursuant to a proposed change to the I.R.C. § 861 regulations, however, the sourcing rule will change for "digital content." This proposed change could prove extremely significant for foreign-based companies selling digital content into the U.S. market.
The proposed regulations expand the scope of the existing computer program regulations to apply to all transfers of "digital content," defined 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[,]" with the purpose of the change to include articles such as books, music, and videos in digital, downloadable formats.
The proposed regulations provide a new sourcing rule for the sale of digital copyrighted articles over the internet. These sales will now be sourced to the location of download or installation on an end-user's device. If the location of download or installation is unknown, such sales will be deemed to have taken place at the end user's location, determined by recorded sales data for business or financial reporting purposes.
Importantly, the proposed sourcing rule for digital content is a significant change from existing principles. Foreign businesses which sell copyrighted content through the internet to U.S. customers should monitor the proposed sourcing rule – should the proposed rule become final as written, such businesses could find themselves generating U.S.-source income from these sales, and thus could be deemed to be conducting a U.S. trade or business with effectively connected income. Foreign businesses selling digital content with marketing subsidiaries and/or personnel in the U.S., but which heretofore have not had U.S.-sourced sales, are advised to review their operating structures and to consider planning for the new regime.
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.