United States: Treasury And The Service Propose Regulations On Cloud And Digital Content Transactions

Last Updated: October 16 2019
Article by Barry Herzog and Jay Geiger


On Aug. 14, 2019, the Department of the Treasury (Treasury) and the Internal Revenue Service (the Service) published proposed regulations (the Proposed Regulations) regarding the classification of “cloud transactions” for purposes of the international provisions of the Internal Revenue Code of 1986, as amended (the Code). The Proposed Regulations would also modify current regulations regarding the classification of certain transactions involving computer programs, including by making such rules applicable more broadly to transactions involving “digital content” and stipulating the location of sales involving nonphysical transfers of digital content.

The Proposed Regulations are significant inasmuch as they would delineate rules classifying items of income with respect to an entire universe of transactions that simply did not exist a relatively short time ago but are now increasingly prevalent. Such classification rules will enable taxpayers to determine, among other things, the source of income from such transactions, which is critical to assessing a person’s U.S. federal income tax liability. The Proposed Regulations avoid overreliance on technical jargon and provide a series of relatively straightforward, useful examples with respect to both digital content transactions and cloud transactions, illustrating the application of such rules in a variety of common transactional settings. The Preamble accompanying the Proposed Regulations indicates that Treasury and the Service believe current industry practice is generally consistent with the principles underlying the Proposed Regulations, but request comments as to whether this belief is accurate.

All income is considered either domestic or foreign source. The United States generally taxes U.S. taxpayers on both their domestic and foreign source income. U.S. taxpayers are generally permitted credits against foreign source income for foreign taxes imposed. U.S. taxpayers with significant foreign tax credits typically prefer their income to be considered foreign source in order to maximize their utilization of such credits and thereby reduce their U.S. federal income tax liability. For non-U.S. taxpayers, in general U.S. source income (other than certain gains) is subject to U.S. withholding tax at a flat rate, while foreign source income is not subject to tax. For non-U.S. taxpayers engaged in a U.S. trade or business, the source of income will affect whether it will be considered “effectively connected” with such trade or business and subject to U.S. federal income tax at graduated income tax rates.

Proper classification of an item of income (e.g., as interest, dividend, services income, royalty or gain in respect of a sale) is a predicate for determining its source.1 The Preamble notes that cloud and digital content transactions typically produce sales, license, or services income, but no regulations currently provide rules classifying such transactions (other than computer programs). The Proposed Regulations provide such needed guidance.

Cloud Transactions

The Proposed Regulations are principally intended to clarify the treatment under the Code of income from the relatively recent emergence of cloud transactions, defined generally as transactions “through which a person obtains on-demand network access to computer hardware, digital content . . . or other similar resources,” other than certain de minimis transactions.2 Proposed Treasury Regulation § 1.861-19 would apply for purposes of a variety of international provisions under the Code, including sections 59A, 245A, 250, 267A, 367, 404A, 482, 679 (as well as with respect to transfers to a foreign trust not covered by section 679), 1059A, subchapter N of chapter 1, chapters 3 and 4, and sections 842 and 845 (to the extent a foreign person is involved).3 The Preamble indicates that cloud transactions encompass cloud computing — characterized by on-demand network access to computing resources including networks, servers, storage and software — as well as other transactions that are not solely related to computing but that still involve on-demand network access to technological resources.

The Preamble notes that cloud computing transactions are typically described in nontax contexts as following one of several models, including software as a service (SaaS), platform as a service (PaaS) and infrastructure as a service (IaaS). The Preamble describes SaaS as allowing customers to access applications on a provider’s infrastructure through an interface such as a web browser. PaaS allows customers to deploy self-created applications onto a provider’s cloud infrastructure using programming languages, libraries, services and tools supported by the provider. IaaS allows customers to access processing, storage, networks and other infrastructure resources on a provider’s cloud infrastructure. The Preamble acknowledges that while certain cloud computing transactions may appear superficially similar to computer program transactions described in existing Treasury Regulation § 1.861-18, they are distinguishable inasmuch as cloud computing transactions do not typically involve any transfer of a computer program classified under current Treasury Regulation § 1.861-18 (or other digital content transaction subject to Proposed Treasury Regulation § 1.861-18), and Treasury Regulation § 1.861-18 does not address the provision of online access to use a computer program.

In addition to cloud computing, cloud transactions include transactions engaged in by average consumers with increasing frequency on a daily basis, including streaming music and video, interacting with mobile device applications (apps), and accessing data through remotely hosted software (e.g., Westlaw and Lexis). Cloud transactions do not, however, encompass the mere download or other electronic transfer of digital content for storage or use on a person’s computer or other electronic device.

The Preamble indicates that, inasmuch as cloud transactions generally involve access to property or use of property as opposed to a transfer (e.g., a sale, exchange or license) of property, such transactions typically would be classified as either a lease of property or the provision of services. The Preamble notes a non-exhaustive variety of factors under Code Section 7701(e) and case law that are relevant for classifying a transaction as either a lease of property or the provision of services. Some factors demonstrating that a cloud transaction is properly classified as the provision of services rather than a lease are set forth in the Proposed Regulations and include:

  • The customer is not in physical possession of the subject property;
  • The customer does not control the property, beyond network access and use;
  • The provider has the right to determine the specific property used in the cloud transaction and to replace such property with a comparable substitute;
  • The property is a component of an integrated operation in which the provider has other responsibilities, including maintenance and updating of such property;
  • 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 customer use rather than on the mere passage of time; and
  • The total contract price substantially exceeds the rental value of the property for the contract period.4

The Preamble notes that, in general, application of the relevant factors to a cloud transaction “will result in the transaction being treated as the provision of services rather than a lease of property.” While the Proposed Regulations treat a cloud transaction as either a lease or the provision of services, without bifurcation, the Preamble notes that in appropriate cases the facts and circumstances may support the conclusion that an arrangement involves multiple cloud transactions, each of which would be subject to separate classification under Proposed Treasury Regulation § 1.861-19 unless de minimis.

Certain arrangements may involve multiple transactions, including one or more transactions that could be classified as cloud transactions under the Proposed Regulations and one or more transactions that would not be so classified. The Proposed Regulations provide that in such cases the classification rules would apply only to classify the cloud transaction(s); other transactions would be classified under other sections of the Code or regulations or under general tax law principles. No transaction would be classified separately if it was considered de minimis, however.

A number of examples apply the proposed cloud transaction rules to the access of (i) computing capacity, (ii) a software development platform and website hosting, (iii) software (including downloaded software), software accessible via an app and offline software with limited online functionality, (iv) data storage, (v) streaming digital content through third-party servers, (vi) downloaded digital content, and (vii) online databases.

The Proposed Regulations do not set forth any special sourcing rules with respect to income arising from cloud transactions. In general, services income is sourced based on where the services are performed and leasing income is sourced where the subject property is used. While it may be relatively straightforward in the cloud computing context to determine where leased property is used, it is less clear where services are performed. A rule sourcing cloud transaction services income with respect to on-demand access to software, for instance, based simply on the physical location of a server would appear easily manipulable and would fail to take into account the efforts of parties to develop and update such software. It is anticipated that guidance with respect to the sourcing of income derived from cloud transactions will be forthcoming. Toward that end, in the Preamble, Treasury and the Service requested taxpayer comments on administrable rules for sourcing income from cloud transactions in a manner consistent with existing rules set forth in Code Sections 861 through 865.

Digital Content Transactions  

Current Treasury Regulation § 1.861-18 is generally limited to the classification of transactions involving computer programs, including electronic downloads of software, for a variety of international provisions of the Code.6 That regulation categorizes computer program transfers as the transfer of a copyright, the transfer of a copy of a computer program (a copyrighted article), the provision of services for the development or modification of a computer program, or the provision of know-how relating to computer programming techniques.7In the case of a transfer of a copyright right, Treas. Reg. § 1.861-18 provides rules for determining whether the transactions should be classified as a sale or exchange, or a license generating royalty income. In the case of a transfer of a copyrighted article, that regulation provides rules for determining whether the transaction should be classified as a sale or exchange, or a lease generating rental income. The rules set forth in Treas. Reg. § 1.861-18 apply irrespective of the medium (e.g., physical or electronic) by which a computer program is transferred.

The Preamble notes that since Treasury Regulation § 1.861-18 was promulgated in 1998, content in digital format and subject to copyright law — including music, video and books — has become an increasingly common basis for commercial transactions, with consumption of digital content growing in part because new electronic devices (e.g., laptops, tablets and smartphones) allow users to more readily obtain and use such digital content. Treasury and the Service determined that for the past 20 years the rules and principles underlying current Treasury Regulation § 1.861-18 have provided useful guidance in the context of computer programs and that such rules and principles would provide useful guidance with respect to these more recent digital content innovations. As a result, the Proposed Regulations would expand the scope of Treasury Regulation § 1.861-18 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.”8 Thus, digital content includes computer programs as well as, for example, books, movies and music in digital format. In view of such expansion, the Proposed Regulations would update references to “computer programs” in current Treasury Regulation § 1.861-18 to references to “digital content.”

Several examples address the application of the proposed digital content transactions rules to electronic book downloads, music downloads, and movie and television show streaming, rentals, and purchases.

Proposed Treasury Regulation § 1.861-18 also addresses the source of income for sales of copyrighted articles in electronic format. In that connection, the Preamble notes that taxpayer comments made in the 1990s highlighted the uncertainty regarding how to apply the title passage rule of Treasury Regulation § 1.861-7(c) to sales of computer programs through electronic downloads,9 which existing regulations did not specifically address. In light of the uncertainty in determining the source of sales of copyrighted articles under Treasury Regulation § 1.861-7(c), particularly in the context of electronically downloaded software, as well as the potential for manipulation in applying such rule in the case of transfers by electronic medium, the Proposed Regulations provide that when copyrighted articles are sold and transferred electronically the sale is generally deemed to occur at the location of download or installation on the end user’s device used to access the digital content.10 While such a rule is expected by Treasury and the Service to be generally administrable by vendors, in the event the location of download or installation cannot be ascertained, the Proposed Regulations provide that 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.

Effective Date

The Proposed Regulations are proposed to apply to transactions involving digital content and cloud transactions occurring pursuant to contracts entered into during taxable years beginning on or after the date final regulations are published in the Federal Register.11 The Preamble notes that “[n]o inference should be drawn from the proposed effective date concerning the treatment of transactions involving digital content or cloud transactions entered into before the regulations are applicable.”


1.  The Preamble notes that classification of income from digital content and cloud transactions may also impact whether such income is treated as subpart F income as defined in Section 952, as well as calculations with respect to Section 59A (relating to the tax on certain base erosion payments) and the availability of taxpayer incentives under Section 250 (foreign-derived intangible income and global intangible low-taxed income).

It remains to be seen whether states will seek to follow the classification scheme set forth in the Proposed Regulations for purposes of, among other things, determining sales and use tax liability with respect to digital content and cloud transactions.

2. Prop. Treas. Reg. § 1.861-19(b).

3.   Prop. Treas. Reg. § 1.861-19(a).

4. Prop. Treas. Reg. § 1.861-19(c)(2).

5. Although not listed as a regulation project on Treasury’s current priority guidance plan, Treasury officials have previously indicated that sourcing rules would be addressed in guidance following the release of the character rules. See, e.g., Ryan Finley, “ABA Section of Taxation Meeting:  Cloud Computing Regulations Will Address Character, Not Source,” Tax Notes, Feb. 8, 2016, at 667.  

6. Treas. Reg. § 1.861-18(a). A computer program is defined for this purpose as a set of statements or instructions to be used in a computer in order to bring about a certain result, including any media, user manuals, documentation, data base, or similar item if such item is incidental to the operation of the compute program.

7. Treas. Reg. § 1.861-18(b).

8. Prop. Treas. Reg. § 1.861-18(a)(3).

9. Treasury Regulation § 1.861-7(c) currently provides in general that a sale of personal property is consummated at the place where the rights, title and interest of the seller in the property are transferred to the buyer, or, when bare legal title is retained by the seller, where beneficial ownership and the risk of loss passes.

10. Sales income that would be treated as U.S. source as a result of the interplay of this rule and Section 861(a)(6) of the Code, for example, could be considered “effectively connected income” for non-U.S. taxpayers engaged in a trade or business in the United States. The Preamble states that Treasury and the Service do not believe that the download or installation rule will affect non-U.S. taxpayers eligible for the benefits of an applicable income tax treaty.

An early comment on the Proposed Regulations suggests that, given the likelihood that countries will increasingly seek to impose tax on digital earnings from some form of digital presence in their jurisdictions, to the extent the download or installation rule of Proposed Treasury Regulation § 1.861-18(f)(2)(ii) results in foreign source income, U.S. taxpayers may be able to utilize foreign tax credits to eliminate double taxation.

11. See Prop. Treas. Reg. §§ 1.861-18(i) & -19(e).

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.

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