IRS provides important clarity for cloud transactions

 

The IRS published final (TD 10022) and proposed regulations (REG-107420-24) on Jan. 14 providing much-needed clarity addressing the classification and sourcing of income from certain digital content and cloud transactions.

 

The new regulations mark a significant step forward in updating tax rules for the ever-evolving digital economy and are applicable across a number of international tax rules. Additionally, the IRS published Notice 2025-06, requesting comments regarding issues to consider in deciding whether to apply the characterization rules of the final regulations to all provisions of the code.

 

The final regulations retain the overall approach of the proposed regulations issued in 2019, but certain important changes were made, including:

  • Eliminating the services vs. lease test in favor of classifying cloud transactions solely as the provision of services
  • Replacing the de minimis rule with a new predominant character rule for circumstances where a larger transaction may have elements that could, when viewed in isolation, have different characterizations

The final regulations provide resolution for taxpayers, concluding that all “cloud transactions” are treated as the provision of services and remove the lease vs. services factors listed in the proposed regulations. The IRS indicated they could not identify a transaction that satisfies the definition of a cloud transaction that would be properly classified as a lease. The final regulations do not, however, address the sourcing rules for where the cloud transaction service is performed. The IRS instead proposed new regulations that introduce a three-factor test for determining the source of income from cloud transactions for purposes of the international provisions of the Internal Revenue Code. 

 

 

Grant Thornton Insight

 

The rules apply to many key international tax provisions, including foreign tax credits (FTC), the global intangible low-taxed income (GILTI) regime and effectively connected income (ECI). They will be particularly important for technology companies, as well as businesses offering other types of on-demand network access to computer hardware, digital content, or other similar resources.  The final regulations generally apply to taxable years beginning on or after Jan. 14, 2025, but taxpayers can adopt them early for years beginning on or after Aug. 14, 2019. 

 

Background

 

Sections 861 and 862 contain many of the U.S. tax rules related to determining the source of different types of income. Treasury and the IRS have similarly provided regulatory guidance to assist taxpayers with determining both the character and the source of an item of income. Determining the character and source of income are essential for taxpayers engaged in cross-border activities.

 

Regulations related to the classification of transactions involving computer programs were originally published in 1998 and have remained largely unchanged. As the number and types of transactions involving digital and cloud-based content have exploded over the past two and a half decades, a need for more precise rules related to characterizing and sourcing income generated through such transactions has become increasingly important.

 

These rules are particularly relevant for technology companies, including software-as-a-service (SaaS) providers, as well as businesses offering other types of on-demand network access to computer hardware, digital content, or other similar resources. Determining the character and source of income arising from these types of transactions may impact a number of international tax provisions, including those addressing FTCs calculations, income inclusions under the GILTI or Subpart F income regimes, computations of ECI and withholding tax obligations.

 

 

 

Final regulations

 

The final regulations under Treas. Reg. Sec 1.861-18 provide rules for determining the character and source of gross income from digital content transactions. Additionally, Treas. Reg. Sec. 1.861-19 finalized the rules for characterizing income from cloud transactions, but did not address rules for determining the source of income arising from cloud transactions. The rules in these regulations are limited in scope to Sections 59A, 245A, 250, 267A, 367, 404A, 482, 679, and 1059A; Subchapter N of Chapter 1; Chapters 3 and 4; and Sections 842 and 845 (to the extent involving a foreign person); and apply with respect to transfers to foreign trusts not covered by Section 679.

 

 

Characterization of digital content and cloud services

 

Generally, the final regulations characterize a transaction as a transfer of digital content or as a provision of a cloud service based on whether the customer downloads the content to their device or if they access the content through a cloud platform. Digital content transactions are characterized as transfers of content protectable by copyright law. Digital content also includes content not protected by copyright law solely because (1) a creator dedicated the content to the public domain, or (2) the copyright is no longer protectable due to the passage of time.

 

In a typical cloud transaction, the cloud provider retains economic control and possession over the relevant property. In the preamble to the final regulations, the IRS notes that, when a customer downloads digital content, a copy is transferred to the customer’s device; in contrast, streaming digital content involves no such transfer.

 

The final regulations treat all cloud transactions solely as the provision of services and removed the services vs. lease test that was previously proposed. The regulations now specifically define a “cloud transaction” as “a transaction through which a person obtains on-demand network access to computer hardware, digital content [], or other similar resources… [however, it] does not include network access to download digital content for storage and use on a person’s computer or other electronic device.”

 

The final regulations also confirm that downloading digital content (even if it is a temporary download) is fundamentally different from accessing digital content online. When a customer downloads digital content, there is a transfer of a copy of that digital content to the customer and the customer must use its own device to host the content for viewing or listening. Contrast this with a customer that accesses digital content on a cloud platform, as there is no transfer of content to the customer. Instead, the customer receives access to the digital content through the provider’s servers ̶ placing a higher burden on the provider to maintain a server that is capable of hosting the digital content that is made available through the cloud platform. These differences warrant different character determinations for each type of transaction. In cases where a customer is able to choose whether to temporarily download content or access content in the cloud, a new predominant character rule in the final regulations applies to characterize the transaction as either a transfer of digital content or as the provision of a cloud service.

 

 

Predominant character rule

 

In business models that include both online and offline functionality or have mixed elements (i.e., transactions that may include both a transfer of a copyrighted article and access to a cloud platform), it may be difficult to bifurcate a single transaction into its separate parts (a digital content transaction and a cloud transaction). Previously, the 2019 proposed regulations provided that multiple transactions in an arrangement would generally be treated separately, unless one or more segments were de minimis in the context of the overall transaction.

 

In the final regulations, the IRS introduced a new predominant character rule, which applies to both digital content transactions and cloud transactions. This new rule provides that a transaction with multiple elements should be characterized based on the predominant character of the transaction, taking into account the overall transaction and surrounding facts and circumstances.

 

Under a general rule, the predominant character is determined by ascertaining the primary benefit or value received by the customer in the transaction. If that information is not reasonably ascertainable, a special rule provides that the predominant character is instead determined by the primary benefit or value received by a “typical customer” in a substantially similar transaction (based on how a typical customer uses or accesses the digital content).

 

 

Sourcing rules for digital content transactions

 

The 2019 proposed regulations provided that when a copyrighted article was sold and transferred through an electronic medium, the sale was deemed to have occurred at the location of download or installation onto the end-user’s device. Comments observed practical challenges with applying a location-based rule and cited internet privacy laws, use of virtual private networks (VPNs), and issues with both identifying end-users in certain scenarios as well as determining the location of download in multi-level distribution channels. Because of these challenges, the IRS adopted a single sourcing rule for sourcing income from the sale of digital content, which deems the sale to have occurred at the location of the customer’s billing address. 

 

Grant Thornton Insight

 

The IRS appears to take a different approach to determining customer location when sourcing income under the final regulations, as compared to determining the location of an end user when computing the foreign derived intangible income (FDII) deduction under Section 250. In issuing the final regulations, the IRS rejected the use of IP address information to determine the source of income, as collecting the necessary information could be burdensome and result in selective sourcing of income. Contrast this with a sale of intangible property used in providing a service (see Treas. Reg. Sec. 1.250(b)-4(d)(2)(ii)(B)), which may require the taxpayer to determine foreign use based on the IP address information of end users, depending on the type of service. In the preamble to the final regulations, the IRS noted that the Section 250 regulations are outside the scope of the final regulations on digital content and cloud transactions and did not make changes for comments requesting consistency between the two regulations. 

 

 

Accounting methods impact

 

The final regulations provide that if a method change is necessary, it will be treated as initiated by the taxpayer and subject to the rules under Section 446. The preamble to the final regulations indicates that IRS does not anticipate that taxpayers need to make a change, but if they do, such a change must be filed under the nonautomatic procedures because the IRS wants to ensure that any changes are consistent with the appropriate treatment of the transactions under "all" code sections or regulations. 

 

 

 

Proposed regulations

 

Concurrent with its issuance of the final regulations, the IRS also proposed rules to establish specific sourcing rules for income generated through cloud transactions. As described above, the final regulations classify a cloud transaction as the provision of services. Under existing rules, which were adopted long before the advent of online transactions and the internet, gross income from the provision of services is sourced to the place where the service is performed. The code does not, however, provide any guidance on how to determine the place of performance for specific types of services transactions.

 

The IRS notes in the preamble to the proposed regulations that the distinctive attributes of cloud transactions, including the network-based and increasingly automated nature of the service delivery and the role of intangible property in ensuring functionality, reliability and performance for the service, raise questions regarding how to determine the place of performance of a cloud transaction. To address this, the proposed regulations propose a three-factor test for determining the place of performance:

  1. Personnel factor: The employees who manage, operate, and maintain the cloud infrastructure are fundamental to the provision of the service and such efforts.
  2. Tangible property factor: Expenses, such as depreciation and rent expense, for tangible property owned or leased by the taxpayer that are directly used to provide the cloud transaction.
  3. Intangible property factor: Certain research and experimental expenses, amortization, and royalties incurred during the taxable year in which the cloud transaction is performed could serve as an administrable proxy for reflecting the contribution of intangible property to the performance of the cloud transaction.

The IRS also indicated that the location where a contract for a cloud transaction is executed should not dictate the source of the resulting gross income because that location may not bear any connection to where the service is performed.

 

 

 

Applicability dates

 

The final regulations generally apply to taxable years beginning on or after the date of publication in the federal register (Jan. 14, 2025), consistent with the effective date proposed in the 2019 proposed regulations. Taxpayers may elect to apply all of the rules of the final regulations to taxable years beginning on or after Aug. 14, 2019, and all subsequent taxable years, if (1) certain consistency requirements for related persons are met, (2) the period of limitations on assessment for each taxable year and all related parties is open under Section 6501, and (3) the taxpayer would not be required to change its method of accounting as a result of electing to early adopt the final regulations.

 

The 2025 proposed regulations are proposed to apply to taxable years beginning on or after the date of publication of Treasury adopting these regulations as final regulations in the Federal Register and includes similar rules allowing early application to those in the final regulations.

 

Grant Thornton Insight

 

The change in administration could affect the outlook for the finalization of the proposed regulations. It is possible that Treasury and the IRS shift guidance priorities or view issues differently under new leadership. The final regulations, however, will remain effective as written until and unless there is formal guidance changing, rescinding, or postponing them. 

 

 

 

Next steps

 

This guidance expands and clarifies characterization and sourcing rules related to digital content transactions, and also provides much needed guidance in the areas of digital content and cloud computing. It is important to note that these rules are applicable to most of the international tax provisions contained in the Internal Revenue Code (FTC, GILTI, BEAT, Subpart F, withholding tax, ECI, etc.). Affected taxpayers should begin assessing the impact of these rules immediately, including whether to retroactively apply all of the rules of the final regulations to open tax years.

 
 

For more information, contact:

 
 
Cory Perry

Washington DC, Washington DC

Industries
  • Manufacturing, Transportation & Distribution
  • Technology, media & telecommunications
  • Private equity
Service Experience
  • Tax
 
 
 
 
Content disclaimer

This Grant Thornton Advisors LLC content provides information and comments on current issues and developments. It is not a comprehensive analysis of the subject matter covered. It is not, and should not be construed as, accounting, legal, tax, or professional advice provided by Grant Thornton Advisors LLC. All relevant facts and circumstances, including the pertinent authoritative literature, need to be considered to arrive at conclusions that comply with matters addressed in this content.

Grant Thornton Advisors LLC and its subsidiary entities are not licensed CPA firms.

For additional information on topics covered in this content, contact a Grant Thornton Advisors LLC professional.

 

 

Tax professional standards statement

This content supports Grant Thornton Advisors LLC’s marketing of professional services and is not written tax advice directed at the particular facts and circumstances of any person. It is not, and should not be construed as, accounting, legal, tax, or professional advice provided by Grant Thornton Advisors LLC. If you are interested in the topics presented herein, we encourage you to contact a Grant Thornton Advisors LLC tax professional. Nothing herein shall be construed as imposing a limitation on any person from disclosing the tax treatment or tax structure of any matter addressed herein.

The information contained herein is general in nature and is based on authorities that are subject to change. It is not, and should not be construed as, accounting, legal, tax, or professional advice provided by Grant Thornton Advisors LLC. This material may not be applicable to, or suitable for, the reader’s specific circumstances or needs and may require consideration of tax and nontax factors not described herein. Contact a Grant Thornton Advisors LLC tax professional prior to taking any action based upon this information. Changes in tax laws or other factors could affect, on a prospective or retroactive basis, the information contained herein; Grant Thornton Advisors LLC assumes no obligation to inform the reader of any such changes. All references to “Section,” “Sec.,” or “§” refer to the Internal Revenue Code of 1986, as amended.

Grant Thornton Advisors LLC and its subsidiary entities are not licensed CPA firms.