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Proposed IRS rules to guide cloud transactions

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Proposed IRS rules to guide cloud transactions The IRS recently released proposed regulations (REG-130700-14) providing guidance that would classify many types of cloud transactions as a provision of a service, rather than a lease of property. The regulations also modify the rules for classifying computer programs, including the transfers of digital content. Notably, the rules address sourcing of income from the sale of digital content through electronic downloads, but do not address sourcing of cloud transactions.  

Treas. Reg. Sec. 1.861-18 currently provides rules for classifying transactions involving computer programs. Under these regulations, a transaction may be classified as either (1) a transfer of a copyright right in a computer program, (2) a transfer of a copy of a computer program (i.e., transfer of a copyrighted article), (3) the provision of services for the development or modification of a computer program, or (4) the provision of know-how relating to computer programming techniques. The regulations further classified a transfer of a copyright right as either a sale or a license, and a transfer of a copyrighted article as either a sale or a lease. The existing rules do not address the proper classification of transactions that involve more modern forms of digital transactions, such as software as a service, online platforms and other cloud-based transactions.

The regulations are proposed to apply to various international tax provisions (i.e., 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 of involving a foreign person), as well as transfers to foreign trusts not otherwise covered by Section 679). The proposed regulations are not effective until final, but taxpayers should immediately begin assessing their impact. Once final, the rules could have substantial income tax implications and may even require changes in the methods of accounting.

Classification of cloud transactions Prop. Treas. Reg. Sec. 1.861-19 provides the rules and criteria for determining whether a cloud transaction is properly classified as a provision of services or a lease of property. A cloud transaction is one through which a customer obtains on-demand network access to computer hardware, digital content and/or other similar resources. It does not include network access to download “digital content” for storage and use on an electronic device. Digital content is defined as any content in digital format 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 on a physical medium (e.g., computer programs, books, movies, music). Thus, a cloud transaction is generally one that involves on-demand access, including access to streaming music and videos, access to hosted computer programs, and access to information housed in an online database. 

In general, a cloud transaction that involves a customer accessing or using property (rather than the sale, exchange or license of the property) would be classified as either a lease of property or the provision of services. Historically, Section 7701(e) and relevant case law have provided factors used when classifying a transaction as either a lease of property or a provision of services. Such factors focused on which party was in physical possession of the property or controlled the property and which party bore the economic risks and rewards related to the property, among others. 

The proposed regulations provide a non-exhaustive list of factors that should be used when evaluating whether a cloud transaction is properly classified as the provision of services or a lease of property. These factors include those provided in Section 7701(e)(1) as well as other factors applied by the courts. Factors demonstrating that a cloud transaction is classified as the provision of services rather than a lease of property include the following:

  • 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.
  • The total contract price substantially exceeds the rental value of the property for the contract period.

Grant Thornton Insight: The proposed regulations provide several examples of cloud computing transactions as well as the application of the above factors to such transactions. All transactions that properly constitute cloud transactions were determined to be service contracts. Taxpayers should consider whether their existing arrangements would be cloud transactions under the proposed rules.
Many contracts may have characteristics of both a lease of a copyrighted article and a cloud-based service. In such instances, the classification rules apply only to classify the cloud transaction, and any non-cloud transaction is classified separately under other sections of the tax code or regulations, or under general tax law principles. However, if a transaction is de minimis, it should not be analyzed separately but as part of another transaction.  Whether a transaction is de minimis is determined based on the overall arrangement and the surrounding facts and circumstances

Grant Thornton Insight: The de minimis rule may be limited in its applicability because it is unclear how the term “transaction” may interact with other provisions. For example, Section 451(b)(4) generally requires that taxpayers with applicable financial statements follow the allocation of performance obligations, which may be changing under ASC 606. Thus, taxpayers with contracts that have multiple performance obligations may need to consider whether the entire contract or individual performance obligation is considered the “transaction.”
Classification and sourcing of non-cloud transactions In addition to broadening the scope of the existing regulation from computer software to all digital content, the proposed regulations provide that a transfer of a mere right to public performance or display of digital content for purposes of advertising does not constitute a transfer of a copyright right.

A transfer of digital content that is not a cloud transaction, as described above, may then be classified as either a sale or an exchange of a copyrighted article, or as a lease, based on all available facts and circumstances. Generally, a transaction that transfers the benefits and burdens of ownership will be viewed as a sale or exchange.

Income derived from the sale or exchange of copyrighted articles is sourced under the existing rules in Sections 861(a)(6), 862(a)(6), 863 or 865, as appropriate. When the sale is transferred through an electronic medium, the sale is deemed to have occurred at the location of download or installation onto the customer’s device. If the location of download cannot be determined, then the sale will be deemed to have occurred at the location of the customer, based on the recorded sales data. Income derived from leasing copyrighted articles, including digital content, is sourced under Sections 861(a)(4) or 862(a)(4), as appropriate.

Grant Thornton Insight: The proposed regulations add new examples that illustrate the application of Prop. Treas. Reg. Sec. 1.861-18 to digital books, music libraries and video services (that offer purchase, rent and streaming options). The examples clarify when a transfer of a copyrighted article has occurred in the broader context of digital content transactions, and distinguishes such a transfer from a cloud transaction.
Accounting methods impact The proposed regulations note that their application may require taxpayers to make changes to their methods of accounting. Such a change would be viewed as initiated by the taxpayer, and would be subject to the rules of Rev. Proc. 2015-13, or its successor. Taxpayers should consider what, if any changes, may be required (automatic or non-automatic) based on the rules in the proposed regulations.

Effective date The rules are proposed to be effective for cloud transactions, transfers of digital content or the provision of services in connection with digital content pursuant to contracts entered into in taxable years beginning on or after the date that final regulations are published in the Federal Register. For transactions involving transfers of computer programs prior to the proposed effective date, taxpayers should continue to rely on the rules in Treas. Reg. Sec. 1.861-18.

Next steps The guidance expands and clarifies characterization and sourcing rules related to digital content transactions, and also provides much needed guidance in the areas of 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 (global intangible low-taxed income, known as GILTI; the base erosion and anti-abuse tax, known as BEAT; Subpart F, etc.). Once implemented, these rules could require accounting method changes, and may have numerous other income tax impacts. Affected taxpayers should begin assessing the impact of these rules immediately to understand the effects of these regulations.

For more information contact:

David Sites
Partner
Washington National Tax Office 
Grant Thornton LLP
T +1 202 861 4104
 
Cory Perry
Senior Manager
Washington National Tax Office 
Grant Thornton LLP
T +1 202 521 1509

David Zaiken
Managing Director
Washington National Tax Office
Grant Thornton LLP
T +1 202 521 1543

Caleb Cordonnier
Senior Manager
Washington National Tax Office
Grant Thornton LLP
T +1 202 521 1555
 
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