The U.S. Department of Treasury (Treasury) released final¹ and proposed² regulations under § 861 of the Code addressing the U.S. federal income tax classification of digital content and cloud computing transactions (the “Final Regulations” and the “Proposed Regulations” respectively). 

This article provides a brief summary of a few important distinctions between the Final Regulations and its predecessor, the § 861 proposed regulations issued in 2019³ (the “2019 Proposed Regulations”), and of the controversial factor-based apportionment rules for sourcing cloud transactions issued under the Proposed Regulations. 

The Final Regulations are effective for tax years beginning on or after January 14, 2025, but can be applied to open tax years beginning on or after August 14, 2019 (and all subsequent years) if applied consistently to the early application years by related parties and no accounting method change is required. The Proposed Regulations are effective only for tax years beginning on or after the date the proposed regulations are finalized.

Why should U.S. taxpayers care about the digital content and cloud computing regulations? 

The source and character of income from digital content and cloud transactions is relevant for U.S. taxpayers who have global customers that pay for software or services, employ a global workforce, or otherwise pay for software or services from foreign related or unrelated parties. 

U.S. parented multinationals generally desire to avoid having their foreign affiliates generate U.S. source income as this can create foreign tax credit limitation issues under § 904 of the Code. For example, if a U.S. parented company engages its U.K. branch to distribute its software as a service offering in Europe, and income from the U.K. branch’s activities are subject to U.K. tax, the U.S. parent will be limited in its ability to obtain a foreign tax credit to offset the U.K. tax imposed to the extent that the U.K. branch’s income is U.S. (as opposed to foreign) source income. 

In another example, if a U.S.-based technology company provides a cloud offering to customers in certain non-U.S. jurisdictions, particularly those without an income tax treaty, such as Brazil, foreign withholding tax could apply on payments received from foreign customers with no foreign tax credit available if the transaction is characterized as a service for U.S. federal income tax purposes under Reg. § 1.861-19 and the income is U.S. source. 

Regulations under § 861 in Reg. § 1.861-18 (digital content) and Reg. § 1.861-19 (cloud transactions) address the U.S. federal income tax characterization of digital content and cloud transactions, generally as either: a sale of property, a license, or as a service offering. Reg. § 1.861-18 sets out a two-part test for characterizing a digital content transaction based on:

1. Determining the category of the transaction as a transfer of “copyright rights” or “copyrighted articles,” or the provision of services or know-how
2. Applying the relevant source rules depending on the category of transaction

Transfers of copyrighted rights are characterized by applying the source rules for intangible property, and transfers of copyright “articles” are based on source rules for tangible property, with special rules applying for the transfer of copyright articles transferred through an electronic medium that are discussed below.

Notable Changes in the Final Regulations

1. All cloud transactions are now characterized as services transactions

Final Reg. § 1.861-19(c) provides that all cloud transactions are characterized as services transactions, doing away with the 2019 Proposed Regulations’ factor-based approach. This simplified approach should come as no surprise to taxpayers as it was highly unlikely a cloud transaction would be characterized as anything other than a service transaction based on interpretations under existing law and the factors established in the 2019 Proposed Regulations. 

2. Transactions within the scope of Regs. §§ 1.861-18 and 1.861-19 are now characterized based on a “predominant character” test

The Final Regulations apply a predominant character test for characterizing a transaction. Regs. §§ 1.861-18(b)(2) and (b)(3) provide that a transaction with multiple elements is classified entirely as a digital content transaction if the “predominant character” of the transaction is a digital content transaction. Reg. § 1.861-19(c)(2) similarly applies a predominant character test referencing back to the rules in Reg. § 1.861-18.

The predominant character test looks to the primary benefit or value received by the customer, or failing that, looks to the primary benefit or value received by a “typical customer” in a substantially similar transaction determined based on data on how a typical customer accesses or uses the digital content, or, as a final backstop, looks to “other factors,” such as how the taxpayer’s transaction is marketed, the relative development costs of each element of the transaction, and the relative price paid in an uncontrolled transaction for one or more elements compared to the total contract price of the transaction in question. Ultimately, this simplified approach protects taxpayers from needing to classify each and every non-de minimis component of a transaction .

Example 24 (Reg. § 1.861-18(h)(24)) illustrates an application of the predominant character test. In the example, Corp A (U.S.) owns the copyright to a computer game that has both cloud features (a multiplayer feature) and digital content features (a single-player story). The example involves a two-leg transaction, with leg 1 consisting of an electronic transfer of the game from Corp A to retailers for further right to transfer to customers in exchange for a one-time fee, and leg 2 consisting of a transfer from retailers to ultimate consumers for a one-time fee (each via a download of a digital copy of the game). The game is primarily marketed for its single-player features, with development cost allocated 40% to developing the single-player content, 20% to multiplayer content and 40% to content used throughout the game. 

The example illustrates the transaction-by-transaction approach taken in the Final Regulations, characterizing the first leg as a sale of a copyright article from Corp A to retailers as the primary benefit for retailers is their ability to on-sell downloads of the game to customers in perpetuity without further payment. The second leg of the transaction is then characterized separately. Under the facts of the Example, the primary benefit to customers cannot be ascertained, and the fallback rules are applied, with the Example looking to both the fact that the game was marketed for its single-player feature, and the fact that more of the development costs went into developing the single-player feature of the game (40% single player content, 20% multiplayer, 40% throughout), ultimately characterizing the second leg of the transaction as a digital content transaction and a sale of a copyright article as the customer obtains the right to use the game in perpetuity without further payment. 

Notable in Example 24 is the fact that there is both a cloud transaction (the multiplayer version of the game) and a digital content transaction (the single-player version) provided to customers in a single bundled transaction where customers pay a one-time fee to retailers to play the game. The predominant character rules could thus either benefit or hinder a taxpayer depending on whether it would have been beneficial to characterize at least part of the transaction (the multiplayer version of the game) as a service under the cloud transaction rules in Reg. § 1.861-19.

3. Sourcing rules for transfers of copyright articles transferred electronically are sourced based on customer location

Additional rules were added in the Final Regulations under Reg. § 1.861-18(f)(2)(ii) that provide that when a copyright article is transferred through an electronic medium, the sale is deemed to have occurred at the billing address of the purchaser. However, anti-abuse rules apply if a taxpayer arranges a transaction in a particular manner for a principal purpose of tax avoidance. 

Examples 25 and 26 in the Final Regulations (Regs. §§ 1.861-18(h)(25) and (26)) illustrate the anti-abuse rule. In Example 25, a multinational enterprise distributes products through a foreign procurement hub, and in Example 26, the taxpayer uses a foreign subsidiary in an abusive manner to alter the source of income. 

In Example 25, Corp A (U.S.) is the parent of a multinational group whose foreign affiliate, Corp B (foreign), acts as a procurement hub for Corp A’s affiliates. Corp C (an unrelated company) transfers digital copies of a computer program to Corp B in a transaction characterized as a transfer of copyright articles for Corp B to further distribute amongst Corp A’s affiliates. Under the inventory sourcing rules in the Code for tangible property, the sales by Corp C to Corp B would be sourced where the sale occurred. The sourcing rules in the Final Regulations for electronic transfers of copyright articles however further provide that the sale is sourced to the billing address of the purchaser (Corp B) unless the anti-abuse rule applies. Example 25 concludes that even though Corp B will not use the program, because it regularly acts as a procurement hub, there is no evidence of tax avoidance, and thus the sale is foreign source. 

In Example 26, Corp B does not act as a procurement hub regularly purchasing products for use by Corp A’s affiliates, and instead Corp A negotiates the agreement with Corp C, with Corp C granting rights to Corp A (and Corp C requesting Corp B to be the purchaser of record). The anti-abuse rule applies in Example 26, and the place where the sale occurred must instead be based on all relevant facts and circumstances, notably the fact that Corp A negotiated the purchase, and the sale is sourced to the location of Corp A and is U.S. source income.

4.  The Proposed Regulations provide details on a controversial factor-based approach for sourcing gross income from cloud transactions 

The Proposed Regulations look to the location of a company’s assets and employees in determining the source of gross income from cloud transactions. The Proposed Regulations rely in part on the decision in Piedras Negras (43 B.T.A. 297 (1941), aff’d 127. F2d 160 (5^th Cir. 1942)), in which the income of a radio broadcasting corporation was foreign source because its assets and employees were located in Mexico, even though the corporation broadcasted programs primarily to listeners in the United States. 

To determine source of income for cloud transactions, the Proposed Regulations adopt a three-factor formula based on: 

1. An intangible property factor intended to reflect the contribution of intangible property to the provision of the cloud transaction
2. A tangible property factor intended to reflect the contribution of tangible property to the provision of the cloud transaction
3. A personnel factor intended to reflect the contribution of employees to the provision of the cloud transaction

Each factor is determined by taking into account certain worldwide expenses that represent contributions made through the relevant personnel and assets to the performance of the cloud transaction. The U.S. source portion of a cloud transaction is equal to a taxpayer’s gross income multiplied by the sum of the U.S. source portion of expenses determined under each of the three factors divided by the sum of the worldwide expenses for all of the three factors. Cloud transactions are characterized on a taxpayer-by-taxpayer approach consistent with the principles in Miller (73 T.C.M. 2319 (1997)), which held that the income that a foreign corporation received for performing research and development services was foreign source even though the performance of services was subcontracted to certain related and unrelated entities.

The intangible property factor has been the most controversial element of the Proposed Regulations due to its focus on current-year compensation paid to research and experimentation (R&E) personnel. Since intangible property has no obvious physical location, the location of R&E personnel is substituted as a proxy. 

The intangible factor is equal to the sum of a taxpayer’s § 174(b) specified R&E expenditures for the year (regardless of when deductible) for the year associated with cloud transactions in the same product line as the cloud transaction performed and the taxpayer’s amortization (other than amounts capitalized and amortized under §§ 174(a)(2)(A) and (B)) and royalty expenses for intangible property for the year to the extent they are for intangible property directly used to provide the cloud transaction. Intangible property costs include payments to third-party and related-party research and experimentation providers, however the U.S. source portion of the intangible property factor is determined using a formula based on the location of the taxpayer’s employees by dividing the sum of total compensation paid to R&E personnel for services performed in the U.S. by the sum of total compensation paid to R&E personnel and multiplying it by the R&E factor. 

This approach for determining the U.S. source portion of the intangible property factor arguably provides more favorable sourcing outcomes for companies that perform offshore R&E versus in the United States. Moreover, the location of R&E for a particular year may not be an adequate proxy for the location of intangible property, or where it is used for a given year. Another foundational issue with the intangible factor is that it relies on information about the activities of individual employees that is extremely onerous to collect, relying on determining which R&E employees directly contributed to a cloud transaction.  

¹ T.D. 10022, providing revisions to Regs. §§ 1.861-18 and 1.861-19.

² REG-107420-24, providing revisions to Reg. § 1.861-19.

³ REG-130700-14.