Every Cloud Has a Silver Lining: Proposed Cloud Computing Regs

Last August, during a brief lull in the onslaught of guidance related to the Tax Cuts and Jobs Act, Treasury and the IRS released much-anticipated guidance addressing cloud-based transactions and other transactions involving digital content (the proposed cloud computing regulations).¹ As part of that same guidance package, Treasury and the IRS also proposed several changes that would modernize existing regulations governing transactions involving computer programs (the proposed software regulations).

Although the proposed cloud computing regulations did not necessarily exceed expectations, tempered as they were, they did offer a measure of relief for taxpayers in the cloud computing industry. In general, the proposed cloud computing regulations validated taxpayers’ belief that the existing framework of the software regulations in reg. section 1.861-18 was not particularly well suited for cloud-based software applications and other digital offerings, and they confirmed, in most instances, that those transactions should be characterized as services.²

Further, the proposed cloud computing regulations opted to reserve on other, arguably more challenging, issues, such as the source of income generated by cloud computing transactions and other digital activities. In so doing, Treasury and the IRS solicited comments from taxpayers to help develop “administrable rules” for sourcing income from cloud computing transactions.³ This request may suggest that the government believes the current U.S. sourcing rules are somehow ill-equipped to address sourcing in the cloud computing era, although any regulatory changes presumably must be constrained by the statutory place-of-performance standard.⁴

Also notable is the limited guidance on web-based software applications. The proposed cloud computing regulations address software applications in which there is little or no functionality without an internet connection (cloud transactions) or full functionality without an internet connection (software transactions). This approach raises the question of the proper treatment of the increasingly more common set of applications that have material functionality offline but greater functionality online.

On the other hand, the proposed software regulations introduced a new approach to sourcing sales of copyrighted articles, which largely came as a surprise.⁵ In a sharp departure from the current “title passage” rule, income from sales of copyrighted articles through an electronic medium would now be sourced to the location of download or installation onto the end-user’s device.⁶ In the absence of definitive information, taxpayers must generally resort to sales data as a proxy for geographic location.⁷

In this report, we provide an overview of the proposed regulations (collectively, the proposed cloud computing regulations and the proposed software regulations), preceded by a history of the relevant administrative landscape as it stood before their release. We then discuss several lessons learned regarding the scope and potential impact of the regulations. Finally, we conclude by highlighting several key questions that remain unanswered.

I. The Existing Software Regulations

As we discuss later, the proposed cloud computing regulations’ genetic makeup, as it were, includes traces of statutory authority, case law, and administrative law. On the regulatory front, the rules are closely related to the existing software regulations.⁸ Indeed, the proposed cloud computing regulations are housed in prop. reg. section 1.861-19, adjacent to the software regulations in reg. section 1.861-18. It is thus helpful to provide a summary of the software regulations — a walk down memory lane — given their place in the proposed cloud computing regulations’ regulatory family tree.

Long before the advent of the cloud and the proliferation of software purchases through download, brick-and-mortar stores served as the primary marketplace for consumers looking to purchase computer software. Indeed, some of our readers will recall buying copies of software programs on a floppy disk or, later, a CD-ROM enclosed in a so-called shrink-wrap license at their local electronics store — a transaction that has now effectively been relegated to the dustbin of history.

The software regulations, first proposed in 1996 and finalized in 1998, were issued in large part to provide guidance on a number of tax issues caused by the rapid expansion of software sales, both for commercial and personal use, in the late 1980s and early 1990s. These rules reflected Treasury’s first attempt to construct a framework for determining the character of income from transactions involving computer programs.⁹

As a threshold matter, the software regulations have broad application to many cross-border provisions of the code (for example, subpart F), as well as tax treaties. They also principally apply only to transfers of computer programs, by classifying those transactions as sales, licenses, leases, or the provision of software development services or know-how.¹⁰ Indeed, outside of software development services, the software regulations generally require a transfer of a computer program or the underlying copyright rights. As a result, transfers of other types of digital content, as well as many commonplace cloud computing transactions, did not fit neatly within the ambit of the software regulations.¹¹

At a high level, the software regulations seek to “distinguish between transactions in a copyright and in the subject of the copyright,” as determined by the type of rights transferred.¹² Under this approach, a transfer of a copyright program, whether to related or unrelated persons, may be categorized only as one of the following:

• a transfer of a copyright right in the computer program (a copyright right);

• a transfer of a copy of the computer program (a copyrighted article);

• the provision of services for the development or modification of the computer program; or

• the provision of know-how concerning computer programming techniques.¹³

Next, the software regulations classify a transfer of a computer program as a transfer of a copyright right if a person acquires any one or more of:

• the right to make copies of the computer program for distribution to the public by sale or other means of transferring ownership, or by rental, lease, or lending;

• the right to prepare derivative computer programs based on the copyrighted computer program;

• the right to make a public performance of the computer program; or

• the right to publicly display the computer program.¹⁴

For a transfer of a copyright right, the transaction is classified as either a sale or a license generating royalty income.¹⁵ The determination of whether a transfer of a copyright right is a sale is a fact-intensive inquiry and depends on whether all substantial rights to the copyright right have been transferred, taking into account a large body of relatively well-developed case law.¹⁶

For example, if in exchange for a payment based on “the number of disks copied and sold,” an entity grants a nonexclusive right for a term of years (that is less than the useful life of the software) to a person to make copies of the computer program and distribute them to the public for sale, the transaction constitutes the transfer of a copyright right and will be characterized as a license generating royalties.¹⁷ The concept is that we have a transfer of the underlying intellectual property but of less than substantially all rights to that IP.

By contrast, if a person acquires a copy of the computer program but acquires none of the rights identified earlier (or at least no more than a de minimis amount of those rights), the transfer of the copy of the computer program is classified as a transfer of a copyrighted article.¹⁸ In this manner, a transaction involving a transfer of a computer program (or other digital content under the proposed software regulations) defaults to the transfer of a copyrighted article in the absence of any of the characteristics representing a transfer of a copyright right under the software regulations. The concept here is that we have not transferred any of the underlying IP rights.

A transfer of a copyrighted article is classified either as a sale giving rise to gain or loss or a lease generating rental income.¹⁹ The determination of whether a transfer of a copyrighted article constitutes a sale or lease is a fact-intensive inquiry and depends on whether the benefits and burdens of ownership of the copyrighted article have been transferred.²⁰

As an example, suppose a corporation enters into a distribution agreement to buy copies of a computer program for sale to retailers from another corporation that owns the copyright in the program.²¹ The disks containing the program are shipped in boxes enclosed with a shrink-wrap license. Under the framework set forth in the software regulations, the transfer is a purchase of copyrighted articles, regardless of the use of the term “license,” because the buyer acquired individual copies of the program for sale to others. As such, the buyer is treated as an owner of the copyrighted articles, with the result that the transaction is treated as a sale of a copyrighted article.

Finally, in classifying the transaction, neither the form that the parties to the transaction adopt nor the means of transfer is dispositive.²²

II. The Proposed Cloud Computing Regulations

The proposed cloud computing regulations represent Treasury’s first significant attempt to grapple with cloud computing and related digital tax issues.²³ As will be seen, however, it is a case of in with the new but not out with the old.

The explosive growth of the cloud and the unique nature of cloud transactions presented a serious challenge for existing law, ultimately precipitating the need for a new regulatory approach. Although the software regulations offered Treasury one possible foundation on which to construct rules governing the classification of cloud transactions, the software regulations’ antiquated approach failed to adequately capture many commonplace cloud and digital transactions.²⁴

Unlike the types of transactions covered by the software regulations, cloud computing transactions are typically characterized by on-demand network access to computing resources, such as networks, servers, storage, and software. Significantly, cloud computing transactions ordinarily do not involve a transfer of a copyright right or copyrighted article (or at least a transfer of a right that is considered more than de minimis), as required under reg. section 1.861-18. The software regulations do not provide rules addressing online access to various software programs, servers, or web-based applications — the hallmarks of cloud computing and other digital transactions — thus necessitating a new, more modern regulatory framework.²⁵

Moreover, providers of cloud services are not the only ones that benefit from new guidance. Service recipients and other end-users — many of whom would not view themselves as technology companies — also had a need for clear and administrable guidance given the manner and frequency in which they purchase and access cloud-based services. For example, service recipients and end-users may be concerned about the timing and character of deductible payments, and whether any payments may be subject to withholding.

Prudently, Treasury has attempted to issue guidance that will be insulated from immediate obsolescence by enlarging the scope of the rules to encompass more than just the typical e-commerce models.²⁶ In creating this new framework, the proposed cloud computing regulations reflect a flexible facts and circumstances approach, largely derived from a potpourri of statutory (for example, section 7701(e)), regulatory (for example, the software regulations), and judicial sources.

A. Classifying Cloud Computing Transactions

The proposed cloud computing regulations effectively function to separate cloud-based transactions into one of two categories: (1) the rendition of services or (2) a lease of property.²⁷

For these purposes, a cloud transaction is broadly defined as a “transaction through which a person obtains non-de minimis on-demand network access to computer hardware, digital content (as defined in [prop. reg. section] 1.861-18(a)(3)), or other similar resources.”²⁸ As noted in the preamble, Treasury intended that the proposed cloud computing regulations would apply to a wide variety of cloud-based transactions, not only the traditional service models embraced by industry (for example, infrastructure as a service, platform as a service, and software as a service), but also to streaming media, web-based applications, and access to databases, servers, storage, and software.²⁹

However, to avoid confusion when cloud and software transactions may overlap, the software regulations would still govern transactions involving a transfer of software or digital content (for example, downloading of software or other media that is locally stored and available for use on a computer).³⁰ To illustrate this rule, the proposed cloud computing regulations provide an example in which a company provides both data storage and downloading of computer software with access to limited online features, neither of which is de minimis in relation to the other.³¹ In that situation, the two transactions are treated independently and, as such, classified separately; the data storage offering is treated as a cloud transaction, while the software download is subject to the software regulations.

On the basis that cloud transactions do not involve copyright right transfers, a license giving rise to royalties for the use of intangible property is not among the menu of available classifications, although the proposed cloud computing regulations do request comments on this issue.³² Notably, there are no instances or examples of leases of computer hardware in the proposed cloud computing regulations, although, again, Treasury requested comments on this topic.

B. Singular Treatment as a Service or Lease

Following the Fifth Circuit’s lead in Tidewater,³³ which adopted an all-or-nothing approach to applying the section 7701(e) factors to determine whether a time charter for a sea vessel should be considered a lease or a service agreement, Treasury prescribed a singular treatment of a cloud transaction as solely a lease of property or the provision of services.³⁴ Special rules apply if a cloud-based arrangement consists of multiple transactions, as discussed later.³⁵

C. Rendition of Service vs. Lease of Property

The classification of a cloud transaction as either the provision of a service or a lease of property is a fact-based exercise. The proposed cloud computing regulations provide a non-exhaustive list of nine factors demonstrating that a cloud transaction should be classified as a rendition of services rather than a lease of property:

1. the customer is not in physical possession of the property;

2. the customer does not control the property, beyond the customer’s network access and use of the property;

3. the provider has the right to determine the specific property used in the cloud transaction and replace that property with comparable property;

4. the property is a component of an integrated operation in which the provider has other responsibilities, including ensuring that the property is maintained and updated;

5. the customer does not have a significant economic or possessory interest in the property;

6. the provider bears any risk of substantially diminished receipts or substantially increased expenditures if there is nonperformance under the contract;

7. the provider uses the property concurrently to provide significant services to entities unrelated to the customer;

8. 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

9. the total contract price substantially exceeds the rental value of the property for the contract period.³⁶

Notably, six of the nine factors are representative of those outlined in section 7701(e), which has been the prevailing statutory reference for discerning license and services characterization of cloud transactions for almost all taxpayers.

Moreover, although the proposed cloud computing regulations provide that the relevance of any given factor, and thus the weight, varies depending on the facts and circumstances, the “concurrent use” factor, while not dispositive, appears to hold special significance, at least in our view.³⁷ This factor provides that property used to simultaneously render meaningful services to two or more unrelated customers is highly indicative of a service rather than a lease, especially because in cases of concurrent use, other factors that support classification as a service are likely to be present.³⁸ For example, if the data of several unrelated companies were hosted or processed through the same server at the same time, it is hard to believe the transaction could be anything other than a service.

However, we do not suggest that concurrent use should be viewed as a superfactor; rather, it is indicative that other factors supporting services treatment will be present. Indeed, the proposed cloud computing regulations conclude — correctly, we believe — that even a dedicated server serving a single user would not per se preclude classification of the transaction as a service, if, taking into account all relevant factors, the transaction qualified as a service.³⁹ Indeed, there may be many regulatory (for example, data protection) and technological reasons for service providers to gravitate away from concurrent use of any underlying computer hardware or digital content.

The proposed cloud computing regulations further demonstrate the application of these factors through a series of examples. And, as those examples show, application of the relevant factors to a cloud transaction generally leans toward the transaction being treated as the performance of services. This is particularly true when the end-user or recipient may only access — but not possess, alter, or control — the database, software, or digital content, or the servers that host the database or software, as is common in many cloud-computing transactions.

III. Lessons Learned

Lesson 1: The new sourcing rule for sales of copyrighted articles will cause uncertainty and increase compliance costs.

One of the biggest surprises that the proposed software regulations delivered involved the new sourcing rule for sales of a copyrighted article through a digital medium.⁴⁰ As proposed, income from sales of copyrighted articles will be sourced to the location of download or installation onto the end-user’s device. In the absence of information on the location of download or installation, sales will be deemed to have occurred at the customer’s location (determined based on recorded sales data for business or financial reporting purposes).

The preamble to the proposed software regulations notes that this change is necessary because the existing rules, under which the source of income is determined by the location where rights, title, and interest passed to the buyer, can be easily manipulated and “bear little connection to economic reality” in the context of transactions involving digital content.⁴¹

The proposed sourcing rule will almost invariably result in additional compliance burdens and costs, such as the need to implement new systems and procedures to gather and catalog information on customer location, and sometimes the location of a customer’s customers. Moreover, inbound taxpayers (and in some cases controlled foreign corporations) making sales to U.S. customers should prepare for the possibility that those sales will trigger effectively connected income, especially for taxpayers in non-treaty jurisdictions (for example, Taiwan and Brazil).⁴²

Lesson 2: Digital content is now within the software regulations’ scope.

The proposed software regulations would modernize existing law by enlarging the scope of the existing regulations to encompass digital content, as well as transfers of computer programs.⁴³ Under the proposed software regulations, digital content includes “any content in digital format,” such as e-books, movies, and music, provided the content is or was protected by copyright law.⁴⁴ They contain three additional examples to demonstrate how the software regulations would apply to transfers of digital content.⁴⁵

This expansion is unlikely to result in any meaningful disruption to the marketplace. Given the lack of relevant guidance before the release of the proposed software regulations, many taxpayers had already been applying, by analogy, the existing software regulations to transfers of digital content. If anything, this change should be beneficial, because it helps clarify how the software regulations are intended to interact with some cloud computing provisions in the proposed regulations vis-à-vis transactions in which a consumer is presented with different options for accessing the same content.⁴⁶

For instance, in Example 21, a company offers movies and TV shows with different options — rent, purchase, or streaming — for viewing the content. Although each option permits a consumer to view the same digital content, the example confirms that either the software regulations (rent or purchase) or provisions of the proposed cloud computing regulations (streaming) will apply depending on the option chosen by the consumer, resulting in different tax consequences to the provider.

Lesson 3: The right to public display/performance does not include advertising.

Allaying long-held concerns, the proposed software regulations would clarify that conveying the right to publicly perform or display digital content for purposes of advertising does not alone constitute the transfer of a copyright right.⁴⁷ In these cases, the transaction should generally be viewed as a transfer of a copyrighted article, treated as a sale or lease giving rise to rental income.

Questions may arise about how this rule interacts with the proposed cloud computing regulations, for example, when the right transferred is associated with advertising cloud computing services or other on-demand offerings. In those situations, although the advertisement may portray the software’s interface or even a unique instance of the service itself, presumably the rights transferred for advertising purposes are considered de minimis and treated as part of the service offering.⁴⁸

Lesson 4: The proposed cloud computing regulations introduced a new paradigm for determining a transfer.

Although a transfer of a computer program or other digital content remains a precondition to applying the software regulations, the proposed cloud computing regulations appear to have introduced a new paradigm for determining a transfer. Under that new paradigm, the relevant analysis hinges on the functionality (or lack thereof) of the program or application when used offline versus online. The examples in the proposed cloud computing regulations indicate that the focus for evaluating whether there has been a transfer depends on whether internet access is necessary for full functionality of the program or application.⁴⁹

On one end of the spectrum, when online access affords no or limited increased functionality, the transaction is likely to be governed by the software regulations. The proposed cloud computing regulations provide an example involving the sale of a computer program that is intended for use on the purchaser’s internal network.⁵⁰ In that example, the computer program is purchased under a subscription agreement, and the seller provides annual updates free of charge. On-demand access to the seller’s network is not included or necessary for the purchaser to effectively use the program. As a result, the transaction is treated as a transfer of digital content and governed by the software regulations, not the proposed cloud computing regulations.⁵¹

On the other end of the spectrum, when online access provides a significant increase in, or is required for, functionality, the transaction is likely to be governed by the proposed cloud computing regulations. Another example in the proposed cloud computing regulations illustrates a situation in which the value of the transferred software is largely, if not entirely, a function of the user’s ability to access the seller’s network through the internet.⁵² Although there is technically a transfer of software, the example concludes that the transfer is de minimis and should be disregarded in determining the overriding nature of the transaction. As a result, the transaction is governed by the provisions of the cloud computing rules and classified as a service.⁵³

The lack of guidance for transactions that fall between those two extremes may prove problematic. There are no meaningful guideposts for determining which rules to apply if there is non-de-minimis web-based functionality. There are numerous commercial examples of digital content or software that has substantial functionality offline but greater functionality online. In fact, many applications tend to evolve over time — generally leading to greater functionality online. Moving forward, taxpayers will need to carefully evaluate the level of functionality to determine whether to apply the software regulations or the proposed cloud computing regulations.

Lesson 5: The framework set forth in the proposed cloud computing regulations reflects a bias toward services characterization.

Under the proposed cloud computing regulations, cloud computing transactions are characterized as either a service or a lease. The proposed guidance, however, reflects a bias toward classification as a service, and it is difficult to envision a cloud transaction (that is, on-demand network access to computer hardware or digital content) that primarily involves a lease of cloud equipment, such as data centers and servers (and presumably, the proposed software regulations would govern leases of digital content). These transactions would appear to be limited to those that supply cloud computing providers, not the cloud computing providers themselves. In fact, none of the examples conclude that a transaction should be characterized as a lease, even in the context of dedicated servers. Treasury has requested comments, including “realistic examples of cloud transactions that would be treated as leases.”⁵⁴

Lesson 6: Under the proposed cloud computing regulations’ all-or-nothing rule for classifying cloud transactions, arrangements made up of multiple transactions may have different characterizations.

The proposed cloud computing regulations generally rejected a fragmented approach for characterizing cloud transactions, such that a given transaction is treated as solely a lease of property or a rendition of services. However, when a cloud-based arrangement consists of multiple transactions, the proposed cloud computing regulations would require taxpayers to separately analyze each component under the framework set out in prop. reg. section 1.861-19.⁵⁵

Nevertheless, this proposed rule would not apply to any de minimis transaction.⁵⁶ The proposed cloud computing regulations do not define de minimis, other than to suggest that the concept is inherently a factual inquiry.⁵⁷ Moreover, the approach taken in the examples in the proposed cloud computing regulations suggests that the determination is more qualitative than quantitative. The use of descriptors such as “core functionality”⁵⁸ and “primary benefit”⁵⁹ suggests a less mechanical and fluid standard, more akin to the “predominant character” approach adopted in the subpart F context.⁶⁰ Indeed, as the examples seem to conclude, it appears that as currently construed, “de minimis” should be interpreted broadly, and in most cases bifurcation should be rare.

Lesson 7: The proposed regulations raise the specter of section 481 and other rules governing changes in the method of accounting.

If finalized, the proposed regulations may require a taxpayer to change the way it reports income from a cloud transaction (for example, the sale of a copyrighted article, which is now treated as services). These changes may result in an accounting method change requiring consent of the commissioner. Presumably, these changes would be subject to the same rules under section 481 and the governing revenue procedures.

IV. Questions Raised

The proposed regulations raised several new questions, many of which have no easy or obvious answer.

Question 1: Under the proposed sourcing rule for sales of copyright articles, who is the end-user?

The precise contours of the proposed sourcing rule for sales of copyrighted articles are unclear. The proposed software regulations provide no guidance on what constitutes an end-user. Nor do they address situations involving an intermediary (for example, if Corp. A sells software to Corp. B for further resale). In fact, there are no examples illustrating how the new sourcing rule would apply to transfers of copyrighted articles.

Further, for a purchase of software or other digital content (for example, a movie or book) through a virtual private network (VPN), it is unclear whether the end-user should be considered the owner or administrator of the VPN, or whether the IRS may (or even should be able to) look through the VPN to the IP address of the ultimate purchaser (even assuming no concerns exist regarding privacy rights or sensitive commercial information).

In this manner, uncertainty abounds as to how to source these types of sales transactions. This may result in significant changes for many taxpayers, who previously relied on title passage under the existing law, especially inbound taxpayers who are now faced with the specter of these sales generating ECI, as mentioned earlier.⁶¹

Question 2: Will the proposed sourcing rule for digital sales of copyrighted articles lead to greater U.S. tax?

As discussed earlier, the source of income from copyrighted article sales could change for many taxpayers. Moreover, non-U.S. sellers located in a country that does not have an income tax treaty with the United States will have to consider the ramifications of U.S.-source income. Historically, inbound taxpayers navigated the fact-based U.S. trade or business inquiry by ensuring that title passed outside the United States.

However, under the proposed sourcing rule, even if an inbound seller has no U.S. presence but does business through a digital exchange (for example, website or app stores) or other intermediary, there is an increased risk that those activities will be imputed to the company, resulting in a U.S. trade or business and taxation of any U.S.-source income on a net basis, not to mention a slew of cumbersome reporting and compliance obligations. Also, for U.S.-parented foreign subsidiaries selling into the United States, CFCs must consider, and monitor, the risk of generating U.S.-source global intangible low-taxed income, which could result in excess foreign tax credits in the GILTI basket.⁶²

Questions also linger regarding the potential application of section 863(b) to sales of copyrighted articles through an electronic medium, when the copyrighted article is “produced” entirely or in part in the United States or abroad. As amended by the TCJA, section 863(b) provides that income from the sale of inventory that is either (1) produced (in whole or in part) inside the United States and then sold or exchanged outside the United States or (2) produced (in whole or part) outside the United States and then sold or exchanged inside the United States is allocated and apportioned solely on the basis of the location of production activity.⁶³

To ascertain the potential application of section 863(b) to sales of software, software vendors must first determine whether software-development-related activities qualify as production. Section 864(a) broadly defines produce to include “created, fabricated, manufactured, extracted, processed, cured, or aged.” Given the breadth of this definition, one could reasonably argue that coding or software design constitutes the creation of a copyrighted article. Nevertheless, this construct is consistent with now-repealed section 199, which generally provided that software development constituted qualifying production property for purposes of the domestic production activity deduction.⁶⁴

Second, even if section 863(b) were to apply, software vendors must still resolve whether, for sales of copyrighted articles (for example, computer software) that a seller produces or is treated as producing, section 863(b) trumps the new sourcing rule in prop. reg. section 1.861-18(f)(2)(ii), because the proposed software regulations would no longer source sales of copyrighted articles under the traditional title passage rule.⁶⁵ Prop. reg. section 1.861-7(c), which sets forth the general title passage rule for sales of inventory, refers taxpayers to prop. reg. section 1.861-18(f)(2)(ii) to determine the source of income from the sale of copyrighted articles.

Further, although prop. reg. section 1.861-18(f)(2)(ii) provides that income from sales of copyrighted articles will be sourced, in relevant part, under section 863 “as appropriate,” the regulation as drafted seems to restrict those statutory provisions to sales of copyrighted articles other than those that are sold and transferred through an electronic medium. One reading of the proposed sourcing rule, which preserves section 863(b), is that it should not apply to sales of computer software that the seller itself produces and sells through an electronic medium. And although Treasury does not elaborate, it would seem inappropriate for the proposed sourcing regulation to override a statutory provision that on its face would seem to squarely apply.⁶⁶

Question 3: How do the proposed cloud computing regulations apply to applications and programs that have a high level of functionality when the user is offline, but much greater functionality when the user is online?

As discussed earlier, the proposed regulations appear to have introduced a new paradigm for determining a transfer, by giving greater weight to the level of functionality of the underlying application or program when used offline versus online. The analysis appears to be largely facts and circumstances dependent, although examples 5, 6, and 7 in the proposed regulations provide some limited guiding principles for determining the outer limits of the rule.

However, the waters become muddy in situations in which a program or application offers end-users more than a de minimis level of functionality offline, but a meaningful increase in functionality when used online. For example, how should taxpayers classify a transaction involving a software program that has substantial functionality offline but non-de minimis additional functionality online? Does it matter whether most users take advantage of the additional online functionality?

Helpfully, Treasury and the IRS have requested comments on application of the proposed regulations to “an arrangement that involves non-de minimis rights both to access digital content on-demand over a network and to download such digital content onto a user’s electronic device for offline use.”⁶⁷

Question 4: When do you have to bifurcate cloud-based transactions?

Although the proposed cloud computing regulations provide a general rule for classifying arrangements consisting of multiple transactions, they do not provide specific guidance on when or if taxpayers should bifurcate cloud services that are bundled and sold as part of a single, integrated offering.

In situations in which two or more transactions are bundled, and one of them is considered de minimis, the proposed cloud computing regulations would disregard that de minimis component and would not separately characterize it as a service or lease. This principle is illustrated in Example 11 of the regulations, involving a company that provided end-users paid access to an online database.⁶⁸ Although end-users were permitted to download (and permanently retain) documents retrieved from the database, the fee paid did not depend on the amount — or content — of materials downloaded, because most of the materials were otherwise publicly available. Rather, the fee end-users pay to the company was attributable to the database’s “look and feel.” The example concludes that in that case, the right to download is de minimis in relation to the subscription access to the database, and as such, that function is not treated as a separate transaction. The transaction is thus characterized solely as a service.

As noted earlier, however, the exact contours of what constitutes de minimis under the proposed cloud computing regulations are not well defined. Thus, for example, it is unclear how taxpayers should classify cloud offerings that are treated as an integrated package or are unavailable for purchase separately. Presumably, these transactions should be classified consistent with their substance, even in situations in which the provider’s invoice reflects multiple line items (often included for internal administrative purposes or at the request of specific purchasers), suggesting that the offering could be bifurcated.

Question 5: How should the source of income generated by cloud computing transactions and other digital content be determined?

The proposed cloud computing regulations punt on the question of the source of income generated by cloud computing transactions and other digital content.⁶⁹

The issue is deceptively complex, even though the general sourcing rule for services found in sections 861(a)(3) and 862(a)(3) (place of performance) is relatively straightforward on its face.⁷⁰ Fortunately, case law and other guidance, although dated, provide an enduring and functional framework to address sourcing of income from cloud transactions. Under these pieces of authority, taxpayers have traditionally looked to the location of employees and tangible assets of the service provider.

For example, in an oft-cited case, Piedras Negras,⁷¹ the court addressed the source of advertising income derived in connection with radio broadcasting activities in Mexico. The Fifth Circuit concluded that the taxpayer’s income was entirely foreign-source income, even though 95 percent of its income was from advertisers located in the United States, because the taxpayer’s broadcasting facilities and workforce were located in Mexico.⁷²

Similarly, in LTR 6203055590A, the IRS looked to the location of a foreign corporation’s capital assets and labor to determine the source of advertising income. It ruled that income derived from that foreign entity’s advertising activities was foreign source, even though its customers were located in the United States, because the activities and employees responsible for carrying on the business were located outside the United States.

The issue becomes more complex when the activities and assets of (related or unrelated) subcontractors are used to provide the services. However, under existing law, the activities of related or unrelated parties (at least absent certain agency arrangements) are not imputed to a taxpayer generally, and again, we see no reason why these time-tested principles should not apply in the context of transactions involving cloud computing and digital content. Forcing taxpayers to determine the source of services income based on the place of performance of subcontractors (and subcontractors of subcontractors) could lead to double taxation and, as a practical matter, would be both burdensome and completely unenforceable.

For example, in Miller,⁷³ the Tax Court held, and the Ninth Circuit affirmed, that the performance of services outsourced to a related U.S. subsidiary did not result in U.S.-source income to the foreign parent. The IRS has also taken a similar position.⁷⁴ Of course, any compensation among related parties must be consistent with related principles of section 482, and for a corporation, that entity must also have meaningful substance.⁷⁵

However, as we look to a future in which the OECD, EU, and individual countries take an increasing interest in tax issues involving cloud computing and the digital economy, perhaps there is cause to question whether these initiatives will influence or alter Treasury’s view of the existing domestic sourcing rules. Or perhaps, as artificial intelligence and the internet of things continue to develop, we will eventually see a whole new set of rules for automated services with limited employee involvement — for example, when the controlling factor is customer location (consistent with the foreign-derived intangible income provisions), location of research and development or intangible property, or even formulary apportionment (for example, former section 863(b) and (e)).

In any event, it seems certain that some degree of uncertainty will persist and that the future of sourcing of cloud transactions will remain partly cloudy, at least for the foreseeable future.

V. Conclusion

Although the reaction of taxpayers and tax advisers to the proposed regulations appears largely mixed, there is still a silver lining to behold. Importantly, on the cloud computing front, the proposed regulations represent a significant first step for Treasury and helpfully validate the views adopted by industry taxpayers regarding the classification of cloud and other digital transactions. And although the proposed sourcing rule for software sales comes as an unpleasant surprise to many taxpayers, the proposed rule is just that — proposed. There is still a chance that Treasury and the IRS will react favorably to comments on this — and many other aspects — of the proposed regulations.