Firm Suggests Ways to Refine Cloud, Software Transaction Regs

November 12, 2019

CC:PA:LPD:PR (REG–130700–14)
Room 5203
Internal Revenue Service
P.O. Box 7604
Ben Franklin Station
Washington, DC 20044

Re: Classification of Cloud Transactions and Transactions Involving Digital Content in REG-130700-14

Dear Sirs/Madams:

We are writing on behalf of the Software Coalition¹ to address certain aspects of the proposed regulations regarding modifications to the rules for classifying transactions involving computer programs (the “Proposed Software Regulations”)² and proposed regulations regarding the classification of cloud transactions for purposes of the international provisions of the Code (the “Proposed Cloud Regulations” and together with the Proposed Software Regulations the “Proposed Regulations”).³ In the preamble to the Proposed Regulations (the “Preamble”), Treasury and the Internal Revenue Service (the “IRS”) requested comments “on all aspects of the proposed regulations” including nine specifically enumerated topics.⁴

We recognize and appreciate the considerable thought that underlies the Proposed Regulations. We would like to offer some comments to refine the Proposed Regulations to provide more precise guidance to taxpayers which deliver digital content and engage in cloud transactions.

The Software Coalition appreciates the opportunity to provide input on these important issues.

1. Proposed Software Regulations

1.1 Scope of the Software Regulations.

The Software Regulations provide rules for classifying certain transactions “for purposes of subchapter N of chapter 1 of the Internal Revenue Code, sections 367, 404A, 482, 551, 679, 1059A, chapter 3, chapter 5, sections 842 and 845 (to the extent involving a foreign person), and transfers to foreign trusts not covered by section 679.”⁵ Treasury and the IRS specifically declined to make the Software Regulations applicable for all U.S. tax purposes but noted that consideration would be paid to whether the principles of the Software Regulations should apply to other tax provisions in the Code.⁶ In this regard, the Coalition recommends that the scope of the Software Regulations should be broadened so that they are applicable for all U.S. tax purposes.

1.2 Endorsement of the Digital Content Definition in Prop. Treas. Reg. § 1.861-18(a)(3).

Prop. Treas. Reg. § 1.861-18(a)(3) replaces the definition of “computer program” in the existing Software Regulations with the concept of “digital content.” Prop. Treas. Reg. § 1.861-18(a)(3) defines digital content 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. Digital content includes, for example, books, movies, and music in digital format in addition to computer programs. Although the Coalition endorses this definition and commends Treasury and the IRS on a well-reasoned and helpful definition for digital content, we also note that it may preferable to use a more inclusive term than “content” because of the inclusion of computer programs. “Content” normally connotes material which is valuable due to its literary or artistic expression, while a computer program has value due to its technical functions. Both, of course, are protected as copyrighted works.

1.3 Recommendation to Apply Predominant Character Standard.

Treas. Reg. § 1.861-18(b) provides that a transaction within scope of those regulations must be treated solely as one of the four transactions described in Treas. Reg. § 1.861-18(b)(1). In addition, any “transaction” that involves more than one of the four transactions must be treated as separate transactions.⁷ However, “any transaction that is de minimis, taking into account the overall transaction and the surrounding facts and circumstances, shall not be treated as a separate transaction, but as part of another transaction.”⁸

As we discuss in further detail below, we believe that the final regulations for both the Cloud Regulations and the Software Regulations should be harmonized and should adopt a predominant character standard instead of the de minimis approach that is currently in the unmodified Software Regulations. If Treasury and the IRS adopt our recommendation, then we also recommend that the references in Treas. Reg. § 1.861-18(b)(2), in the examples in Treas. Reg. § 1.861-18(h), and in the proposed examples in Prop. Treas. Reg. § 1.861-18(h) to “de minimis” be removed and conformed as appropriate.

For both taxpayers and the IRS, it has been difficult to determine whether a portion of a transaction that involves an additional element corresponding to one of the four transactions enumerated in Treas. Reg. § 1.861-18(b)(1) is de minimis such that the de minimis element should not be treated as a separate transaction. Modifying the Software Regulations to include a predominant character standard would alleviate this burden to a significant degree because the de minimis standard is inherently unclear as compared to a predominant character standard which is significantly more administrable.

Since the Software Regulations were finalized, taxpayers have encountered and engaged in transactions that clearly involve multiple elements. For example, downloaded software applications which principally execute on the user's device frequently allow access to cloud functionality for some functions. If those transactions were analyzed as separate transactions, the former should be treated as a transfer of a copyrighted article under the Software Regulations and the latter should be treated as the provision of a service. However, given the interrelated nature of the two components, in many cases it has been difficult to conclude that either the downloaded software component or the cloud functionality component would be insubstantial or ancillary to such a degree as to qualify as de minimis within the plain meaning of that term. A de minimis standard is a very imprecise standard that does not have appropriate or reliable benchmarks in the existing Code or Regulations. A comparative analysis that only requires taxpayers and the IRS to determine which part of the combined transaction is “predominant” is much more administrable.

A facts and circumstances analysis of the particular transactions will need to be undertaken regardless of whether the chosen approach is a de minimis standard or predominant character standard. Once that facts and circumstances analysis is completed, it will be more administrable to determine which element is predominant, as opposed to trying to determine whether an element falls above or below a de minimis line, and then if necessary setting a relative value for that element of the transaction.

In that regard, it is worth noting that copyright law generally consists of binaries, that is rights either exist or they do not, and either are exercised or are not. Copyright law does not employ a de minimis concept to inform whether or not rights exist or can be exercised. Thus, we believe that a predominant character standard better aligns with the existing tenets of copyright law as well.

1.4 Recommendation to Clarify That Example 19 Applies Only to Direct Sale Transactions.

Prop. Treas. Reg. § 1.861-18(h)(19) (“Example 19”) of the Proposed Software Regulations appears to describe a licensed distributor model where Corp A, a company that operates an on-line distribution business, licenses content from a content owner and exercises rights under that license to sell copies of a copyrighted article directly to end-users. The content owner grants Corp A the “right to distribute for sale to the public an unlimited number of copies.” Corp A “charges each end-user a fixed fee for each book purchased.” The example analyzes the arrangement between the content owner and Corp A by noting that the content owner has transferred copyright rights to Corp A within the meaning of Treas. Reg. § 1.861-18(c)(2)(i) by transferring “a master copy of the book along with the right to sell an unlimited number of copies to customers.” Accordingly, this example concludes that the arrangement between the content owner and Corp A is a license.

A different common commercial model exists that allows a content owner to distribute copies of its content through a platform operator. Under this model, the copyrighted article is sold under a contract directly between the content owner and the end user. The content owner authorizes an entity which operates an on-line platform to host a master copy of the book or other content, and to allow downloads by purchasers on behalf of the content owner. The platform operator earns a fee for providing the platform and performing other services. Pursuant to the contract between the content owner and the platform operator, the platform operator is granted those rights necessary to allow the platform operator to perform its functions as a platform. Since the actions of an agent generally are imputed to the principal,⁹ actions taken by the agent in performance of its functions as a platform operator are imputed to the content owner. As such, acquiring a master copy of the book and allowing users to download copies of that book should not be regarded as a “transfer of a copyright right” to the platform operator within the meaning of Treas. Reg. § 1.861-18(c)(1)(i).

These two models can be analogized to the manufacturing context. As in the licensed distributor model, a manufacturer that licenses a patent or copyright from the owner and then sells products in its own name that incorporate those rights would typically be characterized as in a market exploitation license arrangement with the patent or copyright owner. In contrast, a manufacturer may provide manufacturing services to a patent or copyright owner and receive a royalty-free license to use the patent or copyright to allow the manufacturer to legally perform the manufacturing services. In both models, the manufacturer needs the relevant patent or copyright rights to manufacture the product, but in the latter case there is no license for commercial exploitation on the market by the manufacturer because the licensor sells the finished products directly to its customers. Similarly, in the context of electronic books and other digital content, a platform operator which merely hosts the master digital copy in order to allow downloads on behalf of the content owner should not be regarded as in a license arrangement with the content owner under Treas. Reg. § 1.861-18(c)(1)(i).

Parties may choose to structure their commercial arrangements under either model, and the Proposed Regulations should provide guidance to distinguish these two commercially important but distinctly different models. Accordingly, we recommend the following changes to Example 19 to clarify that this example describes a direct sale by Corp. A to the end-user, and a new example to describe the platform model.

Additionally, we recommend adding the below additional example to illustrate the platform model.

1.5 Endorsement of the Removal of “Techniques” in Treas. Reg. § 1.861-18(b)(1)(iv) and (e)(1).

Treas. Reg. § 1.861-18(b)(1)(iv) provides that an international transaction involving the transfer of a computer program or the provision of services or know-how with respect to a computer program is treated as the provision of know-how relating to computer programming techniques. Similarly, Treas. Reg. § 1.861-18(e)(1) provides that the provision of information with respect to a computer program will be treated as the provision of know-how only if the information is information relating to computer programming techniques. The proposed amendments to the Software Regulations replace the phrase “the provision of know-how relating to computer programming techniques” in Treas. Reg. § 1.861-18(b)(1)(iv) with “the provision of know-how relating to the development of digital content.”¹⁰ The proposed amendments to the Software Regulations also replace the phrase “information relating to computer programming techniques” in Treas. Reg. § 1.861-18(e)(1) with “information relating to the development of digital content.”¹¹ We believe that the important aspect of the Software Regulations is that this fourth category of copyright right transactions is meant to describe only the transfer of know-how, under terms which constitute a license for U.S. federal tax purposes. We assume that Treasury and the IRS do not intend to change the scope of that fourth category in Treas. Reg. § 1.861-18(b)(1)(iv) and (e)(1) by replacing the term “computer programming techniques” with “development of digital content”. It would be useful to confirm that understanding in the preamble to final regulations.

1.6 Recommendation to Add a Distribution Requirement to the Right to Prepare Derivative Works Pursuant to Treas. Reg. § 1.861-18(c)(2)(i) and (ii).

Treas. Reg. § 1.861-18(c)(2) provides that a transaction involving a computer program is treated as a transfer of a copyright right if, in relevant part, a person acquired as a result of the transaction:

The Coalition recommends that a transfer of the right to prepare derivative digital content should not be treated as the transfer of a copyright right unless it is coupled with the right to distribute the derivative content to the public. This change would make the right to prepare derivative digital content more consistent with the right to reproduce copies, which results in the transfer of a copyright right only if it is coupled with the right to exploit the market, through distribution to the public. One of the underlying policies of the Software Regulations is to classify transactions in which the transferee exercises a copyright to exploit the rights in the market as generating royalty income, and to classify transactions in which the transferee consumes the computer program or digital content as generating income from the sale or lease of a copyrighted article. Given this policy, the current Software Regulations couple reproduction with distribution, because reproduction alone does not indicate a market exploitation transaction. Similarly, with respect to derivative works, unless a licensee is permitted to distribute the derivative work, there would not likely be a market exploitation of the derivative work. Moreover, there is ambiguity in the copyright law as to what modifications of a copyrighted work constitute a derivative work. This ambiguity leads to uncertainty when a grant of rights to modify the software program, for example during installation or customization, constitutes the grant of rights to create a derivative work. Combining the right to prepare derivative works with the right to distribute those works addresses this ambiguity, as it is normally clear when the transferee also has the rights to distribute a work to the public.

1.7 Exception from Public Performance and Display Copyright Rights Pursuant to Prop. Treas. Reg. § 1.861-18(c)(2)(iii) and (iv).

Treas. Reg. § 1.861-18(c)(2) provides that a transaction involving a computer program is treated as a transfer of a copyright right only if, as a result of the transaction, a person acquired one or more of the following rights:

Prop. Treas. Reg. § 1.861-18(c)(2)(iii) amends Treas. Reg. § 1.861-18(c)(2)(iii) to state that a copyright right includes “the right to make a public performance of digital content, other than a right to publicly perform digital content for the purpose of advertising the sale of the digital content performed.” Prop. Treas. Reg. § 1.861-18(c)(2)(iv) amends Treas. Reg. § 1.861-18(c)(2)(iv) to read “the right to publicly display digital content, other than a right to publicly display digital content for the purpose of advertising the sale of the digital content displayed.”

The Coalition agrees with the exceptions in the proposed amendments to Treas. Reg. § 1.861-18(c)(2)(iii) and (iv) that narrow the circumstances in which the right to display or publicly perform digital content will be considered a copyright right and believes that these exceptions are helpful and reasonable clarifications. We note that the Preamble includes an example that provides:

[R]ights provided to a video game retailer allowing the retailer to display screenshots of a video game on television commercials promoting sales of the game generally would not, on their own, constitute a transfer of copyright rights that is significant in context.¹⁴

We believe that this example is a helpful one and should be included in the final regulations.

1.8 Source of Income for Sales of Copyrighted Articles Pursuant to Prop Treas. Reg. § 1.861-18(f)(2)(ii).

Prop Treas. Reg. § 1.861-18(f)(2)(ii) provides that income from transactions that are classified as sales or exchanges of copyrighted articles will be sourced under sections 861(a)(6), 862(a)(6), 863, or 865(a), (b), (c), or (e), as appropriate. Prop. Treas. Reg. § 1.861-18(f)(2)(ii) also provides that when a copyrighted article is sold and transferred through an electronic medium, the sale is deemed to have occurred at the location of download or installation onto the end-user's device used to access the digital content for purposes of Treas. Reg. § 1.861-7(c), and in the absence of information about the location of download or installation onto the end-user's device, the sale will be deemed to have occurred at the location of the customer. The location of the customer is determined based on the taxpayer's recorded sales data for business or financial reporting purposes.

Section 863(b) generally provides that the source of income derived from the sale of inventory property is determined with reference to whether the property was produced entirely within or without the United States, without regard to where title passage occurred. Therefore, income derived from the sale of inventory property outside the United States that was produced entirely within the United States is U.S.-source income, regardless of where the title to the property passed. Income derived from the sale of inventory property within the United States that was produced entirely outside the United States is foreign-source income, regardless of where the title to the property passed. In the event that inventory property is produced partly within and partly without the United States, the income derived from the sale of the property is partly U.S.-source income and partly foreign-source income regardless of where the title to the property passed.¹⁵

We generally agree with the intended result of Prop. Treas. Reg. § 1.861-18(f)(2)(ii) for the same reasons discussed in the Preamble,¹⁶ namely because the location at which rights, title, and interest in electronically downloaded software is transferred is often difficult to determine or not specified. However, Coalition members observe that certain scenarios may make it difficult to determine the location of download or installation onto an end-user's device that is used to access the digital content. For example, some software applications may be sold through multi-level distribution channels, even though the ultimate delivery of the application is through digital means. Similarly, in cases of global enterprise licensing and other contexts, the customer enterprise might be responsible for delivering copies to individual users.

Accordingly, we recommend that the proposed source rule in Prop. Treas. Reg. § 1.861-18(f)(2)(ii) be amended to provide a rule that will operate appropriately for both sales made directly to individual users and through more complex distribution channels. We suggest that income from the sale of copyrighted articles transferred through an electronic medium is sourced to the billing location of the first unrelated purchasing entity, which could be a user or a reseller. As is the case with the proposed rule, we recommend that this rule would apply only for the purposes of Treas. Reg. § 1.861-7(c). In addition, if our recommended rule is adopted, we recommend that the final regulations also include an elective rule that allows taxpayers to apply the proposed rule in Prop. Treas. Reg. § 1.861-18(f)(2)(ii), i.e., the sale is deemed to occur at the location of download or installation onto the end-user's device used to access the digital content. We expect that this will be the method used by most B2C suppliers of digital content, as such suppliers frequently are required to identify the location of the user for other tax compliance purposes, such as VAT.

Our recommended rule creates the same result as the proposed rule in Prop. Treas. Reg. § 1.861-18(f)(2)(ii) with respect to transactions that involve direct sales to customers but would also have the result of simplifying the analysis for transactions that involve complex distribution channels and multiple resellers.

We also recommend that the final regulations allow taxpayers to elect to apply exclusively the proposed source rule to determine the source of income for sales of digital content where section 863(b) may otherwise apply.¹⁷ We appreciate that Treasury and the IRS are sympathetic to the difficulties that U.S. software companies may have under current law to establish that their income from export sales of copyrighted articles constitutes foreign source income. We note that export transactions of limited duration licenses of software copies constitute foreign source income, as the rents are sourced to the location of the user in those cases. Many software companies offer their products both for a perpetual use (sale) or limited duration use (lease) basis. The use of limited duration licenses has become a common approach for software delivery by U.S. software companies. There is no apparent policy purpose to distinguish between sales and leases of software copies for source of income purposes. This election would allow U.S. software companies to create equal treatment between functionally similar delivery methods for their software products.

We note that Treasury in the past has made similar allowances for the special characteristics of software. In Treas. Reg. § 1.199-3(i)(6)(iii), Treasury concluded that certain on-line software supplied as a service (i.e., SaaS) should be treated the same for section 199 purposes as software delivered as a sale or lease of a copyrighted article, due to the functional equivalence of the two delivery models, even though the statute did not extend section 199 benefits to services transactions. We request that Treasury exercise similar authority in this case to allow software suppliers to elect to equalize the source of income results from their sale and lease transactions.

We recommend adding the following examples to illustrate these recommendations:

2. Proposed Cloud Regulations

2.1 Scope of the Proposed Cloud Regulations.

Prop. Treas. Reg. §1.861-19(a) provides that the Proposed Cloud Regulations apply only for certain international tax purposes. We recommend that these rules should be made applicable for all purposes of the Code because the framework of the Proposed Cloud Regulations provides reasonable guidelines for transactions involving cloud transactions.

2.2 Definition of a Cloud Transaction.

The Proposed Cloud Regulations start with the proposition that the purpose of the regulation is to classify a cloud transaction as either a provision of services or a lease of property.¹⁸ The Proposed Cloud Regulations define a “cloud transaction” as follows:

A cloud transaction is a transaction through which a person obtains on-demand network access to computer hardware, digital content (as defined in §1.861-18(a)(3)), or other similar resources, other than on-demand network access that is de minimis taking into account the overall arrangement and the surrounding facts and circumstances. A cloud transaction does not include network access to download digital content for storage and use on a person's computer or other electronic device.¹⁹

This definition is consistent with the definition of cloud computing formulated by the National Institute of Standards and Technology.²⁰ The Coalition agrees with this definition.

2.3 Classification of Cloud Transactions — Provision of Services as a Per Se Rule or a Presumption and Endorsement of the Factors Demonstrating Classification as the Provision of Services in Prop. Treas. Reg. § 1.861-19(c)(2).

Prop. Treas. Reg. § 1.861-19(c)(1) provides that a cloud transaction will be classified “solely” as either a lease of computer hardware or content or the provision of services, taking into account the factors described in Prop. Treas. Reg. § 1.861-19(c)(2). Prop. Treas. Reg. § 1.861-19(c)(2) provides a list of nine, nonexclusive factors that can be used to demonstrate that a cloud transaction is classified as the provision of services rather than a lease of property. As currently constructed, Prop. Treas. Reg. § 1.861-19(c)(2) appears to assume that there exist cloud transactions that could properly be classified as a lease. Indeed, Treasury has specifically requested that taxpayers provide “realistic” examples of cloud transactions that would be treated as leases under proposed Prop. Treas. Reg. §1.861-19.²¹

The Coalition agrees with Treasury and the IRS's use of the factors in section 7701(e), and we agree with the addition of two of the three new factors. We also agree with the analysis and weighting of the factors in the examples at Prop. Treas. Reg. §1.861-19(d).

Although we agree that new factors (iii) and (iv) properly reflect characteristics of cloud service transactions, it is less clear that new factor (viii) should be included in the final regulations. Common business models that employ a compensation model based on work performed or level of use include the provision of processing power or transaction processing. Those transactions normally should be treated as service transactions. On the other hand, payments measured by the passage of time frequently do not necessarily indicate a lease transaction. For example, SaaS subscriptions normally are concluded on a time basis (e.g., annually), but SaaS transactions normally should be analyzed as services. This is one case where the other factors would apply to cause the overall character to be that of a service. Because we do not believe that new factor (viii) is a factor that is necessarily determinative of either a lease or service transaction and because it is a factor that is present in many cloud transactions pursuant to the definition in Prop. Treas. Reg. § 1.861-19(b), we recommend that it be removed from the final regulations. If Treasury and the IRS adopt this recommendation, then we also recommend that the preamble to the final regulations should explicitly state that new factor (viii) is not germane to the analysis of whether a cloud transaction is properly characterized as a service or a lease.

Due to the nature of cloud computing, we believe that a realistic example of a cloud transaction that should be treated as a lease does not exist. The nature of cloud computing is the aggregation of assets, both hardware and software, in a form that the provider can provide the hardware and software functionality in a more efficient way than individual users could if they had to build their own data centers and host software applications themselves. By and large, this economic essence of cloud computing appears in various of the factors at Prop. Treas. Reg. § 1.861-19(c)(2). Users which choose to buy or lease assets are following a different investment, functional and risk management strategy than those which meet their infrastructure and software needs through cloud transactions. Accordingly, we recommend that the final regulations should eliminate the “services — lease” dichotomy implicit in the factors under Prop. Treas. Reg. § 1.861-19(c)(2) in favor of a per se rule that transactions that fall within the definition of a cloud transaction under Prop. Treas. Reg. § 1.861-19(b) are classified as the provision of services. If this recommendation is adopted, the preamble to the final regulations should note that the factors enumerated in section 7701(e) are the basis for reaching this conclusion. If the above recommendation is not adopted, then we recommend that the final regulations should eliminate the “services-lease” dichotomy implicit in the factors under Prop. Treas. Reg. § 1.861-19(c)(2) in favor of a presumption that cloud transactions are classified as the provision of services absent unusual circumstances.²² This presumption should apply for purposes of both third-party customer transactions as well as related-party transactions.

Prop. Treas. Reg. § 1.861-19(b) correctly focuses on “on-demand network access” as the central attribute of a cloud transaction. “On-demand network access” is also the essence of a service transaction; thus, it seems clear that all transactions which fall within the description of a cloud transaction under Prop. Treas. Reg. § 1.861-19(b) should be classified as a service.

If our recommendation is accepted, the proposed examples will not need to address in detail the various factors. Instead, the examples will provide guidance through a description of the various business models that fall within the definition of a cloud transaction under Prop. Treas. Reg. § 1.861-19(b).

We do believe that the factors enumerated under Prop. Treas. Reg. § 1.861-19(c)(2) are the correct analytical framework, and therefore, we suggest that they should be referenced in the preamble if our recommendation for a per se rule is adopted, or they should remain in the final regulations if instead our recommendation for a presumption is adopted.

2.4 Classification of Cloud Transactions — Additional Example.

The Coalition agrees with the analysis in Prop. Treas. Reg. § 1.861-19(d)(2) (“Example 2”) because the facts portray a common commercial transaction and the analysis indicates that merely allocating a particular asset to be accessed by a single user does not diminish the responsibility or control of the service provider. Although Example 2 is a thoughtful and helpful example that describes a common business arrangement from the perspective of the service provider, we recommend that the final regulations should include an example that focuses on the access that the remote user may have to data and software on the equipment. The facts in this example commonly exist in practice. The new example will demonstrate that such access does not taint the services characterization under section 7701(e) principles.

In contrast to Example 2, in the new example Corp B also has the ability to upload and download data, install and uninstall applications, and, if there is a failure of hardware, to power down the server or request employees of Corp A to repair and replace the server. This transaction should fulfill enough of the factors in Prop. Treas. Reg. § 1.861-19(c)(2) to conclude that it is a provision of services. We recommend adding the following additional example:

2.5 Arrangements and Transactions Hierarchy — Recommendation to Eliminate “Arrangements” and Redefinition of “Transactions” in Prop. Treas. Reg. § 1.861-19(c)(3).

The Proposed Cloud Regulations establish a framework that “arrangements” with multiple “transactions” must be bifurcated. In particular, Prop. Treas. Reg. § 1.861-19(c)(3) provides:

An arrangement comprised of multiple transactions generally requires separate classification for each transaction. If at least one of the transactions is a cloud transaction, but not all of the transactions are cloud transactions, this section applies only to classify the cloud transactions. However, any transaction that is de minimis, taking into account the overall arrangement and the surrounding facts and circumstances, will not be treated as a separate transaction, but as part of another transaction.

We believe that the concept of an “arrangement” as currently articulated in the Proposed Cloud Regulations causes confusion and should be eliminated. Coalition members observe that it would be burdensome, from both an administration and compliance perspective, to attempt to allocate revenues to separate transactions that make up a single arrangement. Accordingly, we recommend that the final regulations adopt as a general rule that a “transaction” is defined as an agreement entered into in the ordinary course of business. Examples of relevant facts and circumstances that may be helpful in making this determination would be the taxpayer's treatment of the transaction for non-tax purposes, such as financial reporting purposes, the availability of separate pricing, the use of separate SKUs, and the taxpayer's definition of the transaction for non-tax purposes. If Treasury and the IRS adopt our recommendation, then we also recommend that the references in Prop. Treas. Reg. §1.861-19(c)(3) and in the examples in Prop. Treas. Reg. § 1.861-19(d) to “arrangement,” “de minimis,” and “ancillary” be removed.

This approach would align with the manner in which taxpayers in the software industry currently account for and classify their transactions and would relieve taxpayers from being required to create new internal systems and processes to comply with the Proposed Regulations.

2.6 Recommendation to Apply Predominant Character Standard.

In connection with the above comment and our suggestion that the final Software Regulations should adopt a predominant character standard, we recommend that the final Cloud Regulations should explicitly adopt a predominant character standard, except in unusual circumstances.

Many typical cloud computing transactions will invariably exhibit elements that could be viewed as having different characters. In most cases, one element will represent the predominant character of the transaction, with the other elements playing more of a supporting role. The Coalition believes and suggests that a predominant character rule is appropriate and welcome for determining an integrated transaction's characterization for tax purposes.²³

Including an explicit rule that requires the application of a predominant character standard to an integrated transaction with multiple components would be more administrable than a de minimis standard or another approach that requires allocation of income from a single commercial transaction to all of its constituent elements. Expressly adopting a predominant character would also better reflect the nature of the income producing activity in a transaction.

The recommended predominant character rule would obviate the need for taxpayers and the IRS to allocate consideration in a transaction that commercially is a single transaction. In some unusual cases it may still be necessary to require taxpayers to bifurcate transactions and then allocate consideration between the separate elements of the component parts. In the large majority of cases, however, it will be possible to determine the predominant character of a transaction, at which point it will be more administrable, more predictable, and less burdensome for both taxpayers and the IRS to apply a rule that requires a determination of whether a component part of a transaction is or is not a predominant part of the transaction, instead of requiring that the parties determine whether a component part meets a more amorphous de minimis standard. Relevant facts and circumstances bearing on the predominant character of a transaction include the overall commercial purpose of the transaction, the taxpayer's treatment of the transaction for non-tax purposes, such as for financial reporting purposes, the relative cost of each element, and a comparison of unit prices for components sold separately.

We note that one of the examples in the Proposed Cloud Regulations seems to come close to espousing a predominant character and may indicate Treasury's favorable inclination towards a predominant character standard to be the operative standard in this context. Prop. Treas. Reg. § 1.861-19(d)(7) (“Example 7”) contemplates the scenario where a company provides and makes available for download over the internet word processing, spreadsheet, and presentation software to a customer. The downloaded software contains all the core functions of the software. When online, the software provides a few ancillary functions that are not available offline, such as access to document templates and data collection for diagnosing problems with the software. Example 7 concludes that there is a download of copyrighted articles that is properly analyzed under the Software Regulations. Example 7 also acknowledges that the online ancillary functions would otherwise constitute a cloud transaction, but based on the fact that the online functions are ancillary and not the core functions necessary to make use of the offline component of the software, the example concludes the transaction should be classified solely under the Software Regulations and not the Proposed Cloud Regulations.

We have included an additional example that we recommend should be added to illustrate these points:

2.7 Source of Income for Cloud Transactions.

Generally, income from services is sourced to where the services are performed under section 861(a)(3) and 862(a)(3). With respect to income from services performed partly within and partly without the United States by a person other than an individual, the part of that compensation that is attributable to the services performed within the United States, and that is therefore included in gross income as income from sources within the United States, is determined on the basis that most correctly reflects the proper source of the income under the fact and circumstances of the particular case.²⁴ Treas. Reg. § 1.861-4(b)(1) goes on to provide that, in many cases, the facts and circumstances will be such that an apportionment on a time basis will be acceptable. Treas. Reg. § 1.861-4(b)(2)(ii)(E) provides that on a time basis, compensation for services performed in the United States is the product of total compensation and the ratio of the number of days of performance of services in the United States to the total number of days of performance of services.

In general, if only one legal entity is involved in a given commercial process that results in the delivery of cloud services, the Coalition recommends that cloud computing transactions should be sourced to the location of the personnel and operations of the legal entity which recognizes the revenue from the performance of the service that are directly related to the delivery of the cloud transactions. Challenging allocation issues may arise if the personnel and operations are located partly within and partly without the United States.

If two or more related parties are involved, the question is whether there should be attribution among the related parties. Case law guidance provides that source of income for a taxpayer should be determined by the taxpayer's own activities, and not through attribution of activities performed by other persons.²⁵

Cloud computing transactions require significant personnel and operations that are directly related to the delivery of the cloud computing transactions. Coalition members observe that cloud computing service models require significant personnel and operations to provide the service because automation alone is not currently proficient to a degree that would allow for sufficient network reliability and resiliency. In addition, cloud service providers cannot reliably prevent outages that impact service level availability without the intervention of personnel for manual repairs.

Accordingly, the Coalition recommends that cloud computing transactions should be sourced to the location of the personnel and operations of the legal entity which recognizes the revenue from the performance of the service that are directly related to the delivery of the cloud transactions. This is the guidance provided by applicable case law, and is readily administrable. Service providers in the cloud services context know the location of their operations and employees that are engaged in providing cloud services. Case law dictates that the operations and activities of subcontracting entities and companies would not be relevant for purposes of determining the source of the income for the cloud service provider.

Below, we provide an additional example to illustrate these points:

2.8 SaaS Reseller Example.

We recommend that the final regulations include an example of the characterization of income derived from a reseller of SaaS services. Particularly outside the United States, U.S. software companies have seen inappropriate assertions of withholding tax on such payments, on the basis that such payments constitute royalties. It is clear under the principles of the Software Regulations that such payments do not constitute royalties, as the software company normally does not transfer to the reseller any of the specified rights in Treas. Reg. § 1.861-18(c)(2). Accordingly, we propose that the following example be included in the final regulations:

* * *

We would be pleased to answer any questions you may have regarding the topics raised in this letter. The Software Coalition is grateful for the opportunity to provide comments on the Proposed Regulations, and we hope that the above comments will be taken into account in revising the Proposed Regulations.

In addition, the Coalition requests the opportunity to testify at the public hearing regarding the Proposed Regulations (REG-130700-14). The statements at the hearing will relate to the comments submitted in this letter, and other topics pertinent to the proposed regulations.

Sincerely,

Gary D. Sprague
Partner
(650) 856-5510

Rafic H. Barrage
Partner
(202) 452-7090

Steven Smith
Associate
(415) 984-3818

Baker McKenzie
Washington, DC

---

Appendix A
Software Coalition Members

Adobe Inc.
Amazon.com, Inc.
Autodesk, Inc.
BMC Software, Inc.
Broadcom Corporation
Cisco Systems, Inc.
Electronic Arts Inc.
Dell/EMC
Facebook, Inc.
GE Digital
IBM Corporation
Mentor Graphics Corporation
Microsoft Corporation
Nuance Communications, Inc.
Oracle Corporation
Palo Alto Networks, Inc.
Parametric Technology CorporationPivotal Software, Inc.
ResMed Inc.
Salesforce.com, Inc.
SAP America, Inc.
Symantec Corporation
Synopsys, Inc.
VMware, Inc.