Menu
Tax Notes logo

Transcript Available of IRS Hearing on Digital Transaction Regs

FEB. 11, 2020

Transcript Available of IRS Hearing on Digital Transaction Regs

DATED FEB. 11, 2020
DOCUMENT ATTRIBUTES

UNITED STATES DEPARTMENT OF THE TREASURY
INTERNAL REVENUE SERVICE

PUBLIC HEARING ON PROPOSED REGULATIONS

"CLASSIFICATION OF CLOUD TRANSACTIONS AND TRANSACTIONS INVOLVING DIGITAL CONTENT"

[REG-130700-14]

Washington, D.C.
Tuesday, February 11, 2020

PARTICIPANTS:

For IRS:

ROBERT ZEB KELLEY
Office of Chief Counsel
(International)

JOSEPH P. DEWALD
Office of Chief Counsel
(International)

For U.S. Department of Treasury:

JIM WANG
Attorney-Advisor
Office of International Tax Counsel

Speakers:

AMEEK ASHOK PONDA
Sullivan & Worcester LLP

THOMAS ROESSER
Microsoft

RAFIC BARRAGE
Baker & McKenzie, LLP, on behalf of Entertainment Software Association

GARY D. SPRAGUE
Baker & McKenzie, LLP, on behalf of Software Coalition

SARAH SHIVE
Information Technology Industry Council

* * * * *

P R O C E E D I N G S

(10:00 a.m.)

MR. KELLEY: Good morning everyone. I'd like to get started. It's a little past 10. I'd like to welcome everyone to the public hearing on REG-130700-14 which are proposed regulations relating to the classification of cloud transactions and transactions involving digital content.

My name is Zeb Kelley and I'm with the Office of Associate Chief Counsel International here at the IRS. I'd like to introduce the other panelists. To my immediate left, Joe Dewald, also with the Office of Associate Chief Counsel International. To his left, Jim Wang with the Office of International Tax Counsel at Treasury.

So, we have five speakers on the agenda this morning and we plan to go in the order as listed on the agenda. Each speaker will have 10 minutes to speak. When you speak, please come up here to the podium. There's a light up here that should turn red when your time is up and also should show the actual time you have left on a small digital screen. After you finish speaking, if you could please hang on for a second, the panel may have questions for you. So, I'll go ahead and call the first speaker then. We have Ameek Ponda.

MR. PONDA: Is this working? Hi folks, thank you for making time today. I have a few comments. I'd like to provide a voiceover to the written submission. The written submission is very detailed with some of these ideas and I don't propose to go over them again except in the nature of this voiceover. I make five points, and the first three points, I've offered surgical edits to the regulations that would implement those three points. And then points number four and five are far more conceptual and would require some major changes so I didn't offer up those but I'm happy to do that if folks are interested.

Let me start with point one. The proposed regulations purport to implement and apply section 7701(e), E as in Edward, in analyzing cloud transactions and the various transactions in the proposed regulations. And when they do so, there's a question then of course about whether that analysis or those articulated principles would apply beyond the scope or the intended scope of the proposed regulations.

And by that, I mean in particular, there's a well-developed body of law under section 469, the passive activity loss rules, the UBTI rules, the REIT rules, the publicly traded partnership rules in terms of what is a rent. Or maybe more accurately as I explain later, rent plus services, OK. So, it's not binary for many purposes elsewhere throughout the code as opposed to something which is a pure service.

I think you could adopt a surgical change here in simply clarifying that the proposed regs or their 7701(e) analysis is not applicable outside of the intended scope. And therefore, would have no bearing on the well-settled law in these other code sections. Again, for example, publicly traded partnership, REIT, UBTI, passive activity loss rules.

I think part of the maybe, you know, as Bugs Bunny used to say that I made that left turn at Albuquerque. I think conceptually the 7701(e) regs were a codification of case law principles that were helpful to discern what was a triple net lease versus what was a management contract typically in the area of project finance.

In terms of the more subtle distinction between multi-tenanted property, whether that's multi-tenanted real property or multi-tenanted personal property, that's not what those factors were going to, at least not as originally conceived. I think they could still have bearing in that area. But I think one of the challenges is to think about how to apply those factors correctly with the correct weights. When you're talking about multiuser infrastructure, whether that's real estate or personal property. And I'll come back to that comment a little more.

But let me just offer you an example and you can see how the proposed regs maybe are, you know, a little off on this point. Just take an office building here in downtown D.C. In that multi-tenanted office building, suppose there are 10 floors and 10 different tenants. A law firm, an accounting firm, a hedge fund, whatever. And what you're going to find is that the landlord of that office building provides a wide array of services.

The landlord will be responsible for building security. The landlord will be responsible for cleaning. And I don't mean just the cleaning of the hallways. They're going to go up into those offices, they're going to vacuum, they're going to clean the interior bathrooms, they're going to water the plants, they're going to clean up after the office parties of each of these tenants. They're deeply involved in the space.

But the office building may also provide, if it's cutting edge, car washes to the people who park there, childcare, dry cleaning, some forms of concierge. In short, even a very pedestrian form of landlord like an office landlord, a quintessential kind of landlord, there are a great deal of services involved. And the entire set of rules that we have outside of these proposed regs, again, publicly traded partnership, REIT, UBTI, is designed to understand that landlords of multi-tenanted assets of necessity provide a great deal of services.

And so, when the proposed regs, for example, talk about there's, you know, there's a common maintenance or the tax owner of the asset provides the repair. Well heck, that's every landlord of multi-tenanted real estate and personal property.

I think this is the related point I talked about in my comment letter is that there are contracts where real estate location is either deeply specified in that contract or is a very material implacable component of that contract. Real estate is involved. I think it fundamentally changes the nature of what the relationship is.

And again, I think these relationships fall across a spectrum. It's not as binary as rent or services because indeed, most multi-tenanted assets, be they real estate or personal property, are really rent plus services. The idea that there is this platonic ideal of just pure rent exists only in the case of something which is a triple net leased asset.

And yes, that may have been what 7701(e) was originally about, but in terms of drawing a dividing line, particularly if you're going to have a binary formulation between rent versus services, you have to understand that the multi-tenanted rental world is a rent plus service formulation. Including, for example, as I said under section 469, the passive activity loss rules.

Where real property is either specified, I want my servers in this physically secured location. I want them here because I'm looking for geographical redundancy or I'm looking for secured personnel. I think you have to tell yourself or ask yourself, do I have a real estate contract here, and I think for many of these other code sections, yes, indeed you do.

Let me say a third thing that I offer up in my comment letter and I think this is an area where it's developing, and I'd like to spend some time on this. The 7701(e) and the proposed regulations articulate a very old economy way of thinking about possession and control. Possession and control is one of the common law factors and it's articulated in 7701(e) as how do you know or who is the tax owner of the asset, who is the landlord, et cetera. You know, who gets the investment tax credits, all of that good stuff.

But physical possession and control makes sense for old economy assets. It makes sense for a shovel. It makes sense for a desk. In a new economy asset, you really have to ask yourself whether it's physical possession or control or economic possession and control. And I offer up this idea of economic possession and control because I really do believe that's what's going on here in new economy assets.

Let me give you an example. Today I think we would say even though these are short term rentals, if I call up — if I rent a car or a truck, U-Haul, Avis, Hertz, albeit they are short term arrangements. Fundamentally, they are rental relationships. I have possession and control, I'm doing the driving, that is a form of short-term rental.

Contrast that to when I call an Uber driver or a Lyft driver and someone chauffeurs me, you know, from my starting point to my destination. I think we would all call that a service. I think in the very near future, of course, we're going to have driverless cars. Where I'm going to take out my phone, I'm going to punch in some coordinates, a driverless, you know, hopefully not Stephen King driverless but a car will come up and pick me up and then take me to my coordinates all from my phone.

I'll do you one better. Suppose my father-in-law calls up and says, I need the snowblower, or I'm having a party, I need the, you know, the picnic tables and all this and I just don't have that much time. I think what I'm going to do is I'm going to call up one of these driverless cars, I'm going to put my stuff in the trunk or, you know, in the loading bay and then I'm going to say go to my father-in-law's house and he'll get it, unload it from there.

I would maintain that I have economic possession and control in that transaction. I am using the asset, albeit on a short-term basis and whether that qualifies as rent under these different parts of the code is the question. But I would maintain that I have economic possession and control. And the idea that just because the owner of the truck or the car is depreciating it, is changing the oil, is updating the software — I think yes, they have a form of possession and control and too but I'm renting it from them. Any multi-tenanted asset involves common repair, common maintenance, common sort of upkeep. It does not answer the question of whether the customer is using the asset or receiving a service. So, I would encourage you to look at my comments on economic possession and control.

I have also in that vein talked about some of the factors that were enumerated in the proposed regulations, that either come from 7701(e) but as I said, that has sort of an archaic footing in terms of what those factors mean, or were made up, not made up, you know, enunciated, flushed out for the proposed regulations. I think some of those factors are given an inappropriate weight or are misapplied.

You know, one of the ones I think is most in this category is just because the owner of the assets provides common maintenance doesn't make that an indicium of a service. Common maintenance is something you're going to find in any multi-tenanted asset be it real property or personal property. So, I talked about that in great detail.

I finally say that the proposed regulations, we all know this, it has a binary approach: that there's one polar extreme of rent and then there's another polar extreme of services. And you have to pick between those two. And I'm not questioning that that may be the right answer for these regs. What I'm saying is, other parts of the code have a nuanced view, something can be rent plus services and we colloquially call it rent.

MR. KELLEY: Thank you.

MR. PONDA: Thanks.

MR. KELLEY: Could you hold on for one second —

MR. PONDA: Oh yes, of course.

MR. KELLEY: — to see if the panel has any comments or questions.

MR. PONDA: Of course.

MR. DEWALD: Thanks for your comments and thanks for coming in today. I was wondering, distinction. You stated where real estate is important, you know, to providing, like, cloud services. I'm wondering if you're proposing that there, in those types of situations, there be a split between the characterization of the transactions between a lease of property and services.

MR. PONDA: I'm not sure I understand the question but please tell me if this is responsive or would you like to rephrase it.

MR. DEWALD: I can. I thought you were suggesting that in some types of cloud services transactions, the location, for example, of the server or having a server that's specifically dedicated to you is important, and that looks more like a lease instead of a service. And I'm trying to figure out the distinction you're making here between —

MR. PONDA: Sure.

MR. DEWALD: — lease and service and in-cloud transactions when you think it would be more appropriate to characterize the transaction as a service. And if there are situations where you think it's more appropriate to characterize the transaction as a combination of a lease and a service.

MR. PONDA: Sure. So, let me give you, I think, what would be an easy case. There are some data centers which are hyper-secure. Let's call them Fort Knox just, you know, colloquially. And I think if a customer, and I'll call that person a tenant because that's how I view them. I think if a customer said, I want a dedicated server, OK, or 50 percent capacity on a server in Fort Knox, I think that very much becomes a real property transaction. I think it changes the complexion of the transaction.

What I would say is then all the other things, and to me, thinking about these other code sections, 469, UBIT, REIT, something — you very rarely find a pure rent in those code sections. You find rent plus services which is colloquially called rent by the people who practice in those areas and think about those things. But in an academic way, it's really rent plus services.

So, that example of a customer saying, I want my server in Fort Knox or I want my dedicated server near this particular ecosystem, science-based ecosystem, defense-based ecosystem. They're really asking not just for a server and capacity on a server, they're also asking for it specifically in a particular location. To me, that changes everything and that makes a lease plus services.

MR. DEWALD: And what do you think about the application of 7710(e) and there's some case law, at least, that basically has interpreted that section as saying there's either service or lease. Is there something that you think is wrong with that type of analysis of section 7701(e)? Should 7701(e) in some cases not apply to certain provisions of the code?

MR. PONDA: Well, I'd say to this and so much of this is nomenclature in my view. When we say service versus lease, I think what those cases are saying or that they should say is leases are rent plus services. Except for a triple net lease, there is this — there's no platonic pure rent. Any lease, like the ones I described to you in that office building are rent plus services.

So, when 7701(e) says, for example, to the extent it does, something is either a service by which I think they mean pure service or it's a lease. A lease is rent plus services in my view.

MR. DEWALD: OK.

MR. WANG: OK, just one question, Mr. Ponda. So, as I'm sure you probably saw if you read the other comment letters, in many ways your comments are opposed to the other comments that we have received.

MR. PONDA: Yes. I would say in terms of how I conceptualize them. I think the answers people can come to could be very much the same. But I believe you have to get to the right answers for the right reasons and that's what I'm trying to do.

MR. WANG: Totally makes sense. Yeah so, just a few examples though where I could see it being hard for us. For example, you know, we have some comments that say they want the cloud reg to apply to the whole code. Clearly, I think you would say it should not apply to the whole code or at least if it applies to the whole code it should somehow differentiate between real estate type transactions and services type transactions.

MR. PONDA: I can, do you want me to speak to that?

MR. WANG: Not yet. I'm just going to ask you one question.

MR. PONDA: Yes.

MR. WANG: I'm getting there, it takes me a little while, sorry. And, you know, also comments that say, you know, it's easier if you say it's all services or all rents even though we know in real life it's not — it's almost never all services or all rents. Totally agree with you there.

And so, what my question for you actually is: Do you see a route to some sort of compromise that could actually get what you're requesting, which I think is very specific to your industry and to a certain kind of cloud service? And what, you know, the others are requesting which really deals more with software of service, infrastructures of service, that kind of stuff.

MR. PONDA: I do think there are some compromises. I don't know whether it's in the long run the right way to think and shape the law but I do think there are at least two ways to go about it. One is that the final regulations could articulate that these are an application of 7701(e) principles and they don't necessarily apply outside of their intended scope. And then specifically call out that they don't apply to 469, 512, 856, that's one way.

I think another way to do it is to articulate the standard that I did in Roman numeral two of my comments. Which is to make clear, almost as a super factor, if you will, that — and what I think is already implicit in the proposed regulations that the underlying real estate component is not explicitly or implicitly specified by the contractual relationship and is otherwise inconsequential to that contractual relationship.

If you adopt that as a super factor, I think you remove it from the real estate transactions. And let me just add, as I said in the introduction to my written comments, I think the goal here is not to upset the relationship between a lot of, you know, what's called FAANG companies and their ultimate end users. I think we all have a sense of what the law can or should be in that area. We want to get there for the right reasons.

My comment letter goes to making sure that the infrastructure providers, the ones who provide data centers or leasing arrangements to the FAANG companies are not caught up in the breadth of these regulations. Because I think those people think of themselves as landlords and rent financing participants.

MR. WANG: Thank you.

MR. PONDA: Thank you.

MR. KELLEY: Can I ask you one question.

MR. PONDA: Yes, please.

MR. KELLEY: When you say the regs shouldn't apply or it should sort of ignore cases where the location is specified or consequential. In the hypothetical where you are getting maybe infrastructure as a service but for some reason you wanted the server itself to be on your property, so on the customer's property. For say, you know, security or some other reason. I mean, in your mind could that still be a service or would the specifying that it must be on the customer's property then turn it into something else?

MR. PONDA: Yeah, I mean, where the infrastructure provider is not actually providing the real property, I didn't mean to go that far. I do think there are questions about, and I think there are some subtleties here. Where an infrastructure provider builds out either real property or personal property on site for a customer, there are deep questions about whether they have a real estate interest and then are kind of leasing it back.

Let me give you an example. People build out small cell systems at stadia, at sports stadiums. And they then lease it back to the carriers and maybe even the stadium owners. And so, even though you're at somebody else's property, you've actually obtained a real property interest in that situation.

So, I mean, I do think at the margins these things are hard. But what I'm saying is where you see the provider provide an interest in real estate, I think that is looking like a real estate, a rental transaction to me. Where the personal property and the incidental services get brought into the rental relationship. Call it a lease because it is a lease functionally which is rent plus services.

MR. DEWALD: One last question.

MR. PONDA: Please.

MR. DEWALD: So, in your view, would like infrastructure as a service, sort of one of the cloud computing transactions is referred to, you would view that more in terms of a lease?

MR. PONDA: I think it depends. I think even infrastructure as a service comes along, you know, on a spectrum. I think in its purest sense, infrastructure as a service where the provider is not providing any real property component to that implicitly or explicitly, you know, I would call that a service. But if I see a real property component there, I'm inclined to think that's a very material part of the economic relationship. Which is, I want this server in a particular data center, I want this server in a particular location, and real estate rental is location, location, location.

MR. DEWALD: Thank you.

MR. KELLEY: Thank you.

MR. PONDA: Thank you very much.

MR. KELLEY: Next we have Thomas Roesser.

MR. ROESSER: Good morning. My name is Tom Roesser, I'm senior director of tax affairs at Microsoft. Thank you for the opportunity to provide comments at today's hearing. Microsoft appreciates Treasury and the IRS's willingness to provide guidance specific to cloud computing and digital content as these two technological advancements continue to evolve.

We support the overall direction of these regulations and the aim to providing flexible future proof rules in an area experiencing so much change. My comments today relate to source of digital content, classification and cloud services, the treatment of intercompany transactions, and sourcing of cloud services.

We recommend changes to the sourcing rules of digital content under the Dash 18 proposed rules. We support retention of the title passage rule. While many taxpayers currently may not have the capability to look through the purchasers billing address to the countries where the purchaser will be deploying the digital content, such capability may become available in the future.

As such, if the title passage rule is not retained, then the download install location of the end user rule in the proposed regulations should become an election which will future proof the regulations as systems evolve. In the meantime, we recommend that the primary rule should be the source to the billing location of the first unrelated purchasing entity. Under this rule, the taxpayer must only show that the supporting information, if accurate, would allow the taxpayer to reasonably conclude the primary location of the individual user. This is the information that taxpayers currently have.

In addition, the sourcing rule should clearly state that it only applies for transactions sourced under 861-7(c). We recommend changes to the classification of cloud transactions under the proposed regulations. The proposed regulations in section 861-19(a)-(c) provide a confusing structure for analyzing so-called cloud transactions as either a provision of services or leased property. We believe the analysis can be simplified first by removing the terms arrangement and de minimis.

Secondly, a transaction should be defined based on the facts and circumstances which may include availability of separate pricing, the use of separate skews and the taxpayer's definition for non-tax purposes. Please note that we believe the factors listed in 2(a) and 2(c) should be considered illustrative and not exhaustive since many businesses have different fact patterns.

We would recommend a predominant character test. The predominant character should be determined according to the facts and circumstances. These may include, but are not limited to, overall commercial purpose, the taxpayer's treatment for non-tax purposes, relative cost of each component, and a comparison of unit prices for components sold separately, among others.

The facts and circumstances must provide at least a reasonable basis for determining the predominant character of the transaction. This is a key limiting factor. On the one hand, it means that there must be some threshold level of reasonableness for the taxpayer's position. On the other hand, it does not allow the service to argue some other conclusion as more reasonable.

Various comment letters have advocated for similar rules and the common feel between these comments is that the rule should be flexible enough to account for the different types of transactions potentially within scope. For example, streamed music, use of cloud services to enhance desktop apps, and multiplayer gaming, among others. The contours of each of these transactions are very different and the rule should allow for those differences. We believe the facts and circumstances predominant character approach provides that flexibility both now and in the future.

We recommend changes relating to related party intercompany transactions under the proposed Treasury regulations under Dash 19. The preamble asked that commenters provide realistic examples of cloud transactions that could be treated as leases of property. We are not aware of cloud transactions that are not treated as services.

Cloud transactions as defined in the proposed regulations can be interpreted as including purchases of data center services that allow purchasers to operate dedicated servers in remote locations without the ownership of a physical data center. Some call it data center operations.

For purposes of the proposed regulations, data center operations are distinct from end user cloud transactions where a consumer purchases software platform and/or infrastructure as a service. The distinction between data center operations and an end user cloud transaction is particularly relevant where data center operations are provided to a related party.

Although cloud service providers serve their customers through a distributed network of data centers organized into regions, as such, we recommend that the scope of the characterization rule and proposed Treasury reg 861-19(c)(2) should be clearly stated to be per se services.

Alternatively, the regulations could clearly be limited to apply only to cloud transactions with third party customers. As a result, related party cloud transactions would continue to be characterized as services income, which is consistent with existing law.

We also have comments regarding the sourcing of cloud services. The proposed regulation specifically asks for comments regarding administrable rules for sourcing income from cloud transactions in a manner consistent with sections 861 through 865. We are not aware of any commercially significant cloud transactions that result in this income. Therefore, our comments focus on the appropriate method for sourcing cloud transactions characterized as a provision of services under the proposed regulations.

Regarding the sourcing of cloud services, we believe statutory, regulatory, and case law is sufficient regarding the sourcing of cloud services and do not believe additional guidance is needed. Alternatively, if provided, such guidance should state that cloud services income is sourced on an entity-by-entity basis and in a manner that takes into account all facts and circumstances of the people, functions, and assets that are directly related to the services income. Thank you for the opportunity to provide comments today.

MR. KELLEY: Thank you.

MR. DEWALD: Yeah, thanks for coming in, thanks for your comments. I did have a question that might be a little bit out of the scope of what you talked about today. But I thought you might be a good commentator to ask the question to. And it relates to inventory and sale of copyrighted articles. So, when does your company treat sales of copyrighted articles as sales of inventory?

MR. ROESSER: I think, you know, our view is that digitally distributed software may be inventory property and within the scope of 863(b) depending on the facts and circumstances.

MR. DEWALD: OK. So, is it in some cases it's inventory and some cases it's treated more as a sale of personal property or something else?

MR. ROESSER: I think once again it depends on the facts and circumstances. And I could follow up with you on that.

MR. DEWALD: OK. When treating it as sale of inventory, how do you account for, like, beginning and ending inventory when it's the sale of a copyrighted article that's electronically downloaded from something like a master copy? Would that be something like beginning inventory would be zero and ending inventory would be zero?

MR. ROESSER: I'd have to follow up with you on that.

MR. DEWALD: OK, thank you.

MR. WANG: Mr. Roesser, I want to ask you a little bit about Mr. Ponda's comment. I just wanted to ask you if you did, you know, agree that in those cases or at least in some of the cases he mentioned there could in fact be cloud as a lease or do you still view it as cloud as a service?

MR. ROESSER: We view cloud as a service. We're not aware of any cloud transaction that would actually be treated as a lease. I think the previous speaker was focusing more on the real estate aspects of it and obviously there's other factors associated with the provision of cloud services.

MR. WANG: OK, that's fair. I'm going to switch to a different part of your comment real quick. You also spoke about the idea that, you know, maybe there's no need for additional guidance regarding the sourcing of cloud transactions.

And I wanted to ask, you know, do you think it's sufficiently (inaudible) currently exactly how you would split? As you even said, you know, the facts and circumstances kind of atmospherics to it right now. Do you think it's sufficiently (inaudible) basically like what is the proper split between people functions and assets? What is the proper split between different kinds of value provided by different people? Do you think it would be in the interest of taxpayers to have something very administrable?

I think one of the comments you proposed and sort of by contract conclusion (inaudible) in terms of sourcing. Like where the contract is (inaudible) sourced. Do you view that whole area as just extremely settled and, you know, nobody really needs and guidance there?

MR. ROESSER: I don't think that anything in the tax law is extremely settled. But I think our view is that, you know, the existing statutory, regulatory, and case law is sufficient. And then in the alternative, you know, just make it very clear that cloud services income is sourced on entity-by-entity basis and in a manner that takes into account all the facts and circumstances and the people functions and assets that they're directly related to the services income.

MR. KELLEY: If I could ask you just two more quick questions. First, you were suggesting that we should adopt a predominant character test, with respect to maybe arrangements or fact patterns where you're dealing with two things which may not be either a service or a lease. So, say you're looking at something with an aspect, with aspects of say a service and a sale or a service and a license where the license aspect or the sale aspect wouldn't technically be governed by 7701(e). Can you say anything about how we would adopt a predominant character test or what our legal authority for doing that would be when you have facts that involve not only service or lease aspects?

MR. ROESSER: I think our comments basically related to the notion, the term arrangement, and the use of de minimis and created confusion. And so, we suggest making it limited to a transaction and obviously, that's a fact-based situation. And then the predominant character, I think you'll go through the regular facts and circumstances.

What I wanted to make sure to make the point that there has to be some flexibility in determining the predominant character. Because businesses will evolve and there could be differences down the road that we don't perceive right now and you have to have that flexibility. It's kind of a non-answer to your question but I think we need to preserve your flexibility going forward with the predominant factor.

MR. KELLEY: Just one more question. You mentioned the type of intercompany data center operations fact pattern. Is there, I guess, any reason as a general matter why we should be treating intercompany transactions differently than unrelated party transactions? So, I guess in other words, why we should treat transactions for purposes of say 482 differently than for purposes of some other section.

MR. ROESSER: I think the use of related party data center operators is fairly common. And as I understand it, the way the proposed regs could work using the various factors, you could have inadvertent consequences with relation to inter-company transactions. The purpose of the testimony was to try to minimize that distortion.

You know, another way to possibly treat it is to say that to the extent that the customer — the third party can treat third parties and related parties the same by looking through to the characterization of the related — the third party transaction. That's one idea that we've kind of heard out there. I'm sure other commenters will chime in on that.

MR. KELLEY: All right. Thanks very much.

MR. ROESSER: Thank you.

MR. KELLEY: OK, next we have Rafic Barrage.

MR. BARRAGE: Good morning. My name is Rafic Barrage, and I am a partner in the Washington, D.C. office with Baker & McKenzie. I'm here this morning on behalf of the Entertainment Software Association regarding the proposed regs for the classification of cloud transactions and transactions involving digital content. The ESA is a U.S. trade association serving companies that manufacture video games, equipment, and creates software for game consoles, handheld devices, personal computers, and the internet.

I'd like to thank Treasury and the IRS for their thoughtful work on the proposed regulations which, when finalized, will provide taxpayers and their advisers with much needed guidance in the rapidly involving industry.

This morning, I will address the following topics. First, the source of income with respect to the sale of copyrighted articles sold through an electronic medium; second, the addition of an example under the Dash 18 regulations involving video games sold through a third-party platform; third, a recommendation to include a general rule that classifies cloud transactions as the provision of services; fourth, a predominant character approach for arrangements comprised of multiple transactions; and then fifth, a source of income from cloud transactions; and I welcome questions at any point during the presentation.

Turning to the source of income first, we applaud Treasury and the IRS for attempting to bring some needed clarity to a source of income for the sale of copyrighted articles sold through an electronic medium by reference to the location of the end user. However, the proposed rule will often be difficult to administer, such as where copyrighted articles are sold through unrelated distributors, and so we recommend the general rule that would source the income from the sale of a copyrighted article through an electronic medium to the billing address of the first unrelated customer to whom the taxpayer sells the copyrighted article.

In addition, we also request that taxpayers have the ability to elect to apply the proposed rule regarding the location of download or installation onto the end user's device used to access the copyrighted article. And then, finally, we also recommend that taxpayers have the ability to elect to apply the recommended or proposed source rule where section 863 might otherwise apply to determine the source of income versus consistent with the preamble to the proposed regulations to ensure that the source of income is determined by reference to the end user or location of the customer.

If Treasury and the IRS decline to adopt our recommendation, then we request clarification that the term customer, as used in the backup rule — where the location of download or installation onto the end user's device is not available — means any unrelated third party and not just the end user, or not necessarily the end user.

Turning next to the addition of an example to the Dash 18 regs involving a video game, and sold through a third-party platform, the example 19 in the proposed regulations appears to involve a licensed reseller model where the content creator licenses certain copyright rights with respect to digital content — in that case it's an electronic book — to a third-party platform in exchange for royalties, and then the third-party platform makes those copies and sells them to end-customers through electronic downloads.

The licensed reseller model in the example is one approach for selling digital content, but another common approach used in the video game industry is where the video game developer sells the digital content through a third-party platform operator, such as Apple, Apple's App Store, or the Google Play Store, which then acts as an agent for the game developer. In a typical case, the game developer pays the platform operator a fee equal to the percentage of the price that the end users pay for the video game to facilitate sales of the video game by the game developer to the end user.

The platform operator is authorized to host a master copy of the game on its servers, or servers of a third party, and then allows downloads of copies of the games from those servers to end-user devices. The platform operator usually remits the proceeds from the sale, net of its fee, to the game developer, and the end-user purchases a license to use the copy subject to the terms of an end user license agreement, or EULA, under which the end user agrees, among other things, that it may not reproduce or distribute copies of the game.

The end user has the right to download the game onto a limited number of devices and they play the game in perpetuity with no additional payment where the transaction between the game developer and the end user is properly classified as a sale of a copyrighted article and the platform operator is properly classified as the provision of services by the platform operator to the game developer.

Third, the general rule to classify cloud transactions as a provision of services, as we have discussed, the Dash 19 regs provide that a cloud transaction has to be classified solely as either release of a computer hardware, digital content, or other similar resources or, as the provision of services, taking into account various factors, including factors based on section 7701(e) and the case law.

Treasury and the IRS have requested comments to provide realistic examples of cloud transactions that would be treated as leases under the proposed regs; and similar to Microsoft, we were not aware of any such realistic examples. We agree with the analysis that's set forth in the current proposed regulations, in particular. Example 2, where you have a dedicated server, and view that as properly classified as provision of services.

We therefore recommend that the proposed regulations be revised to provide that, in general, a cloud transaction is classified as the provision of services, except in unusual circumstances where the facts indicate that the cloud transaction is properly classified as a lease. The recommended rule would apply regardless of whether the transaction is between related or unrelated persons; and in determining whether there are unusual circumstances that warrant classification as a lease, taxpayers and the IRS would continue to apply the factors set forth in the proposed regs, and the recommended rule would provide, you know, clarity to taxpayers that afford both taxpayers and the IRS the ability to still classify a cloud transaction as a lease in appropriate cases.

Fourth, a predominant character approach for classifying arrangement comprised of multiple transactions. Both the Dash 18 regulations, as well as the Dash 19 regulations, include rules for classifying arrangements comprised of more than one component transaction. These rules adopt the bifurcation approach that require taxpayers to separately classify each component transaction of an overrule arrangement except for any component transaction that is de minimis, taking into account the overrule arrangement and the surrounding facts and circumstances.

The classification of such overrule arrangements is probably one of the more challenging aspects of both the Dash 18 and the Dash 19 regulations, which attempt to address this challenge through examples that apply somewhat elusive standards of de minimis and ancillary. It's far from clear to us based on these examples why a particular transaction is considered to be de minimis or ancillary under the facts of any given example.

In addition, once it's determined that an overrule arrangement includes more than one component transaction that is not de minimis, taxpayers are then required to allocate income and expenses between each such non-de-minimis component in situations where the third-party commercial transaction is not otherwise bifurcated, and to component parts with a separate price.

So rather than have taxpayers and the IRS grapple with the uncertainty of whether a particular component transaction is de minimis or ancillary, we recommend a more administrable predominant character approach for classifying transactions under which transaction would be defined as an arrangement entered into in the ordinary course of the taxpayer's business, and the predominant character would be based on the character of the arrangement that constitutes more than 50 percent of the arrangement, of the overrule (phonetic) arrangement. So, for example, if a taxpayer ordinarily negotiates for a single price under a contract with its customer, then the contract should constitute the transaction that would be classified according to its predominant character. Other relevant factors for identifying the tested (phonetic) transaction would include the taxpayer's treatment for non-tax purposes, such as for financial accounting, and whether other taxpayers in the industry of the taxpayer offer bundled product for the single price, or separately.

We also request that Treasury and the IRS consider an example to their regulations specific to the video game industry. The example that we have suggested in our comments letter involves a downloaded video game with significant multi-player functionality. The games are often referred to as massively multi-player online games. The facts of the example in our letter are quite involved, or aqua-involved, but it can be boiled down to the following: The end user purchases a license to use a copy of the video game with significant online functionality that is provided by the game developer and pays a separate subscription fee to the game console maker to access the online functionality. That functionality includes the ability to play against other users online and to access only content that enhances the end user's experience.

The core functionality of the game is enjoyed by users through multi-player online capability, and most users prefer to play the game (inaudible).

MR. KELLEY: Sorry, that's 10 minutes.

MR. BARRAGE: Yeah, thanks.

MR. KELLEY: Thank you.

MR. BARRAGE: Questions?

MR. WANG: Just to change the order a little bit, I'll go first this time. Well, first, I wanted to better understand this, services versus lease recommendation. Is the recommendation, basically, that there's a presumption that it's a service, and then, you know, you can somehow overcome the presumption with like some sort of very clear evidence, and then it becomes a lease?

MR. BARRAGE: Yeah, I think that's a fair characterization. I mean we used unusual circumstances, but I think presumption or unusual circumstances are equal.

MR. WANG: OK. So the idea is that it's like a rebuttal presumption?

MR. BARRAGE: Yeah. I think the intent is to say, you know, in general, because we can't think of a situation where it would a lease —

MR. WANG: Mm-hmm.

MR. BARRAGE: — you would characterize it or classify it as a service.

MR. WANG: OK, I got you.

MR. BARRAGE: But then, you know, taxpayers and the IRS will have ability to take a different classification.

MR. WANG: Or you could say maybe you're proposing by default it's a service, and if the taxpayer really wants to they can try to provide evidence that it's a lease, something like that, maybe?

MR. BARRAGE: Or the IRS, yeah.

MR. WANG: Or the IRS, yep, I guess. OK. So my second question, real quick, is more of a factual question. I don't know the answer to this. So you raised the fact pattern about someone who develops software and then they provide a master copy to say, the App Store, and then the App Store kind of sells however many copies on and, you know, part of the revenue goes to the developer, part of the revenue goes to the App Store, and you said, of course, the App Store in that case, you know, is providing a service by hosting and, you know, that kind of stuff. I wanted to ask you is there a case where the developer tells the App Store, you know, I'm going to give you this software but I'm only going to give you a license for so many copies of the software. Say I'm going to give you 10,000 copies. You can sell up to 10,000 copies, and then once the 10,000 copies are sold, basically, you're not allowed to sell anymore. You can come back to me, we can renegotiate, but we're not selling anymore on that term. And in that case — we doubt that exists, and if that exists — does that look more like a license-type structure than a services-type structure?

MR. BARRAGE: I'm not aware of that fact pattern existing, I mean that the premise for the example that we provided is that the App Store or the, you know, the operator of the platform is selling effectively on behalf of the developer; but I'm not aware of a situation where, you know, the game developer would say to the platform operator, you know, you can sell X-number, and then come back and we'll talk about extending that.

MR. WANG: OK.

MR. BARRAGE: I'm not aware of it in the industry.

MR. WANG: OK, sounds good. Thank you.

MR. BARRAGE: Sure.

MR. DEWALD: Just to follow up on Jim's question there. With the case — making the distinction between providing a service to sell a copyrighted article and getting the rights to the, you know, copyrighted material and selling yourself, in the case where it's say, a service of selling the copyrighted article on behalf of someone else, in that case, does the — let's call it service provider — also receive the right to distribute? In those types of cases, is there typically a contract that gives the service provider seller the rights to the copyrighted digital content and the right to distribute unlimited numbers of it?

MR. BARRAGE: I mean, typically, what would happen is the game developer in this industry would receive a master copy that it would host on its server, and then you could have, you know, end-user customers that would be able to download and so distribute by the platform operator an unlimited number of copies of the game. So, yeah I think that's accurate.

MR. DEWALD: I mean even in that example, isn't the, say, we'll call it service provider, receiving copyright rights to the digital content?

MR. BARRAGE: Well, it might be, you know, ordinarily, if you think about it, but I think the key distinction in this fact pattern is that the platform operator is acting as agent on behalf of the game developer; and so it's not acquiring copyright rights for its own benefit other than to, you know, distribute, resell those games, and then remit those proceeds, net of its fee, which is based on a percentage of sales, back to the game developer.

MR. DEWALD: So under copyright law, we would say there is a license of a copyright? Would you agree with that?

MR. BARRAGE: I don't know. I can't really speak to what the copyright law analysis would be as to whether there's been a license of a copyright right other, you know, like Dash 18 principles or not.

MR. DEWALD: Would the sales transaction be between the end-user and the service provider seller?

MR. BARRAGE: It would be between the end-user — in substance, it would be between the end-user and the game developer, with the platform operator acting as agent to facilitate the transaction between the game developer and the end-user because, again, the proceeds, the net proceeds, are going back to the game developer, less the fee that the platform operator receives for its service.

MR. DEWALD: And so there's an agency contract between the content owner and the service provider seller?

MR. BARRAGE: It would be clear, contractually, that the platform operator is acting as agent for the game developer.

MR. DEWALD: OK. One other question. On the sourcing income from sales of copyrighted articles based on location of billing address is sort of the general rule, and then allowing an election or an option to elect location of download, if we were use billing address, what would be the need for having the election for location of download?

MR. BARRAGE: Well, in certain circumstances, even today and certain B2C transactions, location of download may be knowable but, in general, that's difficult, technologically, today. So, I think, it's to allow, depending on the information that you have available as the seller, you know, which location you have and that's reliable that you could use.

MR. DEWALD: So, in an ideal world, if we had all the information, location of download would be the ideal sort of rule, but here there're administration issues about just getting the information?

MR. BARRAGE: Yeah, I think that's a fair characterization. It's currently difficult to know where the location of download or installation is particularly where you have multi-layer distribution models or if you have an Enterprise License, for example, with multiple users.

MR. DEWALD: Can you just speak, maybe briefly, a little bit about also the proposal to allow an election to use 863(b) rules to source income from sales of downloads of a copyrighted article?

MR. BARRAGE: Did you have — is there a specific?

MR. DEWALD: I just wanted to kind of, I think more, if you could kind of expand on how you propose this rule would apply, like give maybe an example of how and when it would?

MR. BARRAGE: Right. Well, the proposal is that you would be able to apply either the proposed reg or the recommended rule even if you would otherwise source the income differently under 863(b), if 863(b) applied. It gives you a different result. That's the idea.

MR. DEWALD: OK; I got you.

MR. KELLEY: Just very briefly. Did you have any thoughts or responses to the question I ask Mr. Roesser about whether the predominant character test would be appropriate where you have maybe components that are not merely services or leases that are covered by 7701(e) but might have other transactions?

MR. BARRAGE: Yeah, and, actually, the example with the multi-player, massively multi-player online game, is potentially that type of situation because in that example, the end-customer has purchased the copy of the gaming license to use a copy of the game, but because of the primary online functionality, the predominant character of the transaction is still a service or a cloud transaction. So there, you would. If you did a bifurcation, you would say OK, I've got to figure out how to bifurcate the income between the online component, the ability to play multi-player online, you know, functionality, versus the fact that you've downloaded or purchased a copy of the game; and so that would be an example where the predominant character rule would apply notwithstanding that if you bifurcated it, you could have a service component and a sale of the copyrighted article.

MR. WANG: But in that case, like if it were a game that you could either play online or play offline, it would depend on what the buyer does with it?

MR. BARRAGE: Well, that's a good question. It depends on a number of facts and circumstances; and, I think, that is one fact and circumstance that you would look at. I mean in the example that we provided, we say that most uses actually, you know, purchase the game to play it online. Some prefer to just sit up, you know, sit and play it by themselves, but most users are online. But then, you know, aside from that fact of how the end-user decides to use it, there are other facts that come into play as well, like, you know, the development costs and, you know, and the costs of actually maintaining the online component versus the rest of it too (phonetic).

MR. WANG: OK. So it's not just what the end-user does?

MR. BARRAGE: No, I don't think that's what's right.

MR. WANG: OK, got you. Thanks.

MR. KELLEY: Thanks.

MR. BARRAGE: Thanks very much.

MR. KELLEY: Next, we have Gary Sprague.

MR. SPRAGUE: OK. Good morning. My name is Gary Sprague. I'm speaking on behalf of the Software Coalition, an informal group of 24 major U.S. software companies, originally formed in 1990. First, we wish to compliment Treasury in the service for this thoughtful regulation package. Our comments are based on having dealt with these transactions in practice for many years. I will address five issues: how to define the commercial transaction, which is to be classified, and then proposing to apply a predominant character role to that transaction; the addition of a platform distribution example, to supplement the licensed reseller example; comments strongly advise title passage rule for (inaudible) content; application of the § 7701(e) factors to cloud transactions; and source of income for cloud services transactions.

The first step in bringing classification analysis is to define the income item to be characterized. We believe that the concept of an arrangement, as prior articulated in the proposed regulations, is confusing. Instead, we suggest that the item of income to be characterized should simply be that arising from a transaction, defined as a promotional agreement, entered into in the ordinary course of business. Once that transaction is defined, software companies frequently face this question of whether revenue from a single transaction, that may have elements of two characters, should be segregated into separate classifications. The existing dash 18 regulations address this through the de minimis standard. We suggest that a predominant character rule will be more appropriate for both the dash 18 and dash 19 regulations.

One practical example is a software antivirus program that includes code, which executes on the user's equipment, but also includes code deployed in the cloud, to detect and capture viruses before they reach the user's equipment. Applying the de minimis rule to that transaction requires two very challenging evaluation determinations. First, the taxpayer must determine whether either element of that transaction is above or below whatever line is de minimis. Second, if neither element is de minimis, the taxpayer must allocate the revenue separately between those two classification categories.

In contrast, a predominant character role is much more objective. The taxpayer needs to make only a single evaluation judgement, mainly to identify which element, on either on device or in the cloud, of that transaction forms the predominant character. We believe this binary determination will be more administrable for both taxpayers and the service.

We are pleased to see the proposed example 19 describing a licensed content reseller distribution model. We note, however, that this model is only one of two predominant cloud-based distribution models for content. We suggest that the final regulations contain examples of both models. Under the second model, a cloud-based platform provider may facilitate the sale of digital content, through its platform, but the user purchases the content directly from the content supplier. In this case, the platform provider acts as an agent, not a principle. The platform intermediary normally invoices and collects the purchase price, and then lets a portion of the content provider, but that intermediary is acting as an agent. Therefore, the character of the remitted revenue is based on the transaction between the content provider and the user.

We generally agree with the intended result of the proposed regulations, or proposed revisions, to the title passage rule, for downloaded digital content. While we believe the proposed rule will work well for direct B2C sales, as a practical matter, it will create challenges in the case of B2B sales, through unrelated resellers and in global deals, where the software provider enters into a single contract with a global enterprise customer, for installations worldwide. In these latter cases, the software supplier may not have ready access to information, as to the ultimate location of download.

To equitably address all transactions, we suggest three elements to this rule, all focused on achieving the goal of allowing suppliers of digitally downloaded software to achieve deemed title passage, at the user location. First, income from the sale of digital downloads should be sourced to the billing location of the first unrelated purchasing entity, which could be either a user or a reseller. For many B2B suppliers, such as those selling through a channel, this is the simplest and most readily available evidence of destination. We submitted, simply, a more precise statement of the proposed recorded sales data rule.

Second, the final regulations should allow taxpayers to elect the proposed rule, i.e. the sale is deemed to occur at the location of download or installation at the end user's device, when the taxpayer has that information. Finally, we also recommend that the final regulations allow taxpayers elect to apply, exclusively, the proposed download rule, in cases where 863B may otherwise apply. Due to changes to Section 863B in — introduced by the TCGA, taxpayers, which produce digital content, in the United States, will be unable to achieve foreign source income on the sale of digitally downloaded copies, which will frustrate the intent behind this proposed regulation. This election equalizes the source treatment for downloaded content sold for perpetual use, compared to limited time use, as the latter transaction, when sold to foreign users, normally produces foreign source income, without regard to Section 863B.

Regarding the § 7701(e) factors, we took on board the request to describe a realistic cloud computing transaction, that should be characterized as a lease. Unfortunately, we came up empty. Upon reflection, we observed that the reason for this lies in the proposed definition of a cloud transaction. The proposed definition refers to on-demand network access to computer hardware, et cetera, et cetera. On-demand network access is the essence of a service's transaction. Therefore, it seems clear that all transactions, which fall within the regulatory definition of a cloud transaction, as defined in the regulations, should be classified as a service.

Accordingly, we suggest that the final regulations dispense with the service lease dichotomy, and simply conclude that transactions fall within the definition of cloud transactions, as defined, are characterized as services transactions, or at least presumed to be services absent on usual circumstances. If this recommendation is adopted, the preamble to the final regulation should note that the § 7701(e) factors could still apply for transactions outside the scope of the regulatory definition. This conclusion should apply for both third party customer transactions and related party transactions.

If the Section § 7701(e) factors are retained, we suggest deleting the passage of time factor, as an indicator of the lease. In our experience (inaudible) terms, measured by the passage of time, do not necessarily indicate a lease transaction. For example, software as a service subscriptions, normally, are concluded on a time basis, such as annually, but SAS transactions, normally, should be characterized as services.

Since the passage of time factor doesn't necessarily indicate a lease transaction, in this particular space, we suggest that it be removed from the list of factors. We also suggest that, if the factors are retained, it is important that the regulations retain the case law foundation of Section § 7701(e), that applies the possession and control factors, based on actual physical possession and control, and not on economic possession and control. Concepts of economic possession do not give clear guidance as to when those factors apply, and there's no policy need to deemphasize actual physical possession and control, in the context of cloud transactions.

We welcome the opportunity to comment on the source of income for cloud transactions. Our experience suggests that the most commonly raised issue is whether the income of the entity recognizing the customer revenue should be sourced according to the location of its own personnel and assets, or whether the source rule should be applied on some (inaudible) basis, to include the personnel and assets of other related or unrelated entities that may be participating in the overall enterprise. We believe that sourcing the cloud transaction income by reference only to the employees and assets of the entity recognizing the revenue is the best answer because it is consistent with existing case law, and does not double count the employees and assets of other entities in the group, which otherwise might be included in a look through analysis.

Other important source of income issues include whether the relevant personnel of the entity are all with personnel, or instead all of those directly in the delivery of the cloud services, and what rate assets, rather than personnel, should play in the source determination. We would welcome guidance on these points, and we'd — would be pleased to discuss those issues further with you, at your convenience. We appreciate this opportunity to testify, and we'll be pleased to respond to any questions.

MR. KELLEY: Thank you.

MR. WANG: Zeb, do you want to go first, this time?

MR. KELLEY: Yeah, just one question on the — on your proposed new, I guess, reseller example, where you suggest a platform operator should be treated more as an agent of the content owner, and not, I guess, paying royalties to the content owner, but, rather, the customer paying sales proceeds to the content owner. Do you know if there's any difference kind of in — in terms of the IP law, or the contract law, with respect to the rights that such a reseller would obtain in your proposed new example versus example 19? Are they any more limited, in terms of the rights the reseller gets, or are they the same?

MR. SPRAGUE: Yes. No, I'm happy to respond to that. First, it's important to emphasize that both of these models are very common in the wild, if you will. So, it will be useful to have examples of both the licensed reseller model and the — what the industry calls the platform model. The most important difference is the entity with which the user is contracting for the acquisition of the app, and you can see this, if you look carefully at your user agreement. In the case of the licensed reseller model, you, the user, are contracting with the licensed reseller. That's the entity that you are obliged to pay your price to, and that is the entity that is obliged to deliver, to you, the content. In the platform model, the purchase transaction actually happens between, say, the app developer and the user, with the platform intermediary not being part of that commercial transaction, and there are many legal differences between the two.

So, for example, content regulation is very important. The seller of software or an app is responsible for complying with content regulation laws. There are laws all around the world. In Germany, we can't talk about Nazi things. In Thailand, we can't criticize the government, and, so, part of the obligation, or part of the reason for the platform model is to make sure that obligation sits with the app developer, not the license seller. Other issues, such as pricing, you know, who gets to set the price, in the platform model, the price is set by the developer because the developer is selling directly in the market. On the licensed reseller model, the reseller sets the price.

In terms of the specific question about copyright law, in the licensed reseller model, the reseller does obtain and exercise the rights to copy and distribute to the public, while in the intermediary, the platform model, the platform provider is essentially hosting, on behalf of the app developer, because the app developer is engaging the platform, essentially, to do two things; one, host the application for it, and also do the marketing, bring the eyeballs to the site to allow the eyeballs, then, to purchase the app. So, there is a different mix of contractual relationships, but the most important one is looking at the user level. Who is the user buying from? In the example 19, that you have, the user was buying from the licensed reseller, itself. In the alternative example, that we're proposing, the user is purchasing directly from the app developer.

MR. DEWALD: I'm curious. So, in the platform model, then, I assume, typically, the end user is purchasing with a credit card, or something like that. Is that transaction going through the service provider, or is that transaction directly with the content owner?

MR. SPRAGUE: In most cases, but not all cases, the platform will collect, but the platform doesn't recognize the revenue. In dash — in example 19, the seller does recognize revenue, and then has expense of the royalty payable to the content provider. In the platform model, the intermediary doesn't recognize customer revenue. If it's the one that's collecting off the credit card, it collects, but then it just remits, the end of its commission, but its income statement shows only its commission, and the app provider, the actual seller, will be recognizing sales proceeds.

MR. DEWALD: And I — so, in one of — in the proposed example, in here, in your comments, there's the — Corp A receives, like, a non-exclusive right to host the content and allow end users to download copies. So, that is — is it — that, to me, looks like it's a right to distribute an unlimited amount of copies, and that would be, potentially, the transfer of the copyright right, but do you think that that is not part of this transaction?

MR. SPRAGUE: Well, it's part of the transaction because, as you point out, and, like I said, as we wrote, if the copy is hosted by the platform intermediary, the app developer will authorize the platform intermediary to do that, but if the platform intermediary isn't making the sale, I don't think that's an exploitation transaction of the sort dash 18 is describing.

If you're an app developer, you can also put your app in any (inaudible) environment. You can put it in, you know, a cloud, run by any cloud provider, and you and the cloud provider will have an agreement, that you can do that, and they won't violate your copyright rights. Well, that doesn't make the cloud provider a licensee under dash 18 because the cloud provider isn't selling anything. They're only providing a service to you, so the fine, but important, distinction is between receiving a copy to host, as a service provided to the app developer, versus receiving a copy that you are, then, allowed to sell, which is the example 19 case.

MR. DEWALD: I also had a question on, I guess, the sort of — the way to determine source, in the main rule. You're proposing being billing location and then election of location of download, and then, I guess, election of download rule, if 863B applies, so, again, I'm wondering if we have billing location, why do — why would we use — when would we apply an election to use location of downloads because I would assume, in every case, you'd have the billing location. That information would be available. So, what's the need for the election, or what's the purpose for the election of — for the location of download?

MR. SPRAGUE: Right. OK, so, our thought process was — we were looking both at direct to consumer transactions, but most of Software Coalition members are very large enterprises, B2B sales, and, so, a lot of those sales are through the channel, or to enterprises, in what we call global deals. So, if you're a U.S. software company, and you're selling to a big foreign enterprise, in most cases, that billing location will be overseas, say it will be German enterprise, but, in some cases, that billing location may be in the U.S., say U.S. affiliate of that German enterprise, but it's clear that a lot of the software is going to be deployed outside of the United States. So, billing location, at least our members' view, is the — that the single most available piece of information to all enterprises across the board, and, so, if we have to put something on the table as our proof, that's an item of proof that everybody's going to have, but if you're going to be selling to that German enterprise, and it's a U.S. purchasing office that makes the purchase, but you know that a lot of the installation was going to be outside the United States, that's when, if you're interested in having a foreign sourced income, you would go through the additional step of trying to approve up, where the download is, either just mechanically, or by — you'll be asking the enterprise to inform you.

So, it's to start out with the rule that is the most administrable for the most number of taxpayers, but still get to the ideal result, which is foreign (inaudible) I should say, title passage, where you either have it automatically because it's a B2C transaction, or you can approve it up, and say a B2B transaction through a channel.

MR. WANG: OK. I have two really quick, well, I'll try to ask them quickly, at least, because I can only — we've been here a long time. So, the first question is, you know, I'm still stuck, I'm sorry, on Mr. Ponda's comments, and the — only because, you know, what he — the way he characterizes these is so different from the way you guys characterize these, at least in the subset that he's talking about, and I think you seem to have commented from the definition of the cloud transaction, in and of itself, so, would you say that, in Mr. Ponda's example, where, you know, you have a Fort Knox type server, where you need it to be in a very specific location, there's really two different — two totally different transactions going on? There's the kind of rental of physical servers in that location, and then there's the totally separate, or (inaudible) but it's separate from a tax perspective transaction, where the services from that server are actually provided to you?

MR. SPRAGUE: Yeah. No, of course, I was listening to Mr. Ponda's comments with interest, and he described the Fort Knox situation, where there will be a dedicated server. So, that's clearly something that's, you know, a common business practice —

MR. WANG: Yeah. Yep.

MR. SPRAGUE: — but he described it, I'm speaking as the user now, he described it as my server. The point is it's not your server. It's an asset of the service provider. So, even though the service provider has agreed that we will, you know, dedicate this particular server to serve you, hold your data, it's not your server.

MR. WANG: I see.

MR. SPRAGUE: I mean, you didn't buy it. If it breaks, you don't fix it, you know? You're not the one that plugs it in, and you're not the one that connects it to the internet, so. So, that, I think, is a little bit of loose language, in terms of —

MR. WANG: Gotcha.

MR. SPRAGUE: — thinking about whose asset that really is, so.

MR. WANG: Gotcha.

MR. SPRAGUE: So, I don't think the fact that a server is dedicated to a particular user or not makes a difference because all of the other important attributes, who bought it, who maintained it, who connects to the internet, who is responsible for breaks, that's all still the responsibility of the buyer.

MR. WANG: OK. I gotcha. OK, and to move on real quick (inaudible) approach to sourcing all transactions. Do you, realistically, do you think that elevates form over substance, such that people would be able to bifurcate, you know, just from a purely legal structural perspective, their personnel, their assets into, you know, whatever mix will give them the best tax result, if we do it entity by entity, such that, you know, we have to do it holistically, in order to not be, you know, susceptible to all different kinds of tax planning, or do you think, realistically, you know, people would never, or wouldn't really do that?

MR. SPRAGUE: I guess two — I guess the direct question is no, I don't think that's a real risk, and I guess two responses; one, this issue has never come up in any other circumstance, you know? The services, income items are sourced by the attributes of the entity, or in the income. So why should it be a different rule for cloud services, compared to anything else? The second aspect is how would you apply any different rule? I think the only different rule is some sort of look through, right? So say you've got, we'll make it easy, two entities, one entity that's contracting with the customer, and another entity that's, say, providing the data center, and that's in a separate country, so it's in a separate legal entity, and the central entity that recognizes the revenue has to pay that data center a fee.

So let's start with the data center, and let's just assume for the moment that it's the service. So that data center's income will be sourced according to wherever it's located, right? So now we go to the entity recognizing the revenue. Normally, you would just look at the assets and employees of that entity and determine where they are performing their services, and then we'd have all assets and personnel of the whole group appropriately sourcing income that ends up in the two different places, you know (inaudible) by transfer pricing, right, but if you look through from the entity recognizing the revenue for the data center, to have data center assets, source income, at the revenue entity, those data center assets have now done double duty. You know, we've counted them twice. So, I don't see how the system can be in balance, if you look through one entity to the other, when the other entity has its own income, whatever that amount of income is, sourced by its own personnel and assets.

MR. WANG: I got it, yes. So you're saying, effectively, we would be using the same assets for two different sourcing —

MR. SPRAGUE: Exactly.

MR. WANG: — determinations, and that seems inappropriate.

MR. SPRAGUE: Yeah [inaudible] yeah, and the sourcing is an interesting thing because you source at the item of income level, but you only care about it at the net income level —

MR. WANG: Yeah, yes, right.

MR. SPRAGUE: — because if you're going to apply the 904 limit, you know, no one cares about gross. You need to have net foreign source income, right —

MR. WANG: Yep.

MR. WANG: Yep.

MR. SPRAGUE: — and so when you apply the sourcing to the two different entities, based on their own employees and assets, you, then, at the bottom, you know, will have a net income number, and even though the sourcing technically happened at the item of income level, your item of net foreign source income will be reduced by the actual assets and employee costs in that entity.

MR. WANG: Yeah, that's true.

MR. SPRAGUE: So I think the system balances, by looking at each entity alone, that (inaudible) not happen, if you start mixing things up.

MR. WANG: Yeah. Yeah. Maybe 482 does the work that I'm thinking of, where if you were to split things up, you'd have to have arm's-length pricing, and maybe that would make it all work. Anyway —

MR. SPRAGUE: Yeah.

MR. WANG: — thank you. Thank you very much.

MR. SPRAGUE: Sure.

MR. KELLEY: If I could ask just —

MR. SPRAGUE: Yeah.

MR. KELLEY: — a very quick follow-up, this is going back to the reseller versus platform model, that you were talking about. I think you were making a distinction, with respect to the IP rights that each sort of distributor would get any — in the two situations, and I think you were suggesting that the right to host is different than the right to make copies and distribute to the public, which would be one of the enumerated copyright rights, under dash 18.

MR. SPRAGUE: Right.

MR. KELLEY: In your view, is the right to host covered by any of the other copyright rights in dash 18, and I'm thinking specifically, could it constitute the right to publicly display or the right to make a public performance of the software or the content?

MR. SPRAGUE: Well, I'm not a copyright lawyer. So, I need to get back to you on the nuances of copyright law, but I think the main difference — maybe it's in the element of dash 18 that refers to the transfer of a computer program, and now, I guess, will refer to the transfer of the content. The purpose of that transfer is to allow a commercial exploitation of the software, by selling or releasing. In the platform context, the platform itself doesn't sell. It doesn't lease. It only provides a service to the app developer, which does sell or lease, if the term is for a limited duration, but I think the main difference is in the fact that, in your example 19, that copy has been transferred for the purpose of allowing the reseller to sell, while, in the other model, in the marketplace, the copy is hosted, but not to allow the platform to sell, but only to allow the platform to host — and if you're interested in copyright law analysis, we can follow up — but commercially, that's the big difference, you know, between an agent. If you go to, you know, United Airlines, you're buying from United Airlines. If you go to a travel agent, you're not buying from the agent. The agent doesn't book your, you know, full airplane ticket. Everyone books its commission.

MR. KELLEY: OK.

MR. DEWALD: Thank you.

MR. KELLEY: Thank you. OK, our final speaker, Sarah Shive.

MS. SHIVE: My name is Sarah Shive and I'm senior director in counsel for government affairs of the Information Technology Industry Council. The Information Technology Industry Council, ITI, represents approximately 70 companies from across the technology sector including hardware, software, semiconductors platforms, services, and nontraditional tech companies that derive a significant part of their value added from technology.

Our association includes both U.S. based and foreign-headquartered companies. As you can image, updated regulations concerning how cloud and digital content transactions are taxed are of particular interest to our membership.

These regulations are also of particular interest to us because we believe that Treasury and the IRS are the first taxing authority to issue regulations to specifically tackle how cloud transactions should be taxed.

Half of all value in the global economy created over the next decade will be created digitally, so we applaud U.S. Leadership in addressing how cloud and digital content transactions should be taxed.

We also appreciate the opportunity to weigh in both because we believe the simplicity and administerability of these regulations can be improved but also because we can provide additional insight about how — about these regulations based on the technology and technological limitations. I hope to hit the high points of our comments today.

With respect to the proposed regulations, in Dash 18 related to sourcing of digital content transactions, we believe that these regulations would be difficult to administer due to technological limitations and we recommend that the government take one of two approaches to significantly simplify them.

We believe the approach laid out in the proposed regulations to source income from these transaction based, transactions based on the location of the user when they downloaded or installed the content would introduce unnecessary ambiguity and would be too burdensome to administer in light of the information realistically available.

Additionally, we believe this approach could intersect unfavorably with various data privacy laws being enacted or proposed both inside and outside the United states.

Notably, the most reliable information that could be used to establish the customer's location is the geolocation corresponding to the device's IP address. However, this information can be very unreliable in terms of either the customer's actual location or the location where the content will be accessed or used.

Moreover, the customer may download the content multiple times on multiple devices across multiple tax years as part of the same transaction. This places the taxpayer in the unenviable situation of attempting to reconcile conflicting information about locations where a download or multiple downloads of the same material may have taken place and attempting to determine which location is more accurate, reliable or controlling.

Additionally, employing geolocation information for income tax reporting and compliance purposes would be difficult, which is reflected in the fact that we do not believe that any taxpayers currently base the source of their sales on this data.

As previously mentioned, data privacy laws may also affect repetition of IP geolocation data by companies, which would make auditing difficult or impossible.

In light of these limitations, we recommend allowing taxpayers to choose between the two approaches included in the regulations rather than allowing the use of sales data, which we believe could be substantiated with the customer's billing address only if information about the customer's location is not available.

Alternatively, we would recommend allowing taxpayers to source sales of digital content based on the customers billing address. These revisions would be consistent with other parts of U.S. law that permit taxpayers to rely primarily on the address of the customer and should not result in abuse as long as they're applied consistently. This would significantly reduce the burden and complexity of complying with these regulations.

In further service of these objectives, we also recommend clarifying that the taxpayers an analysis should not be required to extend beyond the first sale to an unrelated party. It would be very difficult to require the taxpayer to engage in further efforts to obtain information about the location of the ultimate end user, if that information is available to them at all.

We would, however, recommend including an election to allow for sourcing to the primary location of the individual user of the copyrighted article if the taxpayer has that information.

Turning to the Dash 19 regulations related to cloud transactions, we believe these regulations can also be significantly simplified, benefitting both tax payers and the government.

Broadly, we believe the facts and circumstances analysis of these transactions will lead to the conclusion that they are services in virtually every case. Accordingly, to simplify administerability and create consistency, we recommend that Treasury revise the final regulations to conclude that all cloud transactions are services transactions.

In addition to simplifying administration of these regulations for both taxpayers and the IRS, we also believe this would set an excellent global precedent to encourage other taxing authorities to take similar positions. As discussed previously, we applaud U.S. leadership on these issues.

If the decision is not made to presumptively determine that cloud transactions are transactions for services, we recommend updating the relevant factors. Our written comments detail some of the adjustments we think would be most appropriate given the realities of both how cloud services work and the business models under which these services are offered.

We also anticipate that significant complexity will arise under these regulations based on the transaction by transaction characterization rules. An arrangement that involves multiple transactions that includes at least one cloud transaction requires a separate classification of each component transaction except any that is de minimis.

Language in the regulations themselves clarifying that analysis should examine the primary benefit, core function or predominant character based on the facts and circumstances would help to clarify that analysis should be qualitative and should not focus on numerical comparison of the notional value of elements of the transaction which might not be knowable by the taxpayer.

An elective numerical safe harbor might be beneficial in helping tax payers to determine when an element of the transaction is de minimis.

In the absence of adopting a predominant character analysis, it would be helpful for these regulations to further clarify the dissection between what might be considered a separate transaction that is part of an arrangement and what should be considered a component or an ancillary feature that is included in a transaction.

We also recommend that Treasury consider providing additional guidance on sourcing cloud transactions given that the operations that employees involved in providing these services are often dispersed. Our comment letter suggests an election to allow the taxpayer to use the place of contracting if they would like to do so.

Moreover, we suggest broadly that the binary option created by the regulations that categorizes downloaded digital content that is not a sale of a copyrighted article as a lease while considering digital content provided online are streamed to the user to be a transaction for services is not a helpful distinction to draw.

As outlined in our comments, technological and practical reasons rather than differences in the transaction or the underlying business model under which it's provided tend to drive decisions of whether users download digital content to their computer or other device or steam the content instead. Ultimately, the underlying transaction is fundamentally the same.

Finally, we point out that these regulations could have significant impacts on other provisions, specifically the FDII deduction. Whether a cloud transaction is considered a lease or a service would impact eligibility of that income for the FDII deduction given the differing rules for establishing foreign use and providing acceptable documentation and the lack of clarity as to whether certain transactions relate to tangible or intangible property. Broadly, clarity related to intercompany transactions would also be helpful.

Thank you for this opportunity to comment further on our views on these regulations.

MR. KELLEY: Thank you.

MR. WANG: So first, I have what's probably a stupid question, this is something I literally just don't know. So I think your comments touch on and I think ITI does it more than any other, touch on GDPR and similar kinds of data privacy laws. I think GDPR is at the vanguard but, you know, there are other countries, other jurisdictions.

My question is, are you aware of any types of data privacy laws or any aspects of these data privacy laws that could actually make billing address a difficult rule to administer or use in terms of retention of billing address through the end of the year, you know, reporting of billing — obviously you wouldn't report the specific billing address, but reporting of location of customers. I just don't know how far these data privacy laws are going.

MS. SHIVE: Yeah, so, fortunately I am not a privacy lawyer.

MR. WANG: OK.

MS. SHIVE: I'd be happy to follow up on some of the specifics on that point. But obviously we do know it's a rapidly evolving —

MR. WANG: Yeah.

MS. SHIVE: — field of the law and I think clearly it's in the interests of both the business community and the government to ensure that the regulations in, you know, this space which is also so rapidly evolving are going to be administrable for everyone.

MR. WANG: Yeah, yeah, I mean, I see your concern here which is we can't, you know, update the reg every time a new data privacy law comes out.

So is the safest rule like a title passage type rule in that case? If that's, if that were the only thing we were concerned about? Because at least title passage is something that presumably a data privacy law wouldn't.

MS. SHIVE: Yeah, I mean, I think our chief focus in our letter obviously was the fact of the difficulty in ensuring accurate information on customer location, right. If they're accessing it, you know, if they're accessing content at work, you know, you may know the location of the IP gateway report, the company, we don't necessarily know where that person is. You know, and the additional complexity of, as I mentioned too, if you're downloading the same content multiple times on multiple devices, which is the controlling, which is, you know —

MR. WANG: Yep, yep.

MS. SHIVE: — it can kind of quickly become incredibly complex, I think. But yeah, I'm happy to follow up on some of these points.

MR. WANG: OK, great. And one more quick question which deals with the sourcing of cloud transactions. You said that which I think is obviously true nowadays, people are dispersed, you know, in terms of where they are or when they contribute to the development of a cloud transaction.

Now I think you guys were the, maybe the only one or one of the only ones who proposed maybe that just to make it administrable we do like a place of contract either as an election or, you know, as an actual rule.

And of course there are concerns with that because you can control where the place, where the contract is concluded. So going to, let's say we don't do the place of contract, do you have a view on how we should do the sources in terms of looking at the people functions, you know, the time, the relative value of the different functions, and then finally the sport between people functions and value of assets? Or do you think it's just too difficult? Like it has to be place and contract or something like that?

MS. SHIVE: I think, you know, we don't have an explicit position beyond that we think it would be helpful to offer an elective option in the regs to address, you know, this fact of —

MR. WANG: It's very hard to do, yeah.

MS. SHIVE: — (inaudible) and everything dispersed. But, you know, beyond that, we don't have a specific position on whether the existing rules are sufficient or, you know, how it should be decided.

MR. WANG: OK. But your, do you guys have a positon on entity-by-entity, or is that not a thing for you guys?

MS. SHIVE: I don't believe we addressed that in our comment letter.

MR. WANG: OK. All right, thank you.

MR. KELLEY: Just one question from me. At the end of your presentation and your comment letter, you talk about how the, this sort of binary option that's currently in the regs now, when you may have a download transaction that's fundamentally the same as a streaming transaction they should be treated similarly.

You mentioned in your letter that when you have the situation of access to a catalog of content that can be either streamed or downloaded, that transaction should be characterized as a service.

Would you agree, I think some of the other comment letters addressed the different situation of where you buy a — or I guess it would be a purchase, that the situation where you transact for a particular item, like a song or a book, and you an access that either by downloading it or by streaming it or, you know, through a browser.

Do you have a view on how that particular transaction should be characterized, whether a service or a lease or maybe a sale if you're actually —

MS. SHIVE: I mean, it seems like the situation that you're describing is fairly similar to the ones that we described in our comment letter. You know, I think we would also look at that as a service.

I think ultimately our point was, you know, that the factors that are driving whether someone downloads content that's provided as part of — I think you're still talking about, like, a subscription service.

MR. KELLEY: Or —

MS. SHIVE: Or —

MR. KELLEY: — or actually this situation would be, you just want access to a particular song, or it could be a video game or something. So not a catalog, unlimited sort of situation —

MS. SHIVE: OK.

MR. KELLEY: — but just one thing. And, you know, say you want access to it for just a month and you can either download it or you can stream it, you know, totally your choice.

MS. SHIVE: OK.

MR. KELLEY: Do you think the unlimited access to a catalog aspect makes, you know, differentiates a service from a particular item which might be, you know, a lease if you had downloaded it.

Do you think that that particular item situation should still be a lease even if you can, you know, simply stream it and not, never download it?

MS. SHIVE: Yeah, so I think if I'm understanding you correctly, the only difference from the example in our comment letter would be that it's just access to a single —

MR. KELLEY: Right.

MS. SHIVE: — item as opposed to a catalog. So I think we would reach the same outcome in that respect. I think chiefly, you know, what we wanted to make sure to address in our letter is sort of a fact of, you know, if a customer, you know, if it's a movie, you know, somebody may not want to download that to their device because it takes up so much space. They may choose to stream it anyway, you know, for those reasons, their convenience, the storage space, etc.

As opposed to if it's a song, maybe you do want to download it because maybe you want to listen to it on an airplane or, you know, maybe it doesn't take up that much space so why not, just have it on the device.

But the fundamental character of that transaction is the same when we are talking about like a time-limited use of that article.

MR. KELLEY: OK.

MS. SHIVE: Great. Thank you.

MR. KELLEY: Great, thank you. So I believe those are all the speakers we had on the agenda. I don't think there is anyone else who has signed up to speak so I'd like to go ahead and say thank you to all of our speakers.

We really appreciate your input today as well as your willingness to take our questions. And also, thank you to everyone who submitted written comments. So we appreciate it and have a nice day.

(Whereupon, at 11:49 a.m., the PROCEEDINGS were adjourned.)

DOCUMENT ATTRIBUTES
Copy RID