Attorney Seeks to Fine-Tune Proposed Cloud Transaction Regs

September 18, 2019

Hon. Charles P. Rettig
Commissioner
Internal Revenue Service
1111 Constitution Avenue, NW
Washington, DC 20224

Re: Comments on Proposed Regulations Regarding Classifying Computer Programs and Cloud Transactions

Dear Commissioner Rettig:

I appreciate the opportunity to submit comments related to the proposed regulations published by the Department of Treasury (“Treasury”) and the Internal Revenue Service (the “Service”) on August 14, 2019, titled “Classification of Cloud Transactions and Transactions Involving Digital Content” under Treas. Reg. §§1.861-18 and 1.861-19 (the “Proposed Regulations”).

I am a tax attorney with clients that seek my advice regarding various cross-border transactions. The transactions engaged in by my clients sometimes include e-commerce transactions related to computer software and cloud transactions, the subject of the Proposed Regulations.

I applaud Treasury and the Service's efforts to provide taxpayers with guidance relating to the classification of computer programs and cloud transactions.

No Examples Resulting In Lease Classification Of A Cloud Transaction

The Proposed Regulations under Treas. Reg. §1.861-19 provide rules for classifying cloud transactions. According to Prop. Treas. Reg. §1.861-19(c)(1):

The Proposed Regulations include 11 examples. One of the examples (Example 7) results in the transaction not being a cloud transaction and it being classified as a lease under Treas. Reg. §1.861-18. However, none of the examples result in a cloud transaction being classified as a lease under Treas. Reg. §1.861-19. It would be helpful for the Proposed Regulations to include one or more examples where a cloud transaction is classified as a lease.

Source of Services From Cloud Transactions

It would be helpful to obtain guidance regarding the source of income earned from a cloud transaction that is classified as a service. For example, say that a computer server is providing on-demand network access to software via a web browser in a cloud transaction that is classified as the provision of services and say that the computer server is physically located in a no-tax jurisdiction.

• Does that mean that 100% of the services have been performed in that no-tax jurisdiction, and therefore that 100% of the income derived from the cloud transaction is foreign-source income?

• Does it matter if the software is owned by a foreign person but the foreign person has subcontracted with related or unrelated parties in the U.S. to develop the software? Miller v. Commr., 73 T.C.M. 2319 (1997); Perkins v. Commr., 40 T.C. 330 (1963).

• Can a U.S. company that generates income from cloud transactions classified as services create foreign-source income by simply moving its computer servers outside the U.S.?

• Is the source of the services income from the cloud transaction altered if the software either: (1) requires regular updates after initial creation, or (2) alternatively, requires no updates (or isolated updates) after initial creation?

Copyrighted Articles — Distributor Analogy Via Product Keys

An underlying principle of the computer software regulations is to treat economically similar income equally, regardless of whether the income is earned through electronic means or through more conventional channels of commerce. In more conventional channels of commerce, wholesalers or distributors will often acquire a limited amount of inventory from a manufacturer. The wholesalers will then sell the inventory through one or more retail channels.

In the e-commerce context, a wholesaler may receive a limited number of software product keys from the owner of the software. A product key is a specific software-based key for a computer program that certifies the copy of the program is original. Activation is sometimes done offline by entering the key, or online to prevent multiple people using the same key. The wholesaler then sells the limited number of product keys to its customers, earning a margin between the cost of the product keys and the sale price of the product keys.

Prop. Treas. Reg. §1.861-18 includes 3 new examples (Examples 19-21). It would be helpful to include an additional example that describes the activities of a wholesaler of computer software whereby a limited number of product keys are purchased and sold (just as shrink-wrap software can be purchased and sold).

Very truly yours,

Andrew Mitchel
Andrew Mitchel LLC
Centerbrook, CT