Comments Focus on Leasing, Income Sourcing in Cloud Transaction Regs

November 12, 2019

Internal Revenue Service
Attn: CC:PA:LPD:PR (REG-130700-14)
Room 5203
P.O. Box 7604
Ben Franklin Station
Washington D.C. 20044

Re: Comments with respect to Proposed Regulation §1.861-19 and proposed revisions to Regulation §1.861-18

Dear Members of the Tax Legislative Committee:

Proposed Regulation §1.861-19 (“Prop. Reg. §1.861-19”) and the proposed modifications to Regulation §1.861-18 (“Reg. §1.861-18”) that were published in the Federal Register on August 14, 2019, do not adequately identify the following issues:

The committee has specifically requested comments from the public on administering rules for sourcing income from cloud transactions in a manner consistent with Internal Revenue Code Sections 861 through 865 and for classifying cloud computing transactions as leases. The comments and suggestions I've made in this letter reflect solely my own personal and professional views and not the views or opinions of my employer or any person, entity or organization associated with my employer. Below, I've provided a general overview of my recommendations followed by a more detailed discussion which explains the rationale for my viewpoints.

Recommendations

1) Cloud computing transactions that are classified as leases of property

The factors identified under Prop. Reg. §1.861-19(c)(2) are not adequate to distinguish between a lease and a provision of service. I believe most of the factors listed under this section would be satisfied in cloud computing transactions qualifying either as a lease or a provision of services. I recommend that the factors originally published under IRC §7701(e)(1) not be applied to cloud computing transactions because the factors are not adaptable to transactions of this nature. Taxpayers need a set of factors that clearly delineate a service from a lease transaction for cloud computing transactions. If the committee were to proceed with the existing factors listed under Prop. Reg. §1.861-19(c)(2), then I recommend that the committee provide more examples that cover a wider breadth of fact patterns because the current examples are too similar and allow for too much subjectivity in determining when factors have been met and which factors take precedence which will result in varying interpretations and applications of these rules among taxpayers.

2) Income sourcing for “cloud computing” transactions

I am requesting that the committee provide more concrete guidance on sourcing income earned from cloud computing transactions especially when on-demand access to intangible assets is accessible from anywhere in the world via an internet connection. In addition, more guidance is needed to conclude when the use of a computer server constitutes a physical presence versus when the use of a computer server is deemed inconsequential or de mininis when sourcing income from cloud transactions pursuant to Internal Revenue Code Sections 861 through 865.

Detailed Discussions Supporting Recommendations Made

Cloud computing transactions that are classified as leases of property

Whereas Reg. §1.861-18 specifically addresses the sale or lease of computer programs, Prop. Reg. §1.861-19 was written to define “cloud computing” transactions and to further identify them as a sale of services or the lease of property.

Under Prop. Reg. §1.861-19(c)(2), we are directed to use the following factors to identify a transaction that should be classified as a provision of services:

I understand the intent of the proposed regulations is to avoid bifurcating cloud computing transactions and to classify the transactions in their entirety as either a provision of services or a lease transaction. However, I anticipate that the factors provided under Prop. Reg. §1.861-19(c)(2) to classify a cloud computing transaction as a provision of services would also be met for a cloud computing transaction classified as a lease of digital property. Factors (i) through (vii) are virtually constant in Examples 1-11 which leads me to question whether these factors are appropriate in making a distinction between a lease and a provision of services. I would argue that they are not. The differences in the fact patterns used in the examples are so slight that the guidance is not clear and concise enough to ensure that the intended rules will be understood and consistently applied by laypersons lacking a sophisticated understanding and expertise in information technology. The two factors listed under this section that seem to carry the most weight in the examples when determining classification are factors (viii) and (ix) which relate to how the fee is determined. However, even if examples 4 and 9, where there were fee arrangements that were fixed fee arrangements, the transactions were still classified as provisions of services. Furthermore, determining whether factor (ix) has been met may be very difficult to ascertain. Price arrangements vary significantly based on numerous terms and conditions that are included in a customer contract. In many instances, it may be difficult to determine whether the total contract price substantially exceeds the cost of renting the property over the specified contract period. As a result, I believe the factors identified under Prop. Reg. §1.861-19(c)(2) are not adequate to distinguish between a lease and a provision of service.

In Examples 1-11, the transactions were either 1) not cloud computing transactions but leases of copyrighted articles or 2) cloud computing transactions classified as provisions of services. The examples fail to provide us with any example that identifies a cloud computing transaction as a lease of property and, therefore, I fail to understand what factors under Prop. Reg. §1.861-19(c)(2) must be absent to distinguish a transaction as a lease rather than a provision of services.

Based on the analyses provided within these examples, the two main distinguishing factors being used to determine whether a cloud computing transaction is a lease of copyrighted article or a provision of services are:

There remains confusion and ambiguity when software is both accessible on-demand through a website and downloadable onto a computer or electronic device. The examples in the proposed regulations with this fact pattern are examples 6, 10 and 11. In my opinion, these examples highlight the significant level of subjectivity that is being used in determining what constitutes a de minimis activity and, thus, can be ignored when determining whether factors (i) through (ix) have been met.

Please reconsider the fact patterns in examples 10 and 11 under Prop. Reg. §1.861-19(d). The fact patterns appear to be substantively similar yet they render two different classifications. Both examples include on-demand access to an extensive library or database of copyrighted digital content in exchange for a fee. In example 10, it's not clear whether the fee is based on each downloaded item or a fixed fee based on the passage of time. In example 10, the on-demand access to a library of copyrighted music constituted a lease of copyrighted articles under Prop. Reg. §1.861-18 because the end user downloads the content onto an electronic device or computer. In example 11, the on-demand access to a library of copyrighted industry related documents was determined to be a cloud computing transaction classified as a provision for services despite the fact that the end user is also able to download library content onto an electronic device or computer. In example 11, the option to download the digital content is deemed de minimis because the “primary benefit to the end user is access to Corp A's database and its proprietary search engine”. The end users in both examples get to keep copies of the downloaded content in perpetuity. Arguably, the most desirable selling point in both examples is the extensive on-demand libraries of digital content available to the end users. Example 11 (as well as examples 3 and 6) highlights the significant level of subjectivity that is allowed when determining what is considered a de minimis activity that will cause virtually identical transactions to be treated differently for tax purposes.

In summary, the examples under Prop. Reg. §1.861-19(d) suggest that if on-demand digital content is downloadable to a device and able to be used independently without an internet connection, it is likely to be classified as a transfer of a digital content under Reg. §1.861-18 even if the end user doesn't get to keep a copy of the downloaded content when the arrangement expires. However, if the on-demand digital content is not downloadable but must be accessed or used primarily through an internet connection, it will likely be classified as a cloud computing transaction. It will further be identified as a provision of services instead of a lease of property if the terms of the fee arrangement are such that they are based on the work performed or the level of customer use rather than the mere passage of time. However, these general rules do not hold true in examples 3, 6, and 11 where subjective interpretation determined that the software downloads were de minimis and in examples 4, 6 and 9 where fixed fee arrangements did not prevent the transactions from being classified as provisions of services.

Income sourcing for “cloud computing” transactions

Prop. Reg. §1.861-19 does not address income sourcing for cloud computing transactions. As a result, the income sourcing rules governed by Internal Revenue Code (“IRC”) §861 may be inconsistently applied across the industry given the wide breadth of complexities and varying fact patterns involved in cloud computing transactions.

With respect to cloud computing transactions classified as a leases of property, IRC §861(a)(4) dictates that lease income is sourced to where the leased property is being used. The challenges that I foresee in applying the sourcing rules of §861(a)(4) for cloud computing transactions classified as a lease of property under Prop. Reg. §1.861-19 revolve around determining the situs of the property being used when the property is accessed via “the cloud”.

Please consider the following facts:

Based on the analysis and conclusion provided in Example 20 under Reg. §1.861-18(h), the transaction between the foreign website owner and the U.S. company could, arguably, be classified as a lease of copyrighted articles. Despite the fact that in Example 20, the user had to download the content to access it, the end user loses all access to the downloaded content when the fee arrangement expires. Essentially in both scenarios, the end user does not possess any personal property during or at the end of the contractual agreement. Therefore, it's conceivable that the fact pattern I presented could be classified as a lease of copyrighted articles.

However, the fact pattern presented above is also very similar to Example 11 under Prop. Reg. §1.861-19(d) which was deemed to be a cloud computing transaction classified as a provision of services. Even though the user was able to download and retain, in perpetuity, copies of some of the underlying library resources, the transaction was still classified as a provision of services and not a transfer of a digital content under Reg. §1.861-18 because the software download capability was deemed de minimis in relation to the primary functionality being offered to the customer. However, in my example presented above, the fee is based on the passage of time rather than a measure of work or effort. Does the fact that factor (viii) was not satisfied preclude this transaction from being a provision of services? In other examples, not all factors under Prop. Reg. §1.861-19(c)(2) were met but the transaction was still deemed a provision of services. The fact pattern I presented highlights the role of subjectivity in determining when an unmet factor under Prop. Reg. §1.861-19(c)(2) is deemed to be de minimis.

Lastly, my fact pattern could meet the definition of a cloud computing transaction classified as a lease of intangible property which has yet to be defined in the proposed regulations. Almost all of the factors under Prop. Reg. §1.861-19(c)(2) have been met with the exception of factors (viii) and potentially factor (ix) which I believe would be very challenging to evaluate. Again, the question is whether having a fixed fee which causes factor (viii) not to be satisfied would be deemed de minimis or whether it would solidify this as a cloud transaction classified as a lease of intangible property?

In accordance with IRC §861(a)(4), the rental income from a lease of a copyrighted article or a cloud computing transaction classified as a lease of property is sourced to where the real property is located or, in the case of intangible property, where it is used. Under Prop. Reg. §1.861-18(f)(2)(ii), when content is downloadable to a device, the income is sourced to the location of the download. But, when content is not downloadable to a device, where is the income sourced when the content is accessible from anywhere in the world via an internet connection? Where is the intangible property being used if a company has employees who are accessing the same on-demand library of resources from locations all around the world?

If my fact pattern presented in this comment letter is deemed to be a cloud computing transaction that is a provision of services, then the income would be sourced under IRC §861(a)(3) based on where the services are performed which is also not clear. Since the website is owned and maintained by a foreign entity outside of the U.S., is the income deemed foreign sourced income? If the foreign entity is utilizing computer servers in the U.S. to ensure uninterrupted access to its website but the entity has no other physical presence in the U.S. outside of its use of U.S. owned computer servers, does this change the income sourcing? I would advocate that the mere use of U.S. servers does not cause this income to be sourced within the United States. I would argue that the website is owned and operated exclusively outside the U.S. and the use of U.S. based servers would be insignificant physical presence. Therefore, I would conclude that the services are being provided outside of the United States. If there were ever going to be a de minimis element added to cloud computing transactions, I would expect that the use of U.S servers, in this example, to qualify as a de minimis factor in determining the source of income. I acknowledge and understand, however, that the location of computer servers may not be a de minimis factor in all cloud computing transactions but my example was intended to illustrate an example where the services provided outside of the U.S. should be more heavily weighted in determining income sourcing than the physical use of computer servers within the United States.

Thank you for the opportunity to comment on the proposed regulations. I understand and appreciate the challenge of developing guidelines for a rapidly changing and developing technological environment. I hope that my comments are found useful when writing the final regulations.

Respectfully,

Laura House, CPA