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Income Classification Reaches Digital Content and Cloud Computing

Posted on Oct. 28, 2019

Prior to the August release of proposed regs, there was no guidance on income classifications for digital content or transactions involving remote access to digital content through the cloud.

However, new proposed regs specifically revise reg. section 1.861-7, extend the application of existing reg. section 1.861-18 beyond computer programs to digital content, and add a new prop. reg. section 1.861-19 for classifying income from cloud computing and transactions.

Prop. regs under section 861 (REG-130700-14) provide guidance on the character and source of income from transactions involving digital content and cloud computing. Income from these activities is generally classified either as sales of property or services, or as leases, based on surrounding facts and circumstances. The income’s classification determines which source rule applies.

Section 861 generally outlines when various categories of income, including interest, dividends, services, rents, royalties, and real estate and inventory sales, are U.S. sourced. There are additional source rules in sections 862-865. Section 862 outlines when these categories of income are foreign sourced. Section 863 includes guidance on income that is partly U.S. sourced and partly foreign sourced. Section 864 includes definitions. Section 865 has source rules for income from the sale of personal property that is not inventory.

The source of income depends on its type. For digital content and cloud transactions, the relevant income types are sales, licenses, and services. In addition to source, the type of income can also affect U.S. taxation of income earned by controlled foreign corporations. For example, income’s character affects whether subpart F applies, whether section 59A’s services cost method exception is available, and the degree of section 250’s document requirements.

Location of Sales

The proposed regs revise reg. section 1.861-7 rules on the sale of personal property. Because prior regs did not address application of the rule on the sale of copyrighted article’s title passage, a cross-reference was added to reg. section 1.861-7(c) inventory sales rules.

Prop. reg. section 1.861-7(c) provides that income from a personal property sale is sourced where the seller’s rights, title, and interest in the property are transferred. When bare legal title is retained by the seller, the sale occurs at the time and place when and where beneficial ownership and the risk of loss passes to the buyer.

In any case in which a sale arrangement’s primary purpose is tax avoidance, however, the above rules do not apply, and all factors of the transaction (negotiations, agreement execution, property location, and place of payment) will be treated as taking place where the substance of the sale occurred.

Prop. reg. section 1.861-7(c) then directs taxpayers to prop. reg. section 1.861-18(f)(2)(ii) for determining the place where copyrighted articles in an electronic medium are transferred.

Sale or Lease of Digital Content

The proposed regs revise reg. section 1.861-18’s rules on classification of transactions involving digital content and add three examples (19-21) to paragraph (h).

Since reg. section 1.861-18 became a final reg in 1998 (T.D. 8785), content in digital format subject to copyright law (for example, music, videos, and books) is often the subject of commercial transactions. These rules already provide useful guidance on computer programs and are extended to other digital content. The proposed regs replace numerous references to computer programs with references to digital content.

The proposed regs extend the classification rules in existing reg. section 1.861-18 to transfers of digital content other than computer programs and clarify the source of the income from transactions governed by reg. section 1.861-18.

Prop. reg. section 1.861-18(b)(1) applies to four transactions:

  • transferring a copyright right in digital content;

  • transferring a copy of digital content (a copyrighted article);

  • providing services to develop or modify digital content; and

  • providing know-how related to developing digital content.

Prop. reg. section 1.861-18(c) classifies the transfer of digital content as the transfer of a copyright right if there is a non-de-minimis grant of any of the following four rights:

  • the right to make copies of the digital content to distribute to the public via sale, rental, lease, or loan;

  • the right to prepare derivative digital content;

  • the right to make a public performance; or

  • the right to make a public display.

Prop. reg. section 1.861-18(c)(2) clarifies that the right to make a public performance or display of digital content is treated as the transfer of a copyright right only if it is not for the purpose of advertising the sale of the performed or displayed content.

Prop. reg. section 1.981-18(a)(3) defines digital content as a computer program or other content in digital format that is either protected by copyright law or no longer protected by copyright law solely because of the passage of time, regardless of whether the content is transferred in a physical medium. Examples of digital content include books, movies, and music in digital format.

A computer program is defined as a set of statements or instructions used in a computer to bring about a result. This includes media, user manuals, documentation, databases, or similar items if they are incidental to the operation of the program.

Prop. reg. section 1.861-18(f)(2) provides guidance on classifying the transfer of a copyrighted article as a sale or a lease. The classification is a facts and circumstances determination based on whether the benefits and burdens of ownership have passed.

The source of income from transactions classified as sales is determined under sections 861(a)(6), 862(a)(6), 863, and 865(a), (b), or (e). Under prop. reg. section 1.861-7(c), sale of a copyrighted article through an electronic medium is deemed to have occurred at the location of download onto the end-user’s device for purposes of determining the country in which the sale occurs, subject to the antiavoidance rule.

If there is no information about the end-user’s device location, the sale will be deemed to have occurred at the customer location, determined via the taxpayer’s sales data for financial reporting.

The source of income from transactions classified as leases is determined under sections 861(a)(4) or 862(a)(4), which generally provide that income is sourced where the leased property is located.

Cloud Transactions as Services or Leases

Reg. section 1.861-18 does not provide rules for categorizing common transactions involving cloud computing, or on-demand network access to computing resources like networks, servers, storage, and software. New prop. reg. section 1.861-19 fills the gap, distinguishing the two activities within the preamble.

A cloud computing transaction does not involve the transfer of digital content classified as a transfer of a copyright right or copyrighted article. It also does not include providing development services or know-how related to digital content. Cloud computing transactions may, however, provide functionalities that are like these activities (for example, the transfer of a computer program via download may provide similar functionality as the same program access via web browser). On the other hand, reg. section 1.861-18 does not address providing online access to digital content.

The regs’ preamble describes three common models of cloud computing that vary depending on whether the cloud service is linked to software, a platform, or infrastructure.

“Software as a service” allows customers to access applications on a provider’s cloud infrastructure through an interface like a web browser.

“Platform as a service” allows customers to load applications they have created onto a provider’s cloud infrastructure using programming languages, libraries, services, and tools supported by the provider.

“Infrastructure as a service” allows customers to access processing, storage, networks, and other resources on a provider’s cloud infrastructure.

In addition to the three common cloud computing models, cloud transactions unrelated to computing that still involve on-demand network access have increased in frequency and resemble cloud computing models. Examples include streaming music and video, mobile device applications, and access to data via remotely hosted software.

A cloud transaction involves access to and use of property, instead of the sale, exchange, or license of property. Therefore, these transactions should be classified as either a lease of property or a provision of services. Section 7701(e) and case law provide factors relevant to this distinction, and these factors are listed in new prop. reg. section 1.861-19(c)(2).

A cloud transaction is defined in prop. reg. section 1.861-19(b) as a transaction through which a person obtains on-demand network access to computer hardware or digital content that is not de minimis, considering the overall arrangement and the facts and circumstances. A cloud transaction does not include network access to download digital content for storage and use on an electronic device.

Cloud transactions are classified as either the provision of services or leases taking into account all relevant factors, including the list in paragraph (c)(2). Property is computer hardware and digital content and the provider is the party making property available to customers.

The nine factors demonstrating that a cloud transaction is the provision of services (rather than a property lease) include:

  • the customer does not physically possess the property;

  • the customer does not control the property beyond having access and using it;

  • the provider has the right to choose and replace the property;

  • the property is a component of an integrated operation over which the provider has additional responsibilities like maintaining and updating the property;

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

  • the provider bears the risk of diminished receipts or increased expenditures if the contract isn’t performed;

  • the provider uses the property to provide services to entities other than the customer;

  • the provider’s fee is based on work performed or customer use rather than the passage of time; and

  • the contract price exceeds the property’s rental value.

An arrangement with multiple transactions requires separate classification for each one. Any transaction that is de minimis will not be treated as a separate transaction but as part of another transaction.

The classification rules apply for purposes of several code sections, including:

  • section 59A (base erosion and antiabuse tax);

  • section 245A (dividends received deduction);

  • section 250 (global intangible low-taxed income and foreign-derived intangible income deduction);

  • section 267A (related-party payments in hybrid transactions);

  • section 367 (property transfers to foreign corporations);

  • section 482 (allocation of income and deductions between related parties); and

  • section 1059A (transfer prices and customs values).

Examples

The proposed regs include three new examples added to reg. section 1.861-18(h), and 11 new examples in prop. reg. section 1.861-19(d). The examples illustrate the facts and circumstances analysis that applies to determine whether income is a transfer of digital content or a cloud transaction, to characterize digital content income as a sale or lease, and to characterize income from cloud transactions as a service provision or lease.

The three examples in prop. reg. section 1.861-18(h) all have Corp A as a domestic content provider and contain a two-step process: determining whether a transfer occurs that makes the reg. section 1.861-18 regs applicable, and if so, whether that transfer is a sale or a lease.

The first example (19) concludes that the content owner has leased (not sold) the content to Corp A. While this determination is not made in the second example (20), the facts are similar enough to again conclude that Corp A has not purchased the content from its owner.

These examples reach different conclusions, however, on whether Corp A has sold or leased the content to the end-user. The pivotal difference is that the second example assumes an electronic lock takes content access away from an end-user who discontinues paying a monthly fee, while the first example has no electronic lock. The transfer to the end-user without the electronic lock is treated as a sale, while the transfer to the end-user having the lock is a lease.

The third example (21) distinguishes between end-users that can rent, purchase, or stream content. The first two options are governed by reg. section 1.861-18, and are classified as leases and sales, respectively. The third option is a cloud transaction and is subject to the rules in prop. reg. section1.861-19.

The 11 examples in prop. reg. section 1.861-19(d) also generally employ a two-step analysis: determining whether the transaction is a cloud transaction subject to prop. reg. section1.861-19, and if so, determining whether the transaction is a sale of services or a property lease.

All 11 examples that find a cloud transaction then classify the arrangement as the provision of services — none of them conclude that the arrangement is a lease. The proposed regs’ preamble requests comments on realistic transactions that should be classified as leases.

All examples assume that Corp A is a domestic corporation provider, Corp B is a foreign corporation contracting with Corp A, and end-users are individuals. No copyright rights described in prop. reg. section 1.861-18(c)(2) are transferred.

In considering whether a cloud transfer occurs, the examples focus on whether the end-user accesses content online or downloads the content onto a device. In cases in which the end-user downloads the content, the cloud transaction analysis does not apply.

In cases in which both online access and downloading occur, the examples disregard any de minimis activity and analyze the whole arrangement as one transaction. If neither activity is de minimis, the two activities are treated as separate transactions, one subject to reg. section 1.861-18 and the other subject to prop. reg. section 1.861-19.

Examples that analyze whether a cloud transaction is the provision of services or a lease weigh each of the nine factors in prop. reg. section 1.861-19(c)(2). Examples having end-users pay a content fee based on the passage of time nonetheless conclude that Corp A is providing services, either because Corp B’s fee is higher than it would cost to access content outside Corp A’s system, or because the other factors weigh more heavily in favor of service classification.

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