TEI Requests Clarification of Proposed Cloud Computing Regs

November 12, 2019

Internal Revenue Service
1111 Constitution Avenue, NW
Washington, DC 20024

RE: Proposed Cloud Transaction and Digital Content Regulations

Dear Sir or Madam:

The Internal Revenue Service and the United States Department of the Treasury (together, the Government) published proposed regulations regarding the classification of cloud transactions and transactions involving digital content on August 14, 2019 (the Proposed Regulations).¹ The Government requested comments from interested stakeholders no later than November 12, 2019. I am pleased to respond to the Government's request for comments on behalf of Tax Executives Institute, Inc. (TEI).

TEI Background

TEI was founded in 1944 to serve the needs of business tax professionals. Today, the organization has 57 chapters in North and South America, Europe and Asia. As the preeminent association of in-house tax professionals worldwide, TEI has a significant interest in promoting sound tax policy, as well as the fair and efficient administration of the tax laws, at all levels of government. Our nearly 7,000 individual members represent over 2,800 of the leading companies in the world.²

TEI Comments

TEI commends the Government for issuing much needed proposed rules regarding the treatment of income from transactions involving on-demand network access to computing, other similar resources, and other transactions involving digital content under Prop. Treas. Reg. §§ 1.861-18 and -19. The Proposed Regulations are generally consistent with the framework taxpayers currently use to analyze transactions related to digital content and cloud computing. TEI's recommendations therefore generally focus on providing additional clarity to the Proposed Regulations so they more accurately reflect current business practices and fact patterns in this area.

Comments on Proposed Treasury Regulation § 1.861-18

Expanding the scope of Prop. Treas. Reg. § 1.861-18

The Proposed Regulations under § 1.861-18 would expand the scope of the current final regulations beyond rules for “computer programs” to include other “digital content.” TEI applauds the government for this change as it is consistent with the analytical framework taxpayers have been using in the absence of express guidance from the Government.

Source rule for digital content

Proposed Treas. Reg. § 1.861-18(f)(2)(ii) states when a copyrighted article is sold and transferred through an electronic medium, the place of sale (for purposes of Treas. Reg. § 1.861-7(c)) “is deemed to have occurred at the location of download or installation onto the end-user's device used to access the digital content. . . .” In the absence of information about the location of the download or installation, Prop. Treas. Reg. § 1.861-18(f)(2)(ii) further provides the sale will be deemed to occur at the location of the customer, determined based on sales data recorded for business or financial reporting purposes. Focusing on an amorphous determination of the “location of download or installation” for place of sale purposes implies that some information other than current sales data and other business/financial records would be the primary determinant for sourcing income from digital content.

The focus on the “location of download or installation” is both ambiguous and burdensome, particularly for sales of copyrighted articles to end users. TEI recommends the Government amend the Proposed Regulations to expressly provide a taxpayer may rely, in the first instance, on recorded sales data or other business or financial reporting records (such as a billing address) for purposes of determining the “location of download or installation onto an end user's device. . . .” Such a modified rule would be a more reliable indicator of customer location as it is a clear, administrable rule utilizing information already collected in the ordinary course of business, as discussed further below.

The Proposed Regulations do not specify what information might establish the “location of download or installation,” which is likely to create confusion and compliance difficulties for taxpayers. Further, absent knowing what information is sufficient to establish a download or installation location, we are unable to comment on whether taxpayers presently collect, or could collect, such information. Allowing use of existing sales data would provide necessary clarity and ease taxpayers' compliance burden.

The use of existing sales data or other business or financial reporting records would more accurately reflect the location of end-users, which we understand is the intent of the proposed rule. The preamble states that use of a location “other than the customer's location — as the location of transfer . . . would bear little connection to economic reality in the case of a transfer by electronic medium of digital content. . . .”³ While unclear, perhaps the Government was contemplating “geolocation”-type data corresponding to a device's internet protocol (“IP”) address as the location information. Such information, however, is often not a reliable indicator of user location due to the use of virtual private networks (VPNs), “IP spoofing”, downloading digital content while traveling, etc. Using the download or installation location, particularly for sales of copyrighted articles to end-users, may provide a user's location at a specific moment in time, but that location may bear “little connection” to the location where such customer will primarily use the content. Further, taxpayers entering into global enterprise licenses with large customers will also have trouble determining what “download or installation onto [an] end-user's” device means, as well as the same reliability issues as set forth above, when the enterprise's global customers use a VPN masking the download location.

In addition to the availability and reliability issues regarding the location of download and installation discussed above, the Proposed Regulations would impose new, unique documentation requirements to substantiate the source of income from such sales. Requiring taxpayers to collect new data solely for tax purposes creates substantial and burdensome systems and data storage costs. Indirectly, the Proposed Regulations would create a requirement to record, store, and place controls around this data point for every transaction. Such information would need to be maintained for several years to support audit cycles and result in substantial costs to taxpayers.

Finally, the Government should consider the approach of the Proposed Regulations in the context of the Organisation for Economic Co-Operation's (OECD) project concerning reallocating taxing jurisdiction between source/market jurisdictions and residence jurisdictions. The OECD is struggling with many of these same issues addressed in the Proposed Regulations, including how to determine where customers are located for sales sourcing purposes.

Revise Prop. Treas. Reg. §§ 1.861-(h)(20) and (21) to better reflect actual business operations

Proposed Treas. Reg. §§ 1.861-18(h)(20) and (21) provide two examples of the applicability of the revised § 1.861-18 regulations. These examples are not representative of real-world fact patterns and would result in an overly prescriptive treatment of downloads when determining whether there has been a “transfer” for purposes of Prop. Treas. Reg. § 1.861-18 and whether “access” has been provided under Prop. Treas. Reg. § 1.861-19.

Digital content generally means electronic or digital access to copyrighted articles, including books, audio books, music, and videos that are stored in the “cloud” and made available to end-users over the internet. Digital versions of such copyrighted articles are typically offered under a subscription model, which provides unlimited on-line access to an expansive library or catalog of digital content in exchange for a monthly or annual fee. Digital content may also be offered on a stand-alone basis in a separate transaction for a single copyrighted article (a title) not part of a subscription service. The single-title purchase may be offered to access content not available within the subscription library/catalog or for end-users who are not subscribers. Single-title offerings are accessible for either a limited (i.e., a “rent” option) or an indefinite (i.e., a “purchase” option) time.

While a digital content provider may offer access to its content as a “streaming-only” or “download-only” delivery method, this is on balance not the prevailing approach. Most digital content providers offer the end-user the option of either delivery method, subject to certain restrictions (either based on licensed rights, registered devices, or other criteria).

Whether the digital content is accessed through a subscription service, a limited-period option, or an indefinite-period option, the content is generally accessible through on-demand streaming access. Digital content is also made available for a limited number of downloads on a limited number of devices simply as a matter of convenience to the end-user (e.g., downloading a movie title prior to a flight) and subject to certain limitations and restrictions. The decision to stream or download the digital content typically rests solely with the end-user based on individual preference or other factors such as file size, device storage capacity, download speed, total download time, convenience, and available internet access. There is no additional fee charged to the end-user who chooses to download the digital content in these circumstances.

The Proposed Regulations appear to draw a distinction between the treatment of digital content based solely on the end-user's choice of how to access the content — on-demand streaming versus download — rather than on the substance of what rights the customer obtains in a specific copyrighted article. This distinction creates ambiguity, does not reflect real-world functionality, and introduces costly administrative burdens for taxpayers. Moreover, basing the character and source of a digital content transaction on the end-user's method of access to the content creates unintended consequences and uncertainty, leading to double taxation.

TEI recommends the examples make clear technological/practical limitations, or an end user's choice of how to access content on any given occasion, should not determine whether Prop. Treas. Reg. §1.861-18 or -19 applies. For example, if an end-user pays to view a specific copyrighted article in exchange for a discrete fee and the content is available only for a limited period, this should be classified as a lease giving rise to rental income, regardless of whether or not the copyrighted article is downloaded during the viewing period. Whether this is the result under the Proposed Regulations is unclear, solely because the viewer may or may not download the content.

Additional comments on Prop. Treas. Reg. § 1.861-18

TEI agrees with the Proposed Regulations' approach of defining digital content by reference to copyright law. Similarly, carving out copyright right transfers occurring solely for advertising purposes is a reasonable approach.

Separately, TEI recommends the Government provide taxpayers with an election to apply the final regulations to transactions taking place before the effective date of the regulations. Alternatively, the final regulations should apply only to transactions originating in taxable years beginning on or after the regulations' final publication date. This would avoid the difficulty of different rules applying to the same or similar transactions of a single taxpayer.

Comments on Proposed Treasury Regulation § 1.861-19

Confusing use “arrangement” and “transaction”

Proposed Treas. Reg. § 1.861-19 refers to (i) cloud “transactions,” (ii) “arrangement[s] comprised of multiple transactions”, and (iii) de minimis transactions. Regrettably, the distinction between a transaction and an arrangement is unclear, as is what might be considered de minimis. Given this lack of clarity, TEI views the requirement to bifurcate individual “transactions” in an “arrangement” where: (i) one or more transactions could be classified as a cloud transaction under Prop. Treas. Reg. § 1.861-19(b) and, (ii) one or more transactions do not qualify as cloud transaction, as exceedingly difficult to administer and leading to divergent results among taxpayers.

This multi-pronged approach, for example, would be particularly difficult to apply to instances where a provider — in the interest of transparency to the customer — supplies a detailed invoice regarding one or more components of a given offering. However, because a customer typically would not obtain one or any of the components but for obtaining the entire offering from the provider, the business may or may not provide separate pricing for one or more components. In such a case, without more clarity, taxpayers would be left with difficult determinations regarding whether one or more components, individually or together, are de minimis and making value determinations for components of offerings the business considers a single offering.

For these reasons, TEI recommends the Government eliminate the arrangement/transaction distinction and provide that transactions be characterized based on their predominant character.⁴ Further, TEI recommends the Government clarify the de minimis standard to make clear where a customer could not obtain one or more components from a provider, but for the whole, the offering should be treated as a single transaction.

Characterization of cloud transactions

Proposed Treas. Reg. § 1.861-19 classifies “cloud transactions” as either a service or a lease based on nine factor facts and circumstances test. Given the definition of a cloud transaction, TEI submits there is no real-world circumstance under which such a transaction could be characterized as a lease rather than a provision of services. That is, defining a “cloud transaction” by reference to “on-demand access” clearly implies a service. Further, such transactions are akin services as the customer generally does not retain any ownership of the property at the end of the business relationship. TEI therefore recommends the final regulations characterize all cloud transactions as a provision of services. Such a rule would increase the administrability of the provisions, provide consistency across taxpayers, and set a clear standard for other countries.

Should the Government retain the factor test, TEI agrees with the approach of not assigning different weights to the various factors given the speed of technological change. TEI recommends, however, modifications to some of the factors to promote clarity and applicability to today's cloud transactions.

Component of an Integrated Operation: This factor should be expanded beyond a provider's responsibilities in respect of ensuring the property (computer hardware, digital content, or similar resources) is maintained and updated. Specifically, this factor should be expanded to recognize that cloud offerings often are not limited to obligations only with respect to raw computational resources, but also contemplate providing developer tools, operating systems, tools for data portability, data security, etc. Where a customer would not utilize a provider's service offering (e.g., infrastructure) but for the offering's integration with other services should demonstrate the cloud transaction is a service.

Physical Possession: Physical possession seems an outdated factor in the context of cloud transactions. Cloud infrastructure may be operated in any number of deployment models including hybrid cloud, private cloud, and community cloud, all of which could be either provided on a customer's premises (“on-site”) or outsourced to a hosting company (“off-site”), or even a combination thereof. However, in all instances the infrastructure is owned, operated, and managed by the provider, and the customer is not permitted to move or gain access to the infrastructure beyond limited user-specific application configuration settings. TEI recommends clarifying this factor with an example in which the facts stipulate some component of hardware on-site at the customer location, but — considering the overall arrangement and the surrounding facts and circumstances — the transaction should still be classified as the provision of services.

Contract Price v. Rental Value: For some cloud transactions, particularly those heavily weighted to providing raw computing resources such as processing, storage, or computing capacity, this factor may be of limited utility and result in false positives. Economies of scale make the cloud computing model of infrastructure, platform, and software delivery more efficient than the traditional IT service delivery model. Providers who already have an infrastructure of data centers to store and process information can handle additional data and users at a very low marginal cost. These economies of scale can distort a comparable rental value analysis because the scale means cloud providers can price their offerings at close to or less than comparable rental value. TEI recommends limiting application of this factor to such circumstances through an example in which the facts stipulate the provider is able to provide the infrastructure, platform, or other resources at less than comparable rental value, but considering the overall arrangement and the surrounding facts and circumstances, the transaction is classified as the provision of services.

Intercompany Transactions: The Proposed Regulations do not specifically address the application of any of the factors to intercompany transactions. However, affiliates of a cloud provider in a global structure may prefer to obtain infrastructure, platform, or software services from another affiliate rather than a third party. The affiliate may be a subsidiary under common control with the provider, or the parent company responsible for providing funding or setting global procurement strategy. Often in such arrangements, and particularly in the cross-border context, the required arms-length intercompany charge is determined under a cost-plus remuneration model based on the relevant functions performed.

Such arrangements should not influence character determinations under the Proposed Regulations. To provide clarity and certainty to taxpayers, however, it would be helpful if the Government would affirm activities performed in the role of shareholder or at an arms-length cost plus monthly charge would not change a conclusion that a transaction is appropriately treated as services.

Interaction with Foreign-Derived Intangible Income under section 250

TEI recommends the Government establish consistent classification rules for cloud transactions under sections 861 and 250, regardless of the Government's response to our recommendation above. This would assist in determining the foreign use documentation requirements under section 250.

Revise Prop. Treas. Reg. § 1.861-19(d)(9) to better reflect actual business operations

The example in Prop. Treas. Reg. § 1.861-19(d)(9) is not representative of current taxpayer business operations and, as with the examples discussed above under the proposed § 1.861-18 regulations, may result in an overly prescriptive treatment of downloads to determine whether there has been a “transfer” for purposes of §§ 1.861-18 and -19. Most “streaming services” permit limited downloads and are not “stream-only,” as noted above. Thus, TEI recommends revising Prop. Treas. Reg. §1.861-19(d)(9) to state a subscription service generally providing access to a catalog of content via streaming services and offers, at its sole discretion and subject to restrictions (including some type of time limits), the user the option to download a limited number of titles merely as a matter of convenience, retains its character as a service and not be treated as a transfer of a copyrighted article.

Sourcing rule for transactions under Prop. Treas. Reg. § 1.861-19

The Government asks in the Proposed Regulations for comments on an administrable sourcing rule for income from cloud transactions (the Proposed Regulations do not provide such a rule). TEI believes the current authorities sourcing income from services are clear as applicable to services income derived from cloud transactions prior to the Proposed Regulations. While the Proposed Regulations largely adopt the principles of income classification taxpayers have been applying to cloud transactions, they are only proposed. Further, external factors have introduced new variables and unknowns that need to be fleshed out prior to addressing sourcing decisions. Thus, no additional guidance on a sourcing rule for income from cloud transactions is appropriate in TEI's view.

Should the Government decide specific rules are necessary to source income from cloud transactions, however, TEI recommends any such rules be published before the Proposed Regulations are finalized so taxpayers can consider them in conjunction with the rest of the Proposed Regulations and make additional comments on classification issues as impacted by any such proposed sourcing rules. In this regard, the location of cloud infrastructure should not be determinative of income sourcing from cloud transactions. Infrastructure at domestic locations, for example, often supports foreign locations and foreign end-users.

Additional comments on the Proposed § 1.861-19 Regulations

As recommended above regarding the effective date of the proposed § 1.861-18 regulations, TEI recommends the Government similarly provide taxpayers with an election to apply the final regulations to transactions taking place before the effective date of final regulations or the Government should apply the final regulations only to transactions occurring in taxable years beginning on or after the date of publication of the regulations as final. This would avoid the difficulty of having different rules apply to the same or similar transactions of a single taxpayer.

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TEI appreciates the opportunity to comment on the Proposed Regulations. Should you have any questions regarding TEI's comments, please contact Benjamin R. Shreck of the Institute's legal staff at bshreck@tei.org or 202.464.8353.

Respectfully submitted,

TAX EXECUTIVES INSTITUTE
Washington, DC

Katrina H. Welch
International President