On January 14, 2025, the Treasury Department and IRS issued final and proposed regulations on sourcing income from digital content and cloud transactions.
Why is Source Important?
While U.S. persons generally are subject to federal income tax on worldwide income, they are entitled to a credit for certain foreign taxes paid on income that is sourced to foreign country.[1] On the other hand, foreign persons generally are subject to federal income tax only income that is sourced to the United States or that is effectively connected with the conduct of U.S. trade or business. [2]
Final Regulations on Digital Content
The final regulations define “digital content” as a computer program or any other content, such as books, movies, and music, in digital format that is protected by copyright law or not protected by copyright law solely due to the passage of time or because the creator dedicated the content to the public domain.[3]
In characterizing transactions involving digital content or the provision of services or of know-how with respect to digital content is treated as being solely:
- a transfer of a copyright right in the digital content;
- a transfer of a copy of the digital content (a copyrighted article);
- the provision of services for the development or modification of digital content; or
- the provision of know-how relating to development of digital content.[4]
If a transaction has multiple elements, one or more of which would be a transfer of digital content, it is classified in its entirety as a digital content transaction under one of the above categories according to the transaction’s predominant character.[5] The predominant character of a transaction is determined by ascertaining the primary benefit or value received by the customer in the transaction.[6]
Proposed Regulations on Cloud Transactions
The final regulations on digital content transactions define a “cloud transaction” as a transaction through which a person obtains on demand network access to computer hardware, digital content , or other similar resources.[7] But, a cloud transaction does not include network access to download digital content for storage and use on a person’s computer or other electronic device.[8]
The proposed regulations generally treat cloud transactions as the provision of services.[9] The proposed regulations would provide that the location where services associated with a cloud transaction is performed would be determined through a formula involving an intangible property factor (relating to employees performing research and experimentation in the United States), a personnel factor (relating to employees in the United States whose primary function is to contribute to the provision of the cloud transaction other that research and experimentation), and a tangible property factor (relating to depreciable tangible property directly used to provide a cloud transaction that is located United States).[10] As with digital content, however, the proposed rules for cloud transactions call for a transaction to be classified according to its predominant character if the transaction has multiple elements.[11]
[1] See I.R.C. §§ 901, 904; Treas. Reg. § 1.1-1(b).
[2] See I.R.C. § 871.
[3] 90 Fed. Reg. 2977, 2988 (final Treas. Reg. § 1.861-18(a)(2)(i)).
[4] 90 Fed. Reg. 2977, 2988 (final Treas. Reg. § 1.861-18(b)(1)).
[5] 90 Fed. Reg. 2977, 2988 (final Treas. Reg. § 1.861-18(b)(2)).
[6] 90 Fed. Reg. 2977, 2988 (final Treas. Reg. § 1.861-18(b)(3)).
[7] 90 Fed. Reg. 2977, 2999 (final Treas. Reg. § 1.861-19(b)).
[8] 90 Fed. Reg. 2977, 2999 (final Treas. Reg. § 1.861-19(b)).
[9] 90 Fed. Reg. 2977, 2999 (final Treas. Reg. § 1.861-19(c)(1)).
[10] 90 Fed. Reg. 3075m, 3081-82 (proposed Treas. Reg. § 1.861-19(d)).
[11] 90 Fed. Reg. 2977, 2999 (final Treas. Reg. § 1.861-19(c)(2)).