The IRS is working to update 1998 rules on international transactions to reflect the current era of digital content. The proposed rules could have significant international tax implications for companies involved in cloud computing and the distribution of digital content. The proposed rules also could cause a company to need a change in accounting method. Thus, it is important for businesses to start planning by revisiting the classification of their cloud and digital content transactions.
International e-commerce presents special challenges; the sourcing of transactions as domestic or foreign and the character of the income both influence how they are taxed. To determine the character of the income, they must first be classified as sales, leases, licenses, or services. For example, services are sourced where the services are provided. New IRS proposed regulations explain when cloud transactions will be treated as either a lease of property or the provision of services, helping to clarify the tax status.
This article explores the proposed regulations, which are not yet finalized.
Definition of ‘Cloud Transaction’
The new rules define a “cloud transaction” as a transaction through which a person obtains on-demand network access to computer hardware, digital content, or similar resources. This definition is not limited to computer hardware and software but also includes access to streaming digital content and access to information in databases. The IRS notes, however, that this definition does not encompass the mere download or other electronic transfer of digital content for storage and use on a person’s computer or other electronic device.
The new rules say a cloud transaction must be classified solely as either a lease of property (such as computer hardware, digital content) or the provision of services, even if the transaction has characteristics of both. Transactions may not be bifurcated into a lease transaction and a separate service transaction. The new rules use the factors below to determine whether a transaction is a lease or a service.
Lease v. Services
Factors demonstrating that a cloud transaction should be classified as the provision of services rather than a lease of property include the following:
- The customer is not in physical possession of the property.
- The customer does not control the property beyond the customer’s network access and use of the property.
- The provider has the right to determine the specific property used in the cloud transaction and replace that property with comparable property.
- The property is a component of an integrated operation in which the provider has other responsibilities, including ensuring the property is maintained and updated.
- The customer does not have a significant economic or possessory interest in the property.
- The provider bears any risk of substantially diminished receipts or substantially increased expenditures if there is nonperformance under the contract.
- The provider uses the property concurrently to provide significant services to entities unrelated to the customer.
- The provider’s fee is based on a measure of work performed or the level of the customer’s use rather than the mere passage of time.
- The total contract price substantially exceeds the rental value of the property for the contract period.
Examples Cover Common Arrangements
The regulations provide helpful examples showing how the cloud computing classification rules would apply in different situations such as rented space on remote data centers and dedicated servers; access to software development platforms and web hosting; access to software applications and downloaded software; streaming digital content using third-party servers; and access to online search and retrieval databases.
Access to online software via an application. Acme Corp provides Bravo Corp word processing, spreadsheet, and presentation software and allows employees of Bravo Corp to access the software over the internet through a web browser or an application (“app”) downloaded to the employees’ mobile devices. To access the full functionality of the app, the device must be connected to the internet. Only a limited number of features on the app are available without an internet connection. Bravo Corp has no ability to alter the software code. The software is hosted on servers owned by Acme Corp and located at Acme Corp’s facilities. Acme Corp is solely responsible for maintaining and repairing the servers and software and ensuring continued functionality and compatibility with Bravo Corp’s employees’ devices. Acme Corp provides updates and fixes to the software. Bravo Corp pays a monthly fee based on the number of employees with access to the software. Upon termination of the arrangement, Acme Corp activates an electronic lock preventing Bravo Corp’s employees from further utilizing the software.
Analysis: Acme Corp’s provision to Bravo Corp of a non-de minimis right to on-demand network access to Acme Corp’s computer hardware and software resources for the purpose of fully utilizing Acme Corp’s software is a cloud transaction classified as a provision of services. Bravo Corp has neither physical possession of nor control over Acme Corp’s word processing, spreadsheet, and presentation software or computer hardware. Also, the servers and software are maintained by Acme Corp and are available to other customers. Bravo Corp’s employees must be connected to Acme Corp’s servers to run the software on their devices. Acme Corp’s compensation is determined in part by reference to Bravo Corp’s level of use. Taking into account all of the factors, the transaction between Acme Corp and Bravo Corp is classified as the provision of services.
Digital Content Expanded
The 1998 rules covered the taxation of international transactions involving computer programs, such as license or sale of a computer program. However, those rules did not cover transactions involving other digital content, like digital music and video. The new proposed regulations broaden the definition of “digital content” and provide the rules on whether a digital download is a sale or lease/license of copyrighted content and where the transaction is considered to take place. The sale or lease distinction turns on the rights that are being transferred. When copyrighted articles are sold and transferred through an electronic medium, the sale is deemed to occur at the location of download or installation onto the end-user’s device used for access.
Digital content is defined as any content in digital format that is either protected by copyright law or is no longer protected solely due to the passage of time. (Copyright protection is time-limited and lasts for the life of the author plus an additional 70 years.)
Example: Acme Corp offers end-users memberships that provide them with unlimited access to Acme Corp’s catalog of copyrighted music in exchange for a monthly fee. In order to access the music, an end-user must download each song onto a computer or other electronic device. The end-user may download songs onto a limited number of devices. Under the membership agreement terms, an end-user may listen to the songs but may not reproduce or distribute copies. Once the end-user stops paying Acme Corp the monthly membership fee, an electronic lock is activated so that the end-user can no longer access the music.
Analysis. The end-users receive none of the copyright rights and instead receive only copies of the digital content. Therefore, each download is classified as the transfer of a copyrighted article. Although an end-user will retain a copy of the content at the end of the payment term, the end-user cannot access the content after the electronic lock is activated. The activation of the electronic lock is the equivalent of having to return the copy. Therefore, each transaction is classified as a lease of a copyrighted article because the right to access the music is limited.
The proposed regulations will be finalized after the public comment process. Businesses with international digital transactions should talk to their Frazier & Deeter international tax specialist to consider tax planning implications.