On January 14, 2025, the Department of Treasury and the IRS issued final regulations that clarify how cloud transactions are classified for tax purposes and certain rules regarding digital content transactions. On the same day they issued proposed regulations regarding the sourcing of cloud transactions. These regulations aim to provide much-needed guidance on the treatment of digital and cloud-based business models under U.S. tax law.
Classification of Cloud Transactions
The final regulations define a cloud transaction as one where a person obtains on-demand network access to computer hardware, digital content, or similar resources. Examples include software-as-a-service (SaaS), platform-as-a-service (PaaS), and infrastructure-as-a-service (IaaS) arrangements.
Business models that include transactions involving computer hardware, such as a server located at the customer’s premises, may fall outside the definition of a cloud transaction because there is no on-demand network access.
- Proposed Rules: Under the proposed regulations, cloud transactions could be classified as either a lease of property or the provision of services based on various factors.
- Final regulations: The final regulations simplify this approach, stating unequivocally that all cloud transactions are classified as the provision of services.
The IRS and the Treasury Department concluded that cloud transactions inherently align with service transactions as they contain the following characteristics of service transactions:
- Economic Control: Cloud providers retain control and possession of the property involved, such as servers and software.
- Flexibility: Providers generally have the ability to replace or update property used in cloud transactions without customer involvement.
- On-Demand Nature: Cloud transactions typically provide access rather than a transfer of ownership or possession, further distinguishing them from leases.
Business Models and Examples
The final regulations address various cloud-based business models and provide illustrative examples to guide taxpayers:
- Access Models: Scenarios involving subscription services for streaming digital content, such as music or videos, are classified as cloud transactions if the predominant benefit is access rather than ownership of the content.
- Resellers of SaaS: Reseller arrangements, where the transaction between the reseller and its customers is a cloud transaction classified as the provision of services.
- Streaming and Downloading: An updated example illustrates that streaming services allowing limited downloads for offline use are still classified as cloud transactions, provided downloading is not the predominant characteristic.
- Search Engines and Databases: On-demand access to proprietary search engines and online databases remains a cloud transaction, even if the content accessed lacks copyright protection.
- Specific Business Models: The IRS declined to generalize with respect to certain business models, such as advertising-supported “free” platforms, marketplace apps, and job recruiting sites and apps, as cloud transactions, pointing out that classification depends on specific facts.
Sourcing of Certain Electronic Sales
Digital content is defined as “a computer program or any other content in digital format that is either protected by copyright law or no longer protected by copyright law solely due to the passage of time.” It does not include any non-copyrightable content.
- Proposed Rules: Under the proposed regulations previously issued, transfers of a copy of digital content (a copyrighted article) that qualifies as inventory transferred electronically are considered to occur at the location where the content was downloaded or installed onto the end-users device. If that specific location was unable to be determined, the sale was deemed to occur at the customer’s location as indicated by the recorded sales data.
- Final Regulations: Under the final regulations, sales are sourced to the purchaser’s billing address, regardless of whether the purchaser is related or unrelated.
Anti-Abuse Rule
A new anti-abuse rule addresses cases where transactions are structured primarily for tax avoidance. In such cases, the IRS may disregard the billing address rule and consider all relevant facts to determine where the substance of the transaction occurred.
Sourcing Rules for Cloud Transactions – Proposed Regulations
The IRS simultaneously released proposed regulations on the sourcing of cloud transactions in which the sourcing of services from cloud transactions depends on three factors: Intangible Property Factor, Personnel Factor, and Tangible Property Factor.
The proposed cloud transaction sourcing rules would apply on a taxpayer-by-taxpayer basis. Therefore, when determining the gross income of an entity that recognizes services income, only the assets and personnel of that specific legal entity would be considered. Additionally, a similar anti-abuse rule would prevent manipulating these rules to intentionally avoid taxes or gain improper tax benefits, such as Foreign-Derived Intangible Income (FDII) deductions.
Implications for Taxpayers
Using the customer’s billing address simplifies determining the sourcing of income from electronic sales of digital content. This approach also makes it easier for taxpayers to manage and plan for related U.S. tax compliance, such as:
- Determining income-eligible FDII deduction under section 250, and
- Determining foreign income for purposes of determining foreign tax credits.
In addition, the new regulations bring much-needed clarity and uniformity to similar anti-abuse rules in the treatment of cloud transactions. Businesses engaged in cloud transactions should carefully review the regulations to ensure compliance and make pertinent changes to their tax and accounting methods.
Businesses engaged in cloud transactions should also consider the impact the proposed rules may have on their tax implications and look out for final regulations on this topic. Taxpayers may also consider submitting comments on the proposed regulations.
Please contact your WG advisor if you have questions or require further information.
