On Jan. 10, 2025, the Treasury released final regulations under IRC section 861 (2025 final regulations) regarding transactions involving “digital content” and certain “cloud transactions.” Under the regulations, digital content includes computer programs and other content in digital format protected by copyright law, no longer protected by copyright law solely due to the passage of time or released into the public domain. A cloud transaction involves on-demand network access to computer hardware, digital content, or similar resources. 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.
The final regulations affect taxpayers engaging in digital content or cloud transactions and are effective for taxable years beginning on or after Jan. 14, 2025, unless the taxpayer early adopts the regulations. These regulations generally follow the framework of the 2019 proposed regulations with notable revisions.
Additionally, Treasury released proposed regulations to determine the source of income generated from cloud transactions. These proposed regulations aim to provide taxpayers with certainty and ensure auditability by the IRS. They affect taxpayers earning gross income from engaging in cloud transactions, with comments due 90 days after publication in the Federal Register.
Major changes from proposed regulations
The final regulations introduce six significant changes from the 2019 proposed regulations:
1. Predominant character rule: The final regulations replace the de minimis rule with a predominant character rule for transactions involving digital content and other elements. The de minimis rule (under the prior regulation 1.861-18(b)(2)) provided if any transaction involving computer programs consists of more than one transaction, then each transaction is treated separately, except if a transaction is considered ‘de minimis,’ then it is not considered a separate transaction but part of the other transaction. The final regulation would classify the entire transaction based on the predominant character of the transaction.
This new approach simplifies the process for taxpayers by focusing on the primary benefit or value to the customer, rather than breaking apart and valuing various components. If that information is not reasonably ascertainable, a special rule requires examining the benefit or value to a typical customer in a substantially similar transaction. Practitioners advocated for this change, arguing that it would streamline the characterization of transactions with multiple categories, such as online video games and antivirus software, by applying a predominant character rule instead of determining if an element was de minimis.
Observation: Changing the analysis to a ‘predominant character’ rule may simplify the treatment of some transactions, while adding complexity for others (increased documentation to support their conclusions, increased audit risk etc.). Additionally, foreign countries may not have adopted a predominant character rule and instead use either a de minimis rule or characterize each element of a transaction separately. A mismatch in characterization or analysis of a transaction may lead to different tax consequences. In international transactions, a change in law in one country may have tax consequences in the other country as well.
2. Sourcing rule for sales of copyrighted articles: The final regulations move away from the “title passage” rule and instead use the billing address of the purchaser to source income from the sale of copyrighted articles through digital medium. This sourcing rule applies regardless of whether the purchaser is a related party to the vendor. The final regulations also include an anti-abuse rule to prevent artificial election of the source of income. The sourcing rules regarding rental or lease income derived from copyrighted articles have not changed. The source of rental/lease income is where the copyrighted article is used.
This change addresses concerns raised about the ‘title passage’ rule with respect to transfers through digital medium, including data privacy, unreliable IP addresses, artificial election of the source of income and administrative burdens. This change is expected to address and reduce the administrative burdens.
Observation: The new billing address sourcing rule’s anti-abuse provisions operate to disallow transactions with the principal purpose of tax avoidance. While the final regulations do not explicitly define what constitutes a principal purpose, Example 26 provides valuable insight into its application. In this scenario, Corp A, a parent company negotiates the acquisition of a copyrighted article with a third party. However, the article is ultimately purchased by Corp. A’s foreign subsidiary, which then distributes it to Corp A. Since the foreign subsidiary neither functioned as a procurement hub in its regular business operations nor utilized the copyrighted article, the example concludes that the transaction was arranged for a principal purpose of tax avoidance. Conversely, Example 25 involves a situation where the foreign subsidiary purchases a copyrighted article from a third party and distributes it to other affiliates of Corp A. In this scenario, the subsidiary operates as a procurement hub within its ordinary business activities. The example highlights that although the seller’s income from the transaction is deemed foreign source income based on the subsidiary’s billing address, the anti-abuse rules does not apply due to the absence of a tax avoidance purpose.
There is an opportunity to update clients' processes and procedures related to classifying these transactions and corresponding compliance obligations. Given the complexity of the new sourcing rule, it is important to confirm that transactions align with ordinary business operations to mitigate the risk of triggering the anti-abuse provision.
3. Cloud transactions as services: The final regulations characterize all cloud transactions as services, eliminating the need to discern their classification between a property lease or services. The final regulations clarify that treating cloud transactions as services is more appropriate, as it aligns with the nature of these transactions where the provider retains control over the property used. Treasury noted in the comments to the final regulations that they could not find a situation where a cloud transaction would be characterized as a lease as opposed to services.
Observation: Characterizing all cloud transactions as services along with the adoption of a predominant character rules simplifies the character analysis. This change taken in conjunction with the proposed sourcing rule for cloud transactions (discussed below) may result in a change in tax consequences. As with all material changes in regulations, clients should consider whether these changes impact their tax obligations.
4. Distinction between temporary downloads and streaming: The final regulations distinguish between temporary downloads and streaming, indicating that temporary downloads involve a transfer of digital content and could be considered a digital content transaction—or in other words, temporary downloads will be treated as the transfer of a copyrighted article. The temporary nature of the transaction would produce rental or lease income. In contrast, when a customer streams digital content, there is no transfer of digital content; instead, the customer receives access to the digital content through the provider’s servers—the provider is providing the customer a service. This distinction is based on the fundamental differences in character between the two types of transactions. Temporary downloads require the customer to use their own device to host the content, while streaming involves continuous access to the provider’s servers.
5. Definition of digital content: The final regulations generally do not expand the definition of digital content covered by the guidance beyond what is protected under copyright law. Reg. section 1.861-18, as in effect before this final Treasury regulation, applied only to computer programs. The final regulations expanded the scope to include “digital content” defined as a computer program or any other content in digital format that is either protected by copyright law, no longer protected by copyright law solely due to the passage of time or because the content was dedicated (or passed) to the public domain. Several comments recommended broadening the definition to encompass content not protected by copyright law, such as consumer or user data, text files of recipes, government-produced documents and sets of font and typefaces. The final regulations do not adopt these comments.
6. Clarification of the copyright to make copies of digital content: Under the final regulations, the right to make copies of digital content qualifies as the grant of a copyright only if the transferee is simultaneously granted the right to distribute those copies to the public. “Distribution to the public” excludes the making and distribution of copies to related persons or individuals identified by name or legal relationship to the transferee. A related person is defined under sections 267(b)(3), 267(b)(10)– (12), or 707(b)(1)(B), with a 10% threshold substituted for 50% when applying Sections 267(b), 267(f), 707(b)(1)(B) or 1563(a). Notably, the number of employees or other identified individuals entitled to use the program does not affect whether a distribution qualifies as being “to the public.”
Observation: The clarification to making copies of digital content for related parties, as defined in the regulation, simplifies the analysis and ensures that a transfer of a copyrighted article is not characterized as a transfer of a copyright right subject to potential additional tax.
Proposed regulations on cloud transaction income sourcing
The proposed regulations provide a taxpayer-by-taxpayer approach to sourcing income from cloud transactions, focusing on the economic contributions made by certain intangibles, employees and assets of the contracting entity. The proposed regulations include a mathematical formula to determine the source of income, involving three factors:
- Intangible property factor: determined based on current-year research and experimental expenses, amortization, and royalties.
- Personnel factor: personnel directly contributing to a cloud transaction are those who perform technical or operational activities or manage such personnel.
- Tangible property factor: sum of the depreciation and rental expense in the tax year on property directly used to provide the cloud transaction.
U.S. source income for cloud transactions is determined by multiplying the total gross income from the cloud transaction by a ratio that reflects the share of U.S.-related expenses compared to total global expenditures for the three key factors. The formula is as follows: U.S. source income = gross income from cloud transaction × (U.S.-related expenses / (IP factor + personnel factor + tangible property factor)).
Under the proposed regulations, cloud service providers must first identify and quantify the costs associated with the personnel and assets contributing to the cloud transaction. These expenditures serve as a practical measure of each factor’s role in generating income. The proposed regulations then require an allocation of these costs between U.S. and non-U.S. sources, with the portion linked to U.S. expenses determining the amount of U.S. source income. Any remaining income is classified as foreign source income.
The proposed regulations also include an aggregation rule for increased administrability, allowing taxpayers to aggregate substantially similar cloud transactions and source income as one transaction. The proposed regulation includes an anti-abuse rule to prevent a distortion of the source of income.
Observation: The anti-abuse rule applies when a transaction is undertaken with a principal purpose of reducing U.S. tax liability in a way that conflicts with the intent of the sourcing rules. Under this rule, Treasury is empowered to reallocate the source of a taxpayer’s income to better align it with the actual place of performance. The preamble to the proposed regulations emphasizes that statutory provisions (e.g., section 482) and common law doctrines (e.g., economic substance doctrine, step transaction doctrine and agency principles) may be invoked to ensure that U.S. tax consequences reflect the true economic substance of a transaction. This includes recognizing the contributions made by the taxpayer’s affiliates to cloud transactions.
Treasury’s authority to adjust income sourcing to align it with the place of performance highlights the importance of accurate transfer pricing. MNEs involved in cloud computing must analyze whether their services qualify for the service cost method (“SCM”) and ensure their transfer pricing documentation reflects economic realities. By doing so, companies can mitigate risks related to sourcing adjustments and anti-abuse rules while optimizing their tax positions.
The proposed sourcing of cloud transactions presents challenges related to crediting under the Code’s foreign tax credit (“FTC”) provisions. A foreign country may source the services differently than the proposed regulations. This may result in the same foreign tax liability, but with a different foreign source income ratio, the FTC utilization may be different from prior years.
Consider a scenario where Company A, a U.S. corporation, provides software-as-a-service (SaaS) to a customer in Country X. All employees and servers of Company A are located in the United States, and there is no tax treaty between the U.S. and Country X. Country X classifies the transaction as a licensing arrangement rather than a service transaction, treating the payment as compensation for the use of property within its jurisdiction. Under Country X's laws, such payments may satisfy the attribution requirement if those rules are deemed similar to U.S. tax rules. Assuming Country X sources royalty payments based on the place of use, the withholding tax imposed on the payment could qualify as a creditable foreign tax under U.S. tax law if all other requirements are met. However, an issue arises because the related income is considered U.S. source income on the basis that all of Company A's services are performed in the United States (by employees and servers located there). Under this scenario, no FTC would be available unless Company A has other foreign creditable taxes in the same basket to offset the tax.
Conversely, if an income tax treaty existed between the U.S. and Country X that explicitly recognized the withholding tax as creditable, the treaty would govern. Company A would then need to examine the treaty's re-sourcing provisions to determine whether the income could be recharacterized as foreign source income, potentially allowing for FTC utilization.
Conclusion
The final and proposed regulations introduce significant changes that will impact taxpayers engaged in digital content and cloud transactions. Key updates, including the adoption of the predominant character rule, the use of billing addresses for income sourcing, the reclassification of cloud transactions as services, and the sourcing of cloud transactions are designed to provide clarity but also introduce new compliance challenges. RSM professionals should carefully evaluate the implications of these changes on their clients’ operations, processes, and reporting obligations. Refer to the guidance and resources on these regulations.
