Classification of Cloud Transactions Under Proposed Tax Regulations

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Cloud transactions have become part of our daily lives, with most businesses operating in some form of cloud environment. However, until recently, there has been no guidance specifically addressing the treatment of cloud transactions for federal income tax purposes. Proposed regulations under Section 861 issued in 2019 clarify how transactions involving digital content and cloud computing are classified for U.S. tax purposes. The proposed rules would revise and expand current regulations regarding digital content transactions, establish new Treas. Reg. §1.861-19 regarding cloud computing transactions, and propose changes regarding the source rules for sales of personal property. Collectively, the proposed regulations are intended to address whether a digital transaction is characterized as a sale, lease, license or provision of services for purposes of applying various provisions of the income tax code, including whether the income from the transaction is considered U.S. or foreign source, which is critical for determining U.S. withholding and reporting obligations.

Definition of Cloud Transaction

The proposed regulations define a cloud transaction as “a transaction through which a person obtains (non-de minimis) on-demand network access to computer hardware, digital content, or other similar resources.” Cloud computing transactions typically involve one of the following:

  • Software as a Service (Saas), which involves customers obtaining access to a provider’s applications on the provider’s cloud infrastructure, such as a web browser;
  • Platform as a Service (PaaS), which involves customers being permitted to deploy their own applications onto a provider’s cloud infrastructure; or
  • Infrastructure as a Service (IaaS), which involves customers obtaining access to infrastructure resources, such as processing, storage, networks, etc., on a provider’s cloud infrastructure.

The preamble to the proposed regulations provides that the scope of cloud transactions also includes other transactions that share characteristics of “on demand network access to technological resources,” including access to streaming digital content and/or mobile device applications, as well as access to data through remotely hosted hardware.

Proposed Regulations


The proposed regulations provide that a cloud transaction is classified solely as either a lease of property or the provision of services.1 Additionally, the preamble clarifies that even if a cloud transaction resembles both a lease and a service, the treatment of a single transaction should not be bifurcated. However, if an arrangement involves multiple transactions, only some of which are cloud transactions, then the characterization rules of Prop. Treas. Reg. §1.861-19 (as outlined below) would apply only to the cloud transaction(s).2

Characterization of Cloud Transactions

The proposed regulations provide guidance that cloud transactions generally give rise to service income (versus a lease) based on several factors, which include3:

  • 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 such 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 posssessory interest in the property.
  • The customer 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 primarily 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.

The proposed regulations further indicate that the relevance of any factor will vary depending on the facts and circumstances, and some factors may not be relevant in a particular case. However, consistent with the preamble’s statement that “[i]n general, application of the relevant factors to a cloud transaction will result in the transaction being treated as the provision of services rather than a lease of property,” the examples provided in the proposed regulations mostly conclude that the cloud transactions are characterized as a provision of services.

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Sourcing of Cloud Transactions

While all potential tax implications should be considered, importantly, the correct characterization of payments relating to cloud transactions allows the proper sourcing rules to be applied for purposes of Chapter 3 U.S. withholding tax. Generally, a foreign person, including a company, is taxable on all income received from U.S. sources that is fixed, determinable, annual or periodical (FDAP) at the rate of 30%.4
The proposed regulations do not provide special sourcing rules with respect to income arising from cloud transactions. In general, services income is sourced based on where the services are performed, and leasing income is sourced where the subject property is used.

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  • The group generates revenue through SaaS subscriptions.
  • Dutch Headquarters owns all of the IP.
  • Each subsidiary invoices its customers in their respective countries and retains 100% of the revenue. However, Dutch Headquarters charges each subsidiary a 50% license fee.
  • In determining how to characterize the 50% license fee from U.S. Op to Dutch Headquarters,5 the following factors suggest that the payment is for a service:
    • The software resides on Dutch Headquarters’ servers in the Netherlands;
    • Dutch Headquarters has control over the application and the software;
    • The customers access the software in the cloud and do not control access or functionality of the software; and
    • U.S. Op has a right to make sales in the U.S. but does not control the IP or the software.
  • However, the fact that the contract price (the price paid by U.S. Op to Dutch Headquarters) does not substantially exceed the rental value of the property (the fair rent that Dutch Headquarters would have received if it had rented the software instead of provided it in the form of SaaS) supports that the payment is a license.
  • In this example, the preponderance of the factors appears to support that the payment from U.S. Op to Dutch Headquarters should be characterized as a payment for services for U.S. federal income tax purposes. In this case, absent subsequent guidance, the payment would generally be sourced based on where the services are performed and U.S. withholding tax obligations, if any, should be considered.

How BDO Can Help

The analysis required for classification and sourcing of cloud transactions is complex, depending heavily on facts and circumstances. In addition, cloud-based technology and the tax law are evolving, with many uncertainties remaining. BDO can assist multinational companies to identify and characterize cloud transactions, as well as consider and plan for the potential U.S. federal income tax implications of payment streams in anticipation of the proposed regulations being finalized. For more information, contact BDO.


1 Prop. Treas. Reg. §1.861-19.
2 The remaining transaction(s) would be analyzed and characterized under existing U.S. statutory and regulatory rules.
3 The list of factors is non-exhaustive. The ultimate classification is generally based on the preponderance of the factors.
4 Unless reduced by an applicable U.S. income tax treaty.
5 For purposes of this article, we focus our analysis on the U.S. federal income tax side of the payment from U.S. Op to Dutch Headquarters; however, local country implications of all payment streams should also be considered.

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