Treasury Issues Proposed Regulations on the Classification of Cloud Transactions and Transactions Involving Digital Content

Treasury Issues Proposed Regulations on the Classification of Cloud Transactions and Transactions Involving Digital Content


On August 14, 2019, the Department of the Treasury and the Internal Revenue Service (collectively, Treasury) published in the Federal Register proposed regulations regarding the classification of cloud transactions for purposes of international provisions of the Internal Revenue Code (the Code). The proposed regulations also modify the rules for classifying transactions involving computer programs, including by applying the rules to transfers of digital content.
Some of the key sections in the proposed regulations have been summarized below.



The proposed regulations clarify the treatment under certain provisions of the Code of income from transactions involving on-demand network access to computing and other similar resources.
Proposed §1.861-19 provides rules for classifying a cloud transaction as either a provision of services or a lease of property. Proposed §1.861-19(a) specifies that the rules apply for purposes of Sections 59A, 245A, 250, 267A, 367, 404A, 482, 679, and 1059A; subchapter N of chapter 1; chapters 3 and 4; and Sections 842 and 845 (to the extent involving a foreign person), as well as with respect to transfers to foreign trusts not covered by Section 679.
Proposed §1.861-19(b) defines a cloud transaction as a transaction through which a person obtains non-de minimis on-demand network access to computer hardware, digital content (as defined in proposed §1.861-18(a)(3)), or other similar resources. This definition is not limited to computer hardware and software, or to Infrastructure as a Service (IaaS),[1] Platform as a Service (PaaS),[2] and Software as a Service (SaaS)[3] models, because it is intended also to apply to other transactions that share characteristics of on-demand network access to technological resources, including access to streaming digital content and access to information in certain databases. Although this definition is broad, it does not encompass every transaction executed or completed through the internet.
Proposed §1.861-19(c) provides that a cloud transaction is classified solely as either a lease of property or the provision of services. Certain cloud transactions may have characteristics of both a lease of property and the provision of services. Such transactions are generally classified in their entirety as either a lease or a service, and not bifurcated into a lease transaction and a separate service transaction.
Proposed §1.861-19(c)(1) provides that all relevant factors must be considered in determining whether a cloud transaction is classified as a lease of property –  specifically, computer hardware, digital content as defined in proposed §1.861-18(a)(3), or other similar resources – or the provision of services. The relevance of any factor varies depending on the factual situation, and any factor may not be relevant in a given instance.
Proposed §1.861-19(c)(2) contains a non-exhaustive list of factors for determining whether a cloud transaction is classified as the provision of services or a lease of property.[4] The preamble to the proposed regulations (the preamble) notes that in 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.
Proposed §1.861-19(c)(3) provides that, in certain arrangements that involve multiple transactions where one or more transactions could be classified as a cloud transaction under proposed §1.861-19(b) and one or more transactions do not qualify as a cloud transaction and would be classified under other sections of the Code and regulations, or under general tax law principles, the classification rules apply only to classify the cloud transaction, and any non-cloud transaction will be classified separately under such other section of the Code or regulations, or under general tax law principles. However, for purposes of administrability, proposed §1.861-19(c)(3) provides that no transaction will be classified separately if it is de minimis.
The proposed regulations also extend the classification rules in existing Reg. §1.861-18 to transfers of digital content other than computer programs and clarify the source of income for certain transactions governed by existing Reg. §1.861-18.
Proposed §1.861-18 broadens the scope of existing §1.861-18 to apply to all transfers of “digital content,” defined in proposed §1.861-18(a)(3) as any content in digital format and that is either protected by copyright law or is no longer protected by copyright law solely due to the passage of time, whether or not the content is transferred in a physical medium. Digital content includes, for example, books, movies, and music in digital format in addition to computer programs.
Proposed §1.861-18 modifies existing §1.861-18(c)(2)(iii) and (iv) to provide that a transfer of the mere right to public performance or display of digital content for purposes of advertising the digital content does not by itself constitute a transfer of a copyright right.
Proposed §1.861-18(f)(2)(ii) provides that 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 to access the digital content for purposes of §1.861-7(c). In the absence of information about the location of download or installation onto the end user’s device used to access the digital content, the sale is deemed to have occurred at the location of the customer based on the taxpayer’s recorded sales data for business or financial reporting purposes.
Consistent with existing §1.861-18, proposed §1.861-18(f)(2)(ii) provides that income from sales or exchanges of copyrighted articles is sourced under Sections 861(a)(6), 862(a)(6), 863, or 865(a), (b), (c), or (e), as appropriate.
The application of these new rules for purposes of the affected Code sections may require certain taxpayers to change their methods of accounting under Section 446(e) for affected transactions. The preamble states that the change in method of accounting must be implemented under the rules of §1.446-1(e) and the applicable administrative procedures that govern voluntary changes in method of accounting under Section 446(e).
The proposed regulations are proposed to apply to taxable years beginning on or after the date the regulations are published as final regulations in the Federal Register. For transactions involving transfers of computer programs occurring pursuant to contracts entered before publication of the final regulations, the preamble states that the rules in former §1.861-18, T.D. 8785 and T.D. 9870, will apply.
For additional details, see the proposed regulations.

BDO Insight

The proposed regulations largely affirm the way many companies have been treating cloud transactions under existing law and provide helpful guidance for classifying cloud transactions as either a service or a lease. Please contact a BDO International Tax Specialist if you would like more information regarding the proposed regulations.

[1] IaaS allows customers to access processing, storage, networks, and other infrastructure resources on a provider’s cloud infrastructure.
[2] PaaS allows customers to deploy applications created by the customer onto a provider’s cloud infrastructure using programming languages, libraries, services, and tools supported by the provider.
[3] SaaS allows customers to access applications on a provider’s cloud infrastructure through an interface such as a web browser.
[4] Factors demonstrating that a cloud transaction is classified as the provision of services rather than a lease of property include the following factors—
  • 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 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 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.