Classification of Digital Content Transactions and Cloud Transactions

<RULE> DEPARTMENT OF THE TREASURY <SUBAGY>Internal Revenue Service</SUBAGY> <CFR>26 CFR Part 1</CFR> <DEPDOC>[TD 10022]</DEPDOC> <RIN>RIN 1545-BM41</RIN> <SUBJECT>Classification of Digital Content Transactions and Cloud Transactions</SUBJECT> <HD SOURCE="HED">AGENCY:</HD> Internal Revenue Service (IRS), Treasury. <HD SOURCE="HED">ACTION:</HD> Final regulations. <SUM> <HD SOURCE="HED">SUMMARY:</HD> This document contains final regulations modifying the rules for classifying transactions involving computer programs, including by applying the rules to transfers of digital content. These final regulations also provide rules for the classification of cloud transactions. These rules apply for purposes of the international provisions of the Internal Revenue Code and generally affect taxpayers engaging in transactions involving digital content or cloud transactions. </SUM> <EFFDATE> <HD SOURCE="HED">DATES:</HD> <E T="03">Effective date:</E> These regulations are effective on January 14, 2025. <E T="03">Applicability date:</E> For dates of applicability, see §§ 1.861-18(i) and 1.861-19(e). </EFFDATE> <FURINF> <HD SOURCE="HED">FOR FURTHER INFORMATION CONTACT:</HD> Christopher E. Fulle, (202) 317-5367, or Michelle L. Ng, (202) 317-6989 (not toll-free numbers). </FURINF> <SUPLINF> <HD SOURCE="HED">SUPPLEMENTARY INFORMATION:</HD> <HD SOURCE="HD1">Authority</HD> These final regulations are issued under the express delegation of authority under section 7805 of the Internal Revenue Code (Code). Section 7805(a) directs the Secretary of the Treasury or her delegate to prescribe all needful rules and regulations for the enforcement of that section and others in the Code, including all rules and regulations as may be necessary by reason of any alteration of law in relation to internal revenue. <HD SOURCE="HD1">Background</HD> On August 14, 2019, the Department of the Treasury (Treasury Department) and the Internal Revenue Service (IRS) published proposed regulations (REG-130700-14) under section 861 of the Code in the <E T="04">Federal Register</E> (84 FR 40317) (the proposed regulations). The Treasury Department and the IRS received written comments on the proposed regulations, and a public hearing was held on February 11, 2020. All written comments received in response to the proposed regulations are available at <E T="03">www.regulations.gov</E> or upon request. Terms used but not defined in this preamble have the meaning provided in these final regulations. These regulations (the final regulations) extend the classification rules in existing § 1.861-18 to transfers of digital content other than computer programs and clarify the source of income for certain transfers of digital content. The final regulations also clarify the classification of transactions involving on-demand network access to computing and other similar resources. The final regulations retain the overall approach of the proposed regulations, with certain revisions discussed in the preamble. The preamble also discusses comments received in response to the solicitation of comments in the notice of proposed rulemaking. <HD SOURCE="HD1">Summary of Comments and Explanation of Revisions</HD> <HD SOURCE="HD2">I. General Classification Issues</HD> <HD SOURCE="HD3">A. Replacement of De Minimis Rule With a Predominant Character Rule</HD> Section 1.861-18(b)(1), as in effect before this Treasury decision, described four transactions involving computer programs: the transfer of a copyright right, the transfer of a copyrighted article, the provision of services for the development or modification of a computer program, and the provision of know-how relating to the development of a computer program. Section 1.861-18(b)(2) required any transaction that consisted of more than one of the transactions described in § 1.861-18(b)(1) to be treated as separate transactions, unless a transaction was de minimis, in which case it would be treated as part of another transaction. The proposed regulations generally retained the four types of transactions (with the expansions described in Part II.A of this Summary of Comments and Explanation of Revisions) and preserved the de minimis rule, but for clarification purposes, § 1.861-18(b)(2) was proposed to be modified by introducing the term “arrangement” and providing that multiple transactions in an arrangement generally must be characterized separately. Proposed § 1.861-19(b) defined a cloud transaction as a transaction through which a person obtains on-demand network access to computer hardware, digital content (as defined in proposed § 1.861-18(a)(3)), or other similar resources, other than on-demand network access that is de minimis taking into account the overall arrangement and the surrounding facts and circumstances. Similar to proposed § 1.861-18(b)(2), proposed § 1.861-19(c)(3) required separate classification of each transaction comprising an arrangement, except that any transaction that was de minimis would be treated as part of another transaction rather than being classified separately. Comments recommended replacing these rules in proposed §§ 1.861-18(b)(1) and (b)(2), and 1.861-19(c)(3), with a predominant character rule, such that a transaction consisting of more than one category of transactions described in proposed § 1.861-18(b)(1), or a transaction consisting of one or more categories of transactions described in both proposed §§ 1.861-18(b)(1) and 1.861-19(b), would be characterized as only one of those categories of digital content transactions or as a cloud transaction in accordance with the predominant character of that transaction. As an example of a mixed transaction that would be difficult to characterize under the proposed regulations, comments pointed to video game business models where the customer purchases a copy of the game but primarily plays the video game online with other players. As another example, comments pointed to software antivirus programs that include code that executes on the user's equipment as well as code that is deployed in the cloud to detect and capture viruses before they reach the user's equipment. The comments argued that the predominant character rule would avoid the difficult and burdensome task of determining whether an element is de minimis in the context of the overall transaction and allocating income from the transaction among the non-de minimis categories as if they were separate transactions. The comments also argued that a de minimis standard is imprecise, and a predominant character rule that compares components of a transaction to determine which component is predominant would be much more administrable. Furthermore, one comment suggested that a predominant character standard would better align with existing Treasury regulations and other authorities, for instance, § 1.954-1(e)(3), which provides for a predominant character approach in the subpart F context. Finally, the comments noted confusion arising from the use of the term “transaction” to mean two different things in the same provision under proposed § 1.861-18(b)(2), and also recommended removing the term “arrangement” on the grounds that the term was unclear, particularly because it was not defined and rarely appears in other tax rules. The comments recommended that the predominant character of a transaction be determined based on the facts and circumstances. Comments suggested that the relevant facts may include the overall commercial purpose, the taxpayer's treatment for non-tax purposes, the relative cost of each component (including the cost of maintaining online and offline components), and a comparison of unit prices for components sold separately. Comments suggested that the facts and circumstances should provide at least a reasonable basis for determining the predominant character of the transaction. Further, the comments suggested defining a transaction based on the facts and circumstances or as an agreement entered into in the ordinary course. Several comments suggested that relevant factors for determining the scope of a transaction could include the availability of separate pricing, the use of separate stock keeping units (“SKUs”), and the taxpayer's definition for non-tax purposes. The final regulations adopt these comments, in part. The final regulations replace the de minimis rule and the concept of an arrangement with a predominant character rule, which applies to both digital content transactions and cloud transactions. The Treasury Department and the IRS agree that, for purposes of the final regulations, a transaction with multiple elements (including de minimis elements) should be characterized based on the predominant character of the transaction. Predominant character rules also exist in other regulations for international provisions of the Code, such as foreign-derived intangible income and subpart F, and thus are familiar to taxpayers. <E T="03">See</E> §§ 1.250(b)-3(d) and 1.954-1(e)(3). Further, in many business models that include both online and offline functionality it may be difficult to bifurcate a single transaction into a digital content transaction and a cloud transaction. The Treasury Department and the IRS expect that bifurcation will remain difficult and may increase in difficulty as business models and technology evolve. Therefore, § 1.861-18(b)(2) of the final regulations provides that, taking into account the overall transaction and the surrounding facts and circumstances, a transaction that has multiple elements, one or more of which would be a digital content transaction if considered separately, is classified in its entirety as a digital content transaction under one of the categories described in § 1.861-18(b)(1) if the predominant character of the transaction is described in one of the categories in that paragraph. Section 1.861-19(c)(2) of the final regulations provides ━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━ Preview showing 10k of 205k characters. Full document text is stored and available for version comparison. ━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━