Source of Income From Cloud Transactions

DEPARTMENT OF THE TREASURY <SUBAGY>Internal Revenue Service</SUBAGY> <CFR>26 CFR Part 1</CFR> <DEPDOC>[REG-107420-24]</DEPDOC> <RIN>RIN 1545-BR21</RIN> <SUBJECT>Source of Income From Cloud Transactions</SUBJECT> <HD SOURCE="HED">AGENCY:</HD> Internal Revenue Service (IRS), Treasury. <HD SOURCE="HED">ACTION:</HD> Notice of proposed rulemaking. <SUM> <HD SOURCE="HED">SUMMARY:</HD> This document contains proposed rules for determining the source of income from cloud transactions for purposes of the international provisions of the Internal Revenue Code. These proposed rules would generally affect taxpayers who earn gross income from engaging in cloud transactions. </SUM> <DATES> <HD SOURCE="HED">DATES:</HD> Written or electronic comments and requests for a public hearing must be received by April 14, 2025. </DATES> <HD SOURCE="HED">ADDRESSES:</HD> Commenters are strongly encouraged to submit public comments electronically. Submit electronic submissions via the Federal eRulemaking Portal at <E T="03">www.regulations.gov</E> (indicate IRS and REG-107420-24) by following the online instructions for submitting comments. Requests for a public hearing must be submitted as prescribed in the “Comments and Requests for a Public Hearing” section. Once submitted to the Federal eRulemaking Portal, comments cannot be edited or withdrawn. The Department of the Treasury (Treasury Department) and the IRS will publish for public availability any comment received to its public docket, whether submitted electronically or in hard copy. Send hard copy submissions to: CC:PA:01:PR (REG-107420-24), Room 5203, Internal Revenue Service, P.O. Box 7604, Ben Franklin Station, Washington, DC 20044. Submissions may be hand-delivered Monday through Friday between the hours of 8 a.m. and 4 p.m. to: CC:PA:01:PR (REG-107420-24), Courier's Desk, Internal Revenue Service, 1111 Constitution Avenue NW, Washington, DC 20224. <FURINF> <HD SOURCE="HED">FOR FURTHER INFORMATION CONTACT:</HD> Concerning the proposed regulations, Christopher E. Fulle at (202) 317-5367 or Michelle L. Ng at (202) 317-6989 (not toll-free numbers); concerning submissions of comments and requests for a public hearing, contact the Publications and Regulations branch at (202) 317-6901 (not a toll-free number) or by email to <E T="03">publichearings@irs.gov</E> (preferred). </FURINF> <SUPLINF> <HD SOURCE="HED">SUPPLEMENTARY INFORMATION:</HD> <HD SOURCE="HD1">Authority</HD> The proposed 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> Proposed regulations published in the <E T="04">Federal Register</E> (84 FR 40317) in 2019 (REG-130700-14) (the 2019 proposed regulations) set forth proposed rules for identifying and classifying cloud transactions, and the preamble to the 2019 proposed regulations requested comments on rules for sourcing income from cloud transactions. Comments received addressed the necessity of developing specific rules for sourcing gross income from cloud transactions and provided recommendations on the content of such rules. This notice of proposed rulemaking, which is being published with the final regulations for identifying and classifying cloud transactions (TD 10022) (the 2024 final regulations) that are being published in the Final Rules section of this same issue of the <E T="04">Federal Register</E> , proposes rules for sourcing gross income from cloud transactions. <HD SOURCE="HD1">Explanation of Provisions</HD> <HD SOURCE="HD2">I. Source of Gross Income From Cloud Transactions</HD> <HD SOURCE="HD3">A. Overview of Comments Received</HD> The Treasury Department and the IRS received more than a dozen comments in response to the request for comments on administrable rules for sourcing income from cloud transactions in a manner consistent with sections 861 through 865. Comments were split almost evenly with regard to whether specific sourcing rules are needed in this area, with a narrow majority expressing support for such guidance. Of this majority, several comments recommended that services income from cloud transactions be sourced according to the location of the assets and personnel used in providing the service. A number of these comments explained that this approach would align with the result in <E T="03">Piedras Negras Broadcasting Co.</E> v. <E T="03">Comm'r,</E> 43 B.T.A. 297 (1941), <E T="03">nonacq.,</E> 1941-2 C.B. 22, <E T="03">aff'd,</E> 127 F. 2d. 260 (5th Cir. 1942), in which the income of a radio broadcasting corporation was determined to be foreign source because its broadcasting facilities and employees were located in Mexico, even though the corporation broadcasted programs primarily to listeners located in the United States and received almost all of its income from advertisers located in the United States. Other comments voiced the need for specific rules for sourcing income from cloud transactions, but did not recommend a particular sourcing approach, with one comment suggesting that the location of the cloud service provider's assets and personnel and the location of the end-user could be evaluated in developing the rules. Another comment proposed that given the challenges of sourcing cloud transactions when the operations, employees, and customers are dispersed, the sourcing rules could provide taxpayers with the option to source the income to the place where the contract is executed. While almost half of the comments received stated that regulations for sourcing income from cloud transactions are unnecessary because existing statutory, regulatory, and case law provides sufficient guidance, an overwhelming majority of those comments recommended that if issued, the regulations should take into account the location of the assets and people that contribute to the delivery of the cloud service. Many of the comments discussed whether the sourcing determination should be made by taking into account solely the assets and personnel of the taxpayer that recognizes the income from the performance of the cloud service (the taxpayer-by-taxpayer approach), or whether taxpayers should be required to look through to the activities and personnel of other related legal entities that contribute to the provision of the service (the unitary approach). Nearly all comments on this issue stated that income from cloud transactions should be sourced on a taxpayer-by-taxpayer basis. Comments explained that the taxpayer-by-taxpayer approach is administrable and supported by the principles of <E T="03">Miller</E> v. <E T="03">Comm'r,</E> 73 T.C.M. 2319 (1997), <E T="03">aff'd without published decision,</E> 166 F.3d 1218 (9th Cir. 1998), in which income that a foreign corporation received for performing research and development services was held to be foreign source notwithstanding that the performance of those services was subcontracted to certain related and unrelated entities, including a wholly-owned U.S. subsidiary. One comment suggested that a taxpayer-by-taxpayer rule for sourcing services income from cloud transactions could be supplemented with anti-abuse provisions requiring the income to be sourced on a look-through or unitary basis in limited circumstances. However, another comment asserted that sourcing services income from cloud transactions on a look-through or unitary basis should be required, explaining that this approach more accurately reflects the economic realities of the transaction because it accounts for the contributions made by members of the multinational group to the provision of the service. That comment also expressed the concern that sourcing on a taxpayer-by-taxpayer basis could cause U.S. source income to be understated with respect to commonly-used structures in which the development, enhancement, maintenance, protection, and exploitation functions are performed primarily by U.S. entities but the services income is recorded by a foreign entity that contracts directly with the end-users to whom the cloud transaction is provided. <HD SOURCE="HD3">B. Need for Proposed Regulations</HD> The development and advancement of cloud technologies has transformed both the value that businesses deliver to customers and the way that value is delivered, giving rise to cloud-based business models and cloud transactions. The 2024 final regulations classify a cloud transaction (within the definition of § 1.861-19(b)) as the provision of services. <E T="03">See</E> § 1.861-19(c)(1). Under the source rules of the Code, which were designed in the context of more traditional modes of commerce, gross income from the provision of services is sourced to the place where the service is performed. <E T="03">See</E> sections 861(a)(3) and 862(a)(3). The Code does not provide guidance on how to determine the place of performance for specific types of service transactions, including cloud transactions. Further, while section 863(b)(1) specifies that income from services rendered partly within and partly without the United States is treated as derived partly from each source, there is no statutory guidance prescribing how to source the services income, including income from cloud transactions, in such circumstances. The distinctive attributes of cloud transactions, including the network-based and increasingly automated nature of the service delivery and the role of intangible property (such as proprietary software and other proprietary digital content) in ensuring the functionality, reliability, and performance of the service, raise questions r ━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━ Preview showing 10k of 74k characters. Full document text is stored and available for version comparison. ━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━