U.S. Federal Tax Treatment of Digital Content and Cloud Transactions – A Moving Target?

Treasury and IRS proposed regulations addressing the federal income tax treatment of cloud and digital content transactions for the first time.

The proposed regulations specify how cloud and digital content transactions should be classified and sourced, which is used to determine whether such transactions are treated as effectively connected income subject to U.S. taxation. Questions arising from the proposed regulations include how general sourcing rules specifically apply to cloud and digital content transactions and whether it is legally permissible for the U.S. to determine the taxable situs of digital content based on the location where it is downloaded.

There are currently no U.S. laws that specifically address the tax treatment of digital content accessed through the cloud. To remedy this lack of guidance, Treasury and IRS released proposed regulations in August that would provide the first update to a rule adopted in 1998 addressing the tax treatment of computer programs. While adopting a policy on the tax treatment of cloud transactions is an important step forward, the proposed regulations raise significant policy and compliance questions for both U.S. and foreign taxpayers.

The bulk of the proposed regulations address whether a cloud transaction should be classified and sourced as either (1) a lease of computer hardware, digital content or similar resources, or (2) a provision of services. Cloud transactions generally involve access to property or use of property, instead of a sale, exchange, or license of property. As a result, the transactions would typically be classified as either a lease of property or provision of services.

How cloud transactions are classified is important because it dictates the taxing jurisdiction to which the revenue from the transaction is sourced and subject to tax. The Internal Revenue Code generally sources rents and royalties to where the leased or licensed property is used. Services are generally sourced to where the services are performed. The source of sales of inventory may depend on where title passes.

For foreign taxpayers conducting transactions with U.S. customers, the source and classification of cloud and digital content transactions may impact whether income from such transactions is treated as effectively connected income subject to U.S. taxation. It may also trigger withholding requirements for U.S.-based digital platforms that sell items created by foreign individuals or businesses.

For example, assume a U.S.-based company operating a website offering users a selection of designs to be applied to t-shirts or coffee mugs obtains its designs from artists in other countries. To protect itself from claims arising from the content of the designs, the company does not purchase the designs. Instead, it pays the artist a royalty. For each sale, the U.S. company would be required to withhold 30% of the royalty paid to the artist.

One aspect of Treasury and IRS’s proposed regulations that has produced uncertainty is that they stop short of explaining how or if the general sourcing rules would apply to cloud transactions. It is possible that Treasury and IRS may consider proposals emerging from other countries to source cloud transactions based on the location of servers, where the services are consumed or some combination of factors. Proponents of these measures say that such a levy is needed because their country’s tax regimes are geared toward imposing tax on businesses with buildings, equipment and employees within their borders. These tax systems are not equipped to deal with cloud transactions and therefore allow digital behemoths such as Facebook or Google, which are able to maintain a virtual presence, to escape paying their fair share of taxes, proponents argue.

But opponents of this approach point out that the current law in most countries dictate that a business have a permanent establishment within a country’s borders before it can become subject to the nation’s income tax. Among the standard criteria used in most countries for permanent establishment are that the company has a fixed place of business, address, bank account or other physical presence within the country’s borders.

Another aspect of the proposed regulations that has raised questions are the sourcing rules for copyrighted articles, such as digital books, music, or movies sold through an electronic medium. The proposed regulations would deem these sales to occur at the location of the download or installation onto the end-user’s device.

Sale Occurs at Location of Download

Under the proposed rule, a company that is based in France that sells video games on a digital platform and has no buildings, equipment, employees or other physical presence in the U.S. would be subject to U.S. federal income tax on sales of video games downloaded within the U.S. The French company would then need to determine whether they are engaged in a U.S. trade or business and therefore taxable on U.S.-sourced sales income.

The proposed tax treatment of these transactions contravenes the guiding U.S. law established in this area. Since the 1940s, the situs of a taxable transaction is where the production took place. The principle was established in the seminal case of Piedras Negras Broadcasting Co. v. Commissioner, 127 F.2d 260 (5th Cir. 1942). In the facts of that case, a Mexican radio station broadcasted from Mexico (with its broadcasting facilities and other property in Mexico). The station’s programming was targeted at U.S. listeners and 95% of the station’s income came from U.S. advertisers. The radio station met with advertisers and received mail in the U.S. The court ruled that the source of the income is the situs of the income-producing service.

The repeated use in the statute of the words “within” and “without,” the court found, suggests that sourcing determinations are based on a physical presence, with some tangible and visible activity. The court reasoned that if income is produced by the transmission of electromagnetic waves that cover a radius of several thousand miles, free of control or regulation by the sender from the moment of generation, the source of that income is the act of transmission. All of the radio station’s broadcasting facilities were situated outside of the U.S. and all of the service it rendered in connection with its business were performed in Mexico. As a result, the court concluded that the advertising revenues were not subject to U.S. tax because the transactions were deemed to have occurred in Mexico.

The proposed rule would also likely bring compliance headaches to businesses operating digital platforms. Instead of sourcing income based on the location where the product was produced, they would be required to track the locations of each download.

Demise of Physical Presence Standard at State Level

While physical presence has long been the standard for federal income tax purposes, it recently met its demise in the state tax arena. For more than 50 years, U.S. Supreme Court precedent required that a seller have property, employees or some other physical connection to a state before the state could require the seller to collect and remit sales tax. As internet commerce grew, several states enacted statutes asserting the right to impose tax on out-of-state sellers solely based on their level of economic activity within the state’s borders. One of these states was South Dakota, which enacted a statute requiring an out-of-state seller to collect sales tax on a prospective basis if the seller (1) had gross revenue from the sales of taxable goods and services in South Dakota exceeding $100,000; or (2) sold taxable goods and services for delivery in South Dakota in 200 or more separate transactions.

In 2018, the U.S. Supreme Court in South Dakota v. Wayfair upheld the South Dakota law against a taxpayer’s claim that it was unconstitutional because it lacked a physical presence requirement. The court found that the statute did not violate the Interstate Commerce Clause of the U.S. Constitution. Since Wayfair was decided many states have adopted statutes similar to South Dakota’s for sales tax. In addition, several jurisdictions are considering a similar standard for income tax.

The Takeaway

The bulk of the regulations proposed by Treasury and IRS address whether a cloud transaction should be classified and sourced as either a lease or a provision of services. However, the proposal stops short of providing guidance on how the general sourcing rules should specifically apply to cloud transactions. Another problematic aspect of the proposal is that it fixes the situs of a sale of a copyrighted article, such as an electronic book, song or movie to the location where the download took place. This policy would contravene a long-standing U.S. policy of determining the source of income based on a physical presence or location where the production took place. If adopted, the rule would create compliance challenges for digital companies who would be required to move away from sourcing income based on where the product is produced and toward tracking each location where the product is downloaded or consumed. While controversial, the proposed rule is consistent with tax policies emerging in Europe and adopted by most states in the U.S., but it is unclear what the final result will be. As the U.S. and other countries try to update their tax laws to match current technologies and business practices, uncertainty may be the only thing that is guaranteed.