In a year marked by regulatory rollback and uncertainty, the IRS proceeded with a planned rulemaking hearing July 17 on how income from cloud transactions should be sourced under the Tax Code’s international provisions.
The proposed rule, issued at the tail end of the Biden administration, provides that in determining the “place of performance” of a cloud transaction, three factors – the location of contributing employees and tangible and intangible assets – should be accounted for.
Back in January, concurrently with the proposed rule, the Biden administration issued a final rule on the classification of cloud transactions and transactions involving digital content. But that rule left open the question of how to determine the source of gross income in a cloud transaction – the subject of the IRS hearing this Thursday.
Rulemaking Slowdown
Comments on the cloud transaction sourcing proposed rule were initially due in April, with a hearing to be scheduled upon request. In June, the IRS noticed a July 17 hearing. This came despite the agency, under the Trump administration, largely pausing rulemaking activity.
The IRS cancelled hearings earlier this year on rulemakings for the IRC § 30C alternative fuel vehicle refueling property credit and IRC § 45W commercial clean vehicle credit. It also recently withdrew proposed regulations on calculating built-in gains and built-in losses under IRC § 382.
The Trump administration IRS has, however, extended the comment period for a proposed rule on previously taxed earnings and profits (PTEP) accounting, exclusions from gross income, and related determinations and adjustments under IRC § 959 and related basis adjustments under IRC § 961. While the extended comment period closed earlier this week, the docket indicates that, as of July 17, the agency is accepting late comments.
And though IRS rulemaking activity has slowed, stakeholders ranging from the Software Coalition, to the Information Technology Industry Council, to the New York State Bar Association showed a continued interest in working with the agency on its cloud sourcing proposal.
Cloud Transaction Sourcing Concerns
The Software Coalition, along with the Silicon Valley Tax Directors Group, responded harshly to the proposal, viewing it as unnecessary given existing common law and calling for withdrawal. According to the Software Coalition’s written comments, the proposed rule would “introduce complexity and rigidity that do not produce more accurate results than the facts and circumstances mandate of current law.”
The Software Coalition also dismissed as speculative the need to address source of income in light of new “technological developments” – namely, AI “enabling autonomous value creation in cloud services enterprises.” It urges a wait-and-see approach, with the IRS developing such rules after AI models are “better understood.”
The Information Technology Industry Council (ITI), too, called for the rules to be withdrawn. Beyond the administrative burdens, said ITI in its written comments, the rules “create unfortunate incentives to offshore intellectual property rights and R&D [research and development] activities.”
But should the IRS proceed with the rule, said ITI, refinements are needed. Namely, under the proposal, the source of services income would be based on where the service is performed in a tax year, ITI explained. However, the group contends that “the location of the underlying research and development” in a tax year “does not equate to the location of the place of performance of a cloud transaction in that year” and is not “a good proxy for any use of intangible property in the provision of those cloud services.”
Others called for refinement, rather than retraction, of the proposed rule – including two commenters at Thursday’s hearing.
Refinements Suggested
Jeffrey Kadet, speaking at the hearing, views the sourcing rule as “an absolute necessity” given that cloud transactions are a “major economic sector” and that they differ from “traditional services performed by human beings.” Moreover, the sourcing rule can help ensure “similarly situated taxpayers are taxed consistently.”
Kadet, a former CPA and University of Washington lecturer, explained that he does not represent a particular taxpayer or taxpayer type, rather he hopes to “achieve a more administrable system that is fair to both taxpayers and the government.”
He countered critiques of the rule’s treatment of R&D expenditures, saying the IRS has been “crystal clear” that these do not include new product lines, rather “tweaks, bug fixes, regular updates, and security fixes.” Kadet suggested that, when finalized, the rule could refer to these expenditures as “something like IP maintenance expenditures” to ease any confusion.
And for “more theoretical accuracy,” said Kadet, the IRS might consider expanding the proposed one-year period for R&D expenses to a more “cumulative” approach.
The New York State Bar Association, in its written comments, went even further, suggesting the sourcing rules could be tweaked generally to incorporate “a multi-year formula that averages each of the three factors and determines the U.S. source portion thereof over a specified number of prior years.”
“[T]echnology involved in a cloud transaction is often the product of multiple years’ efforts, with incremental improvements building on existing technology,” writes NYSBA. As such, “prior years’ inputs” may often play into current year cloud transactions. But according to NYSBA, “[t]he number of years and approach to each factor need not (and arguably should not) necessarily be the same.” For R&D expenditures, the “lag time” before income is realized may be greater, as an example.
And Ameek Ponda, a partner at Sullivan & Worcester, urged IRS staff to consider potential impacts on Real Estate Investment Trusts (REITs).
“The source rules,” said Ponda, “adopt a composite view, not a bifurcated view, of whether something is a cloud transaction.” He views it as “an all or nothing.”
But REIT and other rules “have a very different framework,” he added, where once you have an “anchor relationship of renting real estate,” you can tack on rent-related services and a de minimis amount of “rental for personal property.”
Speaking at Thursday’s hearing, Ponda cautioned that the cloud regulations should not be applied in the REIT context.
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