Preamble to Prop Reg REG-130700-14; Prop Reg 1.861-7; Prop Reg §1.861-18; Prop Reg §1.861-19
IRS has issued proposed regs regarding the classification of cloud and digital content transactions as either leases or provisions of services for certain international provisions of the Code. The proposed regs 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 Reg. §1.861-18.
Background—existing Reg. §1.861-18. Reg. §1.861-18 provides rules for classifying transactions involving computer programs for certain international provisions of the Code.
Reg. §1.861-18(a)(3) defines a computer program as “a set of statements or instructions to be used directly or indirectly in a computer in order to bring about a certain result” and includes “any media, user manuals, documentation, data base or similar item if the media, user manuals, documentation, data base or similar item is incidental to the operation of the computer program.”
Under Reg. §1.861-18(b)(1), an international transaction to which the section applies is categorized as (i) a transfer of a copyright right in a computer program; (ii) a transfer of a copy of a computer program (a “copyrighted article”); (iii) the provision of services for the development or modification of a computer program; or (iv) the provision of know-how relating to computer programming techniques.
Reg. §1.861-18(c) provides that a transfer of a computer program is classified as the transfer of a copyright right if there is a non-de minimis grant of any of the following four rights: (i) The right to make copies of the computer program for purposes of distribution to the public by sale or other transfer of ownership, or by rental, lease, or lending; (ii) the right to prepare derivative computer programs based upon the copyrighted computer program; (iii) the right to make a public performance of the computer program; or (iv) the right to publicly display the computer program.
Reg. §1.861-18(f) further categorizes: a) a transfer of a copyright right as either the sale or license of the copyright right and b) a transfer of a copyrighted article as either the sale or lease of the copyrighted article.
Reg. §1.861-18 generally does not provide a comprehensive basis for categorizing many common transactions involving what is commonly referred to as “cloud computing,” which typically is characterized by on-demand network access to computing resources, such as networks, servers, storage, and software.
IRS points out that since 1998, when Reg. §1.861-18 was adopted (TD 8785, 10/2/1998), content in digital format and subject to copyright law, including music, video, and books, has become a common basis for commercial transactions. Consumption of such digital content has grown in part because of new computer hardware, including laptops, tablets, e-readers, and smartphones, that allows users to more easily obtain and use digital content.
Background—cloud computing. IRS says that cloud computing transactions typically are described for non-tax purposes as following one or more of the following three models: Software as a Service (“SaaS”); Platform as a Service (“PaaS”); and Infrastructure as a Service (“IaaS”). (Preamble to Prop Reg REG-130700-14)
SaaS allows customers to access applications on a provider’s cloud infrastructure through an interface such as a web browser. 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. IaaS allows customers to access processing, storage, networks, and other infrastructure resources on a provider’s cloud infrastructure.
IRS says that a cloud computing transaction typically does not involve any transfer of a computer program classified under Reg. §1.861-18 as a transfer of a copyright right or copyrighted article or any provision of development services or knowhow relating to computer programs or programming. Although certain cloud computing transactions may provide similar functionality with respect to computer programs as transactions subject to Reg. §1.861-18 (e.g., the transfer of a computer program via download may provide similar functionality as the same program accessed via a web browser), Reg. §1.861-18 does not address the provision of online access to use the computer program. Accordingly, Reg. §1.861-18 does not apply to classify such a transaction.
In addition to the cloud computing models described above, other transactions exist that are not solely related to computing but still involve on-demand network access to technological resources (these transactions and cloud computing transactions are collectively referred to herein as “cloud transactions”). These transactions have increased in frequency over time and share similarities with the three cloud computing models described above. Examples include streaming music and video, transactions involving mobile device applications (“apps”), and access to data through remotely hosted software.
These transactions may not involve, in whole or in part, a transfer under Reg. §1.861-18 of a copyright right or copyrighted article, or a provision of development services or know-how relating to computer programs or programming.
In general, a cloud transaction involves access to property or use of property, instead of the sale, exchange, or license of property, and therefore typically would be classified as either a lease of property or a provision of services. Code Sec. 7701(e) and case law provide factors that are relevant for classifying a transaction as either a lease of property or a provision of services.
For example, Code Sec. 7701(e)(1) provides that a contract which purports to be a service contract is treated as a lease of property if the contract is properly treated as a lease of property, taking into account all relevant factors including whether or not:
- the service recipient is in physical possession of the property,
- the service recipient controls the property,
- the service recipient has a significant economic or possessory interest in the property,
- the service provider does not bear any risk of substantially diminished receipts or substantially increased expenditures if there is nonperformance under the contract,
- the service provider does not use the property concurrently to provide significant services to entities unrelated to the service recipient, and
- the total contract price does not substantially exceed the rental value of the property for the contract period.
Proposed regs—modifications of §1.861-18. IRS has determined that the rules and principles underlying Reg. §1.861-18 have provided useful guidance with respect to computer programs and that these rules and principles should apply to certain other digital content that has become more popular since was Reg. §1.861-18 adopted. Accordingly, Prop Reg §1.861-18 would broaden the scope of Reg. §1.861-18 to apply to all transfers of “digital content” generally by replacing the phrase “computer programs” with “digital content” each place it appears in the existing regs. (Preamble to Prop Reg REG-130700-14)
Digital content would be defined 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 would include, e.g., books, movies, and music in digital format in addition to computer programs. (Prop Reg §1.861-18(a)(3))
A transfer of the mere right to public performance or display of digital content for purposes of advertising the digital content would not by itself constitute a transfer of a copyright right. (Prop Reg §1.861-18(c)(2)(iii) and Prop Reg §1.861-18(c)(2)(iv))
When copyrighted articles are sold and transferred through an electronic medium, the sale would be deemed to occur at the location of download or installation onto the end-user’s device used to access the digital content. (Prop Reg §1.861-18(f)(2)(ii)) IRS expects that vendors generally would be able to identify the location of such download or installation. (Preamble to Prop Reg REG-130700-14)
Proposed regs—cloud computing. Prop Reg §1.861-19 would provide rules for classifying a cloud transaction either as a provision of services or as a lease of property. (Prop Reg §1.861-19(a))
A cloud transaction would be defined as a transaction through which a person obtains non-de minimis on-demand network access to computer hardware, digital content, or other similar resources. (Prop Reg §1.861-19(b))
This definition would not be limited to computer hardware and software, or to the IaaS, PaaS, and SaaS 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. (Preamble to Prop Reg REG-130700-14)
Although this definition is broad, it does not encompass every transaction executed or completed through the Internet. For example, the mere download or other electronic transfer of digital content for storage and use on a person’s computer hardware or other electronic device would not constitute on-demand network access to the digital content and so would not be considered a cloud transaction. (Prop Reg §1.861-19(b))
A cloud transaction would be classified solely as either a lease of property or the provision of services. (Prop Reg §1.861-19(c)(1))
Factors demonstrating that a cloud transaction would be classified as the provision of services rather than a lease of property include:
- 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; and
- The total contract price substantially exceeds the rental value of the property for the contract period. (Prop Reg §1.861-19(c)(2))
For purposes of this list, computer hardware, digital content, or other similar resources are referred to as “the property,” and the party to the transaction making such property available to customers for use is referred to as “the provider.” (Prop Reg §1.861-19(c)(1))
This list of factors is non-exhaustive. (Preamble to Prop Reg REG-130700-14) Some of these factors are also found in Code Sec. 7701(e).
Observation. The proposed regs do not make it clear as to how the case law that has developed under Code Sec. 7701(e) would be used to interpret the Prop Reg §1.861-19(c)(2) factors.
An arrangement comprised of multiple transactions would generally require separate classification for each transaction. If at least one of the transactions is a cloud transaction, but not all of the transactions are cloud transactions, the proposed regs would apply only to classify the cloud transactions. However, any transaction that is de minimis, taking into account the overall arrangement and the surrounding facts and circumstances, would not be treated as a separate transaction, but as part of another transaction. (Prop Reg §1.861-19(c)(3))
Effective date. The modifications made by Prop Reg §1.861-18 would apply to transactions involving the transfer of digital content, or the provision of services or of know-how in connection with digital content, pursuant to contracts entered into in tax years beginning on or after the date the proposed regs are finalized. (Prop Reg §1.861-18(i))
Prop Reg §1.861-19 would apply to cloud transactions occurring pursuant to contracts entered into in tax years beginning on or after the date the proposed regs are finalized. (Prop Reg §1.861-19(e))
References: For the classification of transactions for purposes of the Code’s international provisions, see FTC 2d/FIN ¶I-4100; United States Tax Reporter ¶8614.31.