new irs regulations of cloud transactions and digital...

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New IRS Regulations of Cloud Transactions and Digital Content: Sourcing Rules, Lease vs. Services Tax Treatment

Today’s faculty features:

1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific

TUESDAY, JANUARY 28, 2020

Presenting a live 75-minute webinar with interactive Q&A

David N. de Ruig, Senior Manager - National Tax - International Tax Services, Ernst & Young, San Francisco

Zachary Perryman, Senior Manager - National Tax - International Tax Services, Ernst & Young, San Francisco

Barbara Tolbert, Manager - National Tax - International Tax & Transaction Services, Ernst & Young, San Francisco

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Proposed regulations on cloud-based and other digital transactions

Prop. Treas. Reg. Sections 1.861-18 and -19


Speakers

Zak Perryman

➢ Mr. Perryman is a senior manager in EY’s National Tax Department, based in San Francisco. He advises clients in many sectors on a range of corporate transactional matters including intellectual property alignment, transfer pricing, international restructurings, and mergers and acquisitions.

David de Ruig

➢ Mr. de Ruig is a senior manager in EY’s National Tax Department, based in San Francisco, where he focuses on a broad variety of international tax matters, with a particular emphasis on tax planning for the impact of global tax law related to intellectual property. He also brings extensive experience addressing cross-border payments and international corporate structures. Prior to joining EY, Mr. de Ruig was a tax associate at a leading global law firm where he advised on U.S. tax considerations in connection with restructuring international operations for multinational clients.

Barbara Tolbert

➢ Ms. Tolbert is a manager in EY’s National Tax ITS practice, based in San Francisco. She advises clients on international tax matters, including inbound and outbound planning, intellectual property alignment, global operating model restructuring, and intercompany transactions and arrangements. Ms. Tolbert’s work is primarily focused on the modern tax planning issues resulting from the rapidly changing global tax law landscape, particularly as it relates to intellectual property, digital disruption, and industry convergence.

Disclaimer: The views expressed by the presenters are not necessarily those of Ernst & Young LLP or other members of the global EY organization. These slides are for educational purposes only and are not intended to be relied upon as accounting, tax or other professional advice. Please refer to your advisors for specific advice.


Agenda

1

2

3

5

4

Background and history of the software regulations

Proposed changes to the software regulations

Proposed cloud computing regulations and examples

Areas of concern & open questions

Questions

Background and history of the software regulations


Background and history of the software regulations Treas. Reg. Section 1.861-18

Presentation title

• The software regulations were issued in 1998 to provide guidance about certain transactions involving the transfer of computer programs.

• Generally, they treat transactions as being solely one of the following four categories:

• A transfer of a copyright right

• A transfer of a copyrighted article

• Provision of services for the development or modification of the computer program

• Provision of know-how relating to computer programming techniques

• But, transactions consisting of more than one of the above are treated as separate transactions, unless one of the components is de minimis.

• Transfers of copyrighted articles are further categorized as sales or leases, depending on the benefits and burdens of ownership.

• Transfers of copyright rights are further categorized as sales or licenses, depending on whether all substantial rights are transferred.

Proposed changes to the software regulations


Proposed changes to Treas. Reg. Section 1.861-18Classification of transactions involving digital content

Presentation title

• Adds new sourcing rule for sources of sales of copyrighted articles to the location of download or installation onto the end user’s device:

• If information is not available, sale deemed to occur at the location of the customer

• Previously, such sales were sourced as inventory property and based on location of title passage

• May raise effectively connected income (“ECI”) tension for taxpayers selling inbound into the US since the change likely will result in more US-sourced income

• Expands scope to cover all digital content:

• Such as books, music, movies, etc., provided electronically

• Not a big change from common treatment in industry, given lack of other guidance

• Clarifies that public performance or display solely for advertising purposes is not a copyright right

Proposed cloud computing regulations & examples


Proposed Treas. Reg. Section 1.861-19Classification of cloud transactions

Presentation title

• Applies to cloud transactions:

• Defined as a “transaction through which a person obtains non-de minimis on-demand network access to computer hardware, digital content (as defined in [Prop. Treas. Reg. §] 1.861-18(a)(3)), or other similar resources”

• Intended to apply to SaaS, PaaS, and IaaS transactions; as well as streaming media and web-based applications; and access to databases, servers, storage and software

• Does not apply to transactions covered by Section 1.861-18. Any of these transactions will not be recharacterized and the service will separate these transactions

• Transactions classified as either a service or lease of property:

• Unlike software regulations, does not provide for bifurcation of transactions, but an “arrangement” may be treated as multiple transactions with each transaction treated as a service or lease

• Follows six Section 7701(e) factors and three additional factors from case law for determining characterization (see next slide)

• Examples indicate focus on whether internet access is necessary for full functionality


Proposed Treas. Reg. § 1.861-19Classification of cloud transactions — listed factors

Presentation title

• 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.

• The total contract price substantially exceeds the rental value of the property for the contract period


Coordination with other provisions

Presentation title

• Interaction of Section 1.861-19 with international provisions:

• Proposed regulations would apply to the international provisions of the Internal Revenue Code, including certain provisions enacted as part of the Tax Cuts & Jobs Act (e.g., Sections 59A, 245A, 250 and 267A) and other provisions, including Sections 367(d) and 482

• Interested parties have suggested the following:

• Coordination with Section 250 foreign-derived intangible income rules: either creating an exception from being included in Section 250 calculations or further coordination between the rules


Examples from the Proposed Regulations

Proposed Regulations on Cloud-Based and Other Digital Transactions

• The proposed regulations provide various examples of business operating models and transactions that may fall within the purview of section 1.861-19 and thus be classified as cloud transactions

• The following discussion assesses the examples based on overall concepts and key fact patterns, including:

• General Cloud Storage Transactions

• Subscription Software Transactions

• Coexistence and combination 1.861-18 and -19

• Level of access & functionality

• Companies and end users


Examples: General Cloud Storage TransactionsExamples 1, 2


Basic facts

• Corp A operates data centers on its premises in various locations

• Corp A provides Corp B computing capacity on Corp A's servers in exchange for a monthly fee based

• Corp B provides its own software to run on Corp A's servers

• Corp A controls computing resources, keeps servers operational, performs physical maintenance, repair, and replacement

• Corp B has no ability to physically alter any server

• Cloud transaction √

Corp A Corp B

Servers

Computing Capacity

Monthly Subscription

Corp A Controls Servers


Examples: General Cloud Storage Transactions (cont.)Examples 1, 2


• Cloud storage transactions are likely to fall within the purview of the -19 Regulations, because such transactions do not provide users with a significant economic or possessory interest in the servers.

• Cloud transactions generally involve transactions resulting in a non-de minimis right to on-demand network access to computer hardware.

• Similarly, transactions where a software platform is provided for use to develop and deploy websites with a range of features, including blogs, message boards, and other collaborative knowledge bases, may be treated as cloud transactions.


Examples: Subscription Software TransactionsExample 3, 4


Basic facts

• Corp A provides Corp B access to customer relationship management software under several options such as “entry-level,” “mid-level,” and “advanced-level,” via a standard web browser, which Corp A hosts on its servers for a monthly subscription fee

• Corp B has no ability to alter the software code

• Corp A makes new versions of the software available as they are developed for the duration of Corp B's contract

• Corp A maintains servers


Corp A Corp B

Servers

Monthly Subscription

Corp A Controls Servers

Subscription Software


Examples: Subscription Software Transactions (cont.) Example 3, 4


• The provision of subscription software (with customizable levels of access) may also count as a cloud transaction.

• Although compensation based on the passage of time is generally more indicative of a lease than a service transaction, that factor may be outweighed by other factors which support classification as a service transaction.

• A fact pattern where Corp A is solely responsible for maintaining and repairing the servers and software associated with word processing, spreadsheet, and presentation software may also be treated as a cloud transaction (for a monthly fee, based on access to the app).

• The provision of a non-de minimis right to on-demand network access to computer hardware and software resources for the purpose of fully utilizing the related software may be treated a cloud transaction.


Examples: Level of Access & Functionality Examples 6, 7


Corp A

Data Center

End Users

Digital Content

Basic facts

• Corp A streams digital content in the form of videos and music to end users from its own Data Center servers.

• Each end user uses a computer or other electronic device to access unlimited streaming video and music in exchange for payment of a flat monthly fee to Corp A.

• The end user may select from among the available content the particular video or song to be streamed. Content can be played only while connected to the internet.

• Corp A continually updates its content catalog and adds new content to the end user.



Examples: Level of Access & Functionality (cont.)Examples 6, 7


• Fact patterns involving providing a varying, unlimited catalog of streaming services (such as videos and music) in exchange for a flat monthly fee may be treated as cloud transactions.

• Providing users with access to streaming digital content using third-party servers may be treated as a cloud transaction because the end user obtains a non-de minimis right to on-demand access computer hardware and software resources.

• Levels of accessibility (whether offline or online) may impact classification of transactions.


Examples: Coexistence and combination 1.861-18 and -19Examples 5, 8, 10, 11, 21

Basic facts

• Corp A provides software for download to Corp B that enables Corp B to create a scalable, shared pool of computing resources over Corp B's own network for use by Corp B's employees

• Corp B downloads the software, which runs solely on Corp B's servers

• Corp A provides Corp B with free updates for download as they become available

• Corp B pays Corp A an annual fee, and, upon termination of the arrangement, an electronic lock is activated that prevents Corp B from further using the software

• Not a cloud transaction

Corp A Corp B

Servers

Software for download

Annual fee

Software runs on B’s servers for duration of contract


Examples: Coexistence and combination 1.861-18 and -19(cont.)Examples 5, 8, 10, 11, 21


• Transactions that have traditionally fallen within the purview of § 1.861-18 are still classified as such.

• The download of software for use with a user’s computer hardware likely does not constitute on-demand network access to software, and thus may not a cloud transaction.

• For larger, combined arrangements that may include both cloud transactions and traditional software transactions, 1.861-19 gives the Service the power to split transactions into transactions it deems governed by 1.861-19 and 1.861-18 respectively.

• For example, when end users have the option to pay varying prices for the ability to stream, rent, or buy content (such as movies and TV shows):

• The rent and purchase of content may treated as a classic software transaction involving the transfer of copyrighted articles; and

• The streaming option may be treated as a cloud transaction, whereby users obtain on-demand network access (i.e., no copyrighted articles are transferred)


Examples: Companies and end usersExample 9

Corp A

Data CenterOperator

End Users

Digital Content

Basic facts

• Corp A streams digital content in the form of videos and music to end users (for a flat monthly fee) from servers located in data centers owned and operated by Data Center Operator

• Data Center Operator's content delivery network facility services multiple customers

• The end user may select from among the available content the particular video or song to be streamed

• End user must be connected to internet

• Corp A continually updates its content catalog at no additional charge to the end user.


Monthly

Fee


Examples: Companies and end users (cont.) Example 9


• Transactions where multiple end users are able to concurrently access digital content (that is subject to modification by its owner) may be treated as cloud transactions based on the fact that end users do not obtain a significant economic or possessory interest in any of the catalog’s digital content.

• This appears to be the case even if the comprehensive operating model includes traditional -18 transactions (such as Corp A and the Data Center Operator).

• Although compensation based on the passage of time is generally more indicative of a lease than a service transaction, that factor is outweighed by other factors which support a services classification.

Areas of concern and open questions


Areas of concern (income sourcing rules)

Presentation title

• The proposed regulations do not provide any sourcing rules for cloud computing transactions, so companies will continue to rely on dated case law (see e.g., Piedras Negras Broadcasting Co. v. Comm’r).

• However, in this day and age, this is not how multinational companies typically operate. US taxpayers can provide cloud computing services to US consumers, while having all of their personnel, servers, and property in multiple countries.


• Income sourcing: consistently apply across all digital content transactions: resulting in the majority oftransactions being treated as service

• Treating only cloud transactions as services

• Income sourcing rules by sourcing location: end point vs. point of first unrelated purchasing entity (use of the Title Passage Rule)

• Create specific rules or examples for independent contractors and agents


Areas of concern (scope of digital content)

Presentation title

• Despite the expansion of Digital Content in Section 1.861-19 to include the transfer of digital books, movies, music, and games, the scope of digital content remains narrow.

• The IRS has noted this deficiency and requested comments to broaden its definition of digital content.


• Expansion of the definition or scope of digital content to include non-copyrightable content. A wide variety of non-copyrightable content can be accessed and transferred electronically, such as US federal court decisions

• Streamlining the classification of digital content transactions by eliminating meaningless distinctions for substantially similar and “functionally equivalent” transactions (temporary downloads vs. streaming content).


Other considerations

Presentation title

• If compliance with the proposed regulations requires a change in the taxpayer’s method of accounting initiated by the taxpayer, it may require consent of the Commissioner.

• The effective dates are:

• Prop. Treas. Reg. Section 1.861-19 would apply to cloud transactions entered into in tax years beginning on or after the date of publication of the Treasury Decision adopting the regulations as final

• Prop. Treas. Reg. Section 1.861-18 similarly would be effective for transactions entered into in tax years beginning on or after the date of publication of the Treasury Decision adopting the regulations as final

Questions

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