What’s in the Cloud? Proposed IRS Rules for Digital and Cloud Transactions

By Magnolia M. Movido, Counsel, Snell & Wilmer LLP.

Republished with permission from the author.

The long wait is over – the Internal Revenue Service (IRS) has finally issued proposed regulations (the Cloud Regulations) addressing the tax treatment of cloud transactions.1

Until now, there was no guidance specifically addressing the tax treatment of cloud computing transactions, and as a result, taxpayers were forced to rely upon analogous authorities, not knowing with any certainty whether they were complying with applicable law.2 Below is a summary of the proposed rules and a few examples and observations on the same.

I. Cloud Transactions – Classifying the Transaction as a Lease or a Service

The Cloud Regulations do a decent job of resolving certain basic issues but fall short of providing comprehensive guidance in many areas. 

The Cloud Regulations define a cloud transaction as a transaction through which “a person obtains on-demand network access to computer hardware, digital content, or other similar resources.” For these purposes, cloud transactions do not include network access to download digital content for storage and use on a person’s computer or other electronic device. The key concept for qualifying as a cloud transaction is the “on demand” aspect of accessing computing resources, e.g., networks, servers, storage and software (SaaS, PaaS, IaaS), or other technology such as streaming, mobile device apps, and data from remotely hosted software.

In general, the Cloud Regulations classify cloud transactions as either (i) a lease of property or (ii) a provision of services.3 Classification is based on the entirety of the transaction, and although the rules provide several examples of cloud transactions that would properly be treated as a service, there are no concrete or realistic examples of cloud transactions that would properly be treated as a lease. Obviously, this is something that will hopefully be addressed when final regulations are issued.

The Cloud Regulations prevent a single cloud transaction from being bifurcated into (i) a partial lease and (ii) a separate service. However, in some instances multiple cloud transactions may be separately classified. 

Unfortunately, the Cloud Regulations do not address the source of income rules for cloud transactions. For the time being, it seems reasonable to conclude that (i) if the cloud transaction is treated as a service, then the income generated from such transaction generally should be sourced in the jurisdiction in which the services are provided; and (ii) if the cloud transaction is treated as a lease, then the income generated from such transaction should generally be sourced in the jurisdiction in which the leased property is used. But identifying the actual source for cloud transactions could be complicated because, by the nature of these transactions, it is difficult to pinpoint a specific source given the different access points implicated, as shown in an example below.

II. Computer Program Transactions – Classifying the Transaction and Determining the Source of Income

The Cloud Regulations also modify the regulations previously issued that address the tax treatment of transactions involving computer programs (the Computer Program Regulations).4 The Computer Program Regulations now have a broader scope and apply to all transfers of digital content, defined as “any content in digital format and that is 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.” Examples of digital content include books, movies and music in digital format. The Computer Program Regulations now clarify that the transfer of the right to publicly perform or display digital content for the purpose of advertising the sale of the digital content does not constitute a transfer of a copyright right.

Fortunately, the Computer Program Regulations provide both (i) examples analyzing the character of income from computer-based transactions and (ii) guidance respecting the source of income for computer-based transactions and digital content. For example, when copyrighted articles are sold and transferred through an electronic medium, the sale is deemed to occur (a) at the location of download or installation onto the end-user’s device used to access the digital content, or (b) in the absence of this information, at the location of the customer as determined based on the taxpayer’s/seller’s recorded sales data for business or financial reporting purposes.

III. Cloud Transactions – Determining the Source of Income

It is uncertain whether the source of income rules applicable to Computer Program Regulations will be applicable to Cloud Transactions.

For example, assume Company A (United States) operates data centers on its premises in various locations (United States and other foreign countries) and provides Company B (United States) computing capacity on Company A’s servers for a monthly fee. Servers accessed by Company B may also be used simultaneously by other customers, and the computing capacity provided to Company B can be sourced from a variety of servers in one or more of Company A’s data centers. Assuming the transaction is treated as a service under the Cloud Regulations, and further assuming we follow the general rule that for tax purposes, the source is where the service is performed, the question is whether the source of the income should be: (1) the location of Company B, (2) the location of the data center or (3) the location of the server. Under the Computer Program Regulations, when copyrighted articles are transferred through an electronic medium, the sale is deemed to occur at the location of download or installation onto the end-user’s device used to access the digital content, as vendors generally are expected to be able to identify the location of such download or installation.

In the absence of information about the location of download or installation onto the end-user’s device used to access the digital content, the sale is deemed to have occurred at the location of the customer based on the taxpayer’s recorded sales data for business or financial reporting purposes. An argument, then, could be made that for the cloud transaction example, the source of income should be the location where Company B accesses the computing capacity, or in the absence of such information, the location of Company B based on its recorded sales data for business or financial reporting purposes. It remains to be seen how sourcing will apply for Cloud Transactions.

IV. Practical Implications for Taxpayers Engaging in Cloud Transactions

The Cloud Regulations reflect the Treasury’s efforts to keep up with the fast, major changes in the digital economy in order to simplify compliance. However, taxpayers need to be aware of how the new rules impact their current transactions. Specifically, the source rules for transactions involving computer programs and digital content will require taxpayers to review current contracts to evaluate which revenues will be sourced differently (U.S. source vs. foreign source).

For example, assume U.S. Company (U.S. Co.) sells digital content, via downloads, to its non-U.S. customers located in Country X. Under the proposed regulations, such transactions could give rise to foreign source income, potentially subject to tax (income, indirect sales, etc.) in both the United States and in Country X. U.S. Co. would have to determine whether it could avail itself of foreign tax credits to avoid double taxation – but even if it could, foreign tax credits could be subject to limitations. Alternatively, U.S. Co. could seek to ease its global tax burden pursuant to the benefits of an applicable income tax treaty.

The proposed regulations also apply to inbound transactions. For example, assume Foreign Company (F Co.) supplies digital services and content to U.S.-based customers. Such transactions could give to rise to income for F Co. that is effectively connected with a U.S. trade or business and would therefore be subject to U.S. tax and various filing requirements. F Co. now has to consider whether Country X offers similar tax credit for U.S. taxes paid or if an applicable tax treaty could ease its global tax burden.

Either way, both U.S. Co. and F Co. have the additional administrative burdens to ensure proper compliance with the proposed rules and may want to consider whether it makes sense, from a business perspective, to restructure their business model so that the revised structure is in better alignment with the proposed regulations.

Comments to the Cloud Regulations are requested by November 12, 2019, on various topics such as the administrable source rule, whether a broader definition of digital content is necessary, realistic examples of cloud transactions that should be classified as leases, and whether the classification of cloud transactions as either service or lease is correct or other classification (such as license or sale) might be proper. Until then, taxpayers engaging in business in the digital marketplace should continue to be vigilant in monitoring future developments.


  1. Prop. Treas. Reg. §1.861-19.  
  2. During this time of uncertainty, taxpayers often relied upon the rules applicable to (i) computer transactions (Treas. Reg. §1.861-18), (ii) leases (Code §7701(e)(1)), and (iii) domestic production activities (Code §199).
  3. Factors based on Code §7701(e)(1) and case law principles are used to determine if the transaction qualifies as a lease or service.
  4. Treas. Reg. §1.861-18.

Republished with permission from the author. Click here to read the article on the Snell & Wilmer LLP website.