Tax Considerations of IRS Proposed Rules on Digital and Cloud Transactions
November 26, 2019
Although we are years into a dynamic digital economy of streaming services, social media, and online marketplaces, the Internal Revenue Service has finally caught up and recently issued proposed regulations on federal income tax treatment for cloud-based transactions.
In previous guidance from 1998, which in the tech world may as well be the Stone Age, the IRS focused on tangible off-the-shelf computer programs. The latest rules are an effort to catch up and broaden the scope to include digital content such as e-books, videos, and music, and cover revenue sourcing issues that arise from their transfer.
The proposed rules differentiate cloud from non-cloud transactions, as well as on-demand network access to hardware or digital content downloaded to a device. A focal point of the rules is determining whether a particular cloud transaction is a provision of a service or a lease of property, each of which can have differing book and tax treatment.
The finalized rules define industry best practices on how digital content downloads and cloud transactions are treated. Businesses should therefore review the proposed rules to prepare for their potential impact once regulations are finalized.
1. Digital Content
The proposed rules clarify the treatment of income from digital content transfer.
Under existing rules, income is sourced to the location of title transfer based on the concept of control. The proposed rules shift revenue to the location of end-user download or installation.
This change will shift the impact of state and local taxes. As an example this would affect movies downloaded in zero-tax versus high-tax states. The issue merits careful consideration, as the Wayfair decision has emboldened states to collect taxes on cloud-based e-commerce sellers.
With digital transactions often global in nature, foreign tax regimes can be expected to focus on download location to determine sourcing rules.
2. Cloud Classification
The proposed rules do not address sourcing of cloud-based transactions. However, current tax rules governing provision of services and lease of property classifications can inform sourcing.
Where a cloud transaction is a provision of services, the income is treated as ordinary and sourced to the location where services are performed. If a lease of property, it’s also treated as ordinary income, but sourced to the location where the property is used.
The proposed rules err on the side of treating most cloud transactions as a provision of services. Examples include access to data center servers, software, platforms, and online databases, as well as data storage and streaming services. The IRS offers nine criteria for making the determination of service-based transactions, broadly grouped as follows:
A cloud transaction is a provision of services if the customer does not possess the property and does not control it beyond mere network access. The customer also has no economic interest in the property and no possession rights.
By contrast, the provider can select the specific property used in the transaction and replace it with comparable equipment.
The provision of services classification applies where the provider assumes risk from diminished receipts or increased expenses due to nonperformance. Similarly, the provider assumes liability from breach of contract.
Fees and Scope
The provision of services classification further holds where the provider’s fee is based mainly on the scope of work performed. Similarly, performance is driven by the degree of customer use as opposed to a mere lapse of time.
The provider also uses the same property to service additional customers. By extension, the property is part of an “integrated operation” in which the provider has other responsibilities.
Finally, if the entire contract price vastly exceeds the property’s rental value for the contract term, such would signify services treatment.
3. Varying Income Timelines
Classification is also important to consider since many digital transactions come as tiered packages. For example, a package may comprise of a software license with multiyear customer support or data storage limits. Tax treatment can thus be often uncertain.
Due to ambiguity in current guidance, companies risk reporting all income from multiple transactions the same way, an approach that can compromise income projections or trigger material tax reporting errors.
The proposed rules require each transaction be separately classified unless differences are incidental. With a sale, income would be reported upfront, while income from a cloud-based service would be reported over the contract term.
Companies should assess the proposed rules’ potential impact to revenue reporting, as well as tax exposure across federal, state, and international jurisdictions.
Getting ahead of the proposed changes now can avoid having to fit complex new sourcing and income considerations onto outdated technology rules.