Proposed Treasury Regulations Address Digital Content Transfers and Cloud Transactions

August 19, 2019

The US Treasury Department and Internal Revenue Service focus on the transfer of digital content and cloud transactions in recent proposed regulations. Adding “digital content” to the reach of the current regulations governing transfers of and transactions involving computer programs, the proposed regulations also consider display and performance rights and source of income for such content, and go one step further by including guidance on the characterization and tax treatment of cloud transactions.

The US Department of the Treasury (Treasury) and the US Internal Revenue Service (Service) issued long-awaited proposed regulations addressing digital content transfers and cloud transactions (the Proposed Regulations) on August 9. The guidance addressing digital content largely expands upon existing final regulations found in Treas. Reg. § 1.861-18, which govern transfers of and transactions involving computer programs (the Software Regulations). The Proposed Regulations then introduce new guidance on “cloud transactions,” found in Prop. Reg. § 1.861-19, filling a void previously left unaddressed by the Software Regulations.


By way of background, the Software Regulations prescribe rules for classifying transactions involving computer programs as a sale or license of a “copyright right” in a program, a sale or lease of the program (a “copyrighted article”), the provision of services for the development or modification of a program, or the provision of know-how relating to programming techniques. The Proposed Regulations make several fairly modest changes to the Software Regulations.

Digital Content: The Software Regulations apply only to transactions involving a “computer program,” defined as “a set of statements or instructions to be used directly or indirectly in a computer in order to bring about a certain result.” The Proposed Regulations extend the Software Regulations’ reach to include “digital content”—that is, computer programs as well as any content in digital format that is either protected by copyright law or is no longer so protected solely due to the passage of time (whether or not the content is transferred to a physical medium). Digital content would include electronic books, music, videos, and other similar items.

Display and Public Performance Rights: Under the Software Regulations, a “copyright right” in a program the transfer of which could give rise to sales income or royalties includes the right to make a public performance of or publicly display the program. The Proposed Regulations narrow the circumstances in which the right to display or publicly perform digital content will be considered a copyright right. Specifically, the display or public performance of digital content for the purpose of advertising or selling the content is not considered a copyright right. As a result, transactions involving or that grant such rights are more likely to be characterized as a sale or lease of a copyrighted article.

Source of Income: The Proposed Regulations also modify the manner in which income from the sale of a copyrighted article is sourced. Under the current Software Regulations, such income is sourced to the location where the “rights, title, and interest” of the seller are transferred to the purchaser (i.e., the location of passage of title). The preamble notes that applying the general passage of title rule can be more complicated and can create uncertainty in the context of electronically downloaded software. To address these considerations, the Proposed Regulations provide that a sale of a copyrighted article sold or transferred through an electronic medium is deemed to occur at the location where the end user of the copyrighted article downloads or installs the copyrighted article onto the end user’s device. In the absence of information about the location of the download or installation onto the end user's device used to access the digital content, the sale will be deemed to have occurred at the location of the customer, which is determined based on the taxpayer's recorded sales data for business or financial reporting purposes.

In combination with the 2017 tax legislation and preexisting Internal Revenue Code (Code) rules, this new rule could result in very different results for a foreign taxpayer that sells to a US customer out of its inventory software copies that it purchases outside the United States and software copies that it produces outside the United States, assuming the customer in each case downloads or installs the software onto the customer’s device in the United States.

Under the prior rule, a foreign taxpayer could generally avoid US tax on the gain from a sale to such a US customer of software copies in its inventory that it purchases outside the United States, even if it otherwise engages in a US business, so long as it passes title to the copies outside the United States and does not sell the copies through a US office. Under the rule in the Proposed Regulations, the gain will be subject to net basis tax and possibly the branch profits tax if the taxpayer is engaged in a US business, even an unrelated one.

If, on the other hand, the taxpayer produces rather than purchases the software and performs all production activities outside the United States, the gain should not be taxable, even if the taxpayer otherwise engages in a US business, so long as it does not sell the copies through a US office.


Prop. Reg. § 1.861-19 (Classification of cloud transactions) picks up where the Software Regulations leave off. That is, the Software Regulations govern transfers of computer programs and the provision of related development services and know-how. They do not, however, address online or network access to computer programs (e.g., streaming of music or video content, access to mobile device applications). The Proposed Regulations attempt to fill this void.

Cloud Transactions: Prop. Reg. § 1.861-19 specifically governs the characterization and tax treatment of “cloud transactions.” It defines them as transactions through which a person obtains on-demand network access to computer hardware, digital content (which, under the Proposed Regulations would include computer programs), or other similar resources. This definition was intentionally drafted broadly to cover a range of existing technologies and platforms (e.g., SaaS, PaaS, and IaaS), and presumably future developments that might not fit squarely within existing technological categories. At the same time, however, a transaction or arrangement involving de minimis on-demand network access generally will not be considered a cloud transaction (e.g., network access merely used to download digital content) and, therefore, typically will not fall within the scope of Prop. Reg. § 1.861-19; instead, such transactions will generally be governed by the Software Regulations.

Service vs. Lease Characterization: The Proposed Regulations characterize cloud transactions as either solely a service or solely a lease. This approach mirrors existing service vs. lease authorities (e.g., 26 USC § 7701(e)), which adopt a predominant character approach that characterizes a transaction or arrangement in its entirety, rather than bifurcating the transaction as part service and part lease.

On the other hand, if an overall arrangement involves or consists of multiple transactions, each underlying component transaction must be separately analyzed and then characterized as a cloud transaction (or not).

Interestingly, the Proposed Regulations do not include any type of anti-abuse rule that would prevent taxpayers from bifurcating an arrangement into multiple smaller transactions that, under the rule above, would need to be characterized on a separate, standalone basis.

Factor-Based Test: Whether a cloud transaction constitutes a service or a lease is based on all relevant facts and circumstances. The Proposed Regulations establish a nonexhaustive list of nine factors to be considered in making this determination. The factors largely align with the existing service vs. lease factors found in Section 7701(e), as well as other factors developed over time through case law. The preamble notes that the relevance and importance of a particular factor may vary depending on the factual situation, and, in some instances, certain factors simply may not be relevant at all. If applicable, these nine factors will typically demonstrate the existence of a service, rather than a lease:

  1. The customer is not in physical possession of the property used in the cloud transaction.
  2. The customer does not control the property used in the cloud transaction (beyond access to a network).
  3. The provider has the right to determine the specific property used in the cloud transaction and the right to replace the property with comparable property.
  4. Property used in the cloud transaction is a component of an integrated operation in which the provider has other responsibilities.
  5. The customer does not have a significant economic or possessory interest in the property used in the cloud transaction.
  6. The provider bears any risk of substantially diminished receipts or increased expenditures in the event of nonperformance under the contract governing the cloud transaction.
  7. The provider uses the relevant property concurrently to provide significant services to parties unrelated to the customer.
  8. The provider’s fee is primarily based on measure of work performed or the level of the customer’s use (e.g., computing power or resources), rather than the passage of time (e.g., a monthly fee).
  9. The total contract price for the cloud transaction substantially exceeds the rental value of the property for the contract period.

The Proposed Regulations include 11 examples that apply and analyze these factors in the context of a number of common cloud transactions, such as SaaS and web-based applications and offerings, streaming subscription and membership services, and data hosting services. The examples are highly fact specific and are difficult to generalize in broad strokes. Nevertheless, in reading the examples, several important themes emerge:

  1. Dedicated servers and equipment: Although exclusive access to or dedicated use of property is generally consistent with a lease arrangement, such a presumption can be overcome where a provider bears the typical benefits and burdens of property ownership (e.g., control, possession, risk of loss) and is compensated above and beyond the rental value of the relevant property.
  2. Time-based billing: While compensation based on passage of time (rather than usage) tends to support lease treatment, this factor, standing alone, typically will not be controlling where a provider maintains possession and control over property (including the right to replace the property) and bears the risk of loss with respect to the property and/or nonperformance under the relevant contract.
  3. Downloadable applications and code: Arrangements requiring downloadable software elements, such as scripting code or a mobile application, typically will not preclude or prevent the arrangement from being characterized as a cloud transaction, provided that the core functions of the underlying software are accessed over and operate through the internet or an online network.

Overall, the examples, coupled with the related commentary in the preamble, suggest a general openness on the part of the Service to characterizing cloud transactions as service transactions, rather than leases.


If finalized, the Proposed Regulations will apply to transactions entered into in taxable years beginning on or after the rules therein are published as final regulations. In the meantime, Treasury and the Service have requested comments on all aspects of the Proposed Regulations and, in particular, the nine issues outlined below. Comments must be received by November 12, 2019.

  1. Whether the definition of digital content should be defined more broadly than content protected by copyright law and content that is no longer protected by copyright law solely due to the passage of time
  2. Whether any special considerations should be taken into account in applying the rule in existing Treas. Reg. § 1.861-18 to transfers of digital content other than computer programs
  3. Whether any other aspects of existing Treas. Reg. § 1.861-18 need to be modified if that section is amended as proposed
  4. Whether the classification of cloud transactions as either a service or a lease is correct, or whether cloud transactions are more properly classified in another category (for example, a license or a sale)
  5. Realistic examples of cloud transactions that would be treated as leases under Prop. Reg. § 1.861-19
  6. The existence of arrangements involving both a transaction that would qualify as a cloud transaction and another non–de minimis transaction that would be classified under another provision of the Code or Regulations, or under general tax law principles
  7. Potential bases for allocating consideration in arrangements involving both a transaction that would qualify as a cloud transaction and another non–de minimis transaction that would be classified under another provision of the Code or Treasury Regulations, or under general tax law principles
  8. Administrable rules for sourcing income from cloud transactions in a manner consistent with Treas. Reg. §§ 1.861-865
  9. Application of Prop. Reg. § 1.861-19 to an arrangement that involves non–de minimis rights to access digital content both on demand and over a network


If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following Morgan Lewis lawyers:

Chicago/Silicon Valley
Mike Liu

San Francisco
Greg Hartker
Sarah-Jane Morin

Silicon Valley
Bart Bassett
Rod Donnelly