21 January 2025

United States | Treasury releases guidance package on classifying and sourcing digital content and cloud transactions

  • The 2025 Final Regulations adopt a new "predominant character" test for characterizing digital content and cloud transactions with multiple elements, introduce a new sourcing rule for sales of electronically transferred copyrighted articles that is based on the customer's billing address and provide several examples of common digital content and cloud business models.
  • The 2025 Proposed Regulations would provide long-awaited guidance that bases the sourcing of cloud transactions on specified intangible property, personnel and tangible property costs.
  • Notice 2025-6 requests comments on potentially expanding the application of these rules.
 

On January 14, 2025, the United States (US) Department of Treasury (Treasury) and the Internal Revenue Service (IRS) released guidance addressing the classification and sourcing of digital content and cloud transactions. Specifically, the guidance consists of (i) final regulations on the classification of digital content and cloud transactions and a new sourcing rule for sales of electronically transferred copyrighted articles (T.D. 10022; 2025 Final Regulations), (ii) proposed regulations for sourcing income from cloud transactions (REG-107420-24; 2025 Proposed Regulations); and (iii) Notice 2025-6, which requests comments on potentially expanding these rules beyond their current application to the specifically enumerated international provisions of the Internal Revenue Code (IRC).

The 2025 Final Regulations retain the overall approach of the proposed regulations published on August 14, 2019 (REG-130700-14, 2019 Proposed Regulations) with some revisions (see Tax Alert 2019-1472). The 2025 Final Regulations apply to tax years beginning on or after January 14, 2025. Taxpayers meeting certain requirements may elect to apply all of the rules of the 2025 Final Regulations to tax years beginning on or after August 14, 2019, and all subsequent years.

The 2025 Proposed Regulations would apply to tax years beginning on or after the date the final regulations are published in the Federal Register. Comments on the 2025 Proposed Regulations and Notice 2025-6 are due by April 14, 2025.

Detailed discussion

Background

The 2019 Proposed Regulations reflected Treasury's first significant attempt to create a flexible and coherent framework to resolve a host of complex and dynamic tax issues raised by cloud computing transactions and the digital economy. Coming nearly five years after the 2019 Proposed Regulations, the 2025 Final and Proposed Regulations provide long-awaited guidance addressing questions raised and clarifications requested on several critical issues.

2025 Final Regulations

Digital content and cloud transactions

Consistent with the 2019 Proposed Regulations, the 2025 Final Regulations extend the scope of Treas. Reg. Section 1.861-18 beyond computer software to transactions involving "digital content," which is defined as "a computer program or any other content, such as books, movies and music, in digital format that is (A) protected by copyright law or (B) not protected by copyright law solely (1) due to the passage of time; or (2) because the creator dedicated the content to the public domain."

The 2025 Final Regulations define "cloud transactions" as a transaction through which a person obtains on-demand network access to computer hardware, digital content or other similar resources, but does not include network access for the purpose of downloading digital content for storage and use on a person's computer or other electronic device.

Comparing a digital content transaction with a cloud transaction involving digital content, the Preamble to the 2025 Final Regulations explained that a digital content transaction fundamentally involves a transfer of the digital content to the customer. Further, a digital content transaction generally involves copyright-protected content (with limited exceptions), while a cloud transaction incorporates the catch-all term "other similar resources" to cover beyond digital content.

New "predominant character" test for characterizing transactions with multiple elements

The 2025 Final Regulations contain guidance to determine the characterization of both digital content transactions (in Treas. Reg. Section 1.861-18) and cloud transactions (in Treas. Reg. Section 1.861-19). The tax consequences of a transaction may differ based on whether it is classified as a digital content transaction or a cloud transaction. Moreover, digital content transactions themselves fall into one of four categories: (i) a transfer of a copyright right; (ii) a transfer of a copyrighted article; (iii) the provision of services for the development or modification of digital content; or (iv) the provision of know-how relating to development of digital content.

In reality, transactions are often mixed, containing both cloud and digital content elements, or elements of multiple digital content categories. For characterizing transactions with multiple elements, the 2025 Final Regulations replace a de minimis rule in the 2019 Proposed Regulations and Treas. Reg. Section 1.861-18 with a predominant character rule, which requires a transaction to be characterized entirely as a cloud transaction or as a single-category-of-digital-content transaction.

The predominant character is generally based on the primary benefit or value received by the customer in the transaction. If the primary benefit or value is not reasonably ascertainable, then the taxpayer may rely on data on the primary benefit or value received by a typical customer in a substantially similar transaction. If this data is also unavailable, taxpayers may determine predominant character by examining other factors indicative of the primary benefit or value to a typical customer, such as (i) how the provider markets the transaction; (ii) the relative development cost of each element; or (iii) the relative price paid in an uncontrolled transaction for each of the elements to the total contract price of the transaction.

While required to use reasonable efforts to "identify" data on the primary benefit or value, providers are not required to "develop" any data that they do not otherwise develop in the course of business. This guidance should provide taxpayers with a reasonable level of flexibility in classifying transactions based on available information without requiring new systems to develop information solely for purposes of tax classification.

Moreover, the predominant character rule simplifies characterization by avoiding the bifurcation of a single transaction into multiple elements - a process that could be challenging for taxpayers that do not have reliable data on the precise values of each transaction element. It also removes the challenges for taxpayers to prove that a certain element of the transaction is de minimis under the former de minimis rule, as the proposed rules did not clearly define what constitutes de minimis.

The 2025 Final Regulations illustrate the predominant character rule with an example of a provider that offers access to digital content via streaming or temporary downloads in exchange for a monthly fee. The streamed content requires internet access and is not stored locally on a customer's device, while the temporarily downloaded content is locally stored for one week and can be accessed offline. Although the provider cannot reasonably ascertain the primary benefit or value to its specific customers, data collected indicates that majority of the customers opt for streaming. The example concludes that the predominant character is a cloud transaction (i.e., streaming access) as opposed to transfer of a copyrighted article (i.e., temporary downloads).

New sourcing rule for sales of electronically transferred copyrighted articles

Subject to a new anti-abuse rule, the 2025 Final Regulations source sales of copyrighted articles transferred through an electronic medium based on the purchaser's billing address, rather than the proposed location of download or installation on the end-user's device. The location-of-download-or-installation rule under the 2019 Proposed Regulations raised several practical challenges, including identifying the end-user in a transaction and collecting the relevant location or download data. Determining source using a purchaser's billing address — data often collected in the ordinary course of business — should simplify the sourcing process for many taxpayers.

Moreover, instead of looking to the end user for sourcing purposes (potentially requiring taxpayers to analyze third-party transactions between parties unrelated to the taxpayer), the billing location rule in the 2025 Final Regulations looks exclusively to the billing location of the direct purchaser in the taxpayer's transaction, regardless of whether the purchaser is related or unrelated to the taxpayer (and absent the application of the anti-abuse rule). Limiting sourcing to the purchaser's billing address could significantly impact the foreign-source income outcomes for certain taxpayers, including those selling through domestic intermediaries. For example, consider a taxpayer that sells copyrighted articles to an unrelated purchaser that has a US billing address and then resells the copyrighted article to end users worldwide. Assume the taxpayer collects data on the location of end-user download or installation, and therefore knows that a significant portion of the copyrighted articles are downloaded by end users located outside the US. Under the 2019 Proposed Regulations, the taxpayer could treat a significant portion of its sales as foreign-source income. However, under the 2025 Final Regulations, all of the taxpayer's income from the transaction would be US source because the direct purchaser has a US billing address.

The new anti-abuse rule applies if the transaction is arranged for a principal purpose of tax avoidance and, if applicable, treats the sale as occurring where the substance of the transaction occurred, based on the transaction's relevant facts and circumstances (rather than the purchaser's billing address), such as the place where the copyrighted article is used, the place where negotiations and the execution of the agreement occurred, and the terms of the agreement.

Cloud transactions

In a departure from the 2019 Proposed Regulations characterizing a cloud transaction as either a lease of property or the provision of services, the 2025 Final Regulations classify all cloud transactions as the provision of services. Treasury and the IRS indicated that, consistent with comments received, they could not identify a transaction that would satisfy the definition of a cloud transaction and be properly classified as a lease. While treating all cloud transactions as services provides a measure of certainty, it is unlikely to have a significant impact given taxpayers had generally reached a similar classification conclusion under the 2019 Proposed Regulations.

The 2025 Final Regulations contain additional examples to address common business models and modifications of the examples in the 2019 Proposed Regulations. A new example addresses income earned by a reseller of cloud services, such as software-as-a-service. The example concludes the transaction between the reseller and its customers is a cloud transaction classified as the provision of services. The examples also address cloud transactions that include a download element, as discussed previously with respect to the predominant character rule.

2025 Proposed Regulations

Sourcing rule for gross income from cloud transactions

The 2025 Proposed Regulations address where the "place of performance" occurs for purposes of sourcing gross income from cloud transactions (classified solely as the provision of services). The place of performance would be based on a formula composed of a fraction considering three factors: intangible property (IP), personnel and tangible property, which Treasury and the IRS believe are the key activities contributing to the provision of the cloud transaction. The sum of these three factors would be the fraction's denominator; the fraction's numerator would be determined by summing up the portion of each factor that is from sources within the United States. The gross income from a cloud transaction multiplied by the fraction yields the portion of the gross income that would be US source, with the remaining portion of the gross income treated as foreign source.

Each of the factors would be computed using certain expenses incurred by the taxpayer for the cloud transaction in the tax year. The IP factor would be the sum of (i) the taxpayer's specified research and experimental (R&E) expenses (determined by reference to IRC Section 174(b) and regardless of deductibility) associated with cloud transactions in the same product line; and (ii) deductible amortization and royalty expenses for intangible property directly used to provide the cloud transaction.

The personnel factor would be the total compensation paid to the taxpayer's employees whose primary function is to directly contribute to the provision of the cloud transaction (i.e., performing, supporting, or immediately supervising technical and operational work). The personnel factor would explicitly exclude compensation paid to employees who conduct business strategy, leadership, legal or compliance, marketing, communications, sales, business development, finance, accounting, clerical, human resources or administrative duties. The personnel factor would also exclude compensation paid to R&E personnel whose compensation is included in the IP factor.

The tangible property factor would be the sum of the taxpayer's depreciation and rental expense for owned or leased tangible property directly used to provide the cloud transaction. For purposes of the tangible property factor, depreciation expense would be computed as if the alternative depreciation system (ADS) applied to the tangible property, and without respect to any expensing or accelerated depreciation under IRC Sections 179 or 168(k). Expenses included in a separate factor that contribute to multiple cloud transactions in a tax year would be allocated among those transactions based on a specified allocation key (for example, relative gross income or time spent).

The US-source portion of the IP factor for a cloud transaction would be based on the ratio of (i) the total compensation paid for services performed within the US to employees whose primary function is to perform R&E associated with cloud transactions in the same product line to (ii) total cloud R&E compensation in the product line. Notably, this ratio would also apply to the amortization and royalty expenses that contribute to cloud transactions and are included in the IP factor. In other words, there is no separate rule for establishing the location of amortization or royalty expenses — the ratio of US-based R&E personnel compensation in the same product line would govern the allocation of amortization and royalty expenses regardless of the magnitude of the R&E personnel compensation compared to amortization and royalty expenses. The US-source portion of the personnel and tangible property factors are the amount of that factor paid for services performed in the United States and attributable to property located within the United States, respectively.

The proposed sourcing rule would apply on a taxpayer-by-taxpayer basis and would not take into account the activities and personnel of other related or unrelated persons that contribute to the provision of the service. Consequently, the location of services performed by employees of a party subcontracted by the taxpayer would not be taken into account in determining the portion of cloud income treated as US or foreign source.

The 2025 Proposed Regulations would allow a taxpayer to aggregate substantially similar cloud transactions and source the gross income from those transactions as if they were one transaction, unless the taxpayer knows, or has reason to know, that doing so would materially distort the source of gross income from any cloud transaction. The 2025 Proposed Regulations do not contain guidance on the meaning of "substantially similar" or "materially distort," though the Preamble provides an example that suggests discrete cloud transactions in different product lines can be treated as substantially similar transactions.

A general anti-abuse rule in the 2025 Proposed Regulations would adjust the source of the taxpayer's income to reflect the location where the cloud transaction is performed if the taxpayer has entered into or structured one or more transactions with a principal purpose of reducing its US tax liability in a manner inconsistent with the purpose of the 2025 Proposed Regulations, with the stated purpose being to attribute the source of gross income from a cloud transaction to the place where the transaction is performed.

Notice 2025-6

The 2025 Final Regulations are limited in scope and apply solely to specifically enumerated international provisions of the IRC. The Notice requests comments on (i) the consequences or interactions that would result if the rules in Treas. Reg. Section 1.861-18 and 1.861-19 were to apply to all provisions of the IRC, (ii) possible impacts and guidance that may be necessary, including the suggested approach of the guidance, and (iii) possible impacts and guidance that may be necessary for certain provisions identified in the Notice.

Implications

Changes made by Treasury and the IRS in finalizing the 2025 Final Regulations generally emphasize simplicity and clarity. While that may be welcome news for some taxpayers, others may be surprised to find significant variance in results under the 2025 Final Regulations as compared to the 2019 Proposed Regulations. For example, for the sale of copyrighted articles, taxpayers no longer need to obtain data on the location of download or installation by end users, instead relying on the immediate purchaser's billing address, a data point that may be readily available. However, taxpayers with end users in foreign countries may see significant reductions to their foreign-source income if the purchasers (e.g., resellers or parents of multinational businesses) have US billing addresses.

The predominant character rules answer many questions that arose following the release of the 2019 Proposed Regulations, including the determination of de minimis, the bifurcation of transactions involving digital content transactions and cloud transactions, and classification of transactions with multiple elements above the de minimis threshold. While taxpayers must still evaluate the benefits and value their transactions provide to customers, they now must only determine the primary benefit in order to classify the entire transaction. Furthermore, where data on the actual primary benefit or value received is not reasonably ascertainable for a given transaction, the 2025 Final regulations further minimize the need to develop new systems to capture such data, instead allowing taxpayers to determine transaction classification based on a "typical customer" or other factors indicative of the primary benefit or value received.

For cloud transactions, taxpayers have historically lacked guidance on determining where cloud services are "performed" and how associated cloud transaction income should be sourced. The 2025 Proposed Regulations provide a framework to answer these questions and introduce additional complexity in so doing. Moreover, sourcing cloud services income based on the location of R&E activities appears to be a departure from current law. To estimate the impact of the proposals, taxpayers will need to consider both the availability of data used in the IP, personnel and tangible income factor computations, as well as the qualitative analysis required to match these inputs to the cloud transactions to which they relate.

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Contact Information

For additional information concerning this Alert, please contact:

International Tax and Transaction Services

Published by NTD’s Tax Technical Knowledge Services group; Andrea Ben-Yosef, legal editor

Document ID: 2025-0280