On January 10, 2025, the Treasury Department and IRS released a comprehensive package of guidance addressing the classification and sourcing of digital content and cloud transactions.

The package consists of:

• Final regulations addressing the classification of digital content and cloud transactions (TD 10022)
• Proposed regulations with rules for sourcing income from cloud transactions (REG-107420-24)
• A request for comments on potentially expanding these rules beyond their current application to international provisions (Notice 2025-6)

Final regulations: The final regulations retain the overall approach of the proposed regulations with some revisions (see Tax Alert 2019-1472). Revisions include replacing the proposed de minimis rule with a new "predominant character" rule for characterizing transactions with multiple elements. This “predominant character” rule applies to both digital content transactions and cloud transactions. The predominant character is determined by the primary benefit or value received by the customer.

The final regulations also adopt a new sourcing rule for sales of copyrighted articles, under which sales of electronically transferred copyrighted articles are sourced based on the customer's billing address, rather than the previously proposed location of download or installation on the end-user’s device.  If the sales transaction is arranged for a principal purpose of tax avoidance, however, a new anti-abuse rule treats the sale as having occurred where the substance of the transaction occurred based on the transaction’s facts and circumstances (rather than the customer’s billing address). A sourcing rule for licenses or leases of digital content is not included. 

Other changes in the final regulations include treating all cloud transactions solely as the provision of services (rather than characterizing them as either a lease of property or the provision of services, as provided by the proposed regulations). To illustrate the proper treatment of different types of digital content transactions and cloud transactions, the final regulations include an extensive list of examples.

The final regulations apply to tax years beginning on or after the date the regulations are published in the Federal Register. Taxpayers meeting certain requirements may elect to apply all of the rules of the final regulations to tax years beginning on or after August 14, 2019, and all subsequent years. 

Proposed regulations: The proposed regulations would propose rules for determining the source of income from cloud transactions for purposes of the international provisions of the Internal Revenue Code. Specifically, the proposed regulations would source gross income from a cloud transaction as services income, according to where the service is performed. The place of performance would be based on a formula composed of a fraction considering three factors:

• Intangible property (based on R&D, royalty, and certain amortization expenses)
• Personnel (based on compensation of staff who contribute to cloud transactions)
• Tangible property (based on depreciation/rental of cloud infrastructure)

These three factors make up the denominator of the fraction; the numerator of the faction is 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 is US source; the remaining portion of the gross income is foreign source. As the proposed sourcing rules would apply on a taxpayer-by-taxpayer basis, they would not take into account the activities and personnel of other related legal entities that contribute to the provision of the service.

The 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. A general anti-abuse rule in the 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 proposed regulations.

The proposed sourcing rules would apply to tax years beginning on or after the date the regulations are published in the Federal Register.

A detailed Tax Alert on the guidance package is forthcoming.