Treasury issues final regulations on digital content, proposes cloud transaction sourcing rules

In brief

What happened?

Today, Treasury and the IRS released final regulations under Section 861 (2025 final regulations) regarding transactions involving “digital content” and certain “cloud transactions”. For this purpose, digital content means a computer program or any other content, such as books, movies, and music, in digital format that is protected by copyright law or no longer so protected solely due to the passage of time or because the creator dedicated the content to the public domain.  A cloud transaction is a transaction through which a person obtains on-demand network access to computer hardware, digital content, or other similar resources. 

The final regulations generally affect taxpayers engaging in digital content or cloud transactions and are effective to taxable years beginning on or after the date they are published in the Federal Register, currently scheduled for January 14, 2025.  

The final regulations generally follow the framework of proposed regulations released in 2019 (2019 proposed regulations) with certain revisions. Some key highlights include: (1) replacing certain de minimis rules with a predominant character rule to characterize transactions with multiple components, (2) using the billing address of the purchaser instead of “place of sale” (or “title passage”) or place of download to source income from sales of copyrighted articles through digital mediums not subject to Section 863(b), and (3) characterizing cloud transactions solely as services transactions by eliminating the multifactor services vs. lease test under the 2019 proposed regulations.  

Treasury and the IRS also released the long-awaited proposed regulations (Proposed Regulations) to determine the source of income generated from cloud transactions to “give taxpayers certainty as well as ensure auditability by the IRS.” The Proposed Regulations generally affect taxpayers who earn gross income from engaging in cloud transactions. Comments are due 90 days after the Proposed Regulations are published in the Federal Register, currently scheduled for January 14, 2025. 

The Proposed Regulations provide a taxpayer-by-taxpayer approach to sourcing income from cloud transactions, which focuses on the economic contributions made by certain intangibles, employees, and assets of the contracting entity to the performance of the cloud transaction. The Proposed Regulations also provide a mathematical formula to determine the source of income earned from a cloud transaction which involves the calculation of three factors: the intangible property factor, the personnel factor, and the tangible property factor. 

Finally, the IRS also issued Notice 2025-6, requesting comments on any potential implications if the characterization rules currently contained in Reg. 1.861-18 and 1.861-19, as amended by the 2025 final regulations, were to apply to all provisions of the Code. The 2025 final regulations apply solely to certain international provisions of the Code, as enumerated in the regulations.   

Why is it relevant?   

The 2025 final regulations finalize Prop. Reg. 1.861-18, thereby expanding the application of computer program income classification rules to other digital content and revising certain existing income characterization rules.  The final regulations also finalize Prop. Reg. 1.861-19 to provide guidance on the characterization of income from transactions involving on-demand network access to computer hardware, digital content, and other similar resources. 

The Proposed Regulations highlight the need for specific rules to determine the source of income from cloud transactions, given the unique nature of these transactions. The Proposed Regulations would apply to tax years beginning on or after the date the final rules are published in the Federal Register. 

Actions to consider

Taxpayers engaging in computer software, other digital content, and cloud transactions should determine the extent to which the 2025 final regulations may affect their business. Taxpayers should consider submitting comments on the Proposed Regulations on the income sourcing rules for cloud transactions.    

See also

Cross-border tax talks: Clarity in the cloud: analyzing the new digital content and cloud computing regulations (October 2019)