Tech Groups Want Help to Avoid Cloud Transaction Tax Hit

Business groups and tech giants want the IRS to clarify new cloud computing tax rules and ensure companies won’t take an unexpected tax hit.

Microsoft Corp. and tech groups including the Electronic Software Association, Information Technology Industry Council, and Software Coalition have signed up to speak at a Tuesday IRS hearing on regulations the agency proposed in August.

The proposed rules (REG-130700-14), under tax code Section 861, are largely consistent with how companies have interpreted outdated guidance from 1998, companies and organizations have told the IRS. But questions remain over how transactions are classified and income is sourced. Companies are concerned that without more certainty the rules could force them to withhold tax or affect how income tax and tax credits are calculated.

“The key thing for taxpayers is certainty and ability to file returns with confidence,” said Carol Tello, a partner at Eversheds Sutherland in Washington. She worked on the 861 regulations in 1996.

Cloud computing, defined by the IRS as “on-demand network access,” allows buyers to use a network of remote servers hosted on the internet to store, manage, and process digital content and data. Those products are becoming increasingly lucrative for software giants like Microsoft, Alphabet Inc.'s Google, Amazon.com Inc., Netflix Inc., Spotify Technology SA, and Apple Inc.

Microsoft told investors Jan. 29 that it made $11.9 billion of revenue from the “intelligent cloud” business. Amazon said in a Jan. 31 Securities and Exchange Commission filing that it would continue to invest in growing its Amazon Web Services platform, which increased sales by 37% in 2019.

Here are issues that tax practitioners are watching.

Sourcing Rules

The proposed rules substantially modify regulations Section 861-18, to source the sale to the location of the download or installation onto the end-user’s device. Microsoft said it would address this proposed change at the IRS hearing.

Under the proposed rules, if a transaction is classified as a sale of a copyrighted article, the location of the end-user controls the sourcing of the income. That means if a foreign company sells software that is downloaded to a customer in the U.S., that income will be sourced to the U.S.

“Source of Income is the most significant domestic law consequence,” Gary Sprague, a tax law partner at Baker McKenzie LLP who is speaking on behalf of the Software Coalition, said.

For companies based in countries that don’t have tax treaties with the U.S., it would potentially subject them to U.S. taxation and reporting requirements, Tello said.

Lease vs. Service

The proposed rules also introduced regulations Section 861-19, which guides companies in determining whether to classify their cloud transactions and digital content access as a provision of services or a lease of property—an important distinction that affects other areas of tax law.

“Just like the -18 regulations had significant influence outside the U.S., we hope that the -19 regulations will be similarly influential outside the U.S., because there are very few countries with guidance on the characterization of cloud computing transactions and we very much want to establish the nature as a nonwithhold-able service fee,” Sprague said.

Sprague said some companies are concerned about the characterization because, depending on the nature of a transaction, it could interact with other code sections and result in a withholding tax on gross revenue.

Copyright Definition

The -18 proposed rules define “digital content” as computer programs, audiobooks, movies, and music that are currently copyrighted or no longer protected by copyright because of the passage of time.

But cloud transactions have expanded over time to include the sale of other types of digital content.

Treasury officials have asked practitioners to submit ideas on how to test for which types of content should be covered by the rules.

“When we heard that Treasury was issuing a project on cloud services, we thought that was a really good step to give guidance,” Sprague said.