On January 14, 2025, the Department of the Treasury (Treasury) and the Internal Revenue Service (IRS) issued final regulations addressing the classification of transfers of digital content and cloud transactions for purposes of certain international provisions of the Code, including foreign tax credit (FTC) calculations, subpart F, and global intangible low-taxed income (GILTI). The final regulations principally follow proposed rules issued in 2019, with several taxpayer-favorable adjustments. The final regulations apply to taxable years beginning on or after January 14, 2025, although taxpayers may apply to earlier years subject to a consistency requirement for related parties. Concurrently, Treasury and the IRS published proposed regulations for determining the source of income generated from on-demand cloud services transactions. The proposed sourcing rules for cloud transactions would apply a formula to classify gross income from cloud-based transactions as domestic source, based on the proportion of relevant expenditures (intangible property, personnel, and tangible property) incurred in the U.S. The rules are proposed to apply prospectively, after publication of final regulations, and the notice does not invite taxpayers to rely currently on the proposed rulemaking. 

Final Regulations Addressing Transfers of Digital Content and Cloud Transactions

The 2019 proposed regulations offered classification rules for common transactions involving software with the applicable sourcing rule dependent on whether the transaction was characterized as a sale of the digital content, a lease or license of digital content, or on-demand network access to digital content or similar resources. The 2019 proposed regulations would have required taxpayers to bifurcate transactions involving the transfer of digital content and cloud services — such as the purchase of a downloadable video game played online — unless a particular component represented only a de minimis portion of the transaction. In response to comments, the final regulations replaced the bifurcation approach with a predominant character rule. Transactions involving both online and offline functionality are characterized entirely based on the primary benefit or value received by the customer. If the primary value to a specific customer is not readily ascertainable, the regulations permit reliance on how a typical customer uses or accesses the digital content. If that data is not available, then the final regulations offer a non-exhaustive list of factors for determining the primary value, such as how the content is marketed, the development costs, and the price of components to third parties. Taxpayers are not required to develop new data to determine the predominant character of any transaction. In addition, the final regulations treat all cloud transactions as services, removing the proposed requirement to analyze cloud transactions under section 7701(e), recognizing that neither the IRS nor taxpayers could identify a cloud transaction that would be appropriately classified as a lease. 

The final regulations also modified the sourcing rule for sales of digital content. Instead of looking to the location where the digital content is downloaded or installed, taxpayers may rely on the location of the billing address of the purchaser. The rule does not distinguish between sales to related and unrelated parties, does not apply to inventory sourced under section 863(b), and is subject to an anti-abuse rule. 

Concurrent with the final regulations, Treasury and the IRS published Notice 2025-6, requesting comments on the desirability and effects, if any, of extending the characterization rules for transfer of digital content and cloud computing to apply for all purposes of the Code. The Notice highlights that Treasury and the IRS are particularly interested on the impact the classification rules may have on tax accounting rules, definitions of capital assets, determinations of gain, and adjusted basis. 

Proposed Regulations for Sourcing of Cloud Transactions

In general, income from services is sourced to the location where the services are performed. For cloud transactions, Treasury and the IRS proposed a formulaic rule to determine the amount of U.S. source services income from a cloud transaction, based on the relative proportion of relevant assets and personnel located in the United States. Specifically, the U.S. source portion of cloud services income is based on the ratio of relevant U.S. costs (U.S. intangible property, U.S. personnel, and U.S. tangible property), over relevant worldwide costs (total intangible property, personnel, and tangible property).

For this purpose, intangible property includes the costs of specified research or experimental expenditures, amortization, and royalties associated with the cloud transaction. Specified research or experimental expenditures, as defined in section 174(b), include those provided in that taxable year (regardless of whether and when the expenses are deductible) that are in the same product line as the cloud transaction, allocated, if necessary, among multiple cloud transactions. The location of the costs included in the intangible property calculation is based on the location of the employees performing the research and experimentation activities. Personnel costs are defined as the total compensation of employees who primarily perform technical or operational activities related to the provision of the cloud services. Tangible property is composed of the depreciation expense and rental expense of tangible property, to the extent such property is directly used to provide the cloud transaction. Depreciation expenses for these purposes are determined by dividing the tangible property's adjusted depreciable basis by the applicable recovery period under the section 168(g)(2) alternative depreciation system, without regard to bonus depreciation. 

Treasury and the IRS intend that the sourcing rule be practical and administrable and have requested comments specifically on their approach to intangible property costs, whether rules for resellers are needed, and what additional operating costs should be considered. Comments on the proposed regulations are due April 14, 2025. 

For more information, please contact:

Jeffrey M. Tebbs, jtebbs@milchev.com, 202-626-1480

Caroline R. Reaves, creaves@milchev.com, 202-626-5939

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