The Internal Revenue Service’s proposed regulations on the classification of cloud transactions and transactions involving digital content could mean some unexpected tax bills for some publishers, especially those based abroad who sell copyrighted articles to U.S. readers.
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The part of the proposed regs that’s most likely to generate controversy involves amending section 1.861-18 of the tax code in terms of the rules on sourcing of articles sold online.
“The one thing that may be the most surprising and unanticipated is they gave some guidance in the dash 18 regs on sales of copyrighted articles through a digital medium,” said Joe Calianno, a tax partner and international technical tax practice leader at BDO USA. “There they look at the location of the download or installation on the end user’s device as the focal point. If you can’t get that, then they look at the customer’s location, based on recorded sales data for business or financial reporting purposes. A lot of companies probably weren’t taking that approach to sourcing income related to copyrighted articles. That was something that got a lot of attention when the regs were released.”
He believes that many companies are accustomed to relying on older inventory rules as opposed to the location of the download or installation on the user’s device. “I don’t think that sourcing rule that they included in the dash 18 regs was being applied by most taxpayers,” said Calianno. “It may have been applied by some, but you probably had a number of taxpayers out there who weren’t using that as a sourcing rule for the sale of copyrighted articles through a digital medium. That may come as a surprise to a lot of taxpayers and it could create potential issues for certain taxpayers that may have been sourcing that revenue in a different fashion.”
He is unsure whether it will mean that publishers and distributors of online content will be paying more in taxes. It seems likely that will be the case for foreign publishers who sell to U.S. customers, but it will depend on the taxpayer’s situation.
“You have to look at the particular taxpayer involved to determine the impact on the taxpayer,” said Calianno. “If you’re a foreign person and you have a lot of end users here in the U.S., that could create more U.S. source income. You’d have to analyze it to see if it results in effectively connected income. Those are the kinds of issues taxpayers would have to look at, but it can vary taxpayer to taxpayer.”
Another part of the proposed regulations involving section 1.861-19 of the tax code and cloud computing transactions is more in line with traditional practice and is less likely to provoke controversy. However, Calianno would like to see more clarity in those rules.
“I think a lot of people were looking for guidance in this space because the IRS and Treasury hadn’t really given specific guidance on cloud transactions in the past,” he said. “We had the dash 18 rules, but not specifically addressing cloud transactions. I think that this was a significant development when they issued these regs. The dash 19 regs are generally consistent with what taxpayers were already doing with respect to these transactions, so I don’t think the approach they took in the dash 19 regs was that surprising. They gave the methodology for determining whether it’s a service or a lease, and in most cases they were services.The one area in the dash 19 regs that they didn’t address that I think taxpayers are looking for guidance on is the source of income for cloud transactions, so there’s some uncertainty in this area. They did give the framework, whether it’s going to be a service or lease. In most cases it’s a service, but they didn’t really address the source of the income. Guidance in that area would be welcome.”
