[Federal Register Volume 90, Number 8 (Tuesday, January 14, 2025)]
[Proposed Rules]
[Pages 3075-3085]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2024-31373]
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DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Part 1
[REG-107420-24]
RIN 1545-BR21
Source of Income From Cloud Transactions
AGENCY: Internal Revenue Service (IRS), Treasury.
ACTION: Notice of proposed rulemaking.
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SUMMARY: This document contains proposed rules for determining the
source of income from cloud transactions for purposes of the
international provisions of the Internal Revenue Code. These proposed
rules would generally affect taxpayers who earn gross income from
engaging in cloud transactions.
DATES: Written or electronic comments and requests for a public hearing
must be received by April 14, 2025.
ADDRESSES: Commenters are strongly encouraged to submit public comments
electronically. Submit electronic submissions via the Federal
eRulemaking Portal at www.regulations.gov (indicate IRS and REG-107420-
24) by following the online instructions for submitting comments.
Requests for a public hearing must be submitted as prescribed in the
``Comments and Requests for a Public Hearing'' section. Once submitted
to the Federal eRulemaking Portal, comments cannot be edited or
withdrawn. The Department of the Treasury (Treasury Department) and the
IRS will publish for public availability any comment received to its
public docket, whether submitted electronically or in hard copy. Send
hard copy submissions to: CC:PA:01:PR (REG-107420-24), Room 5203,
Internal Revenue Service, P.O. Box 7604, Ben Franklin Station,
Washington, DC 20044. Submissions may be hand-delivered Monday through
Friday between the hours of 8 a.m. and 4 p.m. to: CC:PA:01:PR (REG-
107420-24), Courier's Desk, Internal Revenue Service, 1111 Constitution
Avenue NW, Washington, DC 20224.
FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations,
Christopher E. Fulle at (202) 317-5367 or Michelle L. Ng at (202) 317-
6989 (not toll-free numbers); concerning submissions of comments and
requests for a public hearing, contact the Publications and Regulations
branch at (202) 317-6901 (not a toll-free number) or by email to
[email protected] (preferred).
SUPPLEMENTARY INFORMATION:
Authority
The proposed regulations are issued under the express delegation of
authority under section 7805 of the Internal Revenue Code (Code).
Section 7805(a) directs the Secretary of the Treasury or her delegate
to prescribe all needful rules and regulations for the enforcement of
that section and others in the Code, including all rules and
regulations as may be necessary by reason of any alteration of law in
relation to internal revenue.
Background
Proposed regulations published in the Federal Register (84 FR
40317) in 2019 (REG-130700-14) (the 2019 proposed regulations) set
forth proposed rules for identifying and classifying cloud
transactions, and the preamble to the 2019 proposed regulations
requested
[[Page 3076]]
comments on rules for sourcing income from cloud transactions. Comments
received addressed the necessity of developing specific rules for
sourcing gross income from cloud transactions and provided
recommendations on the content of such rules. This notice of proposed
rulemaking, which is being published with the final regulations for
identifying and classifying cloud transactions (TD 10022) (the 2024
final regulations) that are being published in the Final Rules section
of this same issue of the Federal Register, proposes rules for sourcing
gross income from cloud transactions.
Explanation of Provisions
I. Source of Gross Income From Cloud Transactions
A. Overview of Comments Received
The Treasury Department and the IRS received more than a dozen
comments in response to the request for comments on administrable rules
for sourcing income from cloud transactions in a manner consistent with
sections 861 through 865. Comments were split almost evenly with regard
to whether specific sourcing rules are needed in this area, with a
narrow majority expressing support for such guidance. Of this majority,
several comments recommended that services income from cloud
transactions be sourced according to the location of the assets and
personnel used in providing the service. A number of these comments
explained that this approach would align with the result in Piedras
Negras Broadcasting Co. v. Comm'r, 43 B.T.A. 297 (1941), nonacq., 1941-
2 C.B. 22, aff'd, 127 F. 2d. 260 (5th Cir. 1942), in which the income
of a radio broadcasting corporation was determined to be foreign source
because its broadcasting facilities and employees were located in
Mexico, even though the corporation broadcasted programs primarily to
listeners located in the United States and received almost all of its
income from advertisers located in the United States. Other comments
voiced the need for specific rules for sourcing income from cloud
transactions, but did not recommend a particular sourcing approach,
with one comment suggesting that the location of the cloud service
provider's assets and personnel and the location of the end-user could
be evaluated in developing the rules. Another comment proposed that
given the challenges of sourcing cloud transactions when the
operations, employees, and customers are dispersed, the sourcing rules
could provide taxpayers with the option to source the income to the
place where the contract is executed. While almost half of the comments
received stated that regulations for sourcing income from cloud
transactions are unnecessary because existing statutory, regulatory,
and case law provides sufficient guidance, an overwhelming majority of
those comments recommended that if issued, the regulations should take
into account the location of the assets and people that contribute to
the delivery of the cloud service.
Many of the comments discussed whether the sourcing determination
should be made by taking into account solely the assets and personnel
of the taxpayer that recognizes the income from the performance of the
cloud service (the taxpayer-by-taxpayer approach), or whether taxpayers
should be required to look through to the activities and personnel of
other related legal entities that contribute to the provision of the
service (the unitary approach). Nearly all comments on this issue
stated that income from cloud transactions should be sourced on a
taxpayer-by-taxpayer basis. Comments explained that the taxpayer-by-
taxpayer approach is administrable and supported by the principles of
Miller v. Comm'r, 73 T.C.M. 2319 (1997), aff'd without published
decision, 166 F.3d 1218 (9th Cir. 1998), in which income that a foreign
corporation received for performing research and development services
was held to be foreign source notwithstanding that the performance of
those services was subcontracted to certain related and unrelated
entities, including a wholly-owned U.S. subsidiary. One comment
suggested that a taxpayer-by-taxpayer rule for sourcing services income
from cloud transactions could be supplemented with anti-abuse
provisions requiring the income to be sourced on a look-through or
unitary basis in limited circumstances. However, another comment
asserted that sourcing services income from cloud transactions on a
look-through or unitary basis should be required, explaining that this
approach more accurately reflects the economic realities of the
transaction because it accounts for the contributions made by members
of the multinational group to the provision of the service. That
comment also expressed the concern that sourcing on a taxpayer-by-
taxpayer basis could cause U.S. source income to be understated with
respect to commonly-used structures in which the development,
enhancement, maintenance, protection, and exploitation functions are
performed primarily by U.S. entities but the services income is
recorded by a foreign entity that contracts directly with the end-users
to whom the cloud transaction is provided.
B. Need for Proposed Regulations
The development and advancement of cloud technologies has
transformed both the value that businesses deliver to customers and the
way that value is delivered, giving rise to cloud-based business models
and cloud transactions. The 2024 final regulations classify a cloud
transaction (within the definition of Sec. 1.861-19(b)) as the
provision of services. See Sec. 1.861-19(c)(1). Under the source rules
of the Code, which were designed in the context of more traditional
modes of commerce, gross income from the provision of services is
sourced to the place where the service is performed. See sections
861(a)(3) and 862(a)(3). The Code does not provide guidance on how to
determine the place of performance for specific types of service
transactions, including cloud transactions. Further, while section
863(b)(1) specifies that income from services rendered partly within
and partly without the United States is treated as derived partly from
each source, there is no statutory guidance prescribing how to source
the services income, including income from cloud transactions, in such
circumstances. The distinctive attributes of cloud transactions,
including the network-based and increasingly automated nature of the
service delivery and the role of intangible property (such as
proprietary software and other proprietary digital content) in ensuring
the functionality, reliability, and performance of the service, raise
questions regarding how to determine the place of performance of a
cloud transaction.
The proposed regulations, which would establish specific sourcing
rules that interpret the place of performance in the context of a cloud
transaction, are therefore necessary to provide clarity and certainty
to both taxpayers and the IRS. To determine the place of performance,
the proposed sourcing rules would take into account the location of the
employees and assets, including both tangible and intangible assets,
that contribute to the provision of the cloud transaction. The Treasury
Department and the IRS are of the view that, because of the technical
nature of a cloud transaction, the place of performance for purposes of
sourcing gross income is the place where the resources and personnel
responsible for the development, management, and delivery of the
service are located because this is where the key activities in the
provision of the service occur, as
[[Page 3077]]
opposed to ancillary activities such as marketing, sales, and
contracting. This approach is consistent with case law on the sourcing
of income involving analogous traditional business models where
services are provided from a location that differs from the customers'
location, specifically, the Piedras Negras case. See 43 BTA at 297,
aff'd, 127 F.2d at 260. In line with the approach in Piedras Negras,
the proposed rules do not consider the location of the customer or end-
user, as it merely reflects the place where the service is consumed,
not where the performance actually takes place as prescribed by
sections 861(a)(3) and 862(a)(3). Similarly, the location where a
contract for a cloud transaction is executed should not dictate the
source of the resulting gross income because that location may not bear
any connection to where the service is performed.
The proposed cloud transaction sourcing rules would apply on a
taxpayer-by-taxpayer basis and therefore, in determining the gross
income of an entity that recognizes the services income, would take
into account solely the assets and personnel of the legal entity. The
Treasury Department and the IRS agree that this approach is
administrable and practical. By focusing on the economic contributions
that the contracting entity makes to the performance of the cloud
transaction, the taxpayer-by-taxpayer approach provides a clear,
straightforward way of determining the source of gross income from the
transaction, while allowing for appropriate deductions from that gross
income in respect of amounts paid or accrued to affiliated or
unaffiliated contributors to the provision of the cloud services,
leading to reduced complexity in tax compliance and enforcement. This
approach is also generally consistent with the current approach for
sourcing other categories of income, including non-cloud services
income such as gross income from certain sales of inventory that is
sourced to the location of production activity under Sec. 1.863-
3(c)(1)(ii). Further, this approach would not impede the IRS's ability
to assert common law principles, such as the economic substance
doctrine, the step transaction doctrine, and the rules of agency, or
existing statutory and regulatory provisions, such as the section 482
rules, to ensure that the Federal income tax consequences more properly
reflect the economic realities of the transaction, including the
contributions to a cloud transaction made by affiliates of the
taxpayer. Notwithstanding the above, the Treasury Department and the
IRS will continue to study the implications of applying the taxpayer-
by-taxpayer approach in the context of sourcing gross income from
services generally, and may refine or propose revisions to the approach
if they determine that this is necessary to adequately account for the
interdependencies and collaboration across entities in a multinational
group, and consequently, to ensure a fair and accurate representation
of where services are performed.
C. Explanation of Proposed Rules for Sourcing Gross Income From Cloud
Transactions
The proposed regulations state that gross income from a cloud
transaction is sourced as services income under section 861(a)(3) or
862(a)(3), as appropriate, according to where the service is performed.
Proposed Sec. 1.861-19(d)(1). The place of performance of a cloud
transaction is established through a formula composed of a fraction
that relies on three factors: the intangible property factor, the
personnel factor, and the tangible property factor (within the meaning
of proposed Sec. 1.861-19(d)(2), (d)(3), and (d)(4), respectively).
Id.
As discussed in detail in Parts I.C.1 through 3 of this Explanation
of Provisions, the intangible property factor is intended to reflect
the contribution of intangible property to the provision of the cloud
transaction; the personnel factor is intended to reflect the
contribution of certain employees to the provision of the cloud
transaction; and the tangible property factor is intended to reflect
the contribution of tangible property to the provision of the cloud
transaction. Each factor is determined by taking into account certain
worldwide expenses by the entity that, in the view of the Treasury
Department and the IRS, properly represent the contributions made by or
through the relevant personnel and assets to the performance of the
cloud transaction. Together, these factors make up the denominator of
the fraction. The numerator of the fraction is determined by summing up
the portion of each factor that is from sources within the United
States.
Under the proposed regulations, the gross income from a cloud
transaction multiplied by the fraction yields the portion of the gross
income that is from sources within the United States. Proposed Sec.
1.861-19(d)(1). The portion of the gross income that remains is gross
income from sources without the United States. Id.
1. Intangible Property Factor
a. Determination of the Intangible Property Factor
The Treasury Department and the IRS consider intangible property to
be a significant contributor to the performance of cloud transactions.
Intangible property, such as software, algorithms, data processing
applications, and other proprietary technologies, often plays a crucial
role in the performance of a cloud transaction, including by shaping
the unique features of the service and ensuring the service's
functionality, reliability, and delivery. This role of intangible
property is becoming particularly important as cloud transactions are
becoming increasingly automated, requiring less and less contribution
from personnel and tangible property to deliver value to customers. In
such cases, the intangible property itself may be the main force that
is effectively performing the service. It would be difficult and
burdensome, however, to ascertain the precise value or contribution of
an item of intangible property to the performance of a cloud
transaction given the challenges inherent in isolating the specific
impact of various intangibles on the cloud transaction's overall
performance. The Treasury Department and the IRS are of the view that
certain research and experimental expenses, amortization, and royalties
incurred during the taxable year in which the cloud transaction is
performed could serve as an administrable proxy for reflecting the
contribution of intangible property to the performance of the cloud
transaction. These expenses serve as the foundation for the intangible
property factor.
Specifically, the intangible property factor is the sum of
specified research or experimental expenditures (as defined under
section 174(b)) incurred during the taxable year that are associated
with the cloud transaction as well as royalty and certain amortization
expenses incurred during the taxable year to the extent they are for
intangible property directly used to provide the cloud transaction
(collectively, ``intangible property costs''). Proposed Sec. 1.861-
19(d)(2)(i). Intangible property costs include payments to third-party
and related-party research and experimentation providers. Because
specified research or experimental expenditures are used as a proxy for
current use of existing self-developed intangible property, those
expenditures are taken into account as they are incurred, regardless of
whether and
[[Page 3078]]
when they are deductible, in order to match the timing of when
compensation is paid to employees performing research or
experimentation activities. As discussed in Part I.C.1.b. of this
Explanation of Provisions, the intangible property factor is sourced
based on this compensation; therefore the Treasury Department and the
IRS are of the view that taking the specified research or experimental
expenditures in the year when incurred provides an administrable rule
that recognizes the economic contribution of the intangible property
and avoids taxpayers having to trace section 174(a)(2)(B) amortization
deductions back to the year in which incurred. However, royalty and
amortization expenses are taken into account for the intangible
property factor when deductible because that is the most administrable
proxy for measuring the economic contribution existing licensed or
acquired intangible property makes to a cloud transaction.
In computing the intangible property factor, the Treasury
Department and the IRS recognize that some specified research or
experimental expenditures may not be directly traceable to a single
transaction because intangible property developed through research and
experimentation conducted in a taxable year may not be monetized in
cloud transactions until a future year. In light of this, and
consistent with the approach taken for allocating and apportioning
deductions for such expenditures, the proposed regulations provide that
the specified research or experimental expenditures to be taken into
account with respect to a cloud transaction from which the gross income
is being sourced are those associated with all cloud transactions
provided in that taxable year that are in the same product line as the
cloud transaction. Id.; cf. Sec. 1.861-17(b) (recognizing that
research and experimentation is an inherently speculative activity,
which when successful ultimately results in the creation of intangible
income, and allocating expenditures for such activity to gross
intangible income earned in the year of the expenditure). The Treasury
Department and the IRS are of the view that the current-year approach
in the proposed rules serves as a workable, reliable, and appropriate
proxy for existing intangible property in the same product line. Under
the proposed regulations, cloud transactions are considered to be in
the same product line if they are within the same Corresponding Index
Entry under a North American Industry Classification System (NAICS)
code number. Proposed Sec. 1.861-19(d)(8). The proposed regulations
also include a consistency requirement to prevent taxpayers from
changing Corresponding Index Entry and NAICS code numbers absent a
change in facts. Id. The intangible property factor focuses on work
done in the same product line as the cloud transaction to balance
between specificity and practicality. The factor aims to capture the
contribution of intangible property to the performance of a cloud
transaction, so a factual relationship between the specified research
or experimentation expenditures and the cloud transaction being tested
needs to exist. At the same time, the Treasury Department and the IRS
are aware that it is not necessarily possible to precisely determine
the product or products that will benefit from a research and
experimentation process at an early stage. To prevent duplication, the
proposed regulations require expenses that would be included in the
intangible property factor for multiple cloud transactions in a taxable
year to be allocated among those transactions (taking into account the
aggregation rule described in Part I.C.4 of this Explanation of
Provisions) based on the relative gross income earned from each
transaction. Proposed Sec. 1.861-19(d)(2)(i). Any intangible property
costs that support cloud transactions in general but that do not relate
to any specific cloud transaction should be allocated in the same
manner.
b. Determination of the Portion of the Intangible Property Factor From
U.S. Sources
Once the intangible property factor is determined, the portion of
this factor that is attributable to sources within the United States
must be identified for inclusion in the numerator. Given the non-
physical nature of intangible property, its location when used in
providing a service may be challenging to ascertain. Under the proposed
rules, the portion of the intangible property factor that is from
sources within the United States is determined based on the extent to
which certain of the taxpayer's employees perform services in the
United States, determined by leveraging the principles of Sec. 1.861-
4(b)(2)(ii)(E) (relating to sourcing compensation from labor or
personal services on a time basis). The employees considered for this
purpose are those whose primary function is to perform research and
experimentation activities associated with cloud transactions in the
same product line as the cloud transaction the gross income of which is
being sourced. Proposed Sec. 1.861-19(d)(2)(ii). The proposed
regulations provide that the employee's primary function is the set of
tasks to which they are assigned to spend the majority of their working
time. Proposed Sec. 1.861-19(d)(5). In order to account for amounts
paid to third-party research and experimentation providers,
amortization, and royalties, the fraction determined by the
compensation that has been paid to the research and experimentation
personnel is applied to the total research and experimental expense
determined under Sec. 1.861-19(d)(2)(i). See proposed Sec. 1.861-
19(d)(2)(ii).
The Treasury Department and the IRS are of the view that the
location of research and experimentation personnel is a logical and
accurate proxy for the location of intangible property that contributes
to the performance of a cloud transactions for a number of reasons.
First, the research and experimentation personnel contribute to the
creation, design, and refinement of the intangible property either
through their own efforts or by managing and facilitating research and
experimentation work carried out by third parties. Therefore, the value
of the intangible property used to provide the cloud transaction
depends on their personal efforts and expertise. Additionally, while
intangible property does not have a physical form that can be easily
located, the place where research and experimentation personnel operate
is tangible and verifiable. Relatedly, taxpayers generally know or
should know the location of their research and experimentation
personnel, and thus, relying on the location of these personnel would
avoid a burdensome compliance process that might otherwise be required
to determine the location of intangible property used to provide cloud
transactions. For similar reasons, in determining gross income of a
taxpayer, the rule does not look to research and experimentation
personnel other than those of the taxpayer, and uses the taxpayer's own
personnel as a proxy for all research and experimentation personnel
working on the relevant intangible property.
The determination of which research and experimentation employees
should be taken into account focuses on the employees whose primary
function is the performance of research and experimentation activities,
without limiting the analysis to nonmanagerial employees or first-line
managers who undertake these activities. This is because research and
experimentation typically involves contributions from personnel across
various levels of the organization, including senior
[[Page 3079]]
leadership and technical staff, as an idea for a product or service
moves from concept to design, implementation, and testing. Accordingly,
focusing solely on nonmanagerial employees or first-line managers could
result in missing key contributors to the research and experimentation
activities associated with a cloud transaction, including individuals
within the organizational structure who oversee or engage in higher-
level experimentation efforts.
2. Personnel Factor
a. Determination of the Personnel Factor and the Portion From U.S.
Sources
The Treasury Department and the IRS are of the view that while the
underlying technology and infrastructure are important in providing a
cloud transaction to customers, the employees who manage, operate, and
maintain these systems are also fundamental to the provision of the
service. Accordingly, the efforts of personnel employed by the taxpayer
who directly contribute to the provision of the cloud transaction must
be taken into account in sourcing gross income from that cloud
transaction. To properly reflect the contribution of these personnel to
the provision of the cloud transaction, the personnel factor is
composed of the compensation paid to the taxpayer's employees whose
primary function is to directly contribute to the provision of the
cloud transaction. See proposed Sec. 1.861-19(d)(3)(i). However, to
avoid double counting income, compensation that is paid to research and
experimentation personnel described in proposed Sec. 1.861-19(d)(2) is
excluded. Id.
As explained in Part I.C.1.b of this Explanation of Provisions, an
employee's primary function is the set of tasks to which they are
assigned to spend the majority of their working time. Proposed Sec.
1.861-19(d)(5). The proposed regulations provide a rule to account for
situations in which an employee's primary function is to directly
contribute to more than one cloud transaction. In those cases, all of
the employee's compensation must be allocated among those cloud
transactions based on the relative amount of time the employee spends
contributing to each transaction. Proposed Sec. 1.861-19(d)(3)(i). To
illustrate the application of these rules, if an employee spends 30
percent of their working time on Cloud Transaction 1, 30 percent of
their working time on Cloud Transaction 2, and 40 percent of their
working time not on cloud transactions, that employee's primary
function would be working on cloud transactions because a majority of
their working time (60 percent) is spent on cloud transactions.
Consequently, all of this employee's compensation would be allocated
among Cloud Transaction 1 and Cloud Transaction 2 based on the relative
amount of time the employee spends contributing to each of the two
cloud transactions. However, where an employee contributes to multiple
cloud transactions simultaneously, their compensation must be allocated
among those transactions based on the relative gross income earned from
each transaction because it would be impossible to use a time-based
allocation in such cases. Id.
Similar to the determination of the numerator of the intangible
property factor, which is the portion of that factor from sources
within the United States, the proposed regulations provide the
numerator of the personnel factor, which is the portion of that factor
from sources within the United States, is equal to the part of the
personnel factor that is paid for services performed in the United
States using the principles of Sec. 1.861-4(b)(2)(ii)(E). Proposed
Sec. 1.861-19(d)(3)(ii).
b. Direct Contribution to the Provision of the Cloud Transaction
The proposed regulations set forth rules that define which
employees are considered to directly contribute to the provision of the
cloud transaction and which employees are not considered to do so.
Under proposed Sec. 1.861-19(d)(3)(iii), personnel directly contribute
to the provision of a cloud transaction to the extent they personally
perform technical or operational activities for the provision of the
cloud transaction, or to the extent they are managers who directly
support or immediately supervise such technical or operational
personnel. Proposed Sec. 1.861-19(d)(3)(iii) provides a non-exhaustive
list of the functions that fall within the meaning of ``technical and
operational activities.'' These functions are the conduct of
scientific, engineering, or technical activities for the configuration,
delivery, or maintenance of the cloud transaction; the provision of
monitoring, diagnostics, or incident response with respect to the cloud
transaction's performance, reliability, efficiency, or security; the
management of the cloud transaction's infrastructure; the delivery of
end-user support with respect to the cloud transaction; and the conduct
of any similar functions. Id. Further, under proposed Sec. 1.861-
19(d)(3)(iv), personnel are not considered to directly contribute to
the provision of the cloud transaction to the extent they conduct
business strategy, leadership, legal or compliance, marketing,
communications, sales, business development, finance, accounting,
clerical, human resources or administrative duties, or similar
functions.
Proposed Sec. 1.861-19(d)(3)(iii) and (iv) are intended to
identify the individuals that generally have the hands-on, day-to-day
involvement in the software, infrastructure, and processes that enable
the cloud transaction to be provided to the customer and to function as
intended. The Treasury Department and the IRS are of the view that the
individuals who personally perform the technical and operational work
and the immediate managers who direct and supervise that work are
essential to the performance of the service, and therefore, their
contributions must be included. By contrast, employees in higher-level
management or executive positions who are responsible for setting the
strategic direction of the business and making high-level decisions are
too far removed from the hands-on, day-to-day work that ensures the
delivery of any particular cloud transaction to the customer.
Therefore, while their roles are important to the overall business,
they do not directly contribute to the provision of the transaction
itself and are not accounted for as part of the personnel factor. The
Treasury Department and the IRS are of the view that this distinction
properly interprets the statutory requirement to source gross income
from a service to the place where the service is performed.
3. Tangible Property Factor
a. Determination of the Tangible Property Factor and the Portion From
U.S. Sources
Cloud transactions depend on physical infrastructure and hardware,
such as servers and networking equipment. For this reason, the Treasury
Department and the IRS are of the view that tangible property that
directly supports the provision of a cloud transaction must be taken
into account in determining the source of gross income from a cloud
transaction. Under the proposed regulations, the tangible property
factor, which is intended to represent the contribution of the tangible
property to the performance of the cloud transaction, is the sum of the
depreciation and rental expense for the taxable year for tangible
property owned or leased by the taxpayer, to the extent the property is
directly used to provide the cloud transaction. See proposed Sec.
1.861-19(d)(4)(i). To eliminate double counting, the proposed
regulations
[[Page 3080]]
require any depreciation or rental expense that would be included in
the tangible property factor for multiple cloud transactions in a
taxable year to be allocated among those transactions based on the
relative gross income earned from each transaction. The portion of the
tangible property factor that is from sources within the United States
and comprises the numerator is equal to the part of the tangible
property factor attributable to property located within the United
States.
b. Determination of the Depreciation Expense
For purposes of computing the tangible property factor,
depreciation expense for a taxable year is determined by dividing the
adjusted depreciable basis (as defined in Sec. 1.168(b)-1(a)(4)) of
the tangible property by the applicable recovery period as though the
alternative depreciation system in section 168(g)(2) applied for the
entire period the property has been in service. Proposed Sec. 1.861-
19(d)(4)(iii). The Treasury Department and the IRS are of the view that
the determination must be made without taking into account tax
incentives intended to accelerate the recovery of costs in order to
provide an allocation of depreciation that more closely reflects the
asset's actual economic life. Thus, the proposed regulations explicitly
state that the depreciation expense is computed without regard to the
election to expense certain depreciable property under section 179 and
without regard to any additional first-year depreciation provision (for
example, section 168(k)).
4. Aggregation Rule
The proposed regulations include an aggregation rule, set forth in
proposed Sec. 1.861-19(d)(7), that is intended to enhance the
administrability of these regulations and to alleviate the compliance
burden on taxpayers associated with the regulations. The rule allows a
taxpayer to aggregate substantially similar cloud transactions and
source the gross income from those transactions as if they were one
transaction. However, the rule also prohibits a taxpayer from
aggregating substantially similar cloud transactions if the taxpayer
knows, or has reason to know, that doing so would materially distort
the source of gross income from any cloud transaction.
For example, assume a cloud provider offers two distinct but
substantially similar cloud transactions, Service 1 and Service 2, that
are not in the same product line (within the meaning of proposed Sec.
1.861-19(d)(8)). Further, assume the cloud provider incurs
significantly more research and experimentation costs associated with
Service 2 as compared to those incurred for Service 1, and all of the
research and experimentation personnel of the cloud provider are
located in the United States at all times. This leads a significantly
larger percentage of the income from Service 2 to be sourced within the
United States as compared to that of Service 1. Aggregating Service 1
and Service 2 would cause a materially larger amount of gross income
from Service 1 to be sourced within the United States than if the
income were sourced without aggregating Service 1 with Service 2.
Therefore, under the proposed regulations, the cloud provider cannot
aggregate Service 1 and Service 2 to source the gross income from these
transactions.
5. Anti-Abuse Rule
In order to prevent taxpayers from circumventing the purpose of the
proposed regulations--to attribute the source of gross income from a
cloud transaction to the place where the transaction is performed--the
proposed regulations would provide an anti-abuse rule. That anti-abuse
rule, included in proposed Sec. 1.861-19(d)(9), would provide that if
the taxpayer has entered into or structured one or more transactions
with a principal purpose of reducing its U.S. tax liability in a manner
inconsistent with the purpose of the proposed regulations, appropriate
adjustments will be made so that the source of the taxpayer's gross
income reflects the location where the cloud transaction is performed.
II. Request for Comments
Comments are requested on all aspects of the proposed regulations,
including the following topics:
(1) whether there are appropriate and administrable ways to
determine the portion of the intangible property factor from sources
within and without the United States other than by relying on the
location of research and experimental personnel;
(2) whether and to what extent companies presently track specified
research or experimental expenditures by product line;
(3) whether there is a practicable and verifiable way to precisely
link the contribution of intangible property developed in one year to a
cloud transaction provided in a later year;
(4) whether relative gross income is an appropriate allocation
method in cases in which the same cost or expense would be included in
a factor for multiple cloud transactions during a taxable year;
(5) whether additional operating costs incurred with respect to
tangible property directly used in the provision of the cloud
transaction, such as electricity costs associated with cloud
transactions, should be included in the tangible property factor, and
if so, how to capture the costs that contribute to the performance of
the cloud transaction in an administrable manner; and
(6) whether a special rule is needed to source the gross income of
resellers of cloud transactions, for example, whether assets and
employees other than those described in the proposed regulations better
reflect the reseller's role in the cloud transaction.
Proposed Applicability Date
The regulations are proposed to apply to taxable years beginning on
or after the date of publication of the Treasury decision adopting
these regulations as final regulations in the Federal Register.
Special Analyses
I. Regulatory Planning and Review--Economic Analysis
Pursuant to the Memorandum of Agreement, Review of Treasury
Regulations under Executive Order 12866 (June 9, 2023), tax regulatory
actions issued by the IRS are not subject to the requirements of
section 6 of Executive Order 12866, as amended. Therefore, a regulatory
impact assessment is not required.
II. Paperwork Reduction Act
This proposed rulemaking does not impose or revise any information
collections subject to 44 U.S.C. Chapter 35.
III. Regulatory Flexibility Act
The Regulatory Flexibility Act requires consideration of the
regulatory impact on small businesses. It is hereby certified that
these proposed regulations, if adopted, will not have a significant
economic impact on a substantial number of small entities within the
meaning of section 601(6) of the Regulatory Flexibility Act (5 U.S.C.
chapter 6).
These proposed regulations would set forth specific rules for
sourcing income from cloud transactions. Specifically, the proposed
regulations provide guidance on sourcing such income based on three
factors that are broadly consistent with existing case law on sourcing
income from analogous transactions. Although data are not readily
available to estimate the economic impact of the proposed regulations,
the Treasury Department and the IRS project that any economic impact of
the proposed regulations
[[Page 3081]]
would be minimal for businesses regardless of size. This is because the
proposed regulations adopt an approach that is broadly consistent with
the general principles of existing law and reflect current industry
practice. Therefore, the proposed rules are not expected to materially
alter taxpayer behavior and therefore the Treasury Department and the
IRS expect no material economic impact.
For the reasons stated, a regulatory flexibility analysis under the
Regulatory Flexibility Act is not required. Notwithstanding the above,
the Treasury Department and the IRS invite comments on the impact the
proposed rules would have on small entities.
IV. Section 7805(f)
Pursuant to section 7805(f) of the Code, this notice of proposed
rulemaking will be submitted to the Chief Counsel for Advocacy of the
Small Business Administration for comment on its impact on small
business.
V. Unfunded Mandates Reform Act
Section 202 of the Unfunded Mandates Reform Act of 1995 requires
that agencies assess anticipated costs and benefits and take certain
other actions before issuing a final rule that includes any Federal
mandate that may result in expenditures in any one year by a State,
local, or Tribal government, in the aggregate, or by the private
sector, of $100 million in 1995 dollars, updated annually for
inflation. The proposed regulations do not include any Federal mandate
that may result in expenditures by State, local, or Tribal governments,
or by the private sector in excess of that threshold.
VI. Executive Order 13132: Federalism
Executive Order 13132 (entitled Federalism) prohibits an agency
from publishing any rule that has federalism implications if the rule
either imposes substantial, direct compliance costs on State and local
governments, and is not required by statute, or preempts State law,
unless the agency meets the consultation and funding requirements of
section 6 of the Executive Order. The proposed regulations do not have
federalism implications, do not impose substantial direct compliance
costs on State and local governments, and do not preempt State law
within the meaning of the Executive Order.
Comments and Requests for a Public Hearing
Before these proposed regulations are adopted as final regulations,
consideration will be given to any comments that are submitted timely
to the IRS as prescribed in this preamble under the ADDRESSES heading.
All comments will be available at www.regulations.gov.
A public hearing will be scheduled if requested in writing by any
person that timely submits comments. Requests for a public hearing are
also encouraged to be made electronically. If a public hearing is
scheduled, notice of the date, time, and place for the public hearing
will be published in the Federal Register.
Drafting Information
The principal authors of these proposed regulations are Christopher
E. Fulle and Michelle L. Ng of the Office of the Associate Chief
Counsel (International). However, other personnel from the Treasury
Department and the IRS participated in their development.
List of Subjects in 26 CFR Part 1
Income taxes, Reporting and recordkeeping requirements.
Proposed Amendments to the Regulations
Accordingly, the Treasury Department and IRS propose to amend 26
CFR part 1 as follows:
PART 1--INCOME TAXES
0
Paragraph 1. The authority citation for part 1 continues to read in
part as follows:
Authority: 26 U.S.C. 7805 * * *
0
Par. 2. Section 1.861-19, as added in a final rule published elsewhere
in this issue of the Federal Register, effective January 14, 2025, is
amended as follows:
0
a. Revise the section heading and paragraph (a);
0
b. Redesignate paragraphs (d), (e), and (f) as paragraphs (e), (f), and
(g), respectively;
0
c. Add new paragraph (d);
0
d. For each paragraph listed in the following table, remove the
language in the ``Remove'' column and add in its place the language in
the ``Add'' column.
------------------------------------------------------------------------
Paragraph Remove Add
------------------------------------------------------------------------
newly redesignated (e), first paragraph (d)..... paragraph (e).
sentence.
newly redesignated (e)(2)(i), paragraph paragraph
first sentence. (d)(1)(i). (e)(1)(i).
newly redesignated (e)(2)(ii), paragraph (d)(1).. paragraph (e)(1).
first sentence.
newly redesignated (e)(5)(i), paragraph (d)(4).. paragraph (e)(4).
first sentence.
newly redesignated (e)(6)(i), paragraph paragraph
first sentence. (d)(5)(i). (e)(5)(i).
newly redesignated paragraph paragraph
(e)(6)(ii)(A), first sentence. (d)(5)(ii). (e)(5)(ii).
newly redesignated (g), first paragraph (e)..... paragraph (f).
sentence.
------------------------------------------------------------------------
0
e. Add paragraphs (e)(12) and (13); and
0
f. Revise newly redesignated paragraph (f).
The revisions and additions read as follows:
Sec. 1.861-19 Classification of, and source of gross income from,
cloud transactions.
(a) In general. This section provides rules for classifying and
sourcing gross income from cloud transactions (as defined in paragraph
(b) of this section). The rules of this section apply for purposes of
Internal Revenue Code sections 59A, 245A, 250, 267A, 367, 404A, 482,
679, and 1059A; subchapter N of chapter 1; chapters 3 and 4; and
sections 842 and 845 (to the extent involving a foreign person), and
apply with respect to transfers to foreign trusts not covered by
section 679.
* * * * *
(d) Source of income from a cloud transaction--(1) In general.
Gross income from a cloud transaction is sourced as services income
under section 861(a)(3) or 862(a)(3), as appropriate, according to
where the service is performed. The place of performance of the cloud
transaction is based on the intangible property factor described in
paragraph (d)(2) of this section, the personnel factor described in
paragraph (d)(3) of this section, and the tangible property factor
described in paragraph (d)(4) of this section. To determine gross
income from a cloud transaction from sources within the United States,
gross income from the cloud transaction is multiplied by a fraction,
the numerator of which is the sum of the portion of each of the
intangible property factor, personnel factor, and tangible property
factor that is from sources within the United States
[[Page 3082]]
as calculated in paragraphs (d)(2)(ii), (d)(3)(ii), and (d)(4)(ii) of
this section, and the denominator of which is the sum of the intangible
property factor, personnel factor, and tangible property factor as
calculated in paragraphs (d)(2)(i), (d)(3)(i), and (d)(4)(i) of this
section. See paragraph (e)(12) of this section (Example 12). Any
remaining gross income from a cloud transaction is gross income from
sources without the United States.
(2) Intangible property factor--(i) Total. For purposes of
paragraph (d)(1) of this section, the intangible property factor with
respect to any cloud transaction performed by the taxpayer in a taxable
year is equal to the sum of the taxpayer's specified research or
experimental expenditures (as defined in section 174(b) and regardless
of whether and when the expenses are deductible) for that taxable year
that are associated with cloud transactions in the same product line as
the cloud transaction performed and the taxpayer's amortization (other
than amounts capitalized under section 174(a)(2)(A) and amortized under
section 174(a)(2)(B)) and royalty expense for intangible property for
the taxable year to the extent directly used to provide the cloud
transaction. If the same cost or expense would be included by a
taxpayer in the intangible property factor for more than one cloud
transaction during a taxable year, such cost or expense is allocated
among each such cloud transaction based on the relative gross income
earned from each cloud transaction.
(ii) Portion from sources within the United States. With respect to
a cloud transaction provided in a taxable year, the portion of the
intangible property factor from sources within the United States is
determined using a formula based on the location of all of the
taxpayer's employees whose primary function is to perform research and
experimentation activities associated with cloud transactions in the
same product line in that taxable year (the research and
experimentation personnel). The formula is as follows: applying the
principles of Sec. 1.861-4(b)(2)(ii)(E) (relating to sourcing income
from labor or personal services on a time basis), divide the sum of the
total compensation paid to the research and experimentation personnel
for services performed within the United States by the sum of the total
compensation paid to the research and experimentation personnel, and
multiply the resulting quotient by the intangible property factor
described in paragraph (d)(2)(i) of this section.
(3) Personnel factor--(i) Total. For purposes of paragraph (d)(1)
of this section, the personnel factor with respect to a cloud
transaction performed in a taxable year is equal to the sum of the
total compensation paid to all of the taxpayer's employees in that
taxable year whose primary function is to directly contribute to the
provision of the cloud transaction, excluding compensation amounts that
are paid to research and experimentation personnel described in
paragraph (d)(2) of this section. If, however, an employee's primary
function is to directly contribute to multiple cloud transactions, then
all of such employee's compensation is allocated among the cloud
transactions that the employee directly contributes to as part of their
primary function based on the relative amount of time the employee
spends contributing to each cloud transaction. If an employee
contributes to multiple cloud transactions simultaneously, then that
employee's compensation is allocated among those cloud transactions
based on the relative gross income earned from each cloud transaction.
(ii) Portion from sources within the United States. With respect to
a cloud transaction, the portion of the personnel factor described in
paragraph (d)(3)(i) of this section that is from sources within the
United States is equal to the part of that factor paid for services
performed in the United States, as determined using the principles of
Sec. 1.861-4(b)(2)(ii)(E) (relating to sourcing income from labor or
personal services on a time basis).
(iii) Personnel considered to directly contribute to the provision
of the cloud transaction. Personnel are considered to directly
contribute to the provision of the cloud transaction to the extent they
personally perform technical or operational activities for the
provision of the cloud transaction, or to the extent they are a manager
who directly supports or immediately supervises such technical or
operational personnel. Such technical or operational activities are the
conduct of scientific, engineering, or technical activities for the
configuration, delivery, or maintenance of the cloud transaction; the
provision of monitoring, diagnostics, or incident response with respect
to the cloud transaction's performance, reliability, efficiency, or
security; the management of the cloud transaction's infrastructure; the
delivery of end-user support with respect to the cloud transaction; and
the conduct of any similar functions.
(iv) Personnel not considered to directly contribute to the
provision of the cloud transaction. Personnel are not considered to
directly contribute to the provision of the cloud transaction to the
extent they conduct business strategy, leadership, legal or compliance,
marketing, communications, sales, business development, finance,
accounting, clerical, human resources or administrative duties, or
similar functions.
(4) Tangible property factor--(i) Total. For purposes of paragraph
(d)(1) of this section, the tangible property factor with respect to a
cloud transaction performed in a taxable year is equal to the sum of
the depreciation expense for that taxable year for tangible property
owned by the taxpayer and rental expense for that taxable year for
tangible property leased by the taxpayer, in each case to the extent
directly used to provide the cloud transaction. If any depreciation
expense or rental expense would be included in the tangible property
factor for more than one cloud transaction during the taxable year,
such depreciation expense or rental expense is allocated among the
cloud transactions based on relative gross income earned from each
cloud transaction.
(ii) Portion from sources within the United States. The portion of
the tangible property factor described in paragraph (d)(4)(i) of this
section from sources within the United States is equal to the part of
that factor attributable to property located within the United States.
(iii) Determination of depreciation expense. For purposes of
paragraph (d)(4) of this section, depreciation expense for a taxable
year is determined by dividing the adjusted depreciable basis (as
defined in Sec. 1.168(b)-1(a)(4)) of the tangible property by the
applicable recovery period as though the alternative depreciation
system set forth in section 168(g)(2) applied for the entire period
that such property has been in service, without regard to the election
to expense certain depreciable property under section 179 and without
regard to any additional first-year depreciation provision (for
example, section 168(k)).
(5) Primary function. For purposes of this section, an employee's
primary function is the set of tasks to which they are assigned to
spend the majority of their working time.
(6) Employee. For purposes of this section, the term employee has
the meaning given to it in Sec. 31.3121(d)-1(c) of this chapter.
(7) Aggregation rule. For purposes of applying this paragraph (d),
a taxpayer may aggregate substantially similar cloud transactions
unless it knows or
[[Page 3083]]
has reason to know that doing so would materially distort the source of
gross income from any cloud transaction.
(8) Product line. For purposes of this section, a product line is
defined as all products within the same Corresponding Index Entry under
a North American Industry Classification System (NAICS) code number.
Once a taxpayer selects a Corresponding Index Entry and NAICS code
number for the first taxable year for which this section applies, it
must continue to use that Corresponding Index Entry and NAICS code
number in following years unless the taxpayer establishes to the
satisfaction of the Commissioner that, due to changes in the relevant
facts, a change in Corresponding Index Entry and NAICS code number is
appropriate.
(9) Anti-Abuse Rule. The purpose of this paragraph (d) is to
attribute the source of the taxpayer's gross income from a cloud
transaction to the location where the cloud transaction is performed.
Therefore, if the taxpayer has entered into or structured one or more
transactions with a principal purpose of reducing its U.S. tax
liability in a manner inconsistent with the purpose of this paragraph
(d), appropriate adjustments will be made so that the source of the
taxpayer's gross income reflects the location where the cloud
transaction is performed.
(e) * * *
(12) Example 12: Sourcing gross income from a cloud transaction--
(i) Facts. (A) Corp A provides customers on-demand network access to
Program Y in exchange for a monthly fee. All of the transactions with
customers are substantially similar to one another. Customers must be
connected to the internet to access the functionality of Program Y.
(B) Corp A has employees whose primary function (as determined
under paragraph (d)(5) of this section) is to conduct research and
experimentation associated with developing new versions of Program Y
and other products in the same product line (as determined under
paragraph (d)(8) of this section). Corp A paid $160x in compensation to
such employees, of which $80x was paid for services performed within
the United States as determined in accordance with the principles of
Sec. 1.861-4(b)(2)(ii)(E). Besides employee compensation, Corp A spent
an additional $200x for research and experimentation costs associated
with developing new versions of Program Y and other products in the
same product line. Corp A did not take any amortization deductions with
respect to intellectual property used to provide Program Y.
(C) Corp A paid $400x in compensation to employees whose primary
function was to directly contribute (as determined under paragraphs
(d)(3)(iii) and (iv) of this section) to Corp A's provision of Program
Y to customers, of which $100x was paid for services performed in the
United States as determined in accordance with the principles of Sec.
1.861-4(b)(2)(ii)(E). None of these employees were research and
experimentation personnel (as defined in paragraph (d)(2)(ii) of this
section).
(D) Corp A hosts Program Y on servers it owns that are located both
within and without the United States. These servers are used only to
host Program Y. Corp A deducted $140x for depreciation expense
attributable to these servers, $80x of which was attributable to the
servers located within the United States, and $60x of which was
attributable to the servers located without the United States. These
depreciation deductions are in accordance with the rules of section
168(g)(2).
(E) Corp A earned $800x of gross income from providing customers
access to Program Y. Corp A does not know or have reason to know that
any of the costs, functions or assets described in this paragraph are
disproportionately allocated to certain transactions or groups of
transactions among all of the transactions that generated $800x of
gross income.
(ii) Analysis. (A) Under paragraph (b) of this section, each
transaction between Corp A and a customer is a cloud transaction
because Corp A provides on-demand network access to Program Y. Under
paragraph (c)(1) of this section, each cloud transaction is classified
as the provision of services. Under paragraph (d)(7) of this section,
because all of these transactions are substantially similar and Corp A
does not know or have reason to know that there is any disproportionate
allocation of costs, functions or assets among them, all of the
transactions may be considered in the aggregate for purposes of
applying paragraph (d) of this section.
(B) Under paragraph (d)(1) of this section, the source of Corp A's
$800x of gross income from providing access to Program Y to customers
is determined based on the intangible property factor described in
paragraph (d)(2) of this section, the personnel factor described in
paragraph (d)(3) of this section, and the tangible property factor
described in paragraph (d)(4) of this section.
(C) Under paragraph (d)(2) of this section, the intangible property
factor is equal to $360x because Corp A paid $160x in compensation to
employees whose primary function was to conduct research and
experimentation associated with developing new versions of Program Y
and other products in the same product line, and incurred $200x in
other research and experimentation costs associated with developing new
versions of Program Y and other products in the same product line.
$80x/$160x of such compensation, or 50%, is paid to employees for
research and experimentation services performed with respect to Program
Y and other products in the same product line in the United States.
Corp A's $360x intangible property factor is multiplied by the same
quotient to determine that $180x is from sources within the United
States pursuant to paragraph (d)(2)(ii) of this section.
(D) Under paragraph (d)(3) of this section, the personnel factor is
equal to $400x because Corp A paid $400x in compensation to employees
whose primary function was to directly contribute to the provision of
Program Y to customers and none of these employees were research and
experimentation personnel (as defined in paragraph (d)(2)(ii) of this
section). Pursuant to paragraph (d)(3)(ii) of this section, $100x of
the personnel factor is from sources within the United States because
Corp A paid $100x in compensation to employees for services performed
in the United States that directly contributed to the provision of
Program Y to customers.
(E) Under paragraph (d)(4) of this section, the tangible property
factor is equal to $140x because Corp A deducted $140x in depreciation
expense for tangible property directly used to provide Program Y to
customers under the method described in section 168(g)(2). $80x of the
tangible property factor is from sources within the United States
because this amount of the $140x depreciation expense is attributable
to tangible property located within the United States.
(F) The sum of the intangible property factor ($360x), the
personnel factor ($400x), and the tangible property factor ($140x) is
equal to $900x. The sum of these factors from sources within the United
States is $360x ($180x with respect to the intangible property factor,
$100x with respect to the personnel factor, and $80x with respect to
the tangible property factor). Accordingly, Corp A's $800x of gross
income from providing Program Y to customers for the taxable year is
multiplied by the quotient of $360x/$900x pursuant to paragraph (d)(1)
of this section to determine that $320x is from sources within the
United States. Pursuant to paragraph (d)(1) of this section, the
[[Page 3084]]
remaining $480x ($800x-$320x) is from sources without the United
States.
(13) Example 13: Sourcing gross income from multiple cloud
transactions--(i) Facts. (A) The facts are the same as in paragraph
(e)(12) of this section (Example 12), except that Corp A also provides
customers on-demand network access to software platform Z in exchange
for a monthly fee, and Corp A hosts software platform Z on the same
servers it uses to host Program Y (which generate more depreciation
than in Example 12). All of the transactions for software platform Z
customers are substantially similar to one another. Customers must be
connected to the internet to access the functionality of software
platform Z.
(B) Corp A has employees whose primary function (as determined
under paragraph (d)(5) of this section) is to conduct research and
experimentation associated with developing new versions of software
platform Z and other products in the same product line. The software
platform Z product line is not the same as the Program Y product line
under the definition in paragraph (d)(8) of this section. Corp A paid
$200x in compensation to such employees, all of which was paid for
services performed in the United States as determined in accordance
with the principles of Sec. 1.861-4(b)(2)(ii)(E). Corp A also has
employees whose primary function as determined under paragraph (d)(5)
of this section is to conduct research and experimentation associated
with developing functionality for new versions of both Program Y and
software platform Z. Corp A paid $100x in compensation to such
employees, all of which was paid for services performed in the United
States as determined in accordance with the principles of Sec. 1.861-
4(b)(2)(ii)(E). Corp A did not have any other research and
experimentation costs associated with software platform Z.
(C) Corp A paid $100x in compensation to employees whose primary
function was to directly contribute (as determined under paragraphs
(d)(3)(iii) and (iv) of this section) to Corp A's provision of software
platform Z to customers, and that entire amount was paid for services
performed in the United States as determined in accordance with the
principles of Sec. 1.861-4(b)(2)(ii)(E). None of these employees were
research and experimentation personnel (as defined in paragraph
(d)(2)(ii) of this section). Corp A also paid $80x in compensation to
employees whose primary function was to directly contribute (as
determined under paragraphs (d)(3)(iii) and (iv) of this section) to
Corp A's provision of both Program Y and software platform Z to
customers, and that entire amount was paid for services performed in
the United States as determined in accordance with the principles of
Sec. 1.861-4(b)(2)(ii)(E). These employees spent half their time
contributing to software platform Z transactions and half their time
contributing to Program Y transactions. None of these employees were
research and experimentation personnel (as defined in paragraph
(d)(2)(ii) of this section).
(D) Corp A hosts software platform Z on servers it owns that are
located both within and without the United States. These servers are
used to host both Program Y and software platform Z. Corp A deducted
$180x for depreciation expense attributable to these servers, $120x of
which was attributable to the servers located within the United States,
and $60x of which was attributable to the servers located without the
United States. These depreciation deductions are in accordance with the
rules of section 168(g)(2).
(E) Corp A earned $800x of gross income from providing customers
access to software platform Z. Corp A does not know or have reason to
know that any of the costs, functions or assets described in this
paragraph are disproportionately allocated to certain transactions or
groups of transactions among all of the transactions that generated
$800x of gross income.
(ii) Analysis. (A) Under paragraph (b) of this section, each
transaction between Corp A and a customer for software platform Z is a
cloud transaction because Corp A provides on-demand network access to
software platform Z. Under paragraph (c)(1) of this section, each cloud
transaction is classified as the provision of services. Under paragraph
(d)(7) of this section, because all of these software platform Z
transactions are substantially similar and Corp A does not know or have
reason to know that there is any disproportionate allocation of costs,
functions or assets among them, all of the software platform Z
transactions may be considered in the aggregate for purposes of
applying paragraph (d) of this section.
(B) Under paragraph (d)(1) of this section, the source of Corp A's
$800x of gross income from providing access to software platform Z to
customers is determined based on the intangible property factor
described in paragraph (d)(2) of this section, the personnel factor
described in paragraph (d)(3) of this section, and the tangible
property factor described in paragraph (d)(4) of this section.
(C) Under paragraph (d)(2) of this section, the intangible property
factor is equal to $250x. Corp A paid $200x in compensation to
employees whose primary function was to conduct research and
experimentation associated with developing new versions of software
Platform Z and other products in the same product line. Corp A also
paid $100x in compensation to employees whose primary function was to
conduct research and experimentation developing functionality for new
versions of both Program Y and software platform Z, of which Corp A
allocates $50x to software Platform Z and $50x to Program Y based on
Corp A's relative gross income from Program Y and software platform Z
transactions in the taxable year. $250x/$250x of such compensation, or
100%, is paid to employees for research and experimentation services
performed in the United States with respect to software Platform Z and
other products in the same product line. Corp A's $250x intangible
property factor is multiplied by the same quotient to determine that
$250x is from sources within the United States pursuant to paragraph
(d)(2)(ii) of this section.
(D) Under paragraph (d)(3) of this section, the personnel factor is
equal to $140x. Corp A paid $100x in compensation to employees whose
primary function was to directly contribute to the provision of
software platform Z to customers and none of these employees were
research and experimentation personnel (as defined in paragraph
(d)(2)(ii) of this section). Corp A also paid $80x in compensation to
employees whose primary function was to directly contribute to the
provision of both Program Y and software platform Z (and none of these
employees were research and experimentation personnel (as defined in
paragraph (d)(2)(ii) of this section)), and Corp A allocated $40x to
software platform Z and $40x to Program Y based on the relative amount
of time these employees spent contributing to Program Y and software
platform Z transactions in the taxable year. $140x/$140x of such
compensation, or 100%, is paid to employees for services performed in
the United States that directly contributed to the provision of
software platform Z to customers.
(E) Under paragraph (d)(4) of this section, the tangible property
factor is equal to $90x. Corp A deducted $180x in depreciation expense
for tangible property directly used to provide both Program Y and
software platform Z transactions under the method described in section
168(g)(2), of which $120x is from sources within the United
[[Page 3085]]
States because this amount is attributable to tangible property located
within the United States. Based on Corp A's relative gross income from
Program Y and software platform Z transactions in the taxable year,
Corp A reasonably allocates $90x to software platform Z, of which $60x
is from sources within the United States and $90x to Program Y, of
which $60x is from sources within the United States.
(F) The sum of the intangible property factor ($250x), the
personnel factor ($140x), and the tangible property factor ($90x) is
equal to $480x. The sum of these factors from sources within the United
States is $450x ($250x with respect to the intangible property factor,
$140x with respect to the personnel factor, and $60x with respect to
the tangible property factor). Accordingly, Corp A's $800x of gross
income from providing software platform Z to customers for the taxable
year is multiplied by the quotient of $450x/$480x pursuant to paragraph
(d)(1) of this section to determine that $750x is from sources within
the United States. Pursuant to paragraph (d)(1) of this section, the
remaining $50x ($800x-$750x) is from sources without the United States.
(f) Applicability date--(1) In general. Except as otherwise
provided in this paragraph (f), this section applies to taxable years
beginning on or after January 14, 2025. Paragraphs (d) and (e)(12) and
(13) of this section apply to taxable years beginning on or after the
date of publication of the Treasury decision adopting those paragraphs
as final regulations in the Federal Register.
(2) Early application. Except for paragraphs (d) and (e)(12) and
(13) of this section, a taxpayer can apply this section to taxable
years beginning on or after August 14, 2019 and all subsequent taxable
years not described in paragraph (f)(1) (early application years) if--
(i) The taxpayer also applies Sec. 1.861-18 to the early
application years;
(ii) This section and Sec. 1.861-18 are applied to the early
application years by all persons related to the taxpayer (within the
meaning of sections 267(b) and 707(b));
(iii) The period of limitations on assessment for each early
application year of the taxpayer and all related parties (within the
meaning of sections 267(b) and 707(b)) is open under section 6501; and
(iv) The taxpayer would not be required under this section to
change its method of accounting as a result of such election.
* * * * *
Douglas W. O'Donnell,
Deputy Commissioner.
[FR Doc. 2024-31373 Filed 1-10-25; 8:45 am]
BILLING CODE 4830-01-P