David Stewart:   0:00
Welcome to the podcast. I'm David Stewart, editor in chief of Tax Notes Today International. This week: Regulating the Cloud. Earlier this year, Treasury and  the IRS  issued proposed rules on characterizing cloud computing transactions. This came years after the IRS first announced that it intended to produce guidance in this area. I'm joined in the studio by Tax Notes legal reporter Kristen Parillo, who recently spoke to someone about these regs. Kristen, welcome back to the podcast.

Kristen Parillo:   0:29
Thanks for having me, Dave.  

David Stewart:   0:30
Who did you talk to?  

Kristen Parillo:   0:31
I spoke with Joe Myszka, who was a partner with DLA Piper in their Silicon Valley office.

David Stewart:   0:37
What issues did you and Joe talk about?

Kristen Parillo:   0:39
He walked us through why these regs are needed and what the proposed rules do.  He also discussed why the sourcing rule for digital downloads may be the most controversial proposal and may need some fine tuning.

David Stewart:   0:52
All right, let's go to that interview.

Kristen Parillo:   0:54
Hi, Joe. Welcome to the podcast.

Joseph Myszka:   0:56
Kristen, it's great to be here. Thank you for having me. 

Kristen Parillo:   0:00
Thanks for taking the time to be with us. Before we dive into the details, I'll note that Treasury and the IRS announced several years ago that they would issue regulations on cloud transactions. Can you explain why the tax community was so anxious to get this guidance?

Joseph Myszka:   1:13
Sure. Generally, I think it results from the widespread acknowledgment by the tax community that the 861-18 regs, which were designed back in the 1990s focusing on the development of computer software and the transfer of various rights in that computer software, were just basically insufficient and really did not encompass many of the transactions that were now very commonplace in the digital economy. Today, things like streaming services, and access to things in the "cloud" or online services that we don't necessarily think of his transfers of computer software. So I think practitioners had a general solid understanding of how to interpret the existing software regulations in a way that could conform to this new environment. They really wanted some guidance from Treasury as to what they should be doing.

Kristen Parillo:   2:05
So, Treasury finally released proposed regs in August. Can you take us through a high level overview of what the regs do and how they're organized?

Joseph Myszka:   2:12
Yeah, and what's interesting about the new regulations is, rather than try to address cloud transactions through the existing software regulation paradigm in 861-18, they actually create new standalone rules in Treasury reg 861-19 that relates solely to cloud transactions. So, effectively there's a two step approach. The first question is whether or not the transaction being analyzed is a cloud transaction subject to the new 861-19 rules or not a cloud transaction that would remain subject to the 861-18 rules that the same reg package proposes to modify to modernize in a way that would more broadly encompass digital content. For this step one purpose, the regulations do provide a definition of a cloud transaction, which is essentially a transaction where a person obtains a "non de minimus on demand network access," the computer hardware, digital content, or other similar resources. That's step one. Step two, once we've determined that there is a cloud transaction, then the taxpayer evaluates whether based on the facts and circumstances the transaction should be classified as a lease or the provision of services. The 861-19 regulations do provide a non-exhaustive list of factors to be considered in that lease versus services determination, which generally focus on which party has which rights, obligations and functions with respect to the underlying assets that are being taken into account in the transaction. Treasury also looks to the list of factors described in section 7701(e)(1), which are a set of rules that have existed for some period of time for determining when a service contract should instead be treated as a lease.

Kristen Parillo:   3:55
So, how user friendly are these 861-19 regs?

Joseph Myszka:   3:59
My impression is there quite user friendly. I think the two-step framework that we just discussed is quite straightforward. I tend to be in favor of facts and circumstances tests where Treasury identifies the factors that they think are important. But those factors aren't exhaustive and therefore leave enough flexibility for taxpayers to take into account their own facts and circumstances and what's important to their business. I think that seems like the best way to ensure that the tax answer is actually driven by business and economic considerations and not the other way around. The other piece of the new regulations that I think is helpful is that Treasury did include a number of examples to illustrate the various principals. I think as the tax community reviews these examples, I think you can see very direct connections between the example and various business models that exist, whether it's online video streaming or access to online word processing software that they're very familiar with in their day-to-day lives. It helps with balancing the different facts and circumstances for determining whether or not a transaction is a services or a lease transaction. One thing that is interesting here is that in the context of cloud computing transactions or cloud transactions should be characterized as a service. So, I think one area for further development would be to include an example where the cloud transaction is characterized as a lease.

Kristen Parillo:   5:17
The proposed regs don't have any rules for sourcing income from cloud transactions. The IRS said back in 2016 that it would tackle the character rules first and then do guidance on sourcing rules. So, this wasn't a big surprise that there were no sourcing rules, right?

Joseph Myszka:   7:08
I don't think it was a huge surprise. Back in 2016, IRS officials were fairly vocal about the approach that they thought was going to involve addressing character issues first. They thought those issues were simpler and then save the sourcing issues for some other point in time. Also, around the same time, you see the descriptions in the IRS priority guidance plan shift from referring to both the character and source for the "provision of digital goods and services" to referring only to the character of these types of transactions. You know, that all said, 2016 was three years ago, and a lot has happened in the interim. We've seen Treasury make tremendous progress on the 2017 tax reform-related regulations. We're now seeing a lot of progress with respect to the OECD BEPS project, and OECD's efforts as it relates to the digital economy. While it wasn't a huge surprise that the proposed regulations here focused solely on character, I think there was some optimism that maybe Treasury would try to get in front of the sourcing question in mind of all of the other things that are moving at this moment. So, it will be interesting to see in the future as to what Treasury ends up proposing as it relates to sourcing, sort of as the OECD's moving on a parallel path with its program at work for digital economy and the Pillar 1 effort for determining what is a taxing right in the context of the digital economy. I think there's going to be a lot of overlap with the source rules in this case.

Kristen Parillo:   7:08
The proposed regs do have a sourcing rule for digital content transfers that's gotten a lot of attention. Can you explain what the rule is and why a lot of people are happy about it?

Joseph Myszka:   7:09
That's right. So, the proposed regulations do provide a new sourcing rule for digital sales of copyrighted articles, which is covered by the proposed expanded definition of transactions subject to the software regulations, the 861-18 regs.  This new rule overrides the general rule in 861-7 that sources sales of personal property to the location where title passes. In connection with digital transactions, Treasury notes in the preamble that there's just simply too many problems with determining where title passes in the context of a digital download where, for instance, one from a legal perspective but there may not actually be any passage of title, because that's what one of the things that IT lawyers get very concerned about.  Two, even if there is a specified passage of title, that location might be a jurisdiction that doesn't really have any relationship to the transaction. So, I think Treasury was concerned about some artificial sourcing or shifting of the source of the transaction. So, essentially they proposed to override that general rule in 861-7 for downloads of digital content. So only that very limited context and instead, source the transaction to the location of the download or installation onto the end users device that is used to access the digital content. So, that could be a computer or smartphone or what have you. But the taxpayer is not able to readily determine the location of where the download or installation occurs. Then, the proposed regulations source that transaction to the location based on the taxpayers recorded sales data for business or financial reporting purposes. That probably means a lot of different things to a lot of different taxpayers and exactly how granular they can be for identifying a particular jurisdiction for business or financial reporting. So, a few things I think about this rule are especially problematic for the tax community. I think most significantly, this new rule has the potential to create US tax issues for non-US enterprises that don't otherwise have any connection to the US by taking income that historically would have been sourced outside the US or have no nexus to the US and now all of a sudden, if that software was downloaded by an end user in the US, that could be US source income, and then that seller, the foreign corporation, would need to determine whether or not it has a US trader business and therefore, ECI. The flip side is, even if this non-US vendor already has US ECI or a US permanent establishment. The new sourcing rule has the potential to dramatically increase the US source income and therefore, the non-US vendors US tax liability by simply increasing its amount of US source income. The other concern that the tax community has about this rule is, it is especially rigid. It's sort of an either or rule. So, for instance, the source of income must be determined either by the location of the end user download or installation or simply how the sales reported for business or financial reporting purposes. There are no exceptions in this rule.  While those two alternatives might be reasonable in certain cases, and I think Treasury's concern about having the source of income being driven artificially in other cases is valid, the factors that the regulations do specify could also produce anomalous results. So consider, for example, the growing use of virtual private networks, virtual payment options, both of which may identify a location either of the user or of the source of payment for financial reporting purposes but it may be distorted from where the user actually is, or from where the source of actual payment is. Another example of potential distortions might be in the context of enterprise transactions, where software, for instance, is downloaded central in one jurisdiction but then pushed out the end users globally or in another enterprise situation where enterprise users download software through their local offices. But there's central billing to one single office and therefore financial reporting purposes that might be recorded to simply one jurisdiction. So, hopefully Treasury will consider at least expanding or modifying the approach so that in certain circumstances, taxpayers may be able to take into account other factors that reliably demonstrate to which geography the income should be sourced to. One final thought on the sourcing issue, and I think this is particularly interesting in light of the ongoing OECD efforts to establish a consensus is it relates to their proposal for dealing with the various digital taxing proposals that are already out there, as well as trying to reach a consensus approach. In theory, this approach could at least embolden some of the more unilateral proposals or digital services tax proposals that we're seeing in France and other countries in Europe, where income is being sourced to the location of an end user, regardless of the particular nexus that a foreign enterprise may have inner jurisdiction.

Kristen Parillo:   11:56
Are there other provisions in the proposed regs that may need some fine tuning?

Joseph Myszka:   12:00
I think the sourcing rule we were just discussing for digital downloads really seems to be the most controversial and in need of fine tuning. There's also a potential disconnect between the source of income rule for digital downloads and Section 863(b), as amended by the Tax Cuts and Jobs Act. The latter provides that gain from the sale or exchange of inventory property produced by a tax payer in the United States, and sold or exchanged outside of the United States, or the inverse situation, the income is allocated and apportioned between US source and non-U S sources based on the production activities with respect to the property. So, at least theoretically, the two rules could produce conflicting answers. Where in one case, you're looking to the location of production activities, and in the other you're looking to the location of the end user downloads seems that there could potentially be some tension there, so I'd expect Treasury to articulate their position as it relates to a 863(b). For instance, perhaps Treasury believes that Section 863 simply doesn't apply in the case of digital software downloads. I think it would also be helpful to have a few more examples in the 861-19 regulations and in particular where the facts don't as strongly point to either services or lease characterization, where there are more factors that cut in favor of going different ways. So one example might be take a subscription video streaming service. There is an example in the regulation that deals with this where it talks about end users not being able to download the contents onto their local device or being able to download the contents onto their local device with very minimal functionality. Given where we're at in today's world, with respect to the different online streaming business models, I think we're seeing the ability to download content and to retain much more functionality with respect to that downloaded content, being a more prominent feature of some of these offerings. I think it would be helpful for Treasury to expand on exactly how far can you go with respect to this notion of a download and what level of functionality would need to be continued to exist only through the network resources versus on the local device before you cross over in that line from a service to a lease.

Kristen Parillo:   14:08
What comes next for these proposed regs?

Joseph Myszka:   14:11
So comments, I believe, will have already been submitted, and we'll be looking forward to Treasury's announcement of a hearing with respect to these regulations. Depending on the total number of comments submitted, it's possible that we're looking into the new year before the hearing occurs. I think it will also be very interesting to keep a close eye on how Treasury is progressing in it's engagement with the OECD and it's program at work for dealing with the digital economy and see what learnings we can find either from these regulations as it may apply to Treasury's positions in that discussion, or what influence those discussions may ultimately have on the final regulations and in particular, what we may end up seeing with respect to the sourcing issue.

Kristen Parillo:   14:57
Well, thanks, Joe, for taking the time to be with us. This was very helpful.

Joseph Myszka:   15:00
Kristen, again, thanks so much for having me. I really appreciate it.

David Stewart:   16:09
And now, coming attractions. Each week, we preview commentary that will be appearing in the Tax Notes magazines. I'm joined by executive editor for commentary Jasper Smith. Jasper, what do you have for us?

Jasper Smith:   16:09
Thanks, Dave. In Tax Notes Federal, practitioners from Skadden argue that Congress should repeal or modify the five-year REIT lockout rule. Alexander Marcellesi argues that a recent proposed regulation under section 163(j) runs contrary to the treatment of guaranteed payments for the use of capital.  In Tax Notes State, Charles McClure, Jr explains that sales-based nexus standards adopted after Wayfair are probably too low. Justin Cook discusses Karvo Paving Co. v. Testa. In Tax Notes International, Reuven Avi-Yonah and Karen Sam discuss the proposed US Cloud computing regulations.  Assaf Harpaz comments on the OECD secretariat's unified approach proposal under pillar 1. Finally, in the opinions page, Robert Goulder discusses practical alternatives to a federal wealth tax and Carrie Elliot comments on the inherent tension between precision and administrability in tax systems.

David Stewart:   16:10
You could read all that and a lot more in the December 9th editions of Tax Notes Federal, State and International. That's it for this week. You can follow me online @TaxStew. If you have any comments, questions or suggestions for a future episode, you can email us a podcast@taxanalysts.org. As always, if you like what we're doing here, please leave a rating or review wherever you download this podcast. We'll be back next week with another episode of Tax Notes Talk .