On January 10, 2025, the U.S. Department of Treasury (Treasury) and the Internal Revenue Service (IRS) released final regulations (the Final Regulations) regarding the classification of digital content transactions and cloud transactions for certain provisions of the Internal Revenue Code (the Code).¹ Specifically, the Final Regulations assist taxpayers in determining whether certain transactions (and income derived therefrom and its source) constitute a lease of property or provision of services. The Final Regulations retain the overall approach of the proposed regulations that were released on August 9, 2019 (the Proposed Regulations) but adopt several key changes. Our Alert on the Proposed Regulations can be accessed here. The Final Regulations became effective on January 14, 2025, and apply to taxable years beginning on or after that date, though taxpayers can elect to apply them to all taxable years beginning on or after August 14, 2019, if they and all related persons do so on a consistent basis.

In addition to the Final Regulations, the Treasury and the IRS also issued proposed regulations that address the method for establishing the source of gross income from cloud transactions and a request for comments on extending the Final Regulations to apply to all provisions of the Code, both of which are described at the end of this Alert.

Key Changes

The Final Regulations:

• clarify the definitions of digital content and cloud transactions;
• extend existing classification rules for computer programs to all digital content transactions;
• classify cloud transactions solely as the provision of services;
• replace existing guidance on classifying transactions with multiple elements with a predominant character rule rather than independent classification for each element; and
• introduce sourcing rules for sales of copyrighted materials transferred through an electronic medium.

Definitions

• Digital Content. The Final Regulations define digital content as any computer program or other content in digital form that is protected by copyright law or is not protected solely due to the passage of time or because the creator dedicated the content to the public domain. The Treasury and the IRS choose not to adopt a special definition of “transaction” related to digital content because the concept is well established under general tax principles, case law, and existing guidance. A fundamental requirement of a digital content transaction, and one that distinguishes digital content from cloud transactions, is that there must be an actual transfer of digital content to a customer, even if the transfer is only temporary. Whether the transfer is physical, electronic, or through another medium is not taken into account.
• Cloud Transactions. The Final Regulations define a cloud transaction as a transaction through which a person obtains on-demand network access to computer hardware, digital content, or other similar resources. Further, the Final Regulations state that a cloud transaction does not include network access to download digital content for storage and use on a person’s computer or other electronic devices. Unlike digital content transactions, cloud transactions do not involve the actual transfer of digital content. Instead, the provider creates value by allowing the customer continuous access to the provider’s servers. If the customer may choose whether to temporarily download or stream content, the predominant character of the transaction will apply to characterize the transaction (as discussed in more detail below).

Classification of Transactions

• Digital Content Transactions. The Final Regulations extend the categories of computer program transactions to all digital asset transactions. Any digital asset transaction will now be categorized as 1) a transfer of a copyright, 2) a transfer of a copyright article, 3) the provision of services for the development or modification of the digital content, or 4) the provision of know-how relating to the development of the digital content.
• Cloud Transactions. Any cloud transaction is classified as a provision of services.

Classification of Transactions with Multiple Elements

• Background. Under prior guidance, if a transaction had multiple elements, each element was required to be classified independently. For example, suppose Company A operates a hosting site for application developers to market their products to customers. To use the hosting site, each application developer transferred to Company A a digital master copy of their application along with the non-exclusive right to make copies of the application to Company A. Prior guidance required Company A to characterize this arrangement as three distinct transactions—a transfer of a copyrighted article (master copy), a transfer of a copyright right (right to make copies), and a cloud transaction (hosting services).
• Predominant Character Rule. Under the Final Regulations, a transaction with multiple elements is characterized based on the predominant character of the transaction. In general, the predominant character of a transaction is determined by ascertaining the primary benefit or value received by the customer in the transaction. In the example above, the transaction will be treated as the provision of services because the primary value that Company A provides to the application developers is its hosting services, which is a cloud transaction.
• Special Rule. If the primary benefit or value to the customer is not reasonably ascertainable, the predominant character is determined by ascertaining the primary benefit or value received by the typical customer in a substantially similar transaction using data on how a typical customer uses or accesses the digital content. For example, suppose Company B offers video content to millions of customers that can be accessed through streaming or temporary download for a monthly fee. Given the number of customers, Company B cannot reasonably ascertain whether each customer downloads or streams the content. However, if Company B has data that indicates that the vast majority of customers stream digital content rather than temporarily downloading the content, then the predominant character of the transaction is a cloud transaction, which is classified as a provision of services. If such data is not available, then all factors indicative of the primary benefit or value to the typical customer are examined, including how the transaction is marketed, the relative development costs of each element of the transaction, and the relative price in an uncontrolled transfer for each element compared to the total contract price of the transfer in question.

Source Rules

• Source Rule for Sales of Copyrighted Articles Transferred Through an Electronic Medium. Pursuant to the Final Regulations, when a copyrighted article is treated as being sold (rather than, e.g., licensed) and is transferred through an electronic medium, the sale is generally deemed to have occurred at the location of the billing address of the purchaser for purposes of determining the country of sale. However, if the transaction is arranged in a certain manner for the principal purpose of tax avoidance, the foregoing rules do not apply. Instead, all relevant facts and circumstances, including the place of use, the place where the transaction was negotiated and agreed upon, and the terms of the agreement, will be considered, and the sale will be treated as having occurred where the substance of the sale occurred. The Final Regulations also clarify that the source of income from transactions involving digital content is determined under generally applicable sourcing rules, and the location where the sale is deemed to occur is relevant for sourcing income that is sourced based on the location of sales, but not income that is sourced on a different basis (such as licenses, leases, and certain sales of self-produced inventory).

Proposed Regulations (REG-107420-24)

• The Treasury and IRS have issued a notice of proposed rulemaking regarding sourcing gross income from cloud transactions.² Gross income from cloud transactions would be sourced under Sections 861(a)(3) or 862(a)(3) according to where the service is performed. The place of performance is determined using a fraction composed of three factors—the intangible property factor, the personnel factor, and the tangible property factor (Sourcing Factors).
  • Intangible Property Factor: This factor generally includes certain specified research or experimental expenditures and royalty expenses relating to the cloud transaction.
  • Personnel Factor: This factor generally includes certain compensation relating to the cloud transaction that is not taken into account in the intangible property factor.
  • Tangible Property Factor: This factor generally includes certain depreciation and rent expenses for tangible property relating to the cloud transaction.
• To determine gross income from a cloud transaction from sources within the United States, the following formula is used:

Request for Comments (Notice 2025-6)

• Finally, the Treasury and the IRS have requested comments regarding the consequences or interactions that would result if the characterization rules contained in the Final Regulations were extended to all provisions of the Code, including where additional guidance would be necessary.³ Comments should be submitted within 90 days of the publication of Notice 2025-6 in the Internal Revenue Bulletin.

For further information, please contact Greg Broome (gbroome@wsgr.com, 415-947-2139); or any member of the tax practice at Wilson Sonsini Goodrich & Rosati.

Greg Broome, Jason Sacks, and Robert Sherrill contributed to the preparation of this Alert.

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[1] Classification of Digital Content Transactions and Cloud Transactions, 90 Fed. Reg. 8, 2977 (January 14, 2025). Unless otherwise specified, all Section references are to the Internal Revenue Code of 1986, as amended, as of January [16], 2025.

[2] Source of Income From Cloud Transactions, 90 Fed. Reg. 8, 3075 (January 14, 2025).

[3] Currently the Final Regulations provides rules for purposes of subchapter N of chapter 1 of the Code, sections 59A, 245A, 250, 267A, 367, 404A, 482, 679, 1059A, chapters 3 and 4, sections 842 and 845 (to the extent involving a foreign person), and transfers to foreign trusts not covered by section 679.