Background and Purpose

Earlier this year the US Internal Revenue Service (IRS) issued proposed and final regulations to clarify how income from cloud transactions should be treated for U.S. federal income tax purposes. These rules are intended to modernize tax aspects of the expanding digital economy, and (when and as finalized) will be particularly relevant for cross-border transactions involving cloud computing, digital content and related services.

The proposals expand upon IRS guidance from 2019 and are intended to fit into the existing international tax provisions of the US Internal Revenue Code (Code).

Cloud Transactions

The final regulations define a “cloud transaction” is one through which a customer obtains on-demand network access to computer hardware, digital content or other similar computing resources. This includes such items as Software-as-a-Service (SaaS), Infrastructure-as-a-Service (IaaS), Platform-as-a-Service (PaaS), data storage/processing and streaming services. Not included are network access to downloadable content for storage and use on the customer’s own device.

Scope

The proposed rules would align with a wide range of US international tax provisions, including transfer pricing, withholding taxes, foreign tax credits, the controlled foreign corporation regime and trust taxation.

Sourcing Rules

The principal thrust of the proposed regulations is the determination of the source of income from cloud transactions. The IRS distinguishes between two types of these transactions:

• Provision of Services: If the cloud transaction is classified as a service, the source of income is determined by where the services are performed. This is consistent with existing sourcing rules for services under the Code.

• Lease of Property: If the transaction is classified as a lease, the source of income is based on where the property is used. This applies to transactions where the user has significant control over the digital content or hardware.

To determine whether a transaction is a service or a lease, the IRS considers:

• The degree of control the customer has over the resource,
• Whether the provider maintains possession and control of the resource,
• The duration and exclusivity of customer access to the resource, and
• The nature of the payment (e.g., subscription vs. usage-based).

The final regulations lean toward classifying cloud transactions as the provision of services.

The proposed regulations would source gross income from a cloud transaction to the place(s) of performance of the deemed service. That exercise would involve allocating the income to US sources by multiplying the income by a fraction, of which the numerator is the US portion of three factors – intellectual property (IP), personnel and tangible property – and the denominator is the sum of those three factors. The meanings of these factors are as follows:

• IP Factor: Specified research and experimentation expenditures that are associated with cloud transactions in the same product line as the cloud transaction, increased by amortization and royalty expense to the extent directly used to perform the transaction.

• Personnel Factor: Total compensation paid to employees of the taxpayer whose primary function is to directly contribute to the performance of the cloud transaction, excluding compensation amounts reflected in the IP factor.

• Tangible Property Factor: Depreciation expense for tangible property owned, and rental expense for tangible property leased, by the taxpayer and used to perform the cloud transaction.

All other gross income from the cloud transaction would be sourced outside the United States.

Examples and Illustrations

The regulations include examples to illustrate how the sourcing rules apply in practice, covering:

• Customers accessing cloud platforms,
• Streaming services,
• Data analytics tools,
• Transactions involving both services and content delivery.

These examples are designed to help taxpayers apply the rules consistently and reduce ambiguities in the classification of cloud transactions for tax purposes.

Effective Date and Public Comments

If and when issued in final form, the proposals are expected to apply to tax years beginning after the date of issuance.

The IRS held a public hearing on 17 July 2025. Most of the comments suggested various modifications to the proposals (including making the sourcing arithmetic a multi-year calculation, rather an annual one), whereas some called for outright withdrawal.

The IRS is currently accepting further comments through the US federal e-rulemaking portal.

Implications of the Proposals

These regulations are particularly significant for:

• Multinational tech companies offering cloud-based services,
• Digital content providers,
• Overseas entities with US customers, and
• Tax professionals advising on cross-border digital transactions.

The rules aim to provide greater clarity and consistency, but they may also introduce new challenges, especially in determining the location of the relevant activity (the performance of services or the use of property) in a virtual environment.