Since the dawn of the digital age, the Internal Revenue Code has been playing catch up to the sophistication and rapid change that technology companies have ushered in to the global economy. 

The constant evolution has posed difficulties for technology companies in understanding the application of existing tax rules that don’t address their everyday business transactions. This gap has led to uncertainty, which at times, has prevented companies from availing themselves of tax benefits that could be afforded to them with clear tax guidance. 

This has posed an even bigger headache in a cross-border context, particularly when it comes to characterizing and sourcing digital transactions. Characterization and sourcing of income is critical for all areas of tax, especially cross-border transactions. Many tax benefits, such as the foreign derived intangible income (FDII) benefit and utilization of foreign tax credits, depend on specific characterization and sourcing rules.

It is critical for tech companies to correctly source and characterize their transactions properly to minimize their U.S. tax burden and avail themselves of tax benefits.

Guidance for digital content, cloud transactions

On Jan. 14, 2025, the Treasury Department issued Final and Proposed Regulations(Opens a new window) that address some of these issues while also leaving open other areas. The Final and Proposed Regulations primarily cover digital content and cloud transactions.

Cloud transactions

• 2025 Final Regulations treat cloud transactions as the provision of services. Accordingly, technology companies that consider themselves as a Software as a Service (SaaS) provider would characterize income from cloud transactions as a service.
• 2025 Proposed Regulations address how cloud transactions would be sourced under the provision of services characterization. Place of performance would be based on a three-factor formula of intangible property, personnel, and tangible property.

Digital content transactions

• Under the 2025 Final Regulations, digital transactions will have a predominant character test to apply to transactions that have various components to them. For example, a video game company that sells digital copies of its games to consumers but also allows the consumer to play the video game online. If the predominant character of the transaction is a sale of a copyrighted article (as opposed to ability to utilize the cloud service to play the game online), then 100% of the transaction would be sourced according to the predominant factor (i.e. sale of copyrighted article). Previously, proposed regulations considered characterizing each piece of a transaction separately.

Enhanced clarity

The Final and Proposed regulations bring much clarity to the digital world and moving forward, technology companies will have added certainty when undergoing transactions.

CohnReznick’s International Tax team can assist technology companies in understanding these new rules as it relates to their cross-border transactions and help companies properly obtain tax benefits and minimize their tax risk.