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An Introduction to the Complexities of Taxing Cross-Border Transfers of Digital Goods and Services

February 2018 Erik Christenson, Steven Hadjilogiou, and Michael Bruno Tax

Today, many companies use the internet as a distribution channel to offer consumers a variety of digital goods and services. Consumers with smartphones can shop for clothing online or download their favorite flick with the click of a button. Many consumers have replaced file cabinets with the “cloud”1 to safeguard and access their data. The rapid development of the digital economy has created significant challenges with respect to the taxation of cross-border transactions involving digital goods and services. This article provides a summary of the evolving international landscape and an introduction to certain technical U.S. federal tax issues associated with the digital economy.

Recent Changes in International Tax Rules
In recent years, policymakers and legislators from across the world have taken a number of steps to address the challenges of taxing the digital economy. In some cases, countries have enacted legislation unilaterally, and, in other cases, the rule changes are the result of collective effort. For example, in 2013, the Organisation for Economic Co-operation and Development (OECD) published an action, “Addressing the Tax Challenges of the Digital Economy” (Action One), as part of the “Action Plan on Base Erosion and Profit Shifting”2 (BEPS Action Plan) that focused specifically on digital business models. Action One recognized several issues that presented base erosion and profit shifting (BEPS) concerns. These issues included 1) a company’s ability to have a significant digital presence in the economy of another country without being liable to tax due to the lack of nexus under existing international rules; 2) the attribution of value created from the generation of marketable location-relevant data through the use of digital goods and services; 3) mechanisms for properly characterizing income derived from new business models and applying related source rules; and 4) ensuring the effective collection of indirect taxes with respect to cross-border offerings of digital goods and services.3 The BEPS Action Plan recognized the need to form a dedicated task force on the digital economy.4 In response, the OECD Committee on Fiscal Affairs established the Task Force on the Digital Economy (TFDE) to examine these issues and develop detailed options to address them.5

In 2014, the TFDE, with the OECD, released an interim report on Action One, where the TFDE recognized a number of specific challenges6 linked to the digital economy, potential direct tax and indirect tax options,7 and identified the steps it would take in tackling these issues. The TFDE agreed to employ a framework based upon the basic tax principles of neutrality, efficiency, certainty, fairness, flexibility, and proportionality.8

Subsequently, in 2015, the TFDE released its final report on Action One, where the TFDE provided its conclusions9 and recommendations for addressing the BEPS challenges raised by the digital economy.10 Significantly, the TFDE did not recommend that countries adopt specific direct-tax options, such as alternatives to the existing PE threshold (i.e., significant economic presence) or the imposition of withholding taxes on certain types of digital transactions or equalisation levies, because of ongoing work being carried out under other BEPS Actions (e.g., Action Seven).11 The TFDE noted that countries could introduce such options in their domestic laws as additional safeguards against BEPS provided they respect existing treaty obligations or bilaterally agree to include such options in their tax treaties.12 The TFDE recommended that countries should apply the principles of the OECD’s International VAT/GST Guidelines and consider introducing the collection mechanisms contained in such guidelines, particularly with respect to cross-border business-to-consumer transactions.13 Seemingly buoyed by the recommendation, numerous countries have implemented extraterritorial VAT regimes that impose indirect taxes on remote suppliers of electronic services.14 To this day, the OECD and TFDE continue to monitor developments in the digital economy.15 The OECD and TFDE recently announced their intent to publish an interim report in April 2018, which will focus on identifying long-term issues and assessing the consequences of countries acting unilaterally.16

In recent months, there has been a growing buzz in the EU with respect to the taxation of digital companies doing business in Europe. Finance ministers from France, Germany, Italy, and Spain have supported implementing an “equalisation tax” on the “turnover generated in Europe by the digital companies.”17 Essentially, this tax would be imposed “at the source,” i.e., the location where payment is made, rather than where the digital company makes the supply.18 Subsequently, the European Commission released a communication, “A Fair and Efficient Tax System in the European Union for the Digital Single Market,” where it outlined weaknesses in the international tax rules for digital transactions and recommended short-term fixes to address these problems.19 The EU commission expressed its concerns that the current rules no longer fit the modern context, for example, where businesses rely on hard-to-value intangible assets, such as data and automation, to facilitate cross-border online trading without the need for physical presence.20

A number of unilateral measures taken by countries have attempted to address BEPS concerns.21 While some of these unilateral measures (such as the diverted profits tax22) affect digital and nondigital companies alike, in some cases digital companies have been the express or implied targets of such legislation. Among the unilateral measures that directly target the digital economy are taxes directly on specific digital services,23 and special characterization and sourcing rules applied to digital transactions.24

Taxation of Cross-Border Transactions
In determining whether and how tax should be imposed on transactions involving digital goods and services, a threshold question is what degree of nexus is required for a country to be able to tax such transactions.25 To illustrate, if a consumer who resides in the United States downloads a mobile application that was designed by a company in Brazil that owns and operates servers in the United Kingdom, which country is entitled to tax the download? The right of each country to impose tax depends on the character of the transaction and the income derived therefrom, as determined under domestic law, but with each country’s taxing jurisdiction potentially limited by the application of an income-tax treaty. Most domestic law taxing regimes apply principles that focus on either the source of the income or residence of the taxpayer.

If a provider of digital goods and services has sufficient nexus to be taxed in the source jurisdiction (often referred to as a permanent establishment26 (PE) in that country), the person generally would be subject to tax on a net basis and be required to comply with local registration and reporting requirements. Most income tax treaties embody this principle, that the source country has jurisdiction to tax a nonresident with a local PE, but only to the extent of the business profits attributable to the PE. Even if the provider does not have a PE, the provider’s income may nonetheless be subject to local withholding tax on a gross basis (an applicable treaty might reduce the rate of withholding or even exempt such income from withholding).27 Finally, most countries have indirect taxes, such as value-added taxes, that may also apply to payments for digital goods and services.

Key Technical Considerations
Cloud Computing, Servers, and Websites —Digital companies often use the cloud to deliver a variety of different products and services to their customers. This includes hosted software, storage, and processing hardware infrastructure, and hosted platforms that allow developers to create applications or other programs. A familiar cloud service model is software as a service (SaaS).28 As discussed in more detail below, a key distinction is between SaaS and software itself. This is important because each gives rise to a different character of income and, therefore, might be governed by a different set of tax rules to determine how the transaction will be characterized for U.S. federal tax purposes.

SaaS solutions are typically delivered to a consumer over the internet for a fee. In most cases, the customer has restricted access to the software enabling the SaaS solution. In contrast, software as a product in and of itself can be delivered on a tangible medium, such as a CD or USB, or a customer might be able to download a copy of software from a master file that otherwise is hosted remotely. In most cases, whether software is accessed as SaaS, or on tangible media, or via download, the customer will typically have to agree to the terms of a license to use the software.

Providers in the area of electronic commerce may deploy hardware and software in one or more locations to supply digital goods and services to customers in yet another location, raising the question of whether the provider should be taxed in the jurisdiction in which its employees are located or where the hardware or software elements are located. In this context, a distinction should be made between websites and the servers that host them. Websites generally do not constitute PEs under OECD treaties because they lack a tangible physical component and, therefore, do not use a location that can constitute a “place of business.”29 In contrast, a server on which the website is stored and through which it is accessible is a piece of equipment having a physical location, which could constitute a “fixed place of business” for the company that owns and operates the server if the physical premises are at the disposal of the operator.30 Numerous countries have implemented guidelines on the use of servers as creating PEs.31 In our view, the correct technical result is that merely transacting through an in-country server that is not owned or leased by the nonresident, and that is not at the disposal of the nonresident, should not create a PE.32

Characterizing Income Derived in a Digital Transaction —When faced with the difficult question of determining U.S. federal income tax consequences of international transactions involving digital goods and services, the taxpayer must first determine the nature of the transaction as a provision of a service, a lease of an item of property, a sale of intangible property, a sale of inventory property, or a license of the right to use intangible property (such as a copyright). The nature of the transaction will dictate the character of the income, which, in turn, will dictate the source of the income. Together, these things drive certain U.S. income-tax consequences, particularly in the international context.33 Examples include the effectively connected income (ECI) rules,34 the Subpart F regime,35 and foreign tax credit rules.36

The Treasury regulations under §1.861-18 (hereinafter “software regulations”) provide rules for characterizing transactions involving the transfer of computer programs.37 The software regulations classify computer software transactions into the following four categories: 1) the transfer of copyright rights;38 2) the transfer of a copy of a computer program (copyrighted article); 3) the provision of computer programming services;39 or 4) the provision of know-how40 relating to computer programming techniques.41 Importantly, the scope of the software regulations does not include transactions involving digitized content or digitized services that do not involve the transfer or a computer program.

A transaction involving a transfer of a computer program that involves no more than a de minimis transfer of copyright rights, programming services, or know-how is generally treated as a transfer of a copyrighted article.42 A copyrighted article includes a copy of a computer program from which the work can be perceived, reproduced, or otherwise communicated, either directly or with the aid of a machine or device.43 The copy of the program may be fixed in the magnetic medium of a floppy disk, or in the main memory or hard drive of a computer, or in any other medium, including via electronic download. The means by which the computer program is transferred is irrelevant.44 A transfer of all benefits and burdens of ownership to a copyrighted article is treated as a sale of personal property.45 A transfer of less than all benefits and burdens (e.g., a transfer for a fixed term shorter than the useful life of the copyrighted article) is treated as a lease, giving rise to rental income.46

Transactions involving hosted software, such as SaaS, do not include a transfer of a computer program, and, accordingly, the software regulations should not govern the characterization of such transactions.47 The question, then, is whether the hosted software transaction is a property transaction or services transaction? One area where such a distinction is made is I.R.C. §7701(e), which provides that a contract that “purports to be a service contract” can be recast as a lease, depending on applying certain enumerated factors that might support characterizing the transaction as a lease rather than a service. A number of important cases analyzing the I.R.C. §7701(e) factors (and similar factors predating I.R.C. §7701(e)), should be considered when conducting such analysis in the context of SaaS services or similar digital transactions.48 Payments made in exchange for SaaS services are generally characterized as service income because such transactions do not satisfy a number of the I.R.C. §7701(e) factors.49

Sourcing of Income — In addition to the “character” of the income, the “source” of the income will also drive certain U.S. federal income tax consequences (e.g., application of withholding tax regime to foreign persons,50 application of the foreign tax credit limitation formula).51 Income earned from the performance of “services” is sourced according to the place of performance.52 Thus, if the services are performed in the United States, the income is U.S.-sourced income, and subject to U.S. federal income tax; if the services are performed outside the United States, then the income is foreign-sourced income.53 Determining where a digital service is performed, and, thus, the source of the income derived in connection with such service, can be difficult. For example, computer equipment that facilitates delivery of the digital product might be located in one country, and employees that maintain and monitor such equipment might be located in another country, and the coders who developed the software might reside in a third country.54

Income earned from rents and royalties55 are sourced according to place in which the property is located or used.56 Caselaw and other authorities interpreting this standard as it applies to royalties do not provide a clear framework for the analysis.57 The gain from the sale of personal property, such as a sale of intangible property, is sourced according to the residence of the seller.58 However, sales of intangibles made in exchange for payments that are contingent on the productivity, use, or disposition of the intangible are sourced in the same fashion as royalties.59 On the other hand, sales of inventory property, such as the sale of a computer program at retail, are sourced where title passes.60 Finally, a foreign-sourced gain may be recharacterized as a U.S.-sourced gain if the sale is attributable to an office or fixed place of business in the United States.61

Challenges of Determining Character and Sourcing in the Digital Economy — As described above, the character and source of income plays a pivotal role in determining the U.S. federal income tax and treaty consequences of a particular transaction. In certain transactions involving digital goods and services, determining the character of the transaction can be difficult to discern. The following examples illustrate these complexities.

Character of Income:

• A foreign company offers web-hosting services to global businesses for a monthly fee. The foreign company leases the servers on which it hosts the websites. The foreign company does not obtain any rights in the copyrights created by the developer of the website content. The owner of the copyrighted material on the website may exploit and manipulate the website and content. The foreign company qualifies for the benefits of a tax treaty, which has a royalty article (art. 12) that defines payments for “industrial, commercial, or scientific” equipment as royalties.62 Is the monthly fee characterized as a service or lease under U.S. domestic law? The I.R.C. §7701(e) factors should be applied to make this determination. Is the payment for the hosting service governed by art. 12 of the treaty?

• Determining character can become challenging when a person downloads software with hosted features and enhancements. For example, assume that customers download certain software. In addition, the provider of the software agrees that it will 1) allow the end user to remotely access numerous hosted device management software applications and customize such applications; 2) provide updates to the software applications; and 3) provide technical support for the hardware and software. Would this transaction be characterized as a sale, lease, or service?63 The contract has multiple elements; the hosted software element, perhaps, can be analyzed by applying the I.R.C. §7701(e) factors.

• Under an intercompany agreement, a U.S. parent grants its foreign subsidiary a perpetual and exclusive license of the right to reproduce the software and make copies available for its trade partners. The U.S. parent retains the right to sue and the right to restrict sublicensing. The U.S. parent also agrees to provide technical support services to the foreign subsidiary with respect to using, reproducing, and personalizing the software. Is the transaction characterized as a sale of the software, a license for the right to use the software copyright, or a provision of service? At issue is whether there has been a transfer of all substantial rights64 to the software and if the technical services would be considered de minimis.65

A company provides a marketplace that enables third-party sellers to provide digital goods, such as applications, directly to customers. The marketplace terms of use provide that the company does not take title to the digital goods, and does not act as sublicensor with respect to same. The company has a number of payment options that it offers to the sellers on the marketplace, including a commission-fee arrangement, which calls for a commission as a percentage of the sales price, and a listing fee arrangement, which calls for a fee for listing the item on the company’s website for a certain period of time and determined based upon duration. What is the character of the company’s income under the commission-fee arrangement? The listing fee arrangement? What is the result if the company does take title or act as sublicensor?

Source of Income:

• Assume a U.S. company’s provision of streaming access to online content is characterized as a service. Is the “place” of the performance of the services where the developer created the underlying software enabling the online content, where the server hosting the software is located, or where other necessary functions are performed by employees of the service provider?

• An Indian resident company is granted a term-limited enterprise license to use financial services software in exchange for fees that are characterized as rental payments. The license permits the Indian company’s employees to download copies to their individual devices or laptops, but some employees will travel and use the software while in the United States. What is considered the place of “use” for purposes of sourcing the rental income received from the Indian resident company?

• A Brazilian company develops software to be used as a computer operating system. The software is protected under Brazilian copyright law. The Brazilian company licenses to its U.S. subsidiary the rights to sell, copy, use, manufacture, and sublicense such software. The U.S. subsidiary renders it compatible with U.S. and Asian manufactured computers. The U.S. subsidiary makes copies of the software and sells individual copies to end-users located throughout the United States and Asia. Is the software copyright used where the copyright is legally protected, where the copying and sublicensing takes place, or where the users reside?

• A Peruvian company develops restaurant management software that allows restaurants to manage employee scheduling, inventory, and accounting. For a higher price, a restaurant can modify the software to make it compatible with its personal operational needs. The Peruvian company has a management team located in New York that markets and negotiates the licensing of software to chain restaurants located across the United States. Many of the U.S. restaurants have chains in Asian, European, and South American countries that utilize the software. The Peruvian company derives a substantial amount of rental or royalty income from these U.S. chain restaurants. Would all or part of such income be U.S.-source income? Even if it were foreign-source, would the Peruvian company be taxable in the United States under the ECI regime?

There are numerous intricacies involved in taxing cross-border offerings of digital goods and services. With the rapid influx of newer technology and digital advancements, the tax landscape will constantly change and evolve. This article only scratches the surface of these issues. For companies and individuals operating in this space, it is critical to stay abreast of the latest developments.

1 Cloud computing has been technically defined as “a model for enabling ubiquitous, convenient, on-demand network access to a shared pool of configurable computing resources (e.g., networks, servers, storage, applications, and services) that can be rapidly provisioned and released with minimal management effort or service provider interaction.” Peter Mell & Timothy Grance, The National Institute of Standards and Technology, The NIST Definition of Cloud Computing 3 (Sept. 2011) (hereinafter the “NIST Report”), available at In plain terms, it represents access to computing resources in a virtualized environment across a public connection, such as the internet. All references made to the Internal Revenue Code shall mean the Internal Revenue Code of 1986 as amended.

2 OECD, Action Plan on Base Erosion and Profit Shifting 14-15, OECD Publishing (2013), available at

3 Id.

4 Action Plan Ch. 3 at 14-15.

5 See OECD, BEPS Action One: Address the Tax Challenges of the Digital Economy 6, Public Discussion Draft (2014) available at

6 Among others, this included 1) ensuring that core activities cannot inappropriately benefit from the exception from permanent establishment (PE) status and that artificial arrangements relating to sales of goods and services cannot be used to avoid PE status; 2) the importance of intangibles, the use of date, and the spread of global value chains, and their impact on transfer pricing; 3) the possible need to adapt controlled foreign corporation (CFC) rules that would subject income that is commonly earned in the digital economy to tax in the jurisdiction of the ultimate parent company; and 4) address opportunities for tax planning by businesses engaged in VAT-exempt activities. See OECD, Addressing the Tax Challenges of the Digital Economy 13-16, OECD/G20 Base Erosion and Profit Shifting Project, OECD Publishing (2014) (hereinafter “Action One – 2014 Interim Report”), available at

7 With respect to nexus and data, options included changes to the definition of PE to the introduction of a new nexus based on a “significant presence” in a market, and also the creation of a withholding tax on sales of digital goods and services. See Action One-2014 Interim Report at 18, 143-46, 153. One consumption tax option replaced threshold exemptions for imports of low-value goods with simplified registration mechanisms so that nonresident vendors, including small and medium enterprises, could easily comply. Id. at 147.

8 Id. at 149-51.

9 The TFDE recognized that its conclusions could evolve as the digital economy continues to develop products, such as robotics, the internet of things, 3D printing, and the peer-to-peer sharing economy.

10 See OECD, Addressing the Tax Challenges of the Digital Economy 11-12, Action One-2015 Final Report, OECD/G20 Base Erosion and Profit Shifting Project, OECD Publishing, Paris (Oct. 5, 2015) (hereinafter, the “Action One – 2015 Final Report”), available at

11 See Action One – 2015 Final Report at 137.

12 Id. at 136, 137, and 148.

13 Id. at 136 and 148.

14 Countries that have enacted or intend to enact extraterritorial VAT regimes include Albania, Australia, the Bahamas, Bahrain, Belarus, Colombia, Egypt, Ghana, Iceland, India, Italy, Japan, Kenya, Korea, Kuwait, Norway, Oman, Qatar, New Zealand, Russia, Saudi Arabia, Serbia, Singapore, South Africa, Sri Lanka, Switzerland, Taiwan, Thailand, Turkey, the United Arab Emirates, and Uruguay.

15 Recently, in October 2017, the OECD released stakeholder comments on the impact of the digital economy on value creation and business models, challenges faced with taxing cross-border digital transactions. See OECD, Tax Challenges of Digitalisation: Comments Received on the Request for Input – Parts I and II (Oct. 25, 2017), available at;

16 See Soong Johnston, Stakeholders Talk Taxation of the Digital Economy at OECD Consultation, Tax Notes (Nov. 6, 2017), available at

17 Bruno Le Maire, et al., Political Statement: Joint Initiative on the Taxation of Companies Operating in the Digital Economy, available at The Italian legislature is currently debating whether to enact such a measure into domestic law. The UK chancellor of the exchequer recently announced in his Autumn budget (2019) a similar proposal, and Treasury released a position paper outlining same.

18 See Council of the European Union, General Secretariat of The Council, Presidency Issues Note on Corporate Taxation Challenges of the Digital Economy (Sept. 4, 2017).

19 See European Commission, A Fair and Efficient Tax System in the European Union for the Digital Single Market (Sept. 21, 2017), available at

20 Id.

21 Several examples include the UK’s introduction of a diverted profits tax (DPT) to catch profits diverted through aggressive PE planning (see also Australia’s Multinational Anti-Avoidance Law), Thailand’s proposed digital PE to capture foreign operators doing extensive business in Thailand remotely by broadening the interpretation of “taxable presence,” and Malaysia’s withholding tax on the gross value of all outbound software and associated services payments.

22 See id.

23 In 2016, India introduced an equalization levy upon certain specified digital services, including advertising revenue. See The Government of India’s Finance Act 2016, Ch. VIII, available at;jsessionid=C6AC032C18BDE289C1FB3A9D3968059A.

24 In 2017, Malaysia amended its definition of “royalty,” which now purports to include consideration derived from the use of software. See Laws of Malaysia, Act 785, Finance Act 2017, available at Additionally, Malaysia amended its income tax act to impose withholding tax on outbound payments for services, including digital services, regardless of whether the services are performed in Malaysia or outside of Malaysia. Section 15A. However, Malaysia recently introduced withholding tax exemptions on these fees for offshore services. See Baker McKenzie Alert, Malaysia Introduces Withholding Tax Exemption on Fees Paid for Offshore Services (Oct. 26, 2017).

25 See Action One-2015 Final Report at 11, available at

26 Under U.S. federal statutory law, a foreign taxpayer is considered to be subject to the tax jurisdiction of the United States if the person is engaged in a trade or business in the United States, and has income effectively connected to the U.S. trade or business. See I.R.C. §§864(b), 871(b), and 882(a).

27 Transactions involving digital goods and services can raise treaty-related issues in a couple of different contexts, including whether automated online contracting affects the issue of whether a PE exists, and whether certain payments in relation to the provision of digital goods and services might be considered royalties and therefore governed by art. 12 of the treaty. Some treaties define royalties to include any consideration paid for the use of computer software or payments for the use “industrial, commercial, or scientific” experience. Income earned from transactions involving SaaS should not be regarded as a payment for the use of “industrial, commercial, or scientific” experience.

28 Customers under SaaS contracts are able to use the provider’s applications running on a cloud infrastructure from various client devices, such as a web browser. See NIST Report at 2. The customer does not manage or control underlying cloud infrastructure (e.g., networks, servers, operating systems) with the possible exception of limited user-specific application configuration settings. Id.

29 OECD Commentary ¶¶42.2 and 42.3. In the context of state and local sales and use tax, physical presence is currently required to impose a tax collection obligation on an out-of-seller. See Quill v. North Dakota, 504 U.S. 298 (1992) (ruling that physical presence is required to impose a sales and use tax collection obligation). However, state statutes based on attributional nexus principles have expanded the circumstances in which an out-of-state seller might be subject to sales/use tax, including recent “click-through nexus” statutes. See, e.g., New York Tax Law §1101(b)(8)(vi) (upheld in, Inc. v. State Dep’t of Taxation and Fin., 987 N.E.2d 621 (N.Y. Ct. App. 2013), cert. den., 134 S. Ct. 682 (2013). Recently, Massachusetts adopted so-called “cookie” nexus for sales and use tax purposes that requires online sellers that do not otherwise have physical presence in Massachusetts to collect and remit sales or use tax if their internet cookies are stored on in-state consumer’s computers and other devices on the basis that the cookies constitute a physical presence in the state. See Massachusetts Regulation, 830 C.M.R. 64H.1.7. In contrast, to impose a state income or other business activity tax on a nonresident, economic presence may be all that is required. See, e.g., Crutchfield Corp. v. Testa, Slip Opinion No. 2016-Ohio-7760 (Ohio S. Ct. Nov. 17, 2016), cert. den. (concluding that an out-of-state company had ‘‘substantial nexus’’ with Ohio for commercial activity tax purposes based on having more than $500,000 of Ohio receipts); Geoffrey, Inc. v. South Carolina Tax Comm’n, 437 S.E.2d 13 (S.C. 1993), cert. den., 510 U.S. 992 (1993) (concluding that substantial nexus with South Carolina was established where an out-of-state taxpayer licensed intangible property for use in the state).

30 See id. at 42.2 and 42.3.

31 For example, in the United Kingdom, the HMRC has clarified that a server by itself or in conjunction with websites cannot constitute a PE of a business. See ¶INTM 266100 of the HMRC International Tax Manual (“[A] server either alone or together with web sites could not as such constitute a PE of a business that is conducting e-commerce through a web site on the server. We take that view regardless of whether the server is owned, rented or otherwise at the disposal of the business.”). In Canada, the tax authority concluded the mere presence of a nonresident’s data and website on a server located in Canada, without more, was insufficient to create a PE. See CRA Document No. 2012-0432141R3 (2012). In Denmark, SKAT concluded that a Danish resident did not have a PE in a particular foreign country because the Danish resident did not own the servers on which its website was stored. SKATR2015.14-5229337 – SKM 2015.369.SR (2015). In contrast, India’s Authority for Advance Rulings (AAR), a quasi-judicial authority on tax matters, ruled that nonresident enterprises’ server can constitute a PE for tax purposes. A.A.R. No.876 of 2010 (Feb. 7, 2012). Other countries that have guidance on servers, include Argentina, Australia, Germany, Hong Kong, Italy, Japan, Malaysia, New Zealand, Singapore, Sweden, and Turkey.

32 As a planning matter, nonresident enterprises should consider whether to use a third-party provider (including potentially an affiliate entity) to own and operate the server. In any case, the nonresident should not have the server premises at its disposal.

33 A closely related issue is whether the transaction proceeds give rise to ordinary income or capital gain. If a U.S. person creates a mobile application, and then sells all substantial rights in the underlying intangible property, the income likely would be characterized as a “sale” of property. In such case, the gain or loss from the sale generally would be characterized as a capital gain or loss, and such gain or loss would be sourced by reference to the seller’s residence, i.e., would be U.S. sourced income. See I.R.C. §865(a)(1); but see I.R.C. §1221(a)(3) (excluding certain “copyrights” from the term “capital asset”). However, if the U.S. resident maintains an office or other fixed place of business in a foreign country, and its income from the sales of such property is attributable to such office or other fixed place of business, then it should be foreign-source income.

34 Character is the threshold determination for determining the “source” of income (as described in Part III.c.), which, in turn, is a critical aspect of the ECI regime. The ECI regime provides exceptions for certain types of income derived from foreign sources. See I.R.C. §864(c)(4)(A) and (B) (exceptions for certain rents, royalties, dividends, interest income, and income derived from sales of inventory). Foreign source income earned from the performance of services can never be ECI.

35 See I.R.C. §954(c) (“foreign personal holding company income” includes certain rents, royalties, and income derived from sales of property); I.R.C. §954(d) (foreign base company sales income); I.R.C. §954(e) (foreign-based company services income).

36 I.R.C. §904(d). “Passive income” generally is defined to mean income that is of a kind that would be considered foreign personal holding company income, which can include certain rents and royalties. This would not include income earned from the performance of services. As such, how the income is characterized (as rent, royalty, or service), can affect whether it is treated as passive or general category income, and, thus, impact a taxpayer’s ability to use foreign tax credits.

37 Treas. Reg. §1.86118(a)(1). The software regulations define a computer program as “a set of statements or instructions to be used directly or indirectly in a computer in order to bring about a certain result…[and] includes any media, user manuals, documentation, database or similar item if [such]…item is incidental to the operation of the computer program.” Treas. Reg. §1.86118(a)(3). If the transaction does not involve the transfer of a computer program, then the software regulations should not apply to determine the tax consequences.

38 A transaction involves a transfer of a copyright right if the transferee receives any one of the following rights: 1) the right to make copies of the computer program for purposes of distribution to the public by sale or other transfer of ownership, or by rental, lease or lending; 2) the right to prepare derivative computer programs based upon the copyrighted computer program; 3) the right to make a public performance of the computer-program; or 4) the right to publicly display the computer program. Treas. Reg. §1.86118(c)(1)(i) and (c)(2).

39 The determination of whether a transaction involving a computer program as the “provision of computer programming services” or one of the other transactions is based on all the facts and circumstances of the transaction, including, as appropriate, the intent of the parties as to which party is to own the copyright rights in the computer program and how the risks of loss are allocated between the parties. Treas. Reg. §1.86118(d).

40 A transaction will be treated as a “provision of know-how” if information relating to computer-programming techniques, is furnished under conditions preventing unauthorized disclosure, specifically contracted for between the parties, when the information transferred is subject to trade secret protection. Treas. Reg. §1.86118(e).

41 Treas. Reg. §1.86118(b)(1).

42 Treas. Reg. §1.86118(c)(1)(ii).

43 Treas. Reg. §1.86118(c)(3).

44 Treas. Reg. §1.86118(g)(2).

45 Treas. Reg. §1.86118(f)(2). A question may arise as to whether a transfer of copyrighted article under an end-user license agreement (EULA) is characterized as a sale or lease. In our view, the EULA (which may provide that the transferor retains various important IP rights) is ancillary to the more important commercial transaction to be analyzed from an income tax perspective, which is the provision of copyrighted article itself in exchange for valuable consideration. If the transaction provides the transferee with the benefits and burdens of ownership over the copyrighted article, then the transaction should be considered a sale. Alternatively, if the transferee’s use of the copyrighted article is subject to limitations (e.g., a limited term), then the transaction might be considered a lease of a copyrighted article. Treas. Reg. §1.86118(f)(2).

46 Id.

47 See Treas. Reg. §1.861-18(b)(1), limiting the scope of the software regulations to transactions “involving the transfer of a computer program” or the provision of services or know-how with respect to a computer program. Because a SaaS transaction involves software, some consideration should be given to determine whether the software might be considered a “copyrighted article” and subject to the software regulations. Generally, the software regulations should not apply to an SaaS transaction, because customers under SaaS contracts are merely provided with remote access to certain hardware and software resources on a pooled basis running on the cloud infrastructure.

48 See Tidewater Inc. v. U.S., 565 F.3d 299 (5th Cir. 2009) (applying the §7701(e) factors to determine the income earned by a time charter that supplied a vessel complete with a crew to its customers as leasing income); Xerox Corp. v. U.S., 656 F.2d 659 (Ct. Cl. 1981) (applying a set of factors predating §7701(e) to determine that a supply of copying machines was treated as a service); E.N. Smith v. Comm’r, T.C. Memo 1989-318 (applying I.R.C. §7701(e) factors to a scanner and camera placed in service after the enactment of I.R.C. §7701(e), but applying pre-I.R.C. §7701(e) factors to xeroxography equipment placed in service before its enactment).

49 The I.R.C. §7701(e) factors supporting service characterization for SaaS transactions are the following: 1) the customer is not in physical possession of the software; 2) the customer does not control the software application; 3) the customer does not have a significant economic or possessory interest in the software; and 4) the provider uses the software to provide services to multiple third parties.

50 Non-U.S. persons are subject to U.S. withholding tax, on a gross basis, on certain types of non-ECI derived from sources within the United States (U.S.-source income) such as dividends, rents, and interest (commonly referred to as FDAP income), and to U.S. federal income tax, on a net basis, on under the ECI regime. See I.R.C. §§871(a)(1)(A), 871(b), and 881(a)(1). Some items, such as capital-gain income earned from the sale of property, are not subject to the FDAP Income withholding tax regime.

51 In 2017, the U.S. House and U.S. Senate released separate tax reform proposals that included proposals to allow a 100 percent deduction for foreign-sourced portion of dividends received from certain 10 percent owned foreign corporations by U.S. shareholders. See Joint Committee on Taxation, Description of the Chairman’s Mark of the “Tax Cuts and Jobs Act,” Nov. 9, 2017, IV.A.; H.R. 1-115, Tax Cuts and Jobs Act §§4001-4004 (Nov. 2, 2017).

52 See I.R.C. §§861(a)(3) and 862(a)(3).

53 Id.

54 See Piedras Negras Broad. Co. v. Comm’r, 43 BTA 297 (1941) (nonacq. 1941-1 CB 18), aff’d, 127 F.2d 260 (5th Cir. 1942) (ruling that the source of a Mexican broadcaster’s income was found to be Mexico, where its broadcast originated, facilities and personnel were located, and not the United States, where its customers were located); see also Korfund v. Comm’r, 1 T.C. 1180 (1943) (interpreting Piedras Negras and noting that “in holding that the source of such income was not within the United States, we pointed out that the studio and broadcasting plant were located, and operated by the employment of capital and labor, in Mexico; that the source of the income was, accordingly, in such studio and power plant, and that the reception of the radio impulses in receiving sets in this country was secondary, not the primary source. The court in affirming the decision said that ‘the source of income is the situs of the income-producing service’ and that the source of the income was ‘the act of transmission.’”).

55 The term “royalties” is often referred to as “amounts received for the privilege of using patents, copyrights, secret processes and formulas, goodwill, trademarks, trade brands, franchises, and other like property.” Treas. Reg. §1.543-1(b)(10).

56 See I.R.C. §§861(a)(4) and 862(a)(4). The sourcing rules on royalties also apply to gains from the sale of an intangible to the extent the income is contingent on its productivity.

57 Compare, e.g., Rev. Rul. 84-78, 1984-1 C.B. 173 (finding that a payment by a foreign corporation to a domestic corporation for the right to broadcast prize boxing fights was foreign sourced income, because it was entitled to broadcast the fight in the country of the foreign corporation) with Sanchez v. Comm’r, 6 T.C. 1141 (1946), aff’d, 162 F.2d 58 (2d Cir. 1947) (finding that royalties paid by a domestic corporation licensee to a nonresident individual were U.S. sourced even though goods were to be used abroad).

58 I.R.C. §865(a).

59 I.R.C. §865(d).

60 See I.R.C. §§861(a)(6) and 862(a)(6); Treas. Reg. §1.861-18(f)(2).

61 I.R.C. §865(e)(2).

62 See note 27.

63 If a transaction is comprised of several components, the taxpayer must determine whether to “unbundle” the transaction into several characterizations. See OECD Commentary to 2014 OECD Model, art. 12, ¶11.6 (Allocate consideration among various parts of a contract unless one part constitutes “by far” the principal purpose of the contract and the other parts are “only of an ancillary and largely unimportant character.”); Treas. Reg. §1.954-1(e)(3) on “predominant character.” See also Tidewater Inc. v. U.S., 565 F.3d 299, 304 (Fifth Court essentially characterized the transaction as a lease based upon the predominant character of the transaction, even though the transaction had attributes of both a service and a lease.). The Tax Court has bifurcated fees received under certain endorsement agreements between royalty and personal services income. See Goosen v. Commissioner 136 T.C. 547 (2011), and Garcia v. Commissioner 140 T.C. 141 (2013). Other courts have recognized that allocation is demanded “where part of a transaction calls for one tax treatment and another for a different kind.” Comm’r v. Ferrer, 304 F.2d 125 (2d Cir. 1962). But see Illinois Cereal Mills, Inc. v. Comm’r, 46 T.C.M. (CCH) 1001 (1983), aff’d, 789 F.2d 1234 (7th Cir. 1986), cert. den., 479 U.S. 995 (1986) (no allocation required between nondepreciable trademarks and nondepreciable goodwill (pre-§197) because the tax consequences would not change).

64 In general, the “all substantial rights” test applies to determine whether the transfer of rights to intangible property should be considered a sale or license for U.S. federal tax purposes. See Pickren v. U.S., 378 F.2d 595 (5th Cir. 1967); The Taylor-Winfield Corp. v. Comm’r, 57 T.C. 205 (1971), aff’d, 467 F.2d 483 (6th Cir. 1972). To qualify as a sale or exchange as opposed to a license, all “substantial rights” in the intangibles must be transferred. See Pickren, 378 F.2d 595 (determining that transfers of secret formulas to a wax product for a 25-year period, under an exclusive right and license was not a sale, but a license, because the useful life of the formula extended beyond the 25-year period).

65 See Treas. Reg. §1.861-18(b)(2).

Erik Christenson is a partner at Baker McKenzie in San Francisco, where he is a member of the tax practice. He graduated with honors from Dartmouth College in Hanover, New Hampshire, and received his J.D. with honors from Hastings College of the Law in San Francisco. Christenson is a member of the California Bar.

Steven Hadjilogiou is a partner in Baker McKenzie’s tax practice group. He focuses on inbound and outbound international tax issues, with emphasis on transfer pricing, intellectual property, Subpart F, foreign investment in U.S. real property, the taxation of partnerships, corporations, international corporate reorganizations, and high-net-worth clients, and state and local tax.

Michael Bruno is an associate in Baker McKenzie’s tax practice group in Miami. He focuses on international tax planning, corporate and partnership taxation, and wealth management. Bruno has experience in advising companies on international tax matters involving technological equipment, digital goods, and services.

This column is submitted on behalf of the Tax Law Section, Joseph B. Schimmel, chair, and Christine Concepcion, Michael D. Miller, and Benjamin A. Jablow, editors.