Source of Income From Cloud Transactions, 3075-3085 [2024-31373]

Agencies

• Internal Revenue Service
• DEPARTMENT OF THE TREASURY

[Federal Register Volume 90, Number 8 (Tuesday, January 14, 2025)]
[Proposed Rules]
[Pages 3075-3085]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2024-31373]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-107420-24]
RIN 1545-BR21


Source of Income From Cloud Transactions

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking.

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SUMMARY: This document contains proposed rules for determining the 
source of income from cloud transactions for purposes of the 
international provisions of the Internal Revenue Code. These proposed 
rules would generally affect taxpayers who earn gross income from 
engaging in cloud transactions.

DATES: Written or electronic comments and requests for a public hearing 
must be received by April 14, 2025.

ADDRESSES: Commenters are strongly encouraged to submit public comments 
electronically. Submit electronic submissions via the Federal 
eRulemaking Portal at www.regulations.gov (indicate IRS and REG-107420-
24) by following the online instructions for submitting comments. 
Requests for a public hearing must be submitted as prescribed in the 
``Comments and Requests for a Public Hearing'' section. Once submitted 
to the Federal eRulemaking Portal, comments cannot be edited or 
withdrawn. The Department of the Treasury (Treasury Department) and the 
IRS will publish for public availability any comment received to its 
public docket, whether submitted electronically or in hard copy. Send 
hard copy submissions to: CC:PA:01:PR (REG-107420-24), Room 5203, 
Internal Revenue Service, P.O. Box 7604, Ben Franklin Station, 
Washington, DC 20044. Submissions may be hand-delivered Monday through 
Friday between the hours of 8 a.m. and 4 p.m. to: CC:PA:01:PR (REG-
107420-24), Courier's Desk, Internal Revenue Service, 1111 Constitution 
Avenue NW, Washington, DC 20224.

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, 
Christopher E. Fulle at (202) 317-5367 or Michelle L. Ng at (202) 317-
6989 (not toll-free numbers); concerning submissions of comments and 
requests for a public hearing, contact the Publications and Regulations 
branch at (202) 317-6901 (not a toll-free number) or by email to 
[email protected] (preferred).

SUPPLEMENTARY INFORMATION:

Authority

    The proposed regulations are issued under the express delegation of 
authority under section 7805 of the Internal Revenue Code (Code). 
Section 7805(a) directs the Secretary of the Treasury or her delegate 
to prescribe all needful rules and regulations for the enforcement of 
that section and others in the Code, including all rules and 
regulations as may be necessary by reason of any alteration of law in 
relation to internal revenue.

Background

    Proposed regulations published in the Federal Register (84 FR 
40317) in 2019 (REG-130700-14) (the 2019 proposed regulations) set 
forth proposed rules for identifying and classifying cloud 
transactions, and the preamble to the 2019 proposed regulations 
requested

[[Page 3076]]

comments on rules for sourcing income from cloud transactions. Comments 
received addressed the necessity of developing specific rules for 
sourcing gross income from cloud transactions and provided 
recommendations on the content of such rules. This notice of proposed 
rulemaking, which is being published with the final regulations for 
identifying and classifying cloud transactions (TD 10022) (the 2024 
final regulations) that are being published in the Final Rules section 
of this same issue of the Federal Register, proposes rules for sourcing 
gross income from cloud transactions.

Explanation of Provisions

I. Source of Gross Income From Cloud Transactions

A. Overview of Comments Received
    The Treasury Department and the IRS received more than a dozen 
comments in response to the request for comments on administrable rules 
for sourcing income from cloud transactions in a manner consistent with 
sections 861 through 865. Comments were split almost evenly with regard 
to whether specific sourcing rules are needed in this area, with a 
narrow majority expressing support for such guidance. Of this majority, 
several comments recommended that services income from cloud 
transactions be sourced according to the location of the assets and 
personnel used in providing the service. A number of these comments 
explained that this approach would align with the result in Piedras 
Negras Broadcasting Co. v. Comm'r, 43 B.T.A. 297 (1941), nonacq., 1941-
2 C.B. 22, aff'd, 127 F. 2d. 260 (5th Cir. 1942), in which the income 
of a radio broadcasting corporation was determined to be foreign source 
because its broadcasting facilities and employees were located in 
Mexico, even though the corporation broadcasted programs primarily to 
listeners located in the United States and received almost all of its 
income from advertisers located in the United States. Other comments 
voiced the need for specific rules for sourcing income from cloud 
transactions, but did not recommend a particular sourcing approach, 
with one comment suggesting that the location of the cloud service 
provider's assets and personnel and the location of the end-user could 
be evaluated in developing the rules. Another comment proposed that 
given the challenges of sourcing cloud transactions when the 
operations, employees, and customers are dispersed, the sourcing rules 
could provide taxpayers with the option to source the income to the 
place where the contract is executed. While almost half of the comments 
received stated that regulations for sourcing income from cloud 
transactions are unnecessary because existing statutory, regulatory, 
and case law provides sufficient guidance, an overwhelming majority of 
those comments recommended that if issued, the regulations should take 
into account the location of the assets and people that contribute to 
the delivery of the cloud service.
    Many of the comments discussed whether the sourcing determination 
should be made by taking into account solely the assets and personnel 
of the taxpayer that recognizes the income from the performance of the 
cloud service (the taxpayer-by-taxpayer approach), or whether taxpayers 
should be required to look through to the activities and personnel of 
other related legal entities that contribute to the provision of the 
service (the unitary approach). Nearly all comments on this issue 
stated that income from cloud transactions should be sourced on a 
taxpayer-by-taxpayer basis. Comments explained that the taxpayer-by-
taxpayer approach is administrable and supported by the principles of 
Miller v. Comm'r, 73 T.C.M. 2319 (1997), aff'd without published 
decision, 166 F.3d 1218 (9th Cir. 1998), in which income that a foreign 
corporation received for performing research and development services 
was held to be foreign source notwithstanding that the performance of 
those services was subcontracted to certain related and unrelated 
entities, including a wholly-owned U.S. subsidiary. One comment 
suggested that a taxpayer-by-taxpayer rule for sourcing services income 
from cloud transactions could be supplemented with anti-abuse 
provisions requiring the income to be sourced on a look-through or 
unitary basis in limited circumstances. However, another comment 
asserted that sourcing services income from cloud transactions on a 
look-through or unitary basis should be required, explaining that this 
approach more accurately reflects the economic realities of the 
transaction because it accounts for the contributions made by members 
of the multinational group to the provision of the service. That 
comment also expressed the concern that sourcing on a taxpayer-by-
taxpayer basis could cause U.S. source income to be understated with 
respect to commonly-used structures in which the development, 
enhancement, maintenance, protection, and exploitation functions are 
performed primarily by U.S. entities but the services income is 
recorded by a foreign entity that contracts directly with the end-users 
to whom the cloud transaction is provided.
B. Need for Proposed Regulations
    The development and advancement of cloud technologies has 
transformed both the value that businesses deliver to customers and the 
way that value is delivered, giving rise to cloud-based business models 
and cloud transactions. The 2024 final regulations classify a cloud 
transaction (within the definition of Sec.  1.861-19(b)) as the 
provision of services. See Sec.  1.861-19(c)(1). Under the source rules 
of the Code, which were designed in the context of more traditional 
modes of commerce, gross income from the provision of services is 
sourced to the place where the service is performed. See sections 
861(a)(3) and 862(a)(3). The Code does not provide guidance on how to 
determine the place of performance for specific types of service 
transactions, including cloud transactions. Further, while section 
863(b)(1) specifies that income from services rendered partly within 
and partly without the United States is treated as derived partly from 
each source, there is no statutory guidance prescribing how to source 
the services income, including income from cloud transactions, in such 
circumstances. The distinctive attributes of cloud transactions, 
including the network-based and increasingly automated nature of the 
service delivery and the role of intangible property (such as 
proprietary software and other proprietary digital content) in ensuring 
the functionality, reliability, and performance of the service, raise 
questions regarding how to determine the place of performance of a 
cloud transaction.
    The proposed regulations, which would establish specific sourcing 
rules that interpret the place of performance in the context of a cloud 
transaction, are therefore necessary to provide clarity and certainty 
to both taxpayers and the IRS. To determine the place of performance, 
the proposed sourcing rules would take into account the location of the 
employees and assets, including both tangible and intangible assets, 
that contribute to the provision of the cloud transaction. The Treasury 
Department and the IRS are of the view that, because of the technical 
nature of a cloud transaction, the place of performance for purposes of 
sourcing gross income is the place where the resources and personnel 
responsible for the development, management, and delivery of the 
service are located because this is where the key activities in the 
provision of the service occur, as

[[Page 3077]]

opposed to ancillary activities such as marketing, sales, and 
contracting. This approach is consistent with case law on the sourcing 
of income involving analogous traditional business models where 
services are provided from a location that differs from the customers' 
location, specifically, the Piedras Negras case. See 43 BTA at 297, 
aff'd, 127 F.2d at 260. In line with the approach in Piedras Negras, 
the proposed rules do not consider the location of the customer or end-
user, as it merely reflects the place where the service is consumed, 
not where the performance actually takes place as prescribed by 
sections 861(a)(3) and 862(a)(3). Similarly, the location where a 
contract for a cloud transaction is executed should not dictate the 
source of the resulting gross income because that location may not bear 
any connection to where the service is performed.
    The proposed cloud transaction sourcing rules would apply on a 
taxpayer-by-taxpayer basis and therefore, in determining the gross 
income of an entity that recognizes the services income, would take 
into account solely the assets and personnel of the legal entity. The 
Treasury Department and the IRS agree that this approach is 
administrable and practical. By focusing on the economic contributions 
that the contracting entity makes to the performance of the cloud 
transaction, the taxpayer-by-taxpayer approach provides a clear, 
straightforward way of determining the source of gross income from the 
transaction, while allowing for appropriate deductions from that gross 
income in respect of amounts paid or accrued to affiliated or 
unaffiliated contributors to the provision of the cloud services, 
leading to reduced complexity in tax compliance and enforcement. This 
approach is also generally consistent with the current approach for 
sourcing other categories of income, including non-cloud services 
income such as gross income from certain sales of inventory that is 
sourced to the location of production activity under Sec.  1.863-
3(c)(1)(ii). Further, this approach would not impede the IRS's ability 
to assert common law principles, such as the economic substance 
doctrine, the step transaction doctrine, and the rules of agency, or 
existing statutory and regulatory provisions, such as the section 482 
rules, to ensure that the Federal income tax consequences more properly 
reflect the economic realities of the transaction, including the 
contributions to a cloud transaction made by affiliates of the 
taxpayer. Notwithstanding the above, the Treasury Department and the 
IRS will continue to study the implications of applying the taxpayer-
by-taxpayer approach in the context of sourcing gross income from 
services generally, and may refine or propose revisions to the approach 
if they determine that this is necessary to adequately account for the 
interdependencies and collaboration across entities in a multinational 
group, and consequently, to ensure a fair and accurate representation 
of where services are performed.
C. Explanation of Proposed Rules for Sourcing Gross Income From Cloud 
Transactions
    The proposed regulations state that gross income from a cloud 
transaction is sourced as services income under section 861(a)(3) or 
862(a)(3), as appropriate, according to where the service is performed. 
Proposed Sec.  1.861-19(d)(1). The place of performance of a cloud 
transaction is established through a formula composed of a fraction 
that relies on three factors: the intangible property factor, the 
personnel factor, and the tangible property factor (within the meaning 
of proposed Sec.  1.861-19(d)(2), (d)(3), and (d)(4), respectively). 
Id.
    As discussed in detail in Parts I.C.1 through 3 of this Explanation 
of Provisions, the intangible property factor is intended to reflect 
the contribution of intangible property to the provision of the cloud 
transaction; the personnel factor is intended to reflect the 
contribution of certain employees to the provision of the cloud 
transaction; and the tangible property factor is intended to reflect 
the contribution of tangible property to the provision of the cloud 
transaction. Each factor is determined by taking into account certain 
worldwide expenses by the entity that, in the view of the Treasury 
Department and the IRS, properly represent the contributions made by or 
through the relevant personnel and assets to the performance of the 
cloud transaction. Together, these factors make up the denominator of 
the fraction. The numerator of the fraction is determined by summing up 
the portion of each factor that is from sources within the United 
States.
    Under the proposed regulations, the gross income from a cloud 
transaction multiplied by the fraction yields the portion of the gross 
income that is from sources within the United States. Proposed Sec.  
1.861-19(d)(1). The portion of the gross income that remains is gross 
income from sources without the United States. Id.
1. Intangible Property Factor
a. Determination of the Intangible Property Factor
    The Treasury Department and the IRS consider intangible property to 
be a significant contributor to the performance of cloud transactions. 
Intangible property, such as software, algorithms, data processing 
applications, and other proprietary technologies, often plays a crucial 
role in the performance of a cloud transaction, including by shaping 
the unique features of the service and ensuring the service's 
functionality, reliability, and delivery. This role of intangible 
property is becoming particularly important as cloud transactions are 
becoming increasingly automated, requiring less and less contribution 
from personnel and tangible property to deliver value to customers. In 
such cases, the intangible property itself may be the main force that 
is effectively performing the service. It would be difficult and 
burdensome, however, to ascertain the precise value or contribution of 
an item of intangible property to the performance of a cloud 
transaction given the challenges inherent in isolating the specific 
impact of various intangibles on the cloud transaction's overall 
performance. The Treasury Department and the IRS are of the view that 
certain research and experimental expenses, amortization, and royalties 
incurred during the taxable year in which the cloud transaction is 
performed could serve as an administrable proxy for reflecting the 
contribution of intangible property to the performance of the cloud 
transaction. These expenses serve as the foundation for the intangible 
property factor.
    Specifically, the intangible property factor is the sum of 
specified research or experimental expenditures (as defined under 
section 174(b)) incurred during the taxable year that are associated 
with the cloud transaction as well as royalty and certain amortization 
expenses incurred during the taxable year to the extent they are for 
intangible property directly used to provide the cloud transaction 
(collectively, ``intangible property costs''). Proposed Sec.  1.861-
19(d)(2)(i). Intangible property costs include payments to third-party 
and related-party research and experimentation providers. Because 
specified research or experimental expenditures are used as a proxy for 
current use of existing self-developed intangible property, those 
expenditures are taken into account as they are incurred, regardless of 
whether and

[[Page 3078]]

when they are deductible, in order to match the timing of when 
compensation is paid to employees performing research or 
experimentation activities. As discussed in Part I.C.1.b. of this 
Explanation of Provisions, the intangible property factor is sourced 
based on this compensation; therefore the Treasury Department and the 
IRS are of the view that taking the specified research or experimental 
expenditures in the year when incurred provides an administrable rule 
that recognizes the economic contribution of the intangible property 
and avoids taxpayers having to trace section 174(a)(2)(B) amortization 
deductions back to the year in which incurred. However, royalty and 
amortization expenses are taken into account for the intangible 
property factor when deductible because that is the most administrable 
proxy for measuring the economic contribution existing licensed or 
acquired intangible property makes to a cloud transaction.
    In computing the intangible property factor, the Treasury 
Department and the IRS recognize that some specified research or 
experimental expenditures may not be directly traceable to a single 
transaction because intangible property developed through research and 
experimentation conducted in a taxable year may not be monetized in 
cloud transactions until a future year. In light of this, and 
consistent with the approach taken for allocating and apportioning 
deductions for such expenditures, the proposed regulations provide that 
the specified research or experimental expenditures to be taken into 
account with respect to a cloud transaction from which the gross income 
is being sourced are those associated with all cloud transactions 
provided in that taxable year that are in the same product line as the 
cloud transaction. Id.; cf. Sec.  1.861-17(b) (recognizing that 
research and experimentation is an inherently speculative activity, 
which when successful ultimately results in the creation of intangible 
income, and allocating expenditures for such activity to gross 
intangible income earned in the year of the expenditure). The Treasury 
Department and the IRS are of the view that the current-year approach 
in the proposed rules serves as a workable, reliable, and appropriate 
proxy for existing intangible property in the same product line. Under 
the proposed regulations, cloud transactions are considered to be in 
the same product line if they are within the same Corresponding Index 
Entry under a North American Industry Classification System (NAICS) 
code number. Proposed Sec.  1.861-19(d)(8). The proposed regulations 
also include a consistency requirement to prevent taxpayers from 
changing Corresponding Index Entry and NAICS code numbers absent a 
change in facts. Id. The intangible property factor focuses on work 
done in the same product line as the cloud transaction to balance 
between specificity and practicality. The factor aims to capture the 
contribution of intangible property to the performance of a cloud 
transaction, so a factual relationship between the specified research 
or experimentation expenditures and the cloud transaction being tested 
needs to exist. At the same time, the Treasury Department and the IRS 
are aware that it is not necessarily possible to precisely determine 
the product or products that will benefit from a research and 
experimentation process at an early stage. To prevent duplication, the 
proposed regulations require expenses that would be included in the 
intangible property factor for multiple cloud transactions in a taxable 
year to be allocated among those transactions (taking into account the 
aggregation rule described in Part I.C.4 of this Explanation of 
Provisions) based on the relative gross income earned from each 
transaction. Proposed Sec.  1.861-19(d)(2)(i). Any intangible property 
costs that support cloud transactions in general but that do not relate 
to any specific cloud transaction should be allocated in the same 
manner.
b. Determination of the Portion of the Intangible Property Factor From 
U.S. Sources
    Once the intangible property factor is determined, the portion of 
this factor that is attributable to sources within the United States 
must be identified for inclusion in the numerator. Given the non-
physical nature of intangible property, its location when used in 
providing a service may be challenging to ascertain. Under the proposed 
rules, the portion of the intangible property factor that is from 
sources within the United States is determined based on the extent to 
which certain of the taxpayer's employees perform services in the 
United States, determined by leveraging the principles of Sec.  1.861-
4(b)(2)(ii)(E) (relating to sourcing compensation from labor or 
personal services on a time basis). The employees considered for this 
purpose are those whose primary function is to perform research and 
experimentation activities associated with cloud transactions in the 
same product line as the cloud transaction the gross income of which is 
being sourced. Proposed Sec.  1.861-19(d)(2)(ii). The proposed 
regulations provide that the employee's primary function is the set of 
tasks to which they are assigned to spend the majority of their working 
time. Proposed Sec.  1.861-19(d)(5). In order to account for amounts 
paid to third-party research and experimentation providers, 
amortization, and royalties, the fraction determined by the 
compensation that has been paid to the research and experimentation 
personnel is applied to the total research and experimental expense 
determined under Sec.  1.861-19(d)(2)(i). See proposed Sec.  1.861-
19(d)(2)(ii).
    The Treasury Department and the IRS are of the view that the 
location of research and experimentation personnel is a logical and 
accurate proxy for the location of intangible property that contributes 
to the performance of a cloud transactions for a number of reasons. 
First, the research and experimentation personnel contribute to the 
creation, design, and refinement of the intangible property either 
through their own efforts or by managing and facilitating research and 
experimentation work carried out by third parties. Therefore, the value 
of the intangible property used to provide the cloud transaction 
depends on their personal efforts and expertise. Additionally, while 
intangible property does not have a physical form that can be easily 
located, the place where research and experimentation personnel operate 
is tangible and verifiable. Relatedly, taxpayers generally know or 
should know the location of their research and experimentation 
personnel, and thus, relying on the location of these personnel would 
avoid a burdensome compliance process that might otherwise be required 
to determine the location of intangible property used to provide cloud 
transactions. For similar reasons, in determining gross income of a 
taxpayer, the rule does not look to research and experimentation 
personnel other than those of the taxpayer, and uses the taxpayer's own 
personnel as a proxy for all research and experimentation personnel 
working on the relevant intangible property.
    The determination of which research and experimentation employees 
should be taken into account focuses on the employees whose primary 
function is the performance of research and experimentation activities, 
without limiting the analysis to nonmanagerial employees or first-line 
managers who undertake these activities. This is because research and 
experimentation typically involves contributions from personnel across 
various levels of the organization, including senior

[[Page 3079]]

leadership and technical staff, as an idea for a product or service 
moves from concept to design, implementation, and testing. Accordingly, 
focusing solely on nonmanagerial employees or first-line managers could 
result in missing key contributors to the research and experimentation 
activities associated with a cloud transaction, including individuals 
within the organizational structure who oversee or engage in higher-
level experimentation efforts.
2. Personnel Factor
a. Determination of the Personnel Factor and the Portion From U.S. 
Sources
    The Treasury Department and the IRS are of the view that while the 
underlying technology and infrastructure are important in providing a 
cloud transaction to customers, the employees who manage, operate, and 
maintain these systems are also fundamental to the provision of the 
service. Accordingly, the efforts of personnel employed by the taxpayer 
who directly contribute to the provision of the cloud transaction must 
be taken into account in sourcing gross income from that cloud 
transaction. To properly reflect the contribution of these personnel to 
the provision of the cloud transaction, the personnel factor is 
composed of the compensation paid to the taxpayer's employees whose 
primary function is to directly contribute to the provision of the 
cloud transaction. See proposed Sec.  1.861-19(d)(3)(i). However, to 
avoid double counting income, compensation that is paid to research and 
experimentation personnel described in proposed Sec.  1.861-19(d)(2) is 
excluded. Id.
    As explained in Part I.C.1.b of this Explanation of Provisions, an 
employee's primary function is the set of tasks to which they are 
assigned to spend the majority of their working time. Proposed Sec.  
1.861-19(d)(5). The proposed regulations provide a rule to account for 
situations in which an employee's primary function is to directly 
contribute to more than one cloud transaction. In those cases, all of 
the employee's compensation must be allocated among those cloud 
transactions based on the relative amount of time the employee spends 
contributing to each transaction. Proposed Sec.  1.861-19(d)(3)(i). To 
illustrate the application of these rules, if an employee spends 30 
percent of their working time on Cloud Transaction 1, 30 percent of 
their working time on Cloud Transaction 2, and 40 percent of their 
working time not on cloud transactions, that employee's primary 
function would be working on cloud transactions because a majority of 
their working time (60 percent) is spent on cloud transactions. 
Consequently, all of this employee's compensation would be allocated 
among Cloud Transaction 1 and Cloud Transaction 2 based on the relative 
amount of time the employee spends contributing to each of the two 
cloud transactions. However, where an employee contributes to multiple 
cloud transactions simultaneously, their compensation must be allocated 
among those transactions based on the relative gross income earned from 
each transaction because it would be impossible to use a time-based 
allocation in such cases. Id.
    Similar to the determination of the numerator of the intangible 
property factor, which is the portion of that factor from sources 
within the United States, the proposed regulations provide the 
numerator of the personnel factor, which is the portion of that factor 
from sources within the United States, is equal to the part of the 
personnel factor that is paid for services performed in the United 
States using the principles of Sec.  1.861-4(b)(2)(ii)(E). Proposed 
Sec.  1.861-19(d)(3)(ii).
b. Direct Contribution to the Provision of the Cloud Transaction
    The proposed regulations set forth rules that define which 
employees are considered to directly contribute to the provision of the 
cloud transaction and which employees are not considered to do so. 
Under proposed Sec.  1.861-19(d)(3)(iii), personnel directly contribute 
to the provision of a cloud transaction to the extent they personally 
perform technical or operational activities for the provision of the 
cloud transaction, or to the extent they are managers who directly 
support or immediately supervise such technical or operational 
personnel. Proposed Sec.  1.861-19(d)(3)(iii) provides a non-exhaustive 
list of the functions that fall within the meaning of ``technical and 
operational activities.'' These functions are the conduct of 
scientific, engineering, or technical activities for the configuration, 
delivery, or maintenance of the cloud transaction; the provision of 
monitoring, diagnostics, or incident response with respect to the cloud 
transaction's performance, reliability, efficiency, or security; the 
management of the cloud transaction's infrastructure; the delivery of 
end-user support with respect to the cloud transaction; and the conduct 
of any similar functions. Id. Further, under proposed Sec.  1.861-
19(d)(3)(iv), personnel are not considered to directly contribute to 
the provision of the cloud transaction to the extent they conduct 
business strategy, leadership, legal or compliance, marketing, 
communications, sales, business development, finance, accounting, 
clerical, human resources or administrative duties, or similar 
functions.
    Proposed Sec.  1.861-19(d)(3)(iii) and (iv) are intended to 
identify the individuals that generally have the hands-on, day-to-day 
involvement in the software, infrastructure, and processes that enable 
the cloud transaction to be provided to the customer and to function as 
intended. The Treasury Department and the IRS are of the view that the 
individuals who personally perform the technical and operational work 
and the immediate managers who direct and supervise that work are 
essential to the performance of the service, and therefore, their 
contributions must be included. By contrast, employees in higher-level 
management or executive positions who are responsible for setting the 
strategic direction of the business and making high-level decisions are 
too far removed from the hands-on, day-to-day work that ensures the 
delivery of any particular cloud transaction to the customer. 
Therefore, while their roles are important to the overall business, 
they do not directly contribute to the provision of the transaction 
itself and are not accounted for as part of the personnel factor. The 
Treasury Department and the IRS are of the view that this distinction 
properly interprets the statutory requirement to source gross income 
from a service to the place where the service is performed.
3. Tangible Property Factor
a. Determination of the Tangible Property Factor and the Portion From 
U.S. Sources
    Cloud transactions depend on physical infrastructure and hardware, 
such as servers and networking equipment. For this reason, the Treasury 
Department and the IRS are of the view that tangible property that 
directly supports the provision of a cloud transaction must be taken 
into account in determining the source of gross income from a cloud 
transaction. Under the proposed regulations, the tangible property 
factor, which is intended to represent the contribution of the tangible 
property to the performance of the cloud transaction, is the sum of the 
depreciation and rental expense for the taxable year for tangible 
property owned or leased by the taxpayer, to the extent the property is 
directly used to provide the cloud transaction. See proposed Sec.  
1.861-19(d)(4)(i). To eliminate double counting, the proposed 
regulations

[[Page 3080]]

require any depreciation or rental expense that would be included in 
the tangible property factor for multiple cloud transactions in a 
taxable year to be allocated among those transactions based on the 
relative gross income earned from each transaction. The portion of the 
tangible property factor that is from sources within the United States 
and comprises the numerator is equal to the part of the tangible 
property factor attributable to property located within the United 
States.
b. Determination of the Depreciation Expense
    For purposes of computing the tangible property factor, 
depreciation expense for a taxable year is determined by dividing the 
adjusted depreciable basis (as defined in Sec.  1.168(b)-1(a)(4)) of 
the tangible property by the applicable recovery period as though the 
alternative depreciation system in section 168(g)(2) applied for the 
entire period the property has been in service. Proposed Sec.  1.861-
19(d)(4)(iii). The Treasury Department and the IRS are of the view that 
the determination must be made without taking into account tax 
incentives intended to accelerate the recovery of costs in order to 
provide an allocation of depreciation that more closely reflects the 
asset's actual economic life. Thus, the proposed regulations explicitly 
state that the depreciation expense is computed without regard to the 
election to expense certain depreciable property under section 179 and 
without regard to any additional first-year depreciation provision (for 
example, section 168(k)).
4. Aggregation Rule
    The proposed regulations include an aggregation rule, set forth in 
proposed Sec.  1.861-19(d)(7), that is intended to enhance the 
administrability of these regulations and to alleviate the compliance 
burden on taxpayers associated with the regulations. The rule allows a 
taxpayer to aggregate substantially similar cloud transactions and 
source the gross income from those transactions as if they were one 
transaction. However, the rule also prohibits a taxpayer from 
aggregating substantially similar cloud transactions if the taxpayer 
knows, or has reason to know, that doing so would materially distort 
the source of gross income from any cloud transaction.
    For example, assume a cloud provider offers two distinct but 
substantially similar cloud transactions, Service 1 and Service 2, that 
are not in the same product line (within the meaning of proposed Sec.  
1.861-19(d)(8)). Further, assume the cloud provider incurs 
significantly more research and experimentation costs associated with 
Service 2 as compared to those incurred for Service 1, and all of the 
research and experimentation personnel of the cloud provider are 
located in the United States at all times. This leads a significantly 
larger percentage of the income from Service 2 to be sourced within the 
United States as compared to that of Service 1. Aggregating Service 1 
and Service 2 would cause a materially larger amount of gross income 
from Service 1 to be sourced within the United States than if the 
income were sourced without aggregating Service 1 with Service 2. 
Therefore, under the proposed regulations, the cloud provider cannot 
aggregate Service 1 and Service 2 to source the gross income from these 
transactions.
5. Anti-Abuse Rule
    In order to prevent taxpayers from circumventing the purpose of the 
proposed regulations--to attribute the source of gross income from a 
cloud transaction to the place where the transaction is performed--the 
proposed regulations would provide an anti-abuse rule. That anti-abuse 
rule, included in proposed Sec.  1.861-19(d)(9), would provide that if 
the taxpayer has entered into or structured one or more transactions 
with a principal purpose of reducing its U.S. tax liability in a manner 
inconsistent with the purpose of the proposed regulations, appropriate 
adjustments will be made so that the source of the taxpayer's gross 
income reflects the location where the cloud transaction is performed.

II. Request for Comments

    Comments are requested on all aspects of the proposed regulations, 
including the following topics:
    (1) whether there are appropriate and administrable ways to 
determine the portion of the intangible property factor from sources 
within and without the United States other than by relying on the 
location of research and experimental personnel;
    (2) whether and to what extent companies presently track specified 
research or experimental expenditures by product line;
    (3) whether there is a practicable and verifiable way to precisely 
link the contribution of intangible property developed in one year to a 
cloud transaction provided in a later year;
    (4) whether relative gross income is an appropriate allocation 
method in cases in which the same cost or expense would be included in 
a factor for multiple cloud transactions during a taxable year;
    (5) whether additional operating costs incurred with respect to 
tangible property directly used in the provision of the cloud 
transaction, such as electricity costs associated with cloud 
transactions, should be included in the tangible property factor, and 
if so, how to capture the costs that contribute to the performance of 
the cloud transaction in an administrable manner; and
    (6) whether a special rule is needed to source the gross income of 
resellers of cloud transactions, for example, whether assets and 
employees other than those described in the proposed regulations better 
reflect the reseller's role in the cloud transaction.

Proposed Applicability Date

    The regulations are proposed to apply to taxable years beginning on 
or after the date of publication of the Treasury decision adopting 
these regulations as final regulations in the Federal Register.

Special Analyses

I. Regulatory Planning and Review--Economic Analysis

    Pursuant to the Memorandum of Agreement, Review of Treasury 
Regulations under Executive Order 12866 (June 9, 2023), tax regulatory 
actions issued by the IRS are not subject to the requirements of 
section 6 of Executive Order 12866, as amended. Therefore, a regulatory 
impact assessment is not required.

II. Paperwork Reduction Act

    This proposed rulemaking does not impose or revise any information 
collections subject to 44 U.S.C. Chapter 35.

III. Regulatory Flexibility Act

    The Regulatory Flexibility Act requires consideration of the 
regulatory impact on small businesses. It is hereby certified that 
these proposed regulations, if adopted, will not have a significant 
economic impact on a substantial number of small entities within the 
meaning of section 601(6) of the Regulatory Flexibility Act (5 U.S.C. 
chapter 6).
    These proposed regulations would set forth specific rules for 
sourcing income from cloud transactions. Specifically, the proposed 
regulations provide guidance on sourcing such income based on three 
factors that are broadly consistent with existing case law on sourcing 
income from analogous transactions. Although data are not readily 
available to estimate the economic impact of the proposed regulations, 
the Treasury Department and the IRS project that any economic impact of 
the proposed regulations

[[Page 3081]]

would be minimal for businesses regardless of size. This is because the 
proposed regulations adopt an approach that is broadly consistent with 
the general principles of existing law and reflect current industry 
practice. Therefore, the proposed rules are not expected to materially 
alter taxpayer behavior and therefore the Treasury Department and the 
IRS expect no material economic impact.
    For the reasons stated, a regulatory flexibility analysis under the 
Regulatory Flexibility Act is not required. Notwithstanding the above, 
the Treasury Department and the IRS invite comments on the impact the 
proposed rules would have on small entities.

IV. Section 7805(f)

    Pursuant to section 7805(f) of the Code, this notice of proposed 
rulemaking will be submitted to the Chief Counsel for Advocacy of the 
Small Business Administration for comment on its impact on small 
business.

V. Unfunded Mandates Reform Act

    Section 202 of the Unfunded Mandates Reform Act of 1995 requires 
that agencies assess anticipated costs and benefits and take certain 
other actions before issuing a final rule that includes any Federal 
mandate that may result in expenditures in any one year by a State, 
local, or Tribal government, in the aggregate, or by the private 
sector, of $100 million in 1995 dollars, updated annually for 
inflation. The proposed regulations do not include any Federal mandate 
that may result in expenditures by State, local, or Tribal governments, 
or by the private sector in excess of that threshold.

VI. Executive Order 13132: Federalism

    Executive Order 13132 (entitled Federalism) prohibits an agency 
from publishing any rule that has federalism implications if the rule 
either imposes substantial, direct compliance costs on State and local 
governments, and is not required by statute, or preempts State law, 
unless the agency meets the consultation and funding requirements of 
section 6 of the Executive Order. The proposed regulations do not have 
federalism implications, do not impose substantial direct compliance 
costs on State and local governments, and do not preempt State law 
within the meaning of the Executive Order.

Comments and Requests for a Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any comments that are submitted timely 
to the IRS as prescribed in this preamble under the ADDRESSES heading. 
All comments will be available at www.regulations.gov.
    A public hearing will be scheduled if requested in writing by any 
person that timely submits comments. Requests for a public hearing are 
also encouraged to be made electronically. If a public hearing is 
scheduled, notice of the date, time, and place for the public hearing 
will be published in the Federal Register.

Drafting Information

    The principal authors of these proposed regulations are Christopher 
E. Fulle and Michelle L. Ng of the Office of the Associate Chief 
Counsel (International). However, other personnel from the Treasury 
Department and the IRS participated in their development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

    Accordingly, the Treasury Department and IRS propose to amend 26 
CFR part 1 as follows:

PART 1--INCOME TAXES

0
Paragraph 1. The authority citation for part 1 continues to read in 
part as follows:

    Authority:  26 U.S.C. 7805 * * *

0
Par. 2. Section 1.861-19, as added in a final rule published elsewhere 
in this issue of the Federal Register, effective January 14, 2025, is 
amended as follows:
0
a. Revise the section heading and paragraph (a);
0
b. Redesignate paragraphs (d), (e), and (f) as paragraphs (e), (f), and 
(g), respectively;
0
c. Add new paragraph (d);
0
d. For each paragraph listed in the following table, remove the 
language in the ``Remove'' column and add in its place the language in 
the ``Add'' column.

------------------------------------------------------------------------
            Paragraph                   Remove                Add
------------------------------------------------------------------------
newly redesignated (e), first     paragraph (d).....  paragraph (e).
 sentence.
newly redesignated (e)(2)(i),     paragraph           paragraph
 first sentence.                   (d)(1)(i).          (e)(1)(i).
newly redesignated (e)(2)(ii),    paragraph (d)(1)..  paragraph (e)(1).
 first sentence.
newly redesignated (e)(5)(i),     paragraph (d)(4)..  paragraph (e)(4).
 first sentence.
newly redesignated (e)(6)(i),     paragraph           paragraph
 first sentence.                   (d)(5)(i).          (e)(5)(i).
newly redesignated                paragraph           paragraph
 (e)(6)(ii)(A), first sentence.    (d)(5)(ii).         (e)(5)(ii).
newly redesignated (g), first     paragraph (e).....  paragraph (f).
 sentence.
------------------------------------------------------------------------

0
e. Add paragraphs (e)(12) and (13); and
0
f. Revise newly redesignated paragraph (f).
    The revisions and additions read as follows:


Sec.  1.861-19  Classification of, and source of gross income from, 
cloud transactions.

    (a) In general. This section provides rules for classifying and 
sourcing gross income from cloud transactions (as defined in paragraph 
(b) of this section). The rules of this section apply for purposes of 
Internal Revenue Code sections 59A, 245A, 250, 267A, 367, 404A, 482, 
679, and 1059A; subchapter N of chapter 1; chapters 3 and 4; and 
sections 842 and 845 (to the extent involving a foreign person), and 
apply with respect to transfers to foreign trusts not covered by 
section 679.
* * * * *
    (d) Source of income from a cloud transaction--(1) In general. 
Gross income from a cloud transaction is sourced as services income 
under section 861(a)(3) or 862(a)(3), as appropriate, according to 
where the service is performed. The place of performance of the cloud 
transaction is based on the intangible property factor described in 
paragraph (d)(2) of this section, the personnel factor described in 
paragraph (d)(3) of this section, and the tangible property factor 
described in paragraph (d)(4) of this section. To determine gross 
income from a cloud transaction from sources within the United States, 
gross income from the cloud transaction is multiplied by a fraction, 
the numerator of which is the sum of the portion of each of the 
intangible property factor, personnel factor, and tangible property 
factor that is from sources within the United States

[[Page 3082]]

as calculated in paragraphs (d)(2)(ii), (d)(3)(ii), and (d)(4)(ii) of 
this section, and the denominator of which is the sum of the intangible 
property factor, personnel factor, and tangible property factor as 
calculated in paragraphs (d)(2)(i), (d)(3)(i), and (d)(4)(i) of this 
section. See paragraph (e)(12) of this section (Example 12). Any 
remaining gross income from a cloud transaction is gross income from 
sources without the United States.
    (2) Intangible property factor--(i) Total. For purposes of 
paragraph (d)(1) of this section, the intangible property factor with 
respect to any cloud transaction performed by the taxpayer in a taxable 
year is equal to the sum of the taxpayer's specified research or 
experimental expenditures (as defined in section 174(b) and regardless 
of whether and when the expenses are deductible) for that taxable year 
that are associated with cloud transactions in the same product line as 
the cloud transaction performed and the taxpayer's amortization (other 
than amounts capitalized under section 174(a)(2)(A) and amortized under 
section 174(a)(2)(B)) and royalty expense for intangible property for 
the taxable year to the extent directly used to provide the cloud 
transaction. If the same cost or expense would be included by a 
taxpayer in the intangible property factor for more than one cloud 
transaction during a taxable year, such cost or expense is allocated 
among each such cloud transaction based on the relative gross income 
earned from each cloud transaction.
    (ii) Portion from sources within the United States. With respect to 
a cloud transaction provided in a taxable year, the portion of the 
intangible property factor from sources within the United States is 
determined using a formula based on the location of all of the 
taxpayer's employees whose primary function is to perform research and 
experimentation activities associated with cloud transactions in the 
same product line in that taxable year (the research and 
experimentation personnel). The formula is as follows: applying the 
principles of Sec.  1.861-4(b)(2)(ii)(E) (relating to sourcing income 
from labor or personal services on a time basis), divide the sum of the 
total compensation paid to the research and experimentation personnel 
for services performed within the United States by the sum of the total 
compensation paid to the research and experimentation personnel, and 
multiply the resulting quotient by the intangible property factor 
described in paragraph (d)(2)(i) of this section.
    (3) Personnel factor--(i) Total. For purposes of paragraph (d)(1) 
of this section, the personnel factor with respect to a cloud 
transaction performed in a taxable year is equal to the sum of the 
total compensation paid to all of the taxpayer's employees in that 
taxable year whose primary function is to directly contribute to the 
provision of the cloud transaction, excluding compensation amounts that 
are paid to research and experimentation personnel described in 
paragraph (d)(2) of this section. If, however, an employee's primary 
function is to directly contribute to multiple cloud transactions, then 
all of such employee's compensation is allocated among the cloud 
transactions that the employee directly contributes to as part of their 
primary function based on the relative amount of time the employee 
spends contributing to each cloud transaction. If an employee 
contributes to multiple cloud transactions simultaneously, then that 
employee's compensation is allocated among those cloud transactions 
based on the relative gross income earned from each cloud transaction.
    (ii) Portion from sources within the United States. With respect to 
a cloud transaction, the portion of the personnel factor described in 
paragraph (d)(3)(i) of this section that is from sources within the 
United States is equal to the part of that factor paid for services 
performed in the United States, as determined using the principles of 
Sec.  1.861-4(b)(2)(ii)(E) (relating to sourcing income from labor or 
personal services on a time basis).
    (iii) Personnel considered to directly contribute to the provision 
of the cloud transaction. Personnel are considered to directly 
contribute to the provision of the cloud transaction to the extent they 
personally perform technical or operational activities for the 
provision of the cloud transaction, or to the extent they are a manager 
who directly supports or immediately supervises such technical or 
operational personnel. Such technical or operational activities are the 
conduct of scientific, engineering, or technical activities for the 
configuration, delivery, or maintenance of the cloud transaction; the 
provision of monitoring, diagnostics, or incident response with respect 
to the cloud transaction's performance, reliability, efficiency, or 
security; the management of the cloud transaction's infrastructure; the 
delivery of end-user support with respect to the cloud transaction; and 
the conduct of any similar functions.
    (iv) Personnel not considered to directly contribute to the 
provision of the cloud transaction. Personnel are not considered to 
directly contribute to the provision of the cloud transaction to the 
extent they conduct business strategy, leadership, legal or compliance, 
marketing, communications, sales, business development, finance, 
accounting, clerical, human resources or administrative duties, or 
similar functions.
    (4) Tangible property factor--(i) Total. For purposes of paragraph 
(d)(1) of this section, the tangible property factor with respect to a 
cloud transaction performed in a taxable year is equal to the sum of 
the depreciation expense for that taxable year for tangible property 
owned by the taxpayer and rental expense for that taxable year for 
tangible property leased by the taxpayer, in each case to the extent 
directly used to provide the cloud transaction. If any depreciation 
expense or rental expense would be included in the tangible property 
factor for more than one cloud transaction during the taxable year, 
such depreciation expense or rental expense is allocated among the 
cloud transactions based on relative gross income earned from each 
cloud transaction.
    (ii) Portion from sources within the United States. The portion of 
the tangible property factor described in paragraph (d)(4)(i) of this 
section from sources within the United States is equal to the part of 
that factor attributable to property located within the United States.
    (iii) Determination of depreciation expense. For purposes of 
paragraph (d)(4) of this section, depreciation expense for a taxable 
year is determined by dividing the adjusted depreciable basis (as 
defined in Sec.  1.168(b)-1(a)(4)) of the tangible property by the 
applicable recovery period as though the alternative depreciation 
system set forth in section 168(g)(2) applied for the entire period 
that such property has been in service, without regard to the election 
to expense certain depreciable property under section 179 and without 
regard to any additional first-year depreciation provision (for 
example, section 168(k)).
    (5) Primary function. For purposes of this section, an employee's 
primary function is the set of tasks to which they are assigned to 
spend the majority of their working time.
    (6) Employee. For purposes of this section, the term employee has 
the meaning given to it in Sec.  31.3121(d)-1(c) of this chapter.
    (7) Aggregation rule. For purposes of applying this paragraph (d), 
a taxpayer may aggregate substantially similar cloud transactions 
unless it knows or

[[Page 3083]]

has reason to know that doing so would materially distort the source of 
gross income from any cloud transaction.
    (8) Product line. For purposes of this section, a product line is 
defined as all products within the same Corresponding Index Entry under 
a North American Industry Classification System (NAICS) code number. 
Once a taxpayer selects a Corresponding Index Entry and NAICS code 
number for the first taxable year for which this section applies, it 
must continue to use that Corresponding Index Entry and NAICS code 
number in following years unless the taxpayer establishes to the 
satisfaction of the Commissioner that, due to changes in the relevant 
facts, a change in Corresponding Index Entry and NAICS code number is 
appropriate.
    (9) Anti-Abuse Rule. The purpose of this paragraph (d) is to 
attribute the source of the taxpayer's gross income from a cloud 
transaction to the location where the cloud transaction is performed. 
Therefore, if the taxpayer has entered into or structured one or more 
transactions with a principal purpose of reducing its U.S. tax 
liability in a manner inconsistent with the purpose of this paragraph 
(d), appropriate adjustments will be made so that the source of the 
taxpayer's gross income reflects the location where the cloud 
transaction is performed.
    (e) * * *
    (12) Example 12: Sourcing gross income from a cloud transaction--
(i) Facts. (A) Corp A provides customers on-demand network access to 
Program Y in exchange for a monthly fee. All of the transactions with 
customers are substantially similar to one another. Customers must be 
connected to the internet to access the functionality of Program Y.
    (B) Corp A has employees whose primary function (as determined 
under paragraph (d)(5) of this section) is to conduct research and 
experimentation associated with developing new versions of Program Y 
and other products in the same product line (as determined under 
paragraph (d)(8) of this section). Corp A paid $160x in compensation to 
such employees, of which $80x was paid for services performed within 
the United States as determined in accordance with the principles of 
Sec.  1.861-4(b)(2)(ii)(E). Besides employee compensation, Corp A spent 
an additional $200x for research and experimentation costs associated 
with developing new versions of Program Y and other products in the 
same product line. Corp A did not take any amortization deductions with 
respect to intellectual property used to provide Program Y.
    (C) Corp A paid $400x in compensation to employees whose primary 
function was to directly contribute (as determined under paragraphs 
(d)(3)(iii) and (iv) of this section) to Corp A's provision of Program 
Y to customers, of which $100x was paid for services performed in the 
United States as determined in accordance with the principles of Sec.  
1.861-4(b)(2)(ii)(E). None of these employees were research and 
experimentation personnel (as defined in paragraph (d)(2)(ii) of this 
section).
    (D) Corp A hosts Program Y on servers it owns that are located both 
within and without the United States. These servers are used only to 
host Program Y. Corp A deducted $140x for depreciation expense 
attributable to these servers, $80x of which was attributable to the 
servers located within the United States, and $60x of which was 
attributable to the servers located without the United States. These 
depreciation deductions are in accordance with the rules of section 
168(g)(2).
    (E) Corp A earned $800x of gross income from providing customers 
access to Program Y. Corp A does not know or have reason to know that 
any of the costs, functions or assets described in this paragraph are 
disproportionately allocated to certain transactions or groups of 
transactions among all of the transactions that generated $800x of 
gross income.
    (ii) Analysis. (A) Under paragraph (b) of this section, each 
transaction between Corp A and a customer is a cloud transaction 
because Corp A provides on-demand network access to Program Y. Under 
paragraph (c)(1) of this section, each cloud transaction is classified 
as the provision of services. Under paragraph (d)(7) of this section, 
because all of these transactions are substantially similar and Corp A 
does not know or have reason to know that there is any disproportionate 
allocation of costs, functions or assets among them, all of the 
transactions may be considered in the aggregate for purposes of 
applying paragraph (d) of this section.
    (B) Under paragraph (d)(1) of this section, the source of Corp A's 
$800x of gross income from providing access to Program Y to customers 
is determined based on the intangible property factor described in 
paragraph (d)(2) of this section, the personnel factor described in 
paragraph (d)(3) of this section, and the tangible property factor 
described in paragraph (d)(4) of this section.
    (C) Under paragraph (d)(2) of this section, the intangible property 
factor is equal to $360x because Corp A paid $160x in compensation to 
employees whose primary function was to conduct research and 
experimentation associated with developing new versions of Program Y 
and other products in the same product line, and incurred $200x in 
other research and experimentation costs associated with developing new 
versions of Program Y and other products in the same product line. 
$80x/$160x of such compensation, or 50%, is paid to employees for 
research and experimentation services performed with respect to Program 
Y and other products in the same product line in the United States. 
Corp A's $360x intangible property factor is multiplied by the same 
quotient to determine that $180x is from sources within the United 
States pursuant to paragraph (d)(2)(ii) of this section.
    (D) Under paragraph (d)(3) of this section, the personnel factor is 
equal to $400x because Corp A paid $400x in compensation to employees 
whose primary function was to directly contribute to the provision of 
Program Y to customers and none of these employees were research and 
experimentation personnel (as defined in paragraph (d)(2)(ii) of this 
section). Pursuant to paragraph (d)(3)(ii) of this section, $100x of 
the personnel factor is from sources within the United States because 
Corp A paid $100x in compensation to employees for services performed 
in the United States that directly contributed to the provision of 
Program Y to customers.
    (E) Under paragraph (d)(4) of this section, the tangible property 
factor is equal to $140x because Corp A deducted $140x in depreciation 
expense for tangible property directly used to provide Program Y to 
customers under the method described in section 168(g)(2). $80x of the 
tangible property factor is from sources within the United States 
because this amount of the $140x depreciation expense is attributable 
to tangible property located within the United States.
    (F) The sum of the intangible property factor ($360x), the 
personnel factor ($400x), and the tangible property factor ($140x) is 
equal to $900x. The sum of these factors from sources within the United 
States is $360x ($180x with respect to the intangible property factor, 
$100x with respect to the personnel factor, and $80x with respect to 
the tangible property factor). Accordingly, Corp A's $800x of gross 
income from providing Program Y to customers for the taxable year is 
multiplied by the quotient of $360x/$900x pursuant to paragraph (d)(1) 
of this section to determine that $320x is from sources within the 
United States. Pursuant to paragraph (d)(1) of this section, the

[[Page 3084]]

remaining $480x ($800x-$320x) is from sources without the United 
States.
    (13) Example 13: Sourcing gross income from multiple cloud 
transactions--(i) Facts. (A) The facts are the same as in paragraph 
(e)(12) of this section (Example 12), except that Corp A also provides 
customers on-demand network access to software platform Z in exchange 
for a monthly fee, and Corp A hosts software platform Z on the same 
servers it uses to host Program Y (which generate more depreciation 
than in Example 12). All of the transactions for software platform Z 
customers are substantially similar to one another. Customers must be 
connected to the internet to access the functionality of software 
platform Z.
    (B) Corp A has employees whose primary function (as determined 
under paragraph (d)(5) of this section) is to conduct research and 
experimentation associated with developing new versions of software 
platform Z and other products in the same product line. The software 
platform Z product line is not the same as the Program Y product line 
under the definition in paragraph (d)(8) of this section. Corp A paid 
$200x in compensation to such employees, all of which was paid for 
services performed in the United States as determined in accordance 
with the principles of Sec.  1.861-4(b)(2)(ii)(E). Corp A also has 
employees whose primary function as determined under paragraph (d)(5) 
of this section is to conduct research and experimentation associated 
with developing functionality for new versions of both Program Y and 
software platform Z. Corp A paid $100x in compensation to such 
employees, all of which was paid for services performed in the United 
States as determined in accordance with the principles of Sec.  1.861-
4(b)(2)(ii)(E). Corp A did not have any other research and 
experimentation costs associated with software platform Z.
    (C) Corp A paid $100x in compensation to employees whose primary 
function was to directly contribute (as determined under paragraphs 
(d)(3)(iii) and (iv) of this section) to Corp A's provision of software 
platform Z to customers, and that entire amount was paid for services 
performed in the United States as determined in accordance with the 
principles of Sec.  1.861-4(b)(2)(ii)(E). None of these employees were 
research and experimentation personnel (as defined in paragraph 
(d)(2)(ii) of this section). Corp A also paid $80x in compensation to 
employees whose primary function was to directly contribute (as 
determined under paragraphs (d)(3)(iii) and (iv) of this section) to 
Corp A's provision of both Program Y and software platform Z to 
customers, and that entire amount was paid for services performed in 
the United States as determined in accordance with the principles of 
Sec.  1.861-4(b)(2)(ii)(E). These employees spent half their time 
contributing to software platform Z transactions and half their time 
contributing to Program Y transactions. None of these employees were 
research and experimentation personnel (as defined in paragraph 
(d)(2)(ii) of this section).
    (D) Corp A hosts software platform Z on servers it owns that are 
located both within and without the United States. These servers are 
used to host both Program Y and software platform Z. Corp A deducted 
$180x for depreciation expense attributable to these servers, $120x of 
which was attributable to the servers located within the United States, 
and $60x of which was attributable to the servers located without the 
United States. These depreciation deductions are in accordance with the 
rules of section 168(g)(2).
    (E) Corp A earned $800x of gross income from providing customers 
access to software platform Z. Corp A does not know or have reason to 
know that any of the costs, functions or assets described in this 
paragraph are disproportionately allocated to certain transactions or 
groups of transactions among all of the transactions that generated 
$800x of gross income.
    (ii) Analysis. (A) Under paragraph (b) of this section, each 
transaction between Corp A and a customer for software platform Z is a 
cloud transaction because Corp A provides on-demand network access to 
software platform Z. Under paragraph (c)(1) of this section, each cloud 
transaction is classified as the provision of services. Under paragraph 
(d)(7) of this section, because all of these software platform Z 
transactions are substantially similar and Corp A does not know or have 
reason to know that there is any disproportionate allocation of costs, 
functions or assets among them, all of the software platform Z 
transactions may be considered in the aggregate for purposes of 
applying paragraph (d) of this section.
    (B) Under paragraph (d)(1) of this section, the source of Corp A's 
$800x of gross income from providing access to software platform Z to 
customers is determined based on the intangible property factor 
described in paragraph (d)(2) of this section, the personnel factor 
described in paragraph (d)(3) of this section, and the tangible 
property factor described in paragraph (d)(4) of this section.
    (C) Under paragraph (d)(2) of this section, the intangible property 
factor is equal to $250x. Corp A paid $200x in compensation to 
employees whose primary function was to conduct research and 
experimentation associated with developing new versions of software 
Platform Z and other products in the same product line. Corp A also 
paid $100x in compensation to employees whose primary function was to 
conduct research and experimentation developing functionality for new 
versions of both Program Y and software platform Z, of which Corp A 
allocates $50x to software Platform Z and $50x to Program Y based on 
Corp A's relative gross income from Program Y and software platform Z 
transactions in the taxable year. $250x/$250x of such compensation, or 
100%, is paid to employees for research and experimentation services 
performed in the United States with respect to software Platform Z and 
other products in the same product line. Corp A's $250x intangible 
property factor is multiplied by the same quotient to determine that 
$250x is from sources within the United States pursuant to paragraph 
(d)(2)(ii) of this section.
    (D) Under paragraph (d)(3) of this section, the personnel factor is 
equal to $140x. Corp A paid $100x in compensation to employees whose 
primary function was to directly contribute to the provision of 
software platform Z to customers and none of these employees were 
research and experimentation personnel (as defined in paragraph 
(d)(2)(ii) of this section). Corp A also paid $80x in compensation to 
employees whose primary function was to directly contribute to the 
provision of both Program Y and software platform Z (and none of these 
employees were research and experimentation personnel (as defined in 
paragraph (d)(2)(ii) of this section)), and Corp A allocated $40x to 
software platform Z and $40x to Program Y based on the relative amount 
of time these employees spent contributing to Program Y and software 
platform Z transactions in the taxable year. $140x/$140x of such 
compensation, or 100%, is paid to employees for services performed in 
the United States that directly contributed to the provision of 
software platform Z to customers.
    (E) Under paragraph (d)(4) of this section, the tangible property 
factor is equal to $90x. Corp A deducted $180x in depreciation expense 
for tangible property directly used to provide both Program Y and 
software platform Z transactions under the method described in section 
168(g)(2), of which $120x is from sources within the United

[[Page 3085]]

States because this amount is attributable to tangible property located 
within the United States. Based on Corp A's relative gross income from 
Program Y and software platform Z transactions in the taxable year, 
Corp A reasonably allocates $90x to software platform Z, of which $60x 
is from sources within the United States and $90x to Program Y, of 
which $60x is from sources within the United States.
    (F) The sum of the intangible property factor ($250x), the 
personnel factor ($140x), and the tangible property factor ($90x) is 
equal to $480x. The sum of these factors from sources within the United 
States is $450x ($250x with respect to the intangible property factor, 
$140x with respect to the personnel factor, and $60x with respect to 
the tangible property factor). Accordingly, Corp A's $800x of gross 
income from providing software platform Z to customers for the taxable 
year is multiplied by the quotient of $450x/$480x pursuant to paragraph 
(d)(1) of this section to determine that $750x is from sources within 
the United States. Pursuant to paragraph (d)(1) of this section, the 
remaining $50x ($800x-$750x) is from sources without the United States.
    (f) Applicability date--(1) In general. Except as otherwise 
provided in this paragraph (f), this section applies to taxable years 
beginning on or after January 14, 2025. Paragraphs (d) and (e)(12) and 
(13) of this section apply to taxable years beginning on or after the 
date of publication of the Treasury decision adopting those paragraphs 
as final regulations in the Federal Register.
    (2) Early application. Except for paragraphs (d) and (e)(12) and 
(13) of this section, a taxpayer can apply this section to taxable 
years beginning on or after August 14, 2019 and all subsequent taxable 
years not described in paragraph (f)(1) (early application years) if--
    (i) The taxpayer also applies Sec.  1.861-18 to the early 
application years;
    (ii) This section and Sec.  1.861-18 are applied to the early 
application years by all persons related to the taxpayer (within the 
meaning of sections 267(b) and 707(b));
    (iii) The period of limitations on assessment for each early 
application year of the taxpayer and all related parties (within the 
meaning of sections 267(b) and 707(b)) is open under section 6501; and
    (iv) The taxpayer would not be required under this section to 
change its method of accounting as a result of such election.
* * * * *

Douglas W. O'Donnell,
Deputy Commissioner.
[FR Doc. 2024-31373 Filed 1-10-25; 8:45 am]
BILLING CODE 4830-01-P