June 17, 2025

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In January of 2025, the IRS finalized long-awaited regulations addressing how income from digital and cloud transactions should be classified and sourced for U.S. tax purposes. These regulations are critical for companies operating across borders, as they directly impact tax exposure, foreign tax credit eligibility, and withholding obligations. For digital businesses, understanding how these rules apply can mean the difference between tax efficiency and costly surprises.

Why Digital Businesses Must Understand Sourcing Rules

Sourcing rules determine whether income is considered U.S. or foreign source. Get them wrong, and you could face unexpected tax bills or miss out on valuable credits:

• U.S. persons are generally taxed on their worldwide income, but sourcing affects eligibility for foreign tax credits.
• Non-U.S. persons are generally taxed only on U.S.-source income; thus, sourcing determines U.S. tax exposure and potentially whether U.S. withholding tax may apply.

How Digital Transactions Challenge Traditional Tax Categories

While income from inventory sales, services, royalties, and rents has long-established sourcing rules, applying those same frameworks to digital deals creates confusion. The IRS tries to classify digital transactions using these traditional buckets, but as technology evolves, it’s often unclear which category applies, making accurate sourcing a challenge.

The New Framework: How the IRS Now Classifies Digital Transactions

To bring clarity to the evolving digital economy, the IRS has introduced a two-part framework for classifying digital income. The final regulations distinguish between digital content transactions and cloud transactions, each with its own sourcing and tax treatment rules. This framework emphasizes substance over labels, focusing on the rights transferred and the predominant character of the transaction to determine whether it should be taxed as a sale, license, or service. Below is a breakdown of how each type is now treated under the updated regulations.

• Digital Content Transactions (Reg. §1.861-18)
• Copyrighted Article (e.g., software download): treated as a sale if all substantial rights have been transferred or a lease of property if less than all substantial rights have been transferred.
• Copyright Right (e.g., license to reproduce software): treated as a sale if all substantial rights have been transferred or as a license if less than all substantial rights have been transferred.
• Service (e.g., custom software development): treated as performance of services.
• For digital content transactions where there may be multiple elements required for a single transaction, the entire transaction is classified by its predominant character. This focuses on the primary benefit to the customer.
• Cloud Transactions (Reg. §1.861-19)
• Cloud transactions – transactions with on-demand network access to computer hardware, digital content, or similar resources.
• All cloud-based transactions (e.g., SaaS, IaaS, PaaS) are treated as services, regardless of embedded software or hardware.
• If a transaction has multiple elements and one of them is a cloud transaction and the cloud transaction is the predominant character of the overall transaction, then the entire transaction is a cloud transaction.

Real-World Applications: How the New Rules Work in Practice

To illustrate how the new rules apply, the IRS included real-world examples in the final regulations (§1.861-18 and §1.861-19) that demonstrate how classification and sourcing are determined in practice:

Example 1: Software License with Country-Specific Exploitation Rights

(Reg. §1.861-18(h), Example 5)

Corp A transfers a disk containing Program X to Corp B (a foreign corporation) and grants it an exclusive license to reproduce, distribute, and publicly display the program in Country Z for the remaining life of the copyright. Corp B pays royalties for a limited three-year period.

• Characterization: Although Corp B receives a copy of the software (copyrighted article), the predominant character of the transaction is the transfer of a copyright right, not a copyrighted article. The rights granted include the rights to reproduce, distribute, and create derivative works and that is where the Corp B primarily derives value.
• Sourcing Rule: The transaction is treated as a sale of copyright rights because all substantial rights were transferred for use in Country Z. The fact that the contract labels the payments as royalties does not matter. Instead, we need to analyze the substance of the transaction.
• What This Means: For software companies: Even if you call it a 'license' and collect ongoing royalties, transferring exclusive rights for a specific territory is treated as a sale. Determining whether a transaction represents a license or sale could change your U.S. tax obligations entirely.

Example 2: Content Creator Video Streaming Platform
(Reg. §1.861-18(h), Example 22)

Corp A operates a video streaming website  where users can either stream content for free with ads or pay for an ad-free subscription. Content creators upload their videos to the platform and retain ownership rights, but grant Corp A and its users limited licenses to display and view videos. These licenses terminate within a commercially reasonable time frame. Corp A pays creators a percentage of ad and subscription revenue.

• Characterization: There are two distinct sets of transactions:
• Between Corp A and Content Creators: This involves both the upload of the video by the content creator (transfer of a copyrighted article) and the transfer of a right to use and display their videos (transfer of a copyright right). The predominant character is the transfer of a copyright right, because Corp A's (the customer’s) primary benefit is the right to use, reproduce, and distribute the videos.
• Between Corp A and End Users: There is no transfer of any copyright rights or copyright articles since the content is not downloaded in this example and is instead streamed through a network. These transactions are therefore not digital content transactions but are instead classified as cloud transactions. 
• Sourcing Rule:
• Content Creator Transactions: Characterized as a license of intangible property (royalty), sourced to the place of use.
• End User Transactions: Characterized as a provision of services, sourced to the place of performance.
• What This Means: For platform businesses: The same content can be taxed differently depending on the transaction structure. Where there are multiple elements and multiple transactions that may take place in a complex digital business the different elements may need to be evaluated separately.

Example 3: Software Development and Hosting Platform
(Reg. §1.861-19(g), Example 3)

Corp A provides Corp B access to a web-based software development platform to build and host websites. The platform includes various tools and copyrighted visual elements, but Corp B cannot alter the code. Corp B accesses the service via a browser. A small amount of copyrighted scripting code is downloaded by Corp B to facilitate secure logins and access the platform. Hosting and execution occur on Corp A’s servers.

• Characterization: The transaction includes software access, hosting, limited copyrighted visual use, and minor code downloads. Individually, these could be treated as cloud transactions, transfers of copyright rights, or copyrighted articles. However, the predominant character is that it is a cloud transaction.
• Sourcing Rule: The transaction is classified solely as a cloud transaction under Reg. §1.861-19, and is treated as a service.
• What This Means: For SaaS providers: Even if customers download some code or access copyrighted materials, if the predominant value is cloud-based services, the entire transaction is treated as a service. This simplifies classification but affects where you source the income for tax purposes.

Note: These examples are simplified summaries of the full examples found in the regulations. For full facts and analysis, consult the original regulatory text.

Tax Savings Opportunity: FDII Benefits for Digital Exporters

Here's some good news for U.S. companies selling digital products overseas: If your digital or cloud-based transactions are properly classified and sourced as foreign under the IRS’s new framework, you might qualify for the Foreign-Derived Intangible Income (FDII). FDII can significantly reduce your effective tax rate on foreign sales, provided certain documentation and foreign use requirements are met. This potentially includes:

• Cloud services provided to foreign users
• Digital downloads by foreign customers
• Subscriptions accessed outside the U.S.

We have an overview of U.S. export tax incentives including FDII here.

Ready to Optimize Your Digital Business Tax Strategy

Digital businesses operating internationally face a patchwork of classification and sourcing rules that can significantly affect their U.S. tax exposure. If you want to better understand how these sourcing rules apply to your business or explore whether you qualify for export incentives like FDII, contact our team to start the conversation.