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Sunday, August 18, 2019

Proposed Regulations on Cross-Border Cloud Transactions and other Digital Content Transactions

Determining the source and character of transactions involving the Internet or digital items for U.S. income tax purposes is not always easy, given the paucity of IRS guidance on the subject. Treas. Regs. §1.861-18 is the exception, which addresses how to characterize transactions involving “computer programs,” but that is as far as it goes.

In an effort to bring clarity and guidance to this exploding area of commerce, the IRS has issued proposed regulations under Treas. Regs. §1.861-18 and introduced a new proposed Treas. Regs. §1.861-19.

The proposals under Treas. Regs. §1.861-18 expand the characterization guidance applicable to computer programs to all transfers of “digital content” including digital books, movies and music. The proposals there also undertake to provide a sourcing rule for title passage for digital content. Generally, the income from such transactions will be sourced to where the downloaded items are installed on the end-user’s device that is used to access the content. Thus, it appears the location of the provider’s servers and storage devices or base of operations is not relevant.

Proposed Treas. Regs. §1.801-19 takes on a different subject and provides rules for classifying a “cloud transaction” as either the provision of services or a lease of property, for income tax purposes. A cloud transaction is one through which a person obtains non-de minimis on-demand network access to computer hardware, digital content, or other similar resources. It includes what are commonly known as Saas, PaaS, and LaaS models, and other transactions relating to on-demand network access of technological resources, including access to streaming digital content and information in databases. It does not include a mere download or other electronic transfer of digital content for storage and use on the devices of the acquirer. The regulation provides a list of factors to be used in making the characterization.

Both of the proposed regulations provide useful examples.

While taxpayer’s may quibble with the details, and perhaps question the source rule for downloaded digital content as the location where the content is installed on the acquirer’s device, the Service’s seeking to provide guidance by regulation in this area is to be applauded.

REG-130700-14

Sunday, August 11, 2019

District Court Strikes Regulation Defining Educational Organization Under Code §170(b)(1)(A)(ii)

EXECUTIVE SUMMARY: The U.S. District Court for the District of Minnesota ruled in favor of the Mayo Clinic and held that in determining whether an organization meets the definition of an educational organization under Code §170(b)(1)(A)(ii), the primary function test imposed by regulation is invalid.

FACTS: The Mayo Clinic sought to exclude debt-financed passive income from unrelated business income by qualifying as an organization described in Code §170(b)(1)(A)(ii). That provision describes an organization that is:

an educational organization which normally maintains a regular faculty and curriculum and normally has a regularly enrolled body of pupils or students in attendance at the place where its educational activities are regularly carried on.

The Government acknowledged that the Mayo Clinic “normally maintains a regular faculty and curriculum and normally has a regularly enrolled body of pupils or students in attendance at the place where its educational activities are regularly carried on.” However, the Government argued that the Mayo Clinic was not an “educational organization” within the meaning of the statute since the Clinic did not meet the primary function and incidental activities requirements of Treas. Regs. §1.170A-9(c)(1). This regulation provides:

An educational organization is described in section 170(b)(1)(A)(ii) if its primary function is the presentation of formal instruction and it normally maintains a regular faculty and curriculum and normally has a regularly enrolled body of pupils or students in attendance at the place where its educational activities are regularly carried on. The term includes institutions such as primary, secondary, preparatory, or high schools, and colleges and universities. It includes Federal, State, and other public-supported schools which otherwise come within the definition. It does not include organizations engaged in both educational and noneducational activities unless the latter are merely incidental to the educational activities. A recognized university which incidentally operates a museum or sponsors concerts is an educational organization within the meaning of section 170(b)(1)(A)(ii). However, the operation of a school by a museum does not necessarily qualify the museum as an educational organization within the meaning of this subparagraph. (emphasis added)

The District Court ruled that the primary function and incidental activities requirements imposed by the regulation were not a valid exercise of regulatory authority and were thus not valid requirements in determining what organizations are described in Code § 170(b)(1)(A)(ii).

Before overriding the regulation, the District Court first had to determine that it had authority to do so under the Chevron deference doctrine arising under Chevron U.S.A., Inc. v. Natural Resources Defense Council, Inc., 467 U.S. 837 (1984). The Court noted that the framing of the Chevron deference issue is critical to the result, and framed the issue as whether Code §170(b)(1)(A)(ii) is silent or ambiguous with respect to the primary-function and merely incidental requirements in the regulation. With that framing, the Court determined that the Government’s regulation was not entitled to Chevron deference, and thus opened the door to an exaination whether the primary function and merely incidental requirements were a proper interpretation of the statute without giving substantial deference and advantage to the Government’s purported interpetation.

The Court determined the Government’s interpretation under the regulation as improper for various reasons. Principal among them is that Congress knew how to impose a primary function test if it wanted, as evidenced by Code § 170(b)(1)(A)(iii) which expressly imposed a principal purpose test for certain medical organizations seeking to be described therein. The Court noted that “principal” and “primary” were essentially the same for these requirements. By not writing such a requirement into the statute, the Court determined that Congress intended that no such requirement applied.

COMMENTS:

The “why” of the rejection of the primary function and merely incidental requirements is less important than the rejection itself. This rejection of the regulatory requirement will assist many organizations in meeting the requirements of Code §170(b)(1)(A)(ii). This will have relevance in determining the deductibility of contributions to such organizations, exclusion of debt-financed income from UBI, and the application of numerous other provisions of the Internal Revenue Code that involve organizations described in Code §170(b)(1)(A)(ii) (such as the exclusion of tuition payments to such educational organizations from taxable gifts under Code §2503).

Of course, the determination is that only of a District Court, and not a Circuit Court of Appeals or the U.S. Supreme Court. Thus, its precedential authority is limited, and may be overturned on appeal (or sustained, of course). Nonetheless, it may presently support reporting positions and litigation positions of taxpayers that are limited by the regulatory requirements invalidated by the Court.

Tax practitioners often deal with regulations which in their opinion exceed statutory authority or are unreasonable. In determining whether to challenge a regulation, Chevron deference is a major obstacle, and typically kills the challenge in its cradle. Any case that acknowledges Chevron deference as something that in the real world can be overcome under the right circumstances is always welcome in my book.

Mayo Clinic v. U.S., 124 AFTR 2d 2019-XXXX (DC MN) (8/6/2019)

Sunday, August 04, 2019

IRS Sending Out Cryptocurrency Warning Letters

According to the IRS, cryptocurrency like Bitcoin is treated as property, not money. Notice 2014-21. Therefore, taxpayers who use it buy things or convert it to dollars are treated as having sold it, and have to recognize gain or loss based on what they receive when the dispose of it compared to what they paid for it.

In 2016, only 802 individual income tax returns reported cryptocurrency transactions out of the 132 million filed electronically. The IRS is clearly concerned about a lack of knowledge and/or intentional lack of compliance in this area. Late last month, it announced it is sending 10,000 warning letters to taxpayers it suspects of having owned cryptocurrency and not reporting.

The letters are of three variations, Letter 6173, 6174, and 6174-A.  The 6173 will require a response from the taxpayer - either the filing of returns (delinquent or amended) reporting cryptocurrency transactions, or providing a statement to the IRS that he or she has fully complied with such reporting. Taxpayers are warned that if they ignore the letter, they may be subject to examination activity. The other two forms do not require a specific response, but warn about potential enforcement activity in the future. Taxpayers who receive the letter will likely have more difficulty in asserting an “ignorance” defense if future penalties for cryptocurrency transactions are ever imposed on them.

IR-2019-132, July 26, 2019