Breaking Down the New Digital Transaction Reporting Rules

The Treasury Department has released new regulations relating to digital and cloud transactions which are effective for 2025. The regulations answer some questions, but key unknowns still remain.

Digital Transactions

Regulation 1.861-18 addresses digital transactions, and says a digital transaction can fall into one of four categories:

• Transfer of a copyright right.
• Transfer of a copyrighted article.
• Provision of services.
• Provision of know-how

Regulation 1.861-18 doesn't say anything we didn't already know. The next regulation, 1.861-19, is where things get a lot trickier.

Cloud Transactions

Within the context of a digital transaction, we have "cloud transactions." For many in this audience, this would be software as a service (SAAS).

There has long been debate about how to treat a SAAS payment – is a lease, or a royalty, or a service? Regulation 1.861-19 gives us a resounding answer – it's a service.

The regulation walks through 11 examples, and in all 11 examples, the Treasury Department determines that the transaction is classified as a service. This means, if you are paying for SAAS services, it's treated as the provision of services (i.e. contract labor). The tricky part here is if your SAAS provider is in another country. Services are typically sourced to where the service is performed.

Sourcing of Cloud Transactions

The final regulations do not address how to source the services provided in a cloud transaction. The Treasury Department has released proposed regulations to address sourcing.

The proposed regulations would require the use of a formula involving the location of R&D expenses, where personnel are located, and where servers are located, with this creating a ratio of U.S.-source versus foreign source.

These factors would require an AP department to know the foreign vendor's financial information, which might be difficult to obtain. This has been brought up to the Treasury Department in comments on the proposed regulations, as it has a major impact on Form 1042-S reporting. The Department's timeline on releasing final regulations is unknown.

Conclusion

If you're making SAAS payments, they are likely considered services. This has two consequences:

1. If you're making payment to a U.S.-based provider, you might need to issue a 1099-NEC.
2. If you're making a payment to a foreign provider, you'll need to consult with applicable counsel on your side to determine how you want to apply the sourcing rules, as this impacts Form 1042-S reporting.