The US Treasury recently issued proposed regulations on "digital content" transactions that may potentially subject to US tax certain non-US companies selling digital content to US customers. For purposes of the regulations, digital content includes content in digital format that is either protected by copyright law or is no longer protected by copyright law solely because of the passage of time. This would cover music, video, books, software and other computer programs in digital format. The proposed rules would not cover granting a right to publicly perform or display content for the purpose of advertising the digital content.
Under existing US tax rules, gain, income and profits on digital content are sourced to the jurisdiction in which title to the content passes. The existing rules do not specify where title passes for copyrighted content, and generally permit parties to agree by contract where title passes. The US Treasury have expressed concern that a rule permitting parties to specify the location of a transfer as other than the customer's location is easily manipulated. The proposed regulations therefore treat the transfer of digital content through an electronic medium as occurring at the location of download or installation onto the end-user's device used to access the content. In the absence of information about the location of download or installation, the proposed regulations deem the sale to have occurred at the customer's location, based on the seller's recorded sales data for business or financial reporting purposes.
Under the proposed regulations, then, a non-US company's sales of digital content to US customers could potentially give rise to US source income. The sourcing of income is important for a number of US tax reasons. It can affect whether a non-US company is subject to US income or withholding tax, and whether a US companies may utilize its foreign tax credits, among other issues.
The proposed regulations will apply prospectively to tax years beginning on or after the date final regulations are published.
Takeaways: US Federal and State/Local Taxes
The proposed regulations on digital content may appear to contradict the broader international tax principle that a country does not have the right to tax based solely on sales to customers in the country.
Under existing US federal tax law, however, digital sales sourced in the US, without more , are not considered to result in a "US trade or business", a necessary prerequisite under internal US tax law for the US to impose federal net income tax on a non-US company. Further, companies eligible for benefits under a US tax treaty continue to enjoy the increased protections offered thereunder, which, consistent with current international treaty standards, require a permanent establishment of a physical nature as a condition to US federal net income tax liability. That said, as noted above international efforts to move to an economic nexus standard ultimately may result in the US modifying their tax treaties and internal federal tax law to address the economic nexus and other issues posed by the digital economy.
Non-US companies should be aware that US states, which are not bound by US tax treaties, have already taken significant strides in this direction. While US states historically were not permitted to tax a company selling to customers in the state unless the company had a physical presence there, many states now seek to collect sales tax from remote sellers. The US Supreme Court, in its June 2018 Wayfair decision, upheld South Dakota's sales tax law in this regard. Interestingly, the South Dakota law shares certain elements with the OECD consultative proposals described above, including a "substantial nexus" threshold of US $100,000 in annual sales or more than 200 separate transactions. As a result of the Wayfair case, physical presence is no longer the standard: US states can now tax remote online sellers. The states have responded quickly. In 2018 and 2019 most US states added economic nexus provisions to their sales tax laws. In addition, while the court in Wayfair specifically addressed a sales tax law, many believe that the implications of Wayfair also support an economic nexus approach for state income taxes as well.
Tax laws differ significantly among the 50 US states (and the numerous localities that separately impose sales taxes). Moreover, state and local tax rules and interpretations change frequently. Non-US companies selling into the US can no longer rely on the absence of physical presence as protection from US state sales and income taxes. Such companies would be well advised to consider the applicable rules in each state (and locality) in which they have customers and must stay on top of a slew of changing regulations and interpretations.
