SECTION 2. BACKGROUND

In 1998, in response to rapid technological advances including the growth of transactions in digitized information, ² the Treasury Department and the IRS pub

lished Treasury Decision 8785, which contains the original final regulations in §1.861-18 (1998 final regulations) that set forth a framework for characterizing transactions involving computer programs. T.D. 8785, 63 FR 52971 (Oct. 2, 1998). This framework is based on copyright law, but takes into account the unique features of digitized information. REG-25152096, 61 FR 58152, 58153 (Nov. 13, 1996) (“Although the proposed regulations are guided by copyright law principles in determining whether a copyright right or a copyrighted article has been transferred, the regulations depart in some cases from a strict reliance on copyright law in order to take into account the special nature of computer programs and to treat functionally equivalent transactions in the same way.”). The 1998 final regulations broadly group computer program transactions into one of the following categories: transfers of copyright rights, transfers of a copy of the program (a copyrighted article), services for the development or modification of the program, or the provision of knowhow relating to computer programming techniques.

The 1998 final regulations focus on the distinction between transfers of the copyright itself and transfers of a copyrighted article with a substance-over-form characterization approach that looks to the underlying rights granted to the transferee. Where a transfer conveys a commercial exploitation right included in the list of enumerated copyright rights (such as the right to make copies of the program for purposes of distribution to the public), the transaction is treated as a transfer of copyright rights. However, if a copy of a program is transferred without one of the enumerated copyright rights (merely granting a right to the transferee to use the copy on its own computer, for example), the transaction is treated as a transfer of a copyrighted article.

The 1998 final regulations further characterize transfers of copyright rights and copyrighted articles as complete or par

tial transfers. For a transfer of a copyright right, if all substantial rights to the underlying copyright right are transferred, the transfer is classified as a sale or exchange of the copyright right under the principles of §§1222 and 1235. If less than all substantial rights are transferred, the transaction is classified as a license. For a transfer of a copyrighted article, if the benefits and burdens of ownership have been transferred, the transaction is classified as a sale of the copyrighted article. If insufficient benefits and burdens of ownership of the copyrighted article have been transferred, the transaction is classified as a lease. See, e.g., Grodt & McKay Realty, Inc. v. Comm’r, 77 T.C. 1221, 1237–38 (1981); Torres v. Comm’r, 88 T.C. 702, 720–27 (1987); Estate of Thomas v. Comm’r, 84 T.C. 412, 431–40 (1985).

The 1998 final regulations apply solely for purposes of subchapter N of chapter 1 of the Code, §§367, 404A, 482, 551, 679, 1059A, chapter 3, chapter 5, §§842 and 845 (to the extent involving a foreign person), and transfers to foreign trusts not covered by §679. The preamble to the 1998 final regulations states that while such regulations apply only to cross-border transactions involving computer programs, the Treasury Department and the IRS may consider whether to apply the principles of the regulations to all transactions in digitized information as part of a separate guidance project.

In general, the 2025 final regulations maintain the basic framework from the 1998 final regulations for characterizing transfers of content as primarily copyright rights or copyrighted articles (and subcategorizing as sales or licenses of copyright rights, or sales or leases of copyrighted articles). The 2025 final regulations extend the characterization framework of the 1998 final regulations to transactions involving digital content, which is generally defined as a computer program or any other content protected by copyright law, not just transactions involving computer programs. The 2025

1 Unless otherwise specified, all “section” or “§” references are to sections of the Code or the Income Tax Regulations (26 CFR part 1).

2 See Treasury Department, “Selected Tax Policy Implications of Global Electronic Commerce,” Nov. 1996, at 27-28.

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final regulations also include §1.86119, which provides that cloud transactions (generally defined as transactions through which a person obtains on-demand network access to computer hardware, digital content, or other similar resources) are characterized as the provision of services. Further, the 2025 final regulations implement a predominant character rule for characterizing digital content and cloud transactions.

The 2025 final regulations continue to apply only to certain listed international Code provisions, with updates to eliminate references to repealed §551 and chapter 5, and to add references to §§59A, 245A, 250, and 267A, and chapter 4. The 2025 final regulations retain this limited scope although the Treasury Department and the IRS received several comments recommending that the regulations apply to all provisions of the Code in response to the proposed regulations preceding the 2025 final regulations. As noted in the preamble to the 2025 final regulations, however, the Treasury Department and the IRS continue to study whether the characterization rules currently contained in §§1.861-18 and 1.861-19 should apply to all provisions of the Code. To inform their consideration of and decision on the issue, section 3 of this notice solicits comments.