The Digital Service Framework

Your engineering team is in Lahore, your sales team is in London, your holding company is in Dubai, and ninety percent of your revenue comes from American customers. You want to know where that revenue is sourced for U.S. federal tax purposes. The intuitive answer, the one nearly every founder arrives at, is wrong in a way that matters.

The rule you expect, and the rule that applies

The intuition is that income follows the customer. It is a reasonable intuition. It is how sales tax works in most U.S. states, how value added tax works in most of Europe, and how the foreign digital services taxes discussed at the end of this piece are designed. It is not how the U.S. federal source rules treat services.

For services, the U.S. rule is place of performance. IRC §861(a)(3) sources compensation for labor or personal services performed in the United States to the United States. IRC §862(a)(3) sources compensation for services performed outside the United States to foreign sources. Neither provision refers to the residence of the payer, the location of the customer, or where the contract was signed. What matters is where the people doing the work were standing.

Two consequences follow immediately. First, a services business with no personnel in the United States generally produces foreign-source income even when every customer is American. Second, and less comfortably, a small amount of U.S.-located work can produce U.S.-source income out of proportion to how the business thinks of itself.

Sourcing is not the same question as effectively connected income, and the two are frequently confused. Source determines where income is treated as arising. Whether income is taxable on a net basis in the United States turns on whether there is a trade or business within the United States under IRC §864(b) and whether the income is effectively connected with it under IRC §864(c). Sourcing is an input to that analysis, not a substitute for it.

Splitting a payment across borders

Most distributed teams do not perform services entirely in one place, so the statute needs an allocation method. Treas. Reg. §1.861-4(b) supplies it. Where services are performed partly within and partly outside the United States, the portion attributable to U.S. performance is determined "on the basis that most correctly reflects the proper source of the income under the facts and circumstances of the particular case." For employees, the regulation accepts a time basis, allocating by days worked inside the United States over total days worked, and states that this is acceptable in many cases.

The "most correct basis" standard is genuinely flexible. Where a time basis distorts the result, an allocation on relative compensation or another measure that better reflects the source may be used. Flexibility cuts both ways: a method you cannot document is not a method.

The narrow de minimis exception in IRC §861(a)(3) requires three conditions simultaneously. The nonresident alien must be temporarily present in the United States for periods not exceeding ninety days in the taxable year, the compensation must not exceed $3,000 in the aggregate, and the employer must be a nonresident alien, foreign partnership or foreign corporation not engaged in a U.S. trade or business. It is rarely available to a founder who travels for sales.

A worked allocation

Illustrative figures. A software company delivers a managed service to U.S. clients for $4,000,000 a year. The engineering function in Lahore represents 60 percent of the personnel cost, the sales and account function in London 30 percent, and a single U.S.-based solutions engineer 10 percent. Nobody else works from the United States.

On a compensation-based allocation reflecting where the work was performed, 10 percent of the service income is attributable to performance inside the United States, or $400,000, with $3,600,000 attributable to performance abroad. If instead the same solutions engineer spent 40 working days of a 240-day year physically in the United States and the remainder in Manchester, the U.S.-performed portion falls accordingly, and the supporting evidence is that person's calendar rather than the company's revenue map.

Notice what did not enter the calculation: the customers were all American, and that fact did not change the source of a dollar of service income. Notice also what the calculation does not decide: whether that $400,000 is taxed on a net basis in the United States depends on the separate trade-or-business and treaty analysis, and one U.S. worker is a fact that analysis takes seriously.

When it is not a service at all

A great deal of what digital businesses sell is not a service under these rules. Treas. Reg. §1.861-18 classifies transactions involving digital content into four categories: a transfer of a copyright right, a transfer of a copyrighted article, the provision of services, and the provision of know-how. Each category carries a different source rule. Get the classification wrong and every downstream conclusion is wrong.

The dividing line between a sale of a copyright right and a license is whether, taking all facts and circumstances into account, all substantial rights in the copyright have been transferred. Where they have not, the transaction is a license and the payment is a royalty, sourced under IRC §861(a)(4) by reference to where the property is used. A perpetual, non-exclusive end-user license to run a copy of your software is ordinarily a transfer of a copyrighted article rather than a copyright right, which is a different result again.

The regulation was expanded and finalized in T.D. 10022, published January 14, 2025. It now reaches digital content generally, defined as a computer program or other content such as books, movies and music in digital format, rather than computer programs alone. The final rules are generally effective for tax years beginning on or after January 14, 2025, with an election available to apply them to tax years beginning on or after August 14, 2019 subject to conditions.

Cloud transactions: classified, not yet sourced

The same 2025 guidance package added Treas. Reg. §1.861-19, which addresses cloud transactions, defined as arrangements providing on-demand network access to computer hardware, digital content or similar resources. The final regulation classifies cloud transactions as the provision of services. It dropped the lease-versus-service split that the 2019 proposed regulations had contemplated. For most SaaS businesses this is the answer to the character question, and it is a helpful one.

The source question was deliberately left open. Treasury issued proposed regulations, REG-107420-24, on the same date, proposing a formulary approach that would source cloud transaction income by reference to factors reflecting research and development expense, employee expense and tangible asset expense. Those proposals drew a comment period and a public hearing and remain in proposed form. They are not law.

Say this plainly rather than papering over it: for a cloud business, the character of the income is now settled and the sourcing method is not. Until the proposals are finalized, sourcing of cloud service income is determined under the general services rules and the place-of-performance principle in IRC §861(a)(3) and IRC §862(a)(3), with allocation under Treas. Reg. §1.861-4(b). A business whose result would change materially under the proposed formula should know that now and monitor the outcome, rather than discover it later.

The evidence problem

Place of performance is a factual question, and distributed teams keep terrible records of facts they consider unremarkable. The following are the artifacts that make an allocation defensible.

• Employment and contractor agreements that state the place of performance and are consistent with reality.
• A payroll register broken out by work location, reconciled to the general ledger, refreshed when someone relocates.
• Travel records for every person who entered the United States on business, with dates.
• A written allocation memorandum stating the method chosen, why it most correctly reflects the source, and the data it uses. Prepared contemporaneously, not on examination.
• System evidence where it exists: repository commit metadata, ticketing timestamps, support queue assignment logs. These are useful corroboration and weak primary evidence, since they record accounts rather than bodies.

Remote work makes the underlying facts unstable. An engineer who moves from Lahore to Toronto to Austin over eighteen months changes the source of the income attributable to their work each time, whether or not anyone tells finance.

What this is not

Foreign digital services taxes are a different regime and outside the scope of this analysis. They are levies imposed by other countries on gross revenue from specified digital activities, generally by reference to user or customer location, and they operate independently of the U.S. federal source rules described above. Nothing in IRC §861, IRC §862 or the digital content regulations governs them. A business with meaningful revenue from jurisdictions that impose them needs that assessed separately, under the law of each jurisdiction.

The order to work in

Start by classifying what you actually sell under Treas. Reg. §1.861-18 and Treas. Reg. §1.861-19, product line by product line, because a business selling a hosted application, a downloadable tool and a content library is running three different source analyzes. Then build the work-location register described above for the last three years and see whether your existing allocation, if you have one, can be supported by it. Then confirm whether any U.S.-located personnel raise a trade-or-business question distinct from the sourcing question.

That sequence is what the firm's diagnostic follows. Further material sits on the international tax matters pillar. This article summarizes published rules, including rules currently in proposed form, and is general information rather than advice on any particular business.