Guidance on the tax implications of cloud computing is scarce. Taxpayers and tax practitioners alike are left looking to current law in analysing and analogising the tax implications of a virtual business against that of a bricks and mortar one.
The most common income tax issues companies engaged in cloud-based transactions face are income characterisation, source of income, nexus, and allocation of profits to different activities. Indirect tax issues also arise, but are not the subject of this article.
What is the cloud anyway?
People are often confused by references to the "cloud". Cloud computing, or the cloud, is a set of technologies that allow for the remote delivery of on-demand computing resources over a network, such as the internet, usually on a pay-for-use basis. Several recognised service models exist for cloud computing: software as a service (SaaS), infrastructure as a service (IaaS) and platform as a service (PaaS). In all three of these models, the user generally does not have control, possession, or any interest in the cloud infrastructure or software used.
Character of income
Perhaps the most critical tax detail with respect to cloud computing transactions is determining the character of income resulting from such transactions. The character of income (service, rent, or royalty) earned by a taxpayer directly impacts how such income is sourced and taxed under the laws of many countries, including the US. It is not always clear whether the character of income derived from contracts within the realm of the cloud computing industry constitutes rents, royalties, or services income.
For US tax purposes, IRC §7701(e) and Treas. Reg. §1.861-18 are relevant in making that determination with respect to cloud-related services, such as hosted offerings. Before discussing whether the character of the income in question may be services or rents under §7701(e), it is important to consider Treas. Reg. §1.861-18.
Treas. Reg. §1.861-18
Cloud computing transactions generally do not fall under the purview of the regulations promulgated in Treas. Reg. §1.861-18. These regulations are relevant only to transactions involving the transfer of computer programs or the transfer of rights to such programmes. Treas. Reg. §1.861-18(b). In cloud computing models, users typically get access to application development tools or the use of software, but do not receive copies of programs or software. For instance, SaaS companies do not deliver software and simply permit users access to their software. The SaaS business model is built on the reality that the SaaS company maintains and operates the software for its customers and keeps it under its control. The customer does not have physical possession, or even constructive possession, because constructive possession would require the exercise of control over the software and clearly that does not exist, because SaaS companies grant multiple users concurrent access to the same version of their software.
The paramount task then in determining the character of income from cloud computing transactions becomes distinguishing between whether a transaction results in a lease or the provision of services. IRC §7701(e) is relevant to making that distinction.
For US tax purposes, a contract that purports to be a service contract may be recharacterised as a lease of property if the following requirements of §7701(e) are met:
- The service recipient is in physical possession of the property;
- The service recipient controls the property;
- The service recipient has a significant economic interest in the property;
- The service provider has no economic risk in the contract;
- The service provider does not provide services to a third party; and
- The contract price does not "substantially" exceed the rental value of the property.
If these factors are present in a contracting arrangement, then the income derived from that arrangement is more likely to be rental income. In the alternative, if the factors are not present in a contractual arrangement, then it is more likely the agreement will be characterised as a service agreement, giving rise to service income. It is important to note that not all six requirements must be satisfied to have a lease or service contract. Section 7701(e) does not assign greater significance to any of the criteria, but simply allows for a contract either resembling a lease or a service contract. Notwithstanding the outcome of some case law to the contrary, it can be said that a simple majority of criteria is necessary for classification.
In considering the list of requirements, it is clear that at least the first three, for example are not met in a typical cloud computing transaction, because the user of the cloud services is not in possession of the software or infrastructure, does not control them, and does not have an economic interest in the property at issue. For these reasons, cloud computing transactions generally will be considered to generate services income for US tax purposes. Our experience indicates that the same conclusion will be reached under the laws of most countries.
Source of income
With the character of income determined, sourcing that income becomes relevant. Generally, the US sources income based on the type of transaction that gives rise to it. IRC §861(a), 862(a). For instance, income from the performance of personal services is sourced to the location where those services are performed (IRC §861(a)(3)) and income from the use of intangible property (royalty income) is sourced to the location where the property is used. IRC §861(a)(4).
However, where should services rendered with little human involvement be deemed to be performed? The source of income in connection with cloud-related service offerings has not been addressed in the existing legal authorities. Thus, taxpayers are left to draw analogies to cases involving brick and mortar businesses.
In Piedras Negras Broadcasting Co. v. Commissioner, affirmed by the Fifth Circuit in Piedras Negras Broadcasting Co. v. Commissioner, 127 F.2d 260, at 261 (5th Cir. 1942) the Tax Court looked to the location of broadcasting equipment (as in capital) and personnel (as in labour) in making its determination as to the situs of the taxpayer's income-producing activities, and found that the situs of the taxpayer's advertising services was the location of its broadcasting facilities in Mexico. 43 B.T.A. 297 (1941). The Fifth Circuit Court stated that the source of income is the "situs of the income producing service" meaning "the services required by the taxpayers under the contract." 127 F.2d at 260-61. The location of the broadcasting company's audience was not a pertinent factor in determining source.
The Piedras case serves as useful guidance in determining the source of income from internet activities, including cloud computing transactions. Piedras confirms that the "situs of the income producing service" is the key factor to determine the source of income from the remote provision of technology, and that the situs of service income can be the location of the equipment.
Cloud computing and the right to tax
Whether the servers from which cloud computing transactions are offered create a taxable presence for a foreign corporation must be analysed on a case-by-case basis. However, the permanent establishment langauge in OECD treaties and the related model treaty commentary offers some guidance.
Income tax treaties, if applicable, present a set of rules to determine whether the presence of a server from which a foreign corporation delivers services to customers creates US tax nexus. Generally, a company resident in a treaty country may be taxed only on business profits in the other treaty country if the company has a PE in the other country and profits are attributable to that PE. A foreign corporation is generally treated as having a PE only if: (1) it maintains a fixed place of business in the other country, or (2) the activities of another person are imputed to the foreign corporation.
When a company's sole activity in another country is the maintenance of servers in a cloud computing business, the question is whether a PE arises in that other country. OECD Model Tax Convention on Income and on Capital 2008. A server on which software or a web site is stored may constitute a "fixed place of business." Commentary to OECD Model Tax Convention, article 5, paragraph 42.2. Conversely, software or an internet web site (a combination of software and electronic data) do not in and of themselves constitute tangible property and thus cannot have a location that constitutes a "place of business" as there is no "facility such as premises" as far as the software and data constituting that web site are concerned. In addressing this, the OECD model treaty commentary states:
".... it is common for the web site through which an enterprise carries on its business to be hosted on the server of an internet service provider (ISP). Although the fees paid to the ISP under such arrangements may be based on the amount of disk space used to store the software and data required by the web site, these contracts typically do not result in the server and its location being at the disposal of the enterprise... even if the enterprise has been able to determine that its web site should be hosted on a particular server at a particular location.... In these cases, the enterprise cannot be considered to have acquired a place of business by virtue of that hosting arrangement. However, if the enterprise carrying on business through a web site has the server at its own disposal, for example it owns (or leases) and operates the server on which the web site is stored and used, the place where that server is located could constitute a permanent establishment of the enterprise if the other requirements of the article are met."
~ Commentary to OECD Model Tax Convention, para. 42.3-4
Thus, in general, if the server on which the software or web site resides is owned by others and is not at the taxpayer's disposal, it is unlikely that a PE will be found to exist. Conversely, if the server is at the taxpayer's disposal, there will be a fixed place of business and a PE.
Transfer pricing and allocation of profits
We are not aware of any transfer pricing guidance in any jurisdiction specific to cloud computing service models. Thus, regular transfer pricing principles should be applied, including the notion that profit is allocated based on functions, assets, and risks. As described above, in cloud computing service models, tax guidance has generally placed the most importance on the operation of the software on the servers, as opposed to any sales or maintenance activity carried on by humans. Absent other guidance, this would seem to be a significant consideration in the allocation of profits among activities.
OECD on base erosion and profit shifting (BEPS)
We have all by now heard of BEPS and its potential impact on the digital economy, which includes cloud computing. The OECD, at the prompting of the G20 finance ministers, developed an action plan to address various BEPS activities noted in the international economy. The report identified actions to be implemented to counter BEPS, the first of which addresses the tax challenges of the digital economy. In describing Action 1, the report states:
"Issues to be examined include, but are not limited to, the ability of a company to have a significant digital presence in the economy of another country without being liable to taxation due to the lack of nexus under current international rules, the attribution of value created from the generation of marketable location-relevant data through the use of digital products and services, the characterisation of income derived from new business models, the application of related source rules, and how to ensure the effective collection of VAT/GST with respect to the cross-border supply of digital goods and services. Such work will require a thorough analysis of the various business models in this sector."
No further elaboration on this action exists, and a report is not expected until September 2014. While the findings of this report will not be known for some time, one thing is certain: The international community has taken notice of the anomalies presented in the digital economy and is looking through the stratus for more concrete guidance.
By Ron Saake and Mandana Malone of Deloitte