For resident cloud service providers, it is relatively straightforward to determine the tax consequences of providing cloud services. The global net income from such transactions would be liable to tax in India at normal tax rates.
However, for non-resident cloud service providers, taxability would depend on the characterization of income (i.e., whether the income is royalty or fees for technical services) and whether the service provider has a taxable presence in India (i.e., whether the service provider has a permanent establishment (PE) in India). Royalties or fees for technical services are generally taxed on a source basis ( i.e., the non-resident service provider is liable for tax in India if the payer is an Indian resident - subject to certain exceptions - even though the services are provided from outside India. In some cases, a payment of royalty or fees for technical services between two non-residents (one being a service provider and the other being a service recipient) could also be subject to taxation in India, provided the recipient is using these services to carry on a business in India or to earn any income from a source in India.
Typically royalties or fees for technical services sourced in India are taxed on a gross basis (i.e., without deduction of any expenditure). On the other hand, if the non-resident service provider constitutes a PE in India, such royalty/fees for technical services may be taxable as business income on net basis.
Characterization of transaction
The characterization of payment arising from a transaction is an important factor in determining the tax liability of a non-resident service provider in India.
According to Indian domestic tax laws, payments inter alia for following items are classified as royalties:
- transfer of all or any rights (including the granting of a license) in respect of secret formulae or processes or trademarks or in respect of any copyright or literary, artistic or scientific work
- use of any patent, invention, model, design, secret formula or process or trademark or similar property
- use, or right to use any industrial, commercial or scientific equipment.
Thus to be classified as a royalty, payments for cloud transactions should fit within any of the above categories. Once classified as royalty, such receipts will generally be subject to withholding tax at 10 percent (plus applicable surcharge and cess) on a gross basis.
Payments under a SaaS arrangement:
Under a SaaS arrangement, the customer makes use of standard software that is available over the cloud. Characterization of payment for use of (off-the shelf or standard) software for tax purposes has caused judicial controversy in India, with a plethora of rulings both for and against the taxpayer, which has only served to present conflicting principles. According to the favorable rulings, payment for access/use of off-the-shelf software (without any right to use/access the copyright therein) is essentially a use of a copyrighted article. Therefore this payment is not a copyright and does not qualify as a royalty. In the adverse rulings however, the Indian courts have dismissed these arguments regarding any distinction between a copyright and a copyrighted article, and held that payment for use of software would qualify as a royalty (irrespective of the nature of the rights being granted).
Furthermore, the Indian Fiscal Budget 2012 has proposed to clarify the definition of royalty in the domestic tax law retrospectively (with effect from 1 June 1976): payment for the use or right to use software in any form or manner will be considered as a royalty, irrespective of the medium through which such software is accessed. Under the proposed amendment payment for software (off-the-shelf or customized) under a SaaS arrangement would be taxable as royalty under Indian domestic tax law.
Payment under an IaaS arrangement:
Under this arrangement, the cloud service provider may make available a specific physical portion of the network to the customer on a dedicated basis. The customer is given the right and means to access and control the equipment. The customer uploads software and data onto the cloud service provider's infrastructure and monitors the software and data remotely. In such a case, since the customer uses the computing infrastructure and also has control over it, the payment may be characterized as a royalty as it is for the use of equipment.
Furthermore, as per a proposed retrospective (with effect from 1 June 1976) and clarifying amendment in the India Fiscal Budget 2012, payment for use of right, property or information would be considered as royalty. This definition is irrespective of whether the possession and control of the right, property or information is with the payer, whether it is actually used by the payer, or whether the location of such right, property or information is in India. Once enacted, the proposed amendment would make payment under an IaaS arrangement taxable as royalty under Indian domestic tax law, even in situations where the customer arguably does not possess or control the right, property or information.
Payments under a PaaS arrangement:
Under this arrangement, a customer typically hires a cloud service provider to supply additional computing resources. The customer sends the data to the cloud service provider to be processed using the service provider's computing infrastructure and software. The data is processed by the cloud service provider, as per the specifications/requirements of the customer, and the results are sent to the customer in the form of a detailed electronic report constructed according to the customer's specifications.
It may be argued that payment under this arrangement is not a royalty for the following reasons: the customer does not use any equipment; such transactions do not involve the transfer of right in any process, trademark or copyright to the customer; the transactions do not involve the use of any patent, process or copyright by the customer. However, the aforementioned proposed retrospective amendment in the domestic tax law (under the Fiscal Budget 2012) is likely to dilute these arguments significantly. In addition, under another retrospective amendment proposed by the Fiscal Budget 2012, payment under a PaaS arrangement may also qualify as a process and consequently be taxable as a royalty.
Applicability of Double Taxation Avoidance Agreement (DTAA)
India has entered into DTAAs with various countries. Where the cloud service provider is a tax resident of a country with which India has entered into a DTAA, the service provider may choose to be governed by the provisions of the DTAA, if these are considered more beneficial.
Accordingly, when determining the taxability of income under the above arrangements, foreign cloud service providers should also consider the provisions of the applicable DTAA with India. However, in seeking a favorable treaty position, it is important to examine the language of the particular Article of the DTAA and the proposed retrospective clarifying amendments in the domestic tax laws.
Fees for technical services
Where the payment by the customer to the cloud service provider is not considered as royalty and is regarded as payment for services, it is likely to be considered as fees for technical services and generally subject to withholding tax at 10 percent (plus applicable surcharge and cess) on a gross basis under the domestic tax law.
It would also be pertinent to examine whether payment for services (such as repair/maintenance and/or transition services) from traditional servers to cloud servers (where the cloud servers are provided by the foreign cloud service provider) can be considered as fees for technical services.
The term 'fees for technical services' is widely defined under the domestic tax law to mean payment for any managerial, consultancy or technical services. In certain judicial pronouncements in India, the courts have taken a view that the payment for providing standard services - which are available to anybody willing to pay - cannot be regarded as fees for technical services, even if these services involve the use of sophisticated equipment.
It could therefore be argued that the payment by the customer to a cloud service provider is for availing standard services. These services are being provided by the cloud service provider to its various customers, and hence are not fees for technical services.
The above position would also need to be examined vis-à-vis the specific Article under the applicable DTAAs dealing with fee for technical services.
Where the payment for services (whether or not it falls under the definition of royalties or fees for technical services) is effectively connected with the PE of the service provider in India, the payment is taxable as business income of the service provider on a net basis at 40 percent (plus applicable surcharge and cess. In addition to the basic tax rates levied under the provisions of the Act, there are additional levies of surcharge (presently 2 percent for foreign companies where the taxable income exceeds INR10,000,000) and cess (presently 3 percent on tax plus surcharge). The total rate inclusive of surcharge plus cess is 42.024 percent).
Typically, where the foreign cloud service provider carries on business in India through an office or dependent agent or other presence in India it may constitute a PE in India. In a cloud scenario, where customers across the globe can store and access their data and applications from virtually anywhere in the world, the PE implications of such a transaction (based on degree of control over the server and location of the server) would need to be evaluated. The existence of a PE of a foreign cloud service provider needs to be examined, based on the specific clauses of the Article in the applicable DTAA dealing with PEs.
Related party transactions
The taxability of a transaction could also be affected by Indian transfer pricing provisions, which are generally in line with Organisation for Economic Co-operation and Development (OECD) guidelines. This is particularly relevant where multiple corporate entities combine efforts to provide cloud services to customers.
The arm's length price for a cloud service needs to be determined by the valuation of the cloud based on intellectual property, infrastructure and personnel supporting the business.
As per the provisions of the Act, taxes need to be withheld in case the subject payment is chargeable to tax in the hands of the recipient. Thus, in the light of the aforementioned discussion, in case it is ascertained that the payments being made are chargeable as per the provisions of the Act read with the applicable DTAA, then the taxes need to be withheld at the rates prescribed in the Act or the DTAA whichever is more beneficial.
Direct taxes code
The existing Income Tax Act is expected to be replaced by a Direct Taxes Code. The coverage of royalty and fees for technical services is largely in line with the proposed amendments by the Fiscal Budget 2012. Therefore it is important to consider the new statute vis-à-vis its coverage of cloud services, as and when this statute is enacted by the Government of India.
Whether a cloud is classified as a service, or as transfer of right to use property, will determine which authority will levy the taxes as well as the applicable tax rates.
If the transaction qualifies as a service, the authority to levy tax lies with the central government; the present service tax rate is 12.36 percent. However, if the transaction qualifies as a transfer of right to use property, then the authority to levy tax lies with the various state governments, with the generic tax rates ranging from 5 percent to 15 percent across various states.
Typically most services of the cloud (such as provisioning of space for data storage) would not involve transfer of right to use property, and hence should qualify as a service transaction on which service tax would be applicable. This would include cases where: customers enter into an agreement with cloud service providers for accessing software on servers managed by the cloud service provider; or the customer hires a cloud service provider for supplying extra computing capacity, and the data processing is carried out by the cloud service provider.
However, in the following scenario, state-level Value Added Tax (VAT) could be applicable: the cloud service provider makes available specific physical equipment that is a portion of the network dedicated to the customer. The customer is given the right and the means to access and control the equipment, in a manner such that the exclusive possession and control of such equipment is transferred to the customer. In this case, the transaction may constitute a transfer of right to use. Not only could state-level VAT be applicable, it is also essential to determine which state would have the right to levy this VAT. This would depend on where the agreement is executed or where the server/equipment is located.
In a cloud service, where both the parties (the cloud service provider and the customer) are in India, the cloud service provider would be liable for service tax or VAT (whichever the case may be). However, where either of the parties (the cloud service provider or the customer) is situated outside India, then the liability for service tax would depend on where the service is provided from or the location of customer.
Such a distinction is crucial because, in a case where a foreign cloud service provider supplies the service from outside India, the liability to discharge the service tax would be on the customer in India. Similarly, when the transaction involves either of the parties (the cloud service provider or the customer) being situated outside India, the liability to pay VAT would depend on where the agreement is executed or where the server/equipment is located.
Goods and services tax
A variety of indirect taxes at the federal and state level (including service tax and VAT) are likely to be replaced by the Goods and Services Tax (GST).
Under the current indirect tax regime, the transfer of right to use goods is taxed as a deemed sale of goods. It remains to be seen whether the GST legislation also identifies the concept of 'deemed sales', and whether it provides for taxation of such transactions of transfer of right to use goods, by considering this transfer as supply of goods or supply of services.
If the cloud services are considered as a transfer of right to use, then the classification of such services may continue to be a matter of discussion even under the proposed GST regime. This classification is especially relevant, given that the tax rates applicable to a service transaction - and to a transaction of transfer of right to use property - are proposed to be different in the first two years of GST implementation. The rates are expected to converge to a common rate from the third year onwards.