For some cloud service providers (CSPs), determining the tax consequences of a cloud computing transaction will be a relatively straightforward exercise, as the tax treatment will flow neatly from the natural design of the transaction. For other CSPs, especially those that desire a specific tax treatment that may not flow intuitively from the natural design of the transaction, the determination may be more complex. Two factors contribute to the potential complexity. First, many of the rules and concepts that govern cloud computing transactions were designed to deal with “old economy” transactions, rather than today’s highly-automated, virtual, and discretely-fragmented businesses. Second, determining the consequences of a cloud computing transaction requires detailed facts. Generally no one-size-fits-all tax-conclusions can or should be drawn about a cloud service provider’s operations. CSPs desiring a specific tax treatment will therefore need to plan carefully.
For service providers transitioning from a more traditional business model to a cloud computing model one thing is clear: the treatment within the cloud will most probably differ considerably from the traditional business model, so diligence and planning are vital when considering tax issues.
Corporation tax considerations
When evaluating a cloud computing business from a tax perspective, the general approach should be as follows. First, classify the nature of the transactions conducted by the cloud service provider, such as a service, sale, lease or license. Classification is an important first step as many jurisdictions apply specific tax provisions to the income derived from each of these transactions. Other factors to consider are:
- the source of the income for purposes of calculating deductible foreign taxes
- whether the income, if earned through an offshore subsidiary, will be subject to controlled foreign company (CFC) or other avoidance legislation
- whether (or to what extent) the income is subject to home territory or foreign withholding tax.
Classifying cloud computing transactions
Transaction classification is determined to a large extent by whether, as part of the transaction, there is a transfer of a property to the customer. In many if not most cloud computing transactions there will be no such transfer and the rules governing the taxation of services income would be likely to apply. However, there may be circumstances where a right is transferred to a customer, in which case the cloud service provider will have to consider whether the income earned is treated as rental, or royalty income (each of which involve the transfer of either a copyrighted article or an intangible property right). Where there is a transfer of property, classification will depend upon the nature of the rights the customer has in the property transferred. It is likely that classification matters will progress along a continuum, from a pure cloud transaction where no property is transferred, through to transactions where property is transferred together with perpetual rights to use, once payments cease. The following five examples demonstrate the range of possibilities when considering using the cloud as part of the supply chain.
Hypothetical Fact Patterns - Scenario A
A customer enters into an arrangement with a cloud service provider to provide access to certain functions that are hosted and performed within the cloud. The customer’s data and transactions are transmitted to the cloud service provider to be processed using the service provider’s computing infrastructure and software. Through algorithmic load-balancing, the customer’s data is processed and hosted on multiple, non-specific servers. If required, the cloud service provider sends the customer a detailed electronic report constructed according to the customer’s specifications at the end of any web session. This transaction is likely to be characterized as a services transaction since no property or property right is transferred to the customer and access ceases if payments stop.
Hypothetical Fact Patterns - Scenario B
This example is similar to the previous one, except that the customer needs to download a small component to allow the hosted software to be operated from the customer's computer. Although the downloaded software will probably be subject to a license, this software is not in a functional form and therefore this is likely to be characterized as a service transaction, since no substantive property or property right is transferred to the customer and access ceases if payments stop.
Hypothetical Fact Patterns - Scenario C
Those parts of the transaction that take place over the web within the service provider’s IT environment are still likely still to be considered as provision of services. However, unlike the previous two examples, in this case the customer can download and use a fully functional version of the software on their computer while not connected to the web. If payments cease, all rights to the software will stop and any physical media must be destroyed. Is the loading of full software onto the customer’s computer more akin to a traditional software license? Or is it a rental transaction, given that no enduring rights exist over the property transferred? In addition, given that a single monthly payment is likely to be made, what amount of this payment should be allocated to each element of the total service provided?
Hypothetical Fact Patterns - Scenario D
This example refers to services provided for those parts of the transaction that take place over the web within the service provider’s IT environment. There will probably be a traditional software license for the software that can be downloaded and installed on the customer's machine; and the rights to this license remain once payments and access to the cloud cease. The question again here is: how to split the monthly fee between the various components?
In all the above examples, one factor has remained constant: the customer has no reserved space in the cloud, so how would this impact the analysis? Consider the following scenario:
- A customer with very specific/unique research needs contacts the cloud service provider for access to the service provider’s computing infrastructure. The cloud service provider makes a specific, physical portion of its computing apparatus available on a dedicated but temporary basis, and the customer is given the right and means to control the apparatus and the activities that this apparatus conducts. Indeed, through a web interface, the customer uploads customized software and data onto the cloud service provider’s computing infrastructure, in order to carry out research. The customer monitors the process remotely through the web interface, making adjustments as needed to achieve good performance.
Income earned from this transaction may constitute rental income since temporary, exclusive use of a specific portion of the cloud service provider’s property is transferred to the customer.
As noted above, cloud computing transactions can give rise to a variety of different types of income. Any of the three prevailing cloud computing models described in the introduction - usage-based, subscription, and ad-supported - could give rise to services income. The usage-based and subscription models have the greatest potential to generate rental income. Rental income is likely to result where the customer has substantial but temporary control over a specific physical portion of the cloud service provider’s property, e.g. a specific server located in the cloud on a service provider’s cloud computing infrastructure. None of the three prevailing models identified in the introduction would, prima facie, appear to give rise to a sales transaction. However the cloud services provider’s client may achieve this characterization by selling its (digital) product using the cloud service provider’s infrastructure; or the service provider itself may deliver its software for use on the customer’s computers over the web. CSPs desiring sales treatment will need to plan carefully to achieve the desired result. Many issues that have arisen over the past few decades in relation to royalties for copyrighted items may now be irrelevant, as any transaction truly performed in the cloud environment is unlikely be seen as involving the transfer of property subject to copyright. Countries applying taxes may of course have a different perspective.
Sourcing income from cloud computing transactions
It is important to determine the source of income as this in turn determines whether the income is from a domestic or foreign source. In many jurisdictions foreign tax credits may only be claimed when foreign taxes paid are associated with foreign source income; various tax treaties may impact such claims. A foreign cloud service provider will be interested in the source since it may affect whether withholding taxes are imposed on payments received from its cloud computing transactions.
Generally, income derived from the provision of services is sourced to where the services are performed – a rule that raises certain complexities for cloud computing. Rarely will all of the inputs that make up the service offering be provided in a single jurisdiction, so income will have to be allocated to different countries. If a transaction is classified as rental income, this income is generally sourced to the place where the property is used (e.g. generally where the servers and other components of the cloud apparatus are located). If a transaction is classified as generating sales income (e.g. the transaction is a sale of an item of property), income is generally sourced to where the sale takes place (e.g. where the contract is concluded and where title, benefits and burdens of ownership pass to the buyer). As with the location of services inputs, it may be challenging to ascertain the location of production activities for cloud computing, requiring a careful consideration of the facts. Royalties are usually sourced from where the intangible property is used (exploited) by the cloud service provider’s customer.
Outbound and inbound tax considerations
Many countries have implemented controlled foreign corporations (CFC) anti-avoidance legislation to limit the transfer of income off-shore to a tax-advantaged location. In developing a cloud infrastructure, income should not inadvertently fall within such legislation, which would bring income onshore for inclusion within a domestic tax return. In the virtual world, transactions and services can be delivered with little or no human involvement. For example, would a server farm that has significant physical presence (in the form of tangible assets) be considered to have substance (i.e. it can demonstrate that it is an independently managed business operation), if minimal individuals are involved in running the server farm?
Another key question is whether operating in the cloud creates a permanent establishment (PE) for tax purposes for both the service provider (through its infrastructure) or for the client (through the use of servers in a territory outside the home jurisdiction)?
The Organisation for Economic Co-operation and Development (OECD) Model Tax Convention describes a permanent establishment as “a fixed place of business through which the business of an enterprise is wholly or partly carried on.” As noted above, cloud computing allows the remote operation of many IT processes. Should some processes be moved onto the cloud, these processes would constitute a fixed place of business in an overseas jurisdiction. The Model Tax Convention discusses this in two parts: firstly what is a place of business? It is considered that “the mere fact that an enterprise has a certain amount of space at its disposal which is used for business activities is sufficient to constitute a place of business.” Indeed, the commentary also mentions the example of a designated space at a market stall. From this description the provision of space, or the right to use the space, would constitute a PE.
At first instance this would seem to capture one of the principal cloud computing activities; the situation where company A rents server capacity from company B to cope with times of peak demand. Especially where transactions occur, this would clearly seem to meet the criteria of a place of business.
Next the commentary considers the term “fixed,” stating that the business activities must be able to be linked to a geographic point. For the server farm outlined above to be clearly linked to a geographic point, the host server must be in a physical location and the processing of information must occur on that particular server.
But what happens when transactions are distributed throughout a server network covering many countries? Could you end up with multiple fixed places of business? And how would this be monitored and reported? There is a glimmer of hope from the output of the OECD Technical Advisory Group, which considered the issue of PEs and servers in the revision to the commentary on Article 5 of the Model Tax Convention, in that the generally accepted conclusion (although some territories did not agree) was that a server in of itself did not create a PE.1 It was and still is important to consider the services that will be performed on the server and the infrastructure around which they are delivered. When servers were primarily used to deliver digital goods, many companies relied on the preparatory and auxiliary services exemption to overcome PE concerns. The provision of services in the cloud changes the whole delivery dynamic. Servers are no longer an insignificant part of the delivery mechanism; they now host the provision of valuable services and as such it may prove difficult to argue that the activities are preparatory and auxiliary.
Related party transactions
Establishing and maintaining a global cloud computing business will raise issues over transfer pricing for transactions undertaken with non-arm’s length non-resident parties (i.e. the pricing of transactions conducted among controlled companies. Cloud computing transfer pricing issues will be influenced by how the value of the cloud computing business is distributed among the intellectual property, cloud computing infrastructure and personnel that support the business. This is a new challenge with complex fact patterns that will be unique to a specific CSP. Thus, where multiple corporate entities combine efforts to provide a cloud computing offering to customers, CSPs will need to evaluate each entity’s economic contribution to the effort, and compensate each entity according to arm’s length principles. Intercompany transactions will need to be documented contemporaneously and supported by economic analyses, but as this is a new business model there are no existing benchmarks for identifying comparable transactions. The cloud also makes cross-border transactions more accessible, which means that CSPs operating multi-nationally will not only have to consider the domestic home territory transfer pricing, but also the rules and guidelines employed by foreign jurisdictions and entities (including the OECD). Finally, this is a new sector in constant flux as businesses develop their models for delivering services in the cloud. Transfer pricing will always be an important issue, causing multinationals to take on a whole new level of complexity.
Determining the Value Added Tax (VAT) liability of cloud computing services is also a fact intensive exercise, with tax decisions varying according to each individual supply chain and associated contract terms.
The general approach to evaluating the CSP’s transactions is to understand:
|What services are sold?
||This informs the “place of supply rules” that need to be applied, which differ according to type of service.|
||Does the head office or local sales office have the VAT accounting obligation?|
||Is there a local or cross-border supply? Is there one supply or many supplies? Is there a “use and enjoyment” override?|
||Is there a continuous supply of services? Is VAT due on invoice, payment, or at the time the service is supplied?|
|For what value?
||To ensure any “barter” elements or retrospective price adjustments are taken into account.|
From a VAT perspective, cloud computing does not represent a particularly new set of services; it is likely to be considered in the same way as software, hosting or electronic services.
The most challenging question is whether there is a ”use and enjoyment” override applying to the basic place of supply, which shifts the liability to tax from one country to another. This is an optional provision used in the 27 EU countries, with very little consistency as to how and when it should be applied. The provisions are intended to be for situations where there is non-taxation (e.g. a supply to a bank that may not be able to recover all VAT), rather than fully taxable businesses; however, over-zealous tax authorities may apply the rules broadly and a dispute could take years to resolve.
In countries outside of the EU, the existence of local VAT obligation or irrecoverable VAT should be determined on a country-by-country basis.
As mentioned for corporate tax above, indirect tax is a complex issue where there is a specific physical portion of hardware infrastructure made available. Income may become rental income for property, which shifts the place of supply to the place where the infrastructure is located, rather than where the CSP contracting party is located.
What is new however is the way these services are being sold, with three key factors adding complexity for CSPs, when evaluating their transactions for VAT purposes:
- Service provision within the cloud is moving increasingly from local contract and delivery to true global service models, with single global contracts. This makes it more difficult to answer the question of who sends and receive the service.
Who supplies the service? In a global CSP organization is it the head office that makes the supply, invoices and accounts for the VAT? Or is it the local sales office that has the VAT obligations, as it delivers day-to-day service and manages relationships? It is often intercompany supplies that bring an unexpected cost, with VAT charged on cross-border supplies to support the top CSP contracting party.
Who receives the service? Is the supply made to the customer’s central procurement company? Or does a ”use and ‘enjoyment” override apply, to shift the place of supply to each country of the beneficiary companies of the corporate group, or even, under the principle of ‘usage’, the underlying employees? If the place of supply is overridden, the CSP will have to register and account for local VAT.
- The pace of technological development and the variety of cloud offerings means that there is very little human intervention required in supplies.
A fixed establishment for VAT purposes has often been easier to create than a permanent establishment for corporate tax purposes. With less need for human resources, it is quite possible that sophisticated technical resources alone could create a fixed establishment, with the associated VAT accounting obligations switched to this establishment.
This becomes more likely when coupled with the new principle of “intervention” in the 27 EU Member States introduced on 1 January 2010. The term “intervention” has yet to be defined, but could be used by some countries as a way of capturing a share of VAT, by arguing that a local agent/company in the global CSP in some way took part and so intervened in the supply, requiring VAT to be charged.
- The natural extension of cloud computing is to the consumer market.
CSPs move from a wholesale market (where VAT is often seen as a “flow through” because it is recoverable (except in the case of banks, insurance companies, charities)) to one where the end VAT decision and cost is theirs. Particularly in Europe, where prices to consumers must be quoted as VAT inclusive, the rate of VAT charged starts to influence margin and profitability. Therefore CSPs should consider supplying from low-rate countries to minimize.
1Clarification of the application of the permanent establishment definition in e-commerce: changes to the commentary on the model tax convention on Article 5.