• Service: Tax, Global Indirect Tax, Global Transfer Pricing Services, Global Compliance Management Services, International Tax
  • Type: Business and industry issue, Regulatory update, Survey report
  • Date: 5/1/2012

Country perspectives on taxing the cloud – United States 

Cloud computing can provide computation, software application, data access, data management and storage resources without requiring cloud users (customers) to know the location and other details of the computing infrastructure. Data is stored on servers at a remote location. The technology allows customers to centralize their system processes, increase performance and reduce system maintenance costs.

Cloud computing technology is deployed in three general types, based on the level of internal or external ownership and the technical merits: public cloud (external), private cloud (internal), or hybrid cloud.

Public cloud is the provision of cloud computing services whereby applications, storage and other resources are shared among multiple customers over the internet or a private network, with varying degrees of data privacy control.

Private cloud uses similar computing architectures to the public cloud, but is generally built, managed and used internally by an enterprise.

Hybrid cloud is a mix of public cloud services, internal cloud computing architectures and traditional IT infrastructure, forming a hybrid model that meets the specific needs of the customers.

Tax treatment of cloud computing

There is no comprehensive set of US guidance for the tax treatment of cloud computing (e.g. characterization, sourcing and reporting obligations). The US Treasury instead adapts existing tax principles to the cloud rather than creating new or additional tax regimes.

Characterization of income

The character of the income earned from cloud computing drives the tax determinations of the treatment and the reporting obligations. Though the rules are not immediately clear, the character classification generally depends on the nature of the underlying interest that is granted to the customers as part of their access. Where the cloud operator earns income by providing access to applications, software, or storage, the transaction could be characterized as either a transfer of a computer program (sale or license) or a service provision that generates services income.

The character of payments to a cloud computing provider generally depends on the following (non-exclusive) factors:

  • Whether any derivative rights (such as the rights to make copies for purposes of distribution or to prepare derivative work) relating to the application or software were transferred as part of the access.
  • Whether the customers have physical possession of or control over their access to the software.
  • Whether the customers bear the risk associated with the maintenance of the software or application.
  • Whether the customers have exclusive access to the applications and software.

The determination will depend on the particular facts and circumstances of the arrangement. Generally, a transaction involving a computer program will be treated as a sales transaction if, subsequent to the transaction, the customer receives all substantial rights and bears the relevant benefits and risks of ownership with respect to the program. A transaction will be treated as a license if less than all substantial rights are transferred. Finally, a transaction will generally be treated as a provision of services if the customer merely has access to the computer program and does not bear the benefits and risks associated with ownership.

Source of income

The source of income depends on the underlying character of the income. Generally, sales income is sourced where title and risk of loss is transferred; royalty income is sourced where the underlying right or property is used or protected; and services income is sourced at the location where the services are performed.

Even after the character of income has been determined, the source of income analysis may still not be straightforward. For example, for services income, there is little guidance over where the services are considered to be performed for business activities conducted over the Internet. Applicable authorities suggest that the US tax authorities may treat the services as being performed at the location of the servers, provided there is limited human or additional outside involvement in the provision of the services.

The source of income can affect whether the income from cloud services will be taxable in the US, and whether withholding taxes are imposed on payments received from its cloud computing transactions.

Corporate income tax

US corporation

Cloud computing providers that are treated as tax residents of the US are generally subject to tax at the graduated corporate income tax rate on all income earned, regardless of its source.

Foreign corporation

Foreign corporations that provide cloud computing services (foreign opcos) are generally subject to corporate income tax in the US where their business income is connected with a US trade or business.

A Foreign OpCo will generally be treated as conducting a US trade or business if it conducts considerable, continuous and regular business activities in the US. In addition, a Foreign OpCo may be treated as having a US trade or business through the activities of its agent, if the agent has the ability to bind or conclude contracts on behalf of the principal.

There are no clear rules on whether a Foreign OpCo should be treated as having engaged in a US trade or business as a result of utilizing servers in the US. However, if the US servers function as a critical part of a foreign opco’s business operations, such fact may be sufficient for US tax authorities to argue that the Foreign OpCo engages in considerable, continuous and regular business activities in the US and therefore has a US trade or business.

If a Foreign OpCo has a US trade or business, it is required to file a US federal income tax return, regardless of whether it has any income subject to tax during the taxable year. Nonetheless, the amount of income subject to US tax may be reduced or wholly exempted if the opco qualifies for benefits under an applicable US income tax treaty.

Income tax treaty and permanent establishment

If a Foreign OpCo qualifies for benefits under an applicable US income tax treaty, certain business income earned may be exempted from US corporate income tax. In most US income tax treaties, a Foreign OpCo must generally meet the requirements of the Limitation on Benefits Article to qualify for benefits under the treaty. While the specifics of the tests vary from treaty to treaty, a Foreign OpCo generally qualifies for benefits if it meets one of the following tests:

  • test based solely on ownership
  • ownership/base erosion test
  • active trade or business test.

Where a Foreign OpCo earns business income that qualifies for benefits under an income tax treaty, it may be exempted from US corporate income tax if it does not have a permanent establishment (PE) in the US. In determining whether a particular cloud provider has a PE in the US, one must consider the location of the servers used by the provider, and the outside functions that may be required to operate the cloud computing operations.

US tax authorities generally adopt the Organisation for Economic Co-operation and Development’s (OECD) approach, published in its commentary on e-Commerce, which considers an enterprise to have a PE at the location of the server, but only if the enterprise has the server at its own disposal. There are no specific criteria for determining when an enterprise may be considered to have a server at its disposal. However, the OECD commentary on PEs generally states that if a taxpayer owns (or leases) and operates the server, it may be treated as having a server at its disposal and, therefore, a PE.

Thus, if a Foreign OpCo conducts its cloud operations through servers located in the US, there is a risk that it will be treated as having a US PE. However, where its cloud operations also require additional human intervention or other functions to be performed outside of the US, the Foreign OpCo may allocate portions of the income earned to those functions in accordance with the profit attribution principles under the treaty.

Withholding tax

A Foreign OpCo may be subject to US withholding tax if it earns US source income that is treated as fixed, determinable, annual and periodic (FDAP) income that is not effectively connected with a US trade or business. FDAP income is defined broadly to include most income that is not derived from gain from the sale of property. In cloud computing, typical FDAP income that may arise includes royalty, interest and dividend payments.

If a Foreign OpCo earns US source FDAP income that is not connected with a US trade or business, such income will generally be subject to a 30 percent US withholding tax. The withhold tax on FDAP income may be reduced or wholly exempted if the Foreign OpCo qualifies for benefits under an applicable income tax treaty.


US trade or business analysis

Foreign OpCo may be treated as having a US trade or business in this case, because it is using its parent company’s US servers to accept orders from its customers. In addition, Foreign OpCo may also be treated as having a US trade or business based on the use of the server co’s US servers to host the platform that the customers access. Though reasonable arguments could be made otherwise, the significance of the US servers to the Foreign OpCo’s business operations is probably sufficient for US tax authorities to argue that Foreign OpCo has a US trade or business.

If Foreign OpCo is treated as having a US trade or business, it will be subject to US tax on its US source income, either as income connected to a US trade or business (subject to graduated corporate income tax) or FDAP (subject to a 30 percent withholding). As previously discussed, the source of income will depend on the income tax characterization of the payments.

If payments for access to the digital platform are treated as payments for the provision of services, the payments may be sourced in the US based on the location of the servers. Such US source income would generally be treated as effectively connected to foreign opco’s US trade or business if the income is derived from assets used in foreign opco’s conduct of a US trade or business, or if the activities of foreign opco’s US trade or business constitute a material factor in the realization of income.

Treaty implications

Assuming Foreign OpCo qualifies for benefits under an applicable income tax treaty, any income that is connected to a US trade or business may be exempted from US taxation if Foreign OpCo can establish that it does not have a US PE. In this case, Foreign OpCo may be treated as having a US PE through the activities of both server co and its US parent.

A Foreign OpCo may argue that the activities of the server co should not establish a US PE on its behalf, if server company is legally and economically independent and does not otherwise act for or on behalf of the Foreign OpCo.

The Foreign OpCo may have more difficulty establishing that its US parent is not its agent, because the parent has (and exercises) the authority to bind Foreign OpCo when the parent accepts the order on the US servers. Unless additional facts exist to establish that the parent acts as the principal and compensates the Foreign OpCo for its marketing services, it is likely that the Foreign OpCo will be treated as having a US PE as a result of its agency relationship with the US parent. As a result, the Foreign OpCo’s income that is attributable to the US PE will be subject to corporate income tax in the US.

Related party transactions

If taxpayers engage in related party transactions as part of their cloud operations, such transactions are generally subject to US transfer pricing principles under Section 482. Generally, taxpayers that engage in related-party or controlled transactions may be subject to adjustments and allocations of income and deductions by the US tax authorities, if the transaction does not meet the arm’s length standard under Section 482.

In order to avoid transfer pricing adjustment-related penalties, taxpayers must maintain adequate transfer pricing documentation that meets the regulatory guidelines.

State-level taxes

State income tax

There are two key state income tax issues that cloud computing providers should address. First, does the enterprise have sufficient connection (nexus) in a particular state that would create an obligation to file state income tax returns? Second, if the enterprise has nexus in the state, does the enterprise have to include income from cloud computing when determining the state’s apportionment formula?

States generally have not issued comprehensive or uniform guidance on how a cloud computing arrangement should be treated and taxed. As a result, enterprises that provide cloud computing services should analyze on a state-by-state basis whether and how much of their income from cloud operations should be subject to state income tax.

Sales and use tax

In addition to state income tax, most states also impose sales and use tax collection responsibility on businesses that operate within their jurisdiction. Generally, the character of the transaction and source of the income derived from the transaction are the issues that need to be analyzed for sales and use tax purposes.

Most states have not issued guidance on how the traditional sales and use tax principles should be applied to the provision of cloud computing services. To the extent that guidance has been issued, it is often limited and differs for each jurisdiction. As there can be significant differences between the states on how the same cloud computing transaction should be treated, cloud providers (and to some extent, their customers) should carefully analyze the transaction on a state-by-state basis, to determine whether they have any sales and use tax obligation.


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Fred Adams

KPMG in United States

+1 (408) 367-2824


Steven Fortier

KPMG in United States

+1 (312) 665-1416


Shirish Rajurkar

KPMG in United States

+1 408 367 2828