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The Cloud affects virtually every business. Companies are looking to increase sales and services offered in cyberspace, harvest consumer information in order to make their offerings more effective, and broaden markets served beyond their “bricks and mortar” footprints. At the same time, internal IT departments are looking to cloud computing as a cost-effective way to grow their infrastructure, enterprise platforms, and use of third-party software applications, while at the same time reducing overhead, capital expenditures and ongoing procurement and maintenance costs.
Transactions that occur in cyberspace raise tax issues that should be examined prior to deciding on a path forward. Issues can arise over character and source of income, permanent establishment, transfer pricing and indirect taxes.
Transactions that occur in the Cloud can take many forms which parallel the “bricks and mortar” world: the sale of goods, the licensing of intangible property, the rental of tangible property (including software, discussed further below), and the provision of services, among others. In the case of software, the US Treasury has issued detailed regulations to distinguish the types of transactions, relying mainly on US copyright law, and in particular the differences between the sale of a copyrighted article and the transfer of rights in the copyright itself. Under this rubric, a sale of a copyrighted article occurs with a transfer of all substantial rights in the copyright, including each of four enumerated rights:
1. the right to distribute copies to the public;
2. the right to make derivative works;
3. the right to display the program in public; and
4. the right to perform the program in public.
The retention of any of these rights converts a sale of a copyrighted article into the transfer of a copyright right, and therefore a licence for royalty. Although these regulations mention services, they refer to services relating to the creation of software, not software transactions in which the end-users pay a service fee to the software provider. The software income characterisation regulations contain a broad statement that changes if the “means of delivery” do not change the fundamental income characterisation, so that a digital download should be characterised the same way as a transfer of a CD, i.e., determined by whether all of the four enumerated rights are transferred and by the term of the use of those rights measured against useful life, rather than whether the software code is transferred on a CD or from a remote server through an Internet connection.
Where there is no transfer of source code, but merely access to that code granted on a remote server, then the better characterisation of the income from providing that access is that of a fee for services. Income from services is also an apt characterisation where the fee is earned in return for server capacity, remote data management and similar functions.
The characterisation of income from transactions that occur in the Cloud, as a first question, then determines much of the subsequent analysis regarding source, taxable presence, applicability of transfer pricing and anti-deferral rules, the incidence of indirect taxes (e.g., VAT, GST and sales taxes), and many other tax issues.
Once income from the Cloud is characterised, applying the source rules alone can be challenging. Consider, for example, the sale of a tangible good where the source rule is the place where title and risk of loss pass from seller to buyer, which is usually specified in each contract or purchase order. The source rule for services income in the US income tax world is the place of performance of the services. Depending on the facts, this place of performance could be the end-user's laptop, the server from which the user accessed the service, or the place where the code was created to be loaded onto the server (especially if the server viewed as is a mere means of delivery).
To mitigate uncertainty, taxpayers may seek to concentrate server capacity and key personnel responsible for creating code for the servers in the same country. However, this concentration of infrastructure and personnel may increase operating costs and capital expenditures as the ability to load manage across geographies and time zones is constrained, and the necessity of having geographically concentrated capacity to cope with peak loads becomes more costly.
In the bricks and mortar world of providing physical products or services by personnel on the ground, the permanent establishment issues and analysis are relatively well established. With respect to the Cloud, the US government has yet to issue any official pronouncements about the application of these rules relating to taxable presence to this new economic trend. In the United States, in the absence of a treaty, there must first be a “trade or business within the United States” and then that trade or business must have “effectively connected income”. The threshold for how much activity constitutes a “trade or business” is factually dependent, but generally quite low. Once a level of activity rises above the “trade or business” threshold, the second step in the analysis, whether the trade or business has “effectively connected” income, depends on the source of the income. All US source income of a US trade or business is treated as effectively connected. Foreign source income is treated as effectively connected only when a US office exists, either directly or through a dependent agent, or when the authority to conclude contracts on behalf of the foreign person is habitually exercised within the United States. However, under the US rules, the analysis of what it means to “habitually exercise the authority to conclude contracts” in the context of retail sales that are made online in the Cloud is less than clear. Ordinarily, under US contract law principles, one would identify the “offer” for which an “acceptance” is made, and determine that the place of acceptance is the place of contracting. But how is this analysis applied in the following circumstances: a customer using a laptop in France purchases a book from a website by clicking on a “button” on his/her screen? Applying traditional contract concepts is arcane at best. So where is the contract concluded? Is it on the server where these instructions are carried out in the blink of an eye after the customer clicks on the right screen-rendered button? Or is it where the standard terms and conditions are drafted by the seller's legal department for uploading to the server? Or is it somewhere within the seller's mechanisms for setting prices at which it is willing to sell? Or, is it acceptance “by performance” in the act of shipping the book to the customer? While jurisprudentially interesting in some academic sense, clear guidance does not exist. The best that taxpayers can do in the current environment where the source of the income from online transactions is important is to concentrate as many of these potentially dispositive acts in the same jurisdiction, or at least make sure that as few of them as possible are performed in the US.
That said, the OECD has made several pronouncements in its commentary to Article 5 (Permanent Establishment or PE) which provide initial guidelines: a website is not a PE, because it isn't a tangible place of business; a server is not automatically a fixed “place of business”; even if a server is a fixed “place of business”, the server is not a PE if the functions it performs are “preparatory and auxiliary” to the business. However, where the functions performed on the server constitute “an essential and significant part of the business enterprise as a whole” or are “core functions” of the business, then the server may in fact create a PE. What is “essential”, “significant” or “core” depends on the facts of each business and cannot be determined in the abstract. Moreover the analysis of when and where contracts are concluded in transactions that occur online is no more certain or developed in the treaty context than under the US domestic income tax rules. There has been some debate about the development of a concept of “substantive acceptance” as contrasted with “legal acceptance” but the contours of what would constitute “substantive acceptance” are blurry.
The Cloud presents two main challenges in the transfer pricing arena. First, new valuation methods must be meshed with recently reissued regulations that have been less frequently used (and debated) than the methods typically used before the Cloud gained prevalence. Second, isolating exactly what drives value - and therefore profit - in the services offered through and by The Cloud is not always clear, and this lack of clarity is bound to create confusion and disagreements between taxpayers and taxing authorities when new valuation methods are applied.
Treasury regulations that govern services transactions among related parties have recently evolved in their sophistication and complexity. Importantly, the regulations now provide several pricing methods and theories under which services may produce non-routine returns traditionally associated with intangible property. Recognising the intangible value of services is important for the business models being used in The Cloud.
The models adopted by businesses to deploy cloud computing sit on a spectrum, ranging from full outsourcing to an external cloud vendor at one end, to a fully internalised cloud in which the resources are owned by a designated group company that provides cloud hosting services to internal clients at the other. In practice, many large multinationals deploy a hybrid, falling somewhere in the middle.
Cloud models present a number of interesting transfer pricing challenges. In an external cloud vendor model, it is likely that there is a single internal point of contact that is responsible for procuring and managing the vendor arrangement. This person may bear some risk related to the provision of services by the vendor (particularly if service level commitments are made in internal service agreements, or if there are fixed fee commitments in the vendor agreements that are not mirrored internally).
The more interesting and challenging transfer pricing issues relate to internal cloud models. The economic foundations of the Cloud lie in the economic efficiency available through the service provider's abilities to achieve economies of scale and operational efficiencies that may not be achievable internally. The Cloud hosting company bears risks related to the necessary capital investments that result from volume of usage and obsolescence risk. Internal cloud hosting companies would want to implement transfer pricing policies that replicate how external hosting companies would price their services. This pricing would include a reasonable price for services, but would also include a return on the assets deployed which reflects the risks mentioned above.
Important to transfer pricing is the alignment of compensation and economic return with the critical functions of managing and controlling the key risks, strategy and investment decisions that drive the business. When an internal company owns assets and contractually provides services, one might expect it to receive the compensation. While this will in fact be right in many cases, it is nonetheless important to identify the people bearing day-to-day responsibility for the internal cloud service provision, as this will also help to determine the most appropriate transfer pricing arrangements.
It is important to take account of indirect tax issues when doing business in the Cloud. Most jurisdictions with VAT systems are aware that the electronic delivery of services in particular is difficult to tax in a local jurisdiction. Goods can always be stopped at the border and taxed on import, but this is much more difficult for services.
This has been a source of much controversy in the EU as VAT systems were not designed to deal with a material quantum of service delivery where the customer base is not itself in business nor in the same country as the service provider. The ability for US businesses to deliver tax free services to EU consumers from a base in the US (gaining a tax advantage of as much as 25 percent) was for a while perfectly within the law and merely reflected the need for European law to be updated for the needs of the internet age.
The EU is still struggling with this problem. We now have in place a system which causes non-EU suppliers of digital services to account for VAT in every member state where they have any private customer. EU based businesses have to account for one rate of VAT, which is the country rate where the service provider has established its business.
Unfortunately, significant differences in VAT rates between EU member states create significant distortions of competition. So, from 2015, we are returning to a universal system in the EU in which all will have to account for VAT at the rate applicable in the member state where the service is consumed by the private customer.
The burden of transition for businesses is significant and is one of other salient challenges. First, where client data has to be collected, an efficient interface with the potential online customer is needed. The addition of even seconds in the online buying process can put a buyer off, so it's important to minimise the number of questions and maximise the amount of data.
Second, the compliance burden is quite significant. Apart from appropriate VAT coding within accounting systems, the plethora of returns that have to be filed for VAT in Europe is unattractive. If goods are sold to private consumers, sellers must be aware of distance selling rules which can cause your business to be VAT registered in other EU countries. It is wise to be informed in advance of how each part of the business will be impacted when selling in the EU, what that may do to pricing and also what compliance burden comes with it. Although the EU has proposed measures for reducing the compliance burden on service providers - notably a one-stop shop similar to that in place for non-EU suppliers that will allow a single return to be filed covering all VAT declarations across the 28 member states - compliance burdens will undeniably increase in 2015.
Thirdly, international service providers need to be aware of differing rules in jurisdictions that appear to share a common system of value added taxes. Assuming that all countries with VAT adopt the same rules and enforce those rules in the same way, may prove costly. Even within the EU, where there is a certain degree of harmonisation, member states differ in how they apply certain rules and how their tax authorities police them. Comparing EU VAT rules with those of countries in Asia and South America will reveal additional substantial differences.
The OECD's latest draft of international VAT guidelines is a good roadmap for designing a VAT system that raises revenue for governments while minimising distortions to the domestic and international provision of services. However it is likely to be some time before we see a country that has implemented a VAT system that adopts all, or even most, of these guidelines.
In conclusion, it is clear that the Cloud poses interesting and complex issues relating to international taxation. Companies must be prepared for these changes before ascending too far into the Cloud. Cyberspace offers companies the chance to develop online sales and services without increasing overhead costs, but a lack of preparation could see these benefits quickly nullified.
Kent Wisner is a Managing Director with Alvarez & Marsal Taxand LLC in San Francisco. Steve Labrum is a Managing Director with Alvarez & Marsal Taxand UK LLP in London. Richard Baxter is a Managing Director with Alvarez & Marsal Taxand UK LLP in London. Leigh Clark is a Director with Alvarez & Marsal Taxand UK LLP in London. The authors may be contacted by email at:
The authors are grateful for contributions and advice from Albert Liguori, Kristina Dautrich, and John Curry. Albert Liguori is a Managing Director with Alvarez & Marsal Taxand, LLC, in New York. Kristina Dautrich is a Senior Director with Alvarez & Marsal Taxand, LLC, in Washington, D.C. John Curry is a Senior Director with Alvarez & Marsal Taxand UK LLP in London.
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