Characterizing Cloud Transactions — Applying §7701(e) to Remote Access Transactions: Part II

By Gary D. Sprague, Esq.  

Baker & McKenzie LLP, Palo Alto, CA 

My last commentary discussed the application of §7701(e) to
characterize transactions involving the provision of hardware or
software capabilities through the cloud.1 In that
commentary, I noted that a subsequent commentary would discuss the
applicability to that analysis of the case of Tidewater Inc. v.
United States
.2 Tidewater deserves
special attention because it is the only case to apply the §7701(e)
factors outside the investment tax credit context after the
enactment of §7701(e) and, more importantly, it offers a view as to
when a user of property should be considered to "possess" or
"control" that property for purposes of a transaction
characterization analysis. In the context of transactions involving
remote access to hardware and software functionality through cloud
transactions, concepts such as "possession" and "control" may be
difficult to apply. Some commentators have raised the question
whether the discussion of the §7701(e) factors in
Tidewater provides guidance to the characterization of
cloud computing remote access transactions.

The Tidewater case addressed the characterization
of vessel time charters for purposes of the foreign sales
corporation rules. Under a time charter, the vessel owner supplies
a vessel complete with a crew. The customer could direct the vessel
to undertake any voyage permitted by the terms of the
agreement.  The charter covered a named vessel with specified
capabilities. While the owner could provide a substitute vessel,
the customer must give its reasonable consent. The customer could
sublet, assign, or loan the vessel to other persons, make
structural alterations to the vessel, or install additional
equipment on the vessel, but in all cases subject to the owner's
reasonable consent.

The taxpayer and the IRS agreed that the time charters included
elements of both service and lease contracts. While the time
charter contracts themselves did not separate the two elements, the
taxpayer accounted separately for a service element and a rental
element. The issue in front of the court was whether the vessels
were "export property" within the meaning of §927(a).  The IRS
argued that the contracts could not be separated into two elements
for this purpose, that §7701(e) provided the proper analytical
framework, and that under those factors the time charter should be
characterized as a service contract.

The Fifth Circuit agreed with the IRS that §7701(e) supplied the
applicable law, and apparently agreed that a single character would
be applied to all revenue under the contract. The Fifth Circuit
disagreed, however, that the contract was more like a service
contract. 

The court applied each of the six §7701(e) factors to the facts
of the time charter. While some of the factors weighed in favor of
service characterization, the court concluded that the most
important factor was the "control" factor.  On that factor,
the court concluded that the customer was in "control" of the
vessel on the basis that the customer directed the movement of the
vessel, cargo, and passengers. In the court's view, this control
was more important than the "operational control" exercised by the
vessel's crew.

The court also concluded that the "physical possession" factor
also weighed in favor of service characterization.  While the
vessel owner provided the crew which actually operated the vessel,
the court noted that the customer "had significant control over the
vessel and the crew, particularly as to when and where the vessel
travelled." In the eyes of the court, that gave the customer
"constructive possession" of the vessel.

At the end of the opinion, the court supported its conclusion
with the following analogy:If a Tidewater employee leased a vehicle
from Avis and operated it himself, this contract, like a bareboat
charter, would be a classic lease. If, on the other hand, the
vehicle was leased with a driver employed by Avis, and the car and
driver were at the beck and call of the lessee, the control the of
[sic] lessee over the vehicle in this latter arrangement
is reduced very little, and is still more like a lease than a
service agreement. We see very little difference in principle
between the lease of a car with a driver and Tidewater's Time
Charter.

 The IRS has nonacquiesced in this result, disagreeing with
the court's application of the "physical possession" and "control"
factors.3

Is the Tidewater analysis relevant for
characterizing cloud computing transactions? Once one considers
carefully what are the relative functions and responsibilities of
the provider and the user in cloud computing transactions, it seems
clear that the Tidewater court's concepts of
"constructive possession" and "control" absent operational control
are inappropriate in the cloud computing remote access context.
Section 7701(e)(1) itself refers to "physical possession." In
typical cloud-based computing models, the service provider is
clearly in physical possession of the equipment. In fact, one of
the business efficiencies offered by cloud-based models is that the
user is relieved of all obligations to acquire and maintain
equipment. The essence of the business model is that the user never
acquires physical possession of the equipment.

With respect to the "control" factor, the ability of the user to
control an output should not be confused with control over the
hardware or software that creates or delivers that output. The
§7701(e)(2) factor is whether the service recipient "controls the
property." It is important to identify what is the relevant
"property" in remote access transactions. In a Software as a
Service (SaaS) transaction, it could be both the server and the
software application running on the server. In an Infrastructure as
a Service (IaaS) transaction, it could be just the equipment and
whatever minimal software is required to allow the user to upload
and download its own applications and data. In all cases, the user
is able to access the hardware and software remotely, and indeed is
able to cause that hardware and software to produce a result. Where
the user is not responsible for the physical maintenance of the
hardware or to assure the continued operation of the software,
however, the user should not be regarded as in "control" of those
properties. Even in circumstances where the user may be able to
designate on which servers its data will be stored or its
applications hosted, and even if the user is able to remotely
manipulate the data and the programs, the user is never in physical
possession of the equipment and thus should not be regarded as
controlling the property.

This distinction between (1) possession and control of the
physical equipment and (2) the ability to remotely access software
or data residing on the equipment is inherent in the OECD
Commentary on Article 5 of the OECD Model Income Tax Treaty
regarding when the use in electronic commerce of computer equipment
could constitute a permanent establishment. While the §7701(e)
characterization test and the definition of a permanent
establishment are different concepts, of course, the guidance in
the Article 5 Commentary provides a useful analogue to the §7701(e)
analysis described above.  Just as remote access to equipment
hosting software or data should not be regarded as possession or
control of that equipment, the Article 5 Commentary also
distinguishes between "operation" of the equipment and remote
access to the website or data that are hosted on the equipment. The
Commentary explains as follows:4

The distinction between a web site and the server on which the
web site is stored and used is important since the enterprise that
operates the server may be different from the enterprise that
carries on business through the web site. For example, 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 (see paragraph 4 above), 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 such a case, the
enterprise does not even have a physical presence at that location
since the web site is not tangible.

The conceptual approach in the OECD Commentary of separating the
operation of the hardware from the communications activity of
accessing software, content, or data residing on that hardware
supports the conclusion that, in the normal case, remote access
transactions should be treated as a provision of services and not
as a lease of property.

Finally, it is worth noting the irony of the Fifth Circuit's
distinction between a lease of a car and the provision of a car
with driver. That exact example came up in the debates of the
OECD's Technical Advisory Group (TAG) on Treaty Characterisation.5 That TAG addressed
various characterization issues relating to e-commerce
transactions, including several remote access transactions. One
characterization issue was whether such transactions should be
regarded as giving rise to business profits or to rents for the
lease of industrial, commercial, or scientific equipment. The OECD
Model no longer distinguishes between rents and service fees in the
"business profits" category. Prior Models, however, and therefore
many existing treaties, carved out for source-based withholding a
category of income of rents or royalties paid for the use of
industrial, commercial, or scientific equipment.  Thus, the
TAG examined the appropriate basis to make that distinction in the
case of remote access transactions.

In general, the TAG considered that §7701(e) provided useful
guidance to make that distinction. The TAG's final report generally
concluded that remote access transactions as typical in the cloud
environment should be characterized as business profits, and not as
rents or royalties for the use of industrial, commercial, or
scientific equipment.6

The irony lies in the fact that the point during the discussion
which finally convinced one of the government delegates that
business profits treatment was proper was exactly the example of
the chauffeured car as referenced by the
Tidewater court to support its conclusion on the
"control" factor. For that delegate, this example sealed the matter
in the opposite direction; the hire of a car is a lease, but
providing a car equipped with a driver constitutes a service. For
future courts considering the character of remote access
transactions, they will find more appropriate guidance in the OECD
TAG report than in Tidewater.

This commentary also will appear in the November 2013 issue
of the
 Tax Management International Journal.
 For more information, in the Tax Management Portfolios,
see Sprague, Chesler, Reid, Cohen, and Hubbard, 555 T.M.
,
Federal Taxation of Software and E-Commerce, and in Tax
Practice Series, see ¶2350, Losses, and ¶4020, Classification as a
Partnership.

 

  1 42 Tax Mgmt. Int'l J. 9
(9/13/13). 

  2 565 F.3d 299 (5th Cir. 2009). 

  3 AOD 2010-001 (5/14/10). 

  4 ¶42.3, Art. 5 Commentary. 

  5 Tax Treaty Characterisation Issues Arising from
E-Commerce, Feb. 1, 2001 (www.oecd.org/ctp/consumption/1923396.pdf). 

  6 Treaty Characterisation Report, ¶¶24-31.