Lack of Cloud Guidance May Have BEPS Implications

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By Allyson Versprille

Aug. 9 — The IRS must release new guidance on cloud transactions to respond to explosive industry growth and combat base erosion and profit shifting, according to attorneys.

“It can no longer be said that cloud computing has the mere potential to revolutionize the way consumers and businesses interact with technology; potential has become a current reality,” the American Bar Association Section of Taxation said in a letter to the Internal Revenue Service. “The tremendous growth in the cloud industry creates a pressing need for guidance from tax authorities,” it added.

That growth is evidenced by recent research. According to the International Data Corporation, worldwide spending on public cloud services will grow at a 19.4 percent compound annual growth rate—almost six times the rate of overall information technology spending growth—from nearly $70 billion in 2015 to more than $141 billion in 2019. And big names like Inc. and Microsoft Corp., are reaping the benefits of that growth.

For the earnings quarter ended June 30, Amazon reported that its cloud services provider, Amazon Web Services Inc., generated net sales of $2.89 billion and achieved a segment operating income of $718 million. For the same three-month period, Microsoft reported that revenue in “Intelligent Cloud” grew 7 percent to $6.7 billion. That amount includes 102 percent revenue growth for the company's cloud computing platform, Azure, according to a press release.

Christopher Kotarba, an associate at DLA Piper who helped draft the Aug. 4 ABA letter, said if the IRS doesn't issue new guidance on cloud transactions, it could run the risk of losing tax revenue from the profits of U.S. multinational companies.

Additionally, from the standpoint of the taxpayer, uncertainty and a lack of guidance could lead to double taxation, said Ben Olivas, a partner also at DLA Piper. “At the end of the day, you just have a bunch of governments wanted to tax pretty much the same thing,” he told Bloomberg BNA Aug. 9.

BEPS Implications

As with other cross-border transactions, tax consequences arising from cloud transactions are rooted in the character and source of the income, the ABA tax section said.

The group's letter only addresses character, but a subsequent letter on source of income is being developed, Kotarba said Aug. 9.

“It’s really where source comes to play in terms of BEPS because traditional source rules are based on where the servers are located, but other countries are taking the view that the source of profits should really be where the activities and the employees are located,” he said.

Those “countries are making legislative efforts to try and grab profits based upon new source rules, and the U.S. rules really need to get up to speed and up-to-date on cloud computing so that the U.S. can protect its own fisc from other countries trying to grab profits from U.S. multinational companies,” Kotarba said.

The ABA letter noted that the Organization for Economic Cooperation and Development—as part of its BEPS Action Plan—issued a public discussion draft, “BEPS Action 1: Address the Tax Challenges of the Digital Economy,” in March 2014, followed by a final report in October 2015 (58 DTR I-1, 3/26/14).

The draft and the final report discuss the lack of clarity as to whether cloud transactions should be characterized as the provision of services—and consequently, as business profits for treaty purposes—or as rent or royalty income—taxable at varying withholding tax rates. The OECD proposed options for addressing the BEPS problem in these documents and indicated in the final report that member countries may pursue different avenues through domestic legislation.

Letter Recommendations

In its letter, the ABA tax section requested that the IRS and Treasury Department address characterization of cloud transactions directly in new guidance because, while traditional tax principles can be applied, their current application is unclear.

The new guidance should use existing income characterizations instead of creating an entirely new category of income, which was the approach taken with respect to transportation income, space and ocean activities income, and international communications income, the group said.

While this route would “give the government the opportunity to determine source rules that make sense from a policy perspective—including administrability—without having to tie the income to, or distinguish it from, the characterization and sourcing authorities that currently exist,” it may necessitate legislation, the group said.

Given that there are several traditional characterizations that are relevant to cloud transactions,” the ABA tax section said it “believes that it is preferable to issue regulations clarifying the application of when the existing characterization rules apply rather than creating new characterization rules.”

Avoiding Obsolescence

Refraining from creating a new category for cloud income could help Treasury and the IRS avoid obsolescence as technology continues to evolve at a rapid pace, Kotarba said.

Cloud computing is prevalent today and growing, he said. But if a new standard solely for cloud income was adopted, that could be outdated in the future, he said.

As an example Kotarba noted 1998 software regulations—Treasury Regulations Section 1.861-18—that the IRS issued to clarify the characterization of transactions involving “computer programs” for certain international provisions of the tax code.

“The traditional methods of delivery of software that were envisioned in the software regulations back in 1998 are—even though it’s only 18 years later—already pretty much rendered obsolete,” he said.

The ABA letter also addresses the need to develop forward-looking guidance. “One thing that is clear about the cloud services industry—the pace of technology may outstrip any country’s ability to tax developments as they arise,” the group said. “Serious consideration must be given to identifying and applying tax principles that will survive into tomorrow’s significantly changing environment,” the letter said.

Services or Leases

The ABA group recommended that the IRS and Treasury promulgate new regulations that would characterize cloud transactions as either services or leases—where appropriate—under tax code Section 861 or 7701(e). Section 861, as mentioned, governs the treatment of software transactions, and Section 7701(e) defines the facts and circumstances under which a services contract will be treated as a lease.

A new regulation would ideally define “cloud transactions” broadly to include both digital content access provider and cloud service provider transactions, while specifying that the Section 861 software regulations govern any cloud transactions falling within their scope, the group said.

In cases where a transaction includes features falling under both sets of regulations—861 and 7701(e)—treatment should be divided, if possible, or otherwise governed by a predominant character test, the tax section said.

Additionally, “new regulations should generally characterize cloud transactions as services arrangements, with the exception of certain transactions that, based on the relevant facts and circumstances, would be treated as leasing transactions where physical equipment (i.e., servers) are dedicated to a user,” the group said in the letter.

Moving Forward

It is possible that Treasury and the IRS will come out with at least proposed regulations on cloud transactions by the end of the year, Kotarba said.

“There is a big push at Treasury and the IRS this year to get out a lot of new regulation projects before the changing of the administration,” he said.

They're rapidly coming out with new guidance, and these types of digital transactions have been on their priority plan for at least a year now, he said.

Whether any of that guidance is adopted in the long term will depend on the 2016 presidential election, Olivas added.

“There may be some push within this administration but the question is whether that will be carried into the next one,” he said.

To contact the reporter on this story: Allyson Versprille in Washington at

To contact the editor responsible for this story: Cheryl Saenz at

For More Information

Text of the American Bar Association letter is in TaxCore. The International Data Corp. press release is at The Amazon statement is at The Microsoft press release is at

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