Tax issues up in the air
Most domestic tax laws and treaty provisions that apply to cross-border transactions were designed for bricks-and-mortar companies. Many rules apply based on physical location to determine whether a payment is from a domestic or foreign source. The source of income can affect whether foreign tax credits are available to offset foreign taxes paid. It can also affect whether withholding taxes are imposed on payments received from cloud computing transactions and whether tax treaty relief is available on that income.
But device and location independence are two of the cloud’s key features. In any given cloud network, the cloud service provider may own or manage many servers, routers and other technical data storage devices off-site, possibly located across multiple systems and countries around the world. Some of the specific tax complexities that can result are as follows.
Nature of payment
The tax treatment of a cloud user’s payments for cloud computing services depends on the extent of the user’s rights to use the cloud computing software. Whether the payment is characterised as sales income, service income or royalty can dramatically affect how and where the income is taxed, and whether withholding taxes or tax treaty relief will apply.
• Sales income – A computer program is sold when the transfer includes all substantial rights and burdens of ownership. Sales income is generally sourced to where the property is produced and/or to where the sale takes place (e.g., where title and benefits and burdens of ownership pass to the buyer). In the cloud computing context, all production activities are rarely conducted in one location, and so pinpointing the payment’s source may not be straightforward.
• Service income – Generally, income derived from the provision of services is sourced to where the services are performed. Like sales transactions, all of the inputs that make up a cloud service offering are rarely conducted in a single jurisdiction.
• Royalties – If the cloud user gains the right to exploit intellectual property, the payment is a royalty. These payments are sourced to where the intangible property is used (exploited) and, unlike payments for services, they may attract withholding taxes in the payer’s jurisdiction.
Providing cloud computing services can create VAT registration, collection and reporting obligations in the jurisdictions where the services are consumed. A number of countries offer relief for electronically delivered services or the possibility of exempting certain forms of software services in their entirety.
Cloud service users and providers need to determine whether their activities or operations are substantial enough to create a taxable presence in a foreign jurisdiction. If so, they may become liable for tax in the foreign country. Relief may be available under an applicable income tax treaty.
Cloud computing businesses face transfer pricing issues raised by how the value of the business is distributed among the intellectual property, cloud computing infrastructure, and supporting personnel. Where more than one entity combine efforts to provide a cloud computing offering to customers, the business will need to evaluate each entity’s economic contribution to the effort and compensate each entity according to arm’s-length principles.
Developing your tax strategy for cloud computing
Clearly, with the high degree of tax uncertainties involved and the current lack of administrative guidelines, it is vital for organisations engaged in cloud computing – whether as providers or customers – to put in place comprehensive tax strategies for undertaking cloud computing projects.
In developing this strategy, organisations should begin by mapping out the project’s system of international payments and services, including their location, direction, risk and beneficiaries. Project managers should then work with their tax teams or independent tax advisers to take a position on the nature of payments and permanent establishment and withholding tax risks inherent in their system. From there, project managers can adjust their systems and take other mitigating steps, such as entering discussions with tax authorities or obtaining advanced rulings, to put the organisations in the best tax position possible.
Organisations that do this from the outset will gain a significant long-term advantage over any competitors who fail to comprehensively address the tax risks and opportunities arising from the burgeoning new cloud computing industry.
- A KPMG whitepaper