FAE speaker: cloud computing tax laws out of step with technology

Published Date:
Mar 13, 2014
In the old days—when tweeting was something birds did and a “face book” was merely a student directory distributed at colleges—software transactions were relatively simple: You walked to the store, picked out the program you wanted—perhaps on a 3.5-inch floppy disk—went to the checkout counter and brought it home.

But in 2014, it is decidedly more complicated. Thanks to the wonders of cloud computing, in which massive, remote servers host multiple websites and store and manage data, a company in Finland can hire programmers in Estonia to write software that’s stored in the Netherlands and ultimately downloaded by consumers in the United States. It’s a new frontier—and one that can lead to ambiguities about how income derived from software should be treated for tax purposes, according to Remy Farag, a tax lawyer and the international editor for Thomson Reuters. Speaking at the intermediate/advanced session of the FAE’s International Taxation Conference on Jan. 31, Farag said that while the means for acquiring software are rapidly evolving, the laws for taxing them have not kept up.

“What makes cloud computing such a relevant and challenging area is the fact that the technology is moving so quickly, as compared to the tax rules we’re still using to address some of these transactions,” he said. “This puts a tremendous burden on tax departments because they’ve got to apply sometimes archaic rules.”

Part of the issue, he explained, is that it can be difficult to know what is even being sold, with the lines between content and service often appearing blurred. He used the Thomson Reuters online tax research system Checkpoint, which offers guidance, libraries, software and other tools as an example.

In subscribing to a website like Checkpoint, he said, “are we buying the content … or are we paying for a service, the ability to search things to get answers for our clients?”

Taking a closer look
To better illustrate the complexities in assessing taxes on cloud computing revenue, Farag walked the audience through a case study involving a fictional company called Cloud Co. This company, he said, is based in a country that does not have a tax treaty with the United States, has no employees or offices in the United States, has no servers in the United States, offers its products as both a website and an app, and retains all rights to its intellectual property, which was also developed outside the United States. People access the website for a subscription fee and download the app for an additional fee. The app is available in traditional online venues, such as the Apple Store and Google Play.

Farag noted that foreign persons are subject to U.S. taxes when they have U.S.-sourced annual or periodic income, or income effectively connected to a U.S. trade or business. They are also subject to U.S. taxes when they satisfy a substantial presence test. To determine whether Cloud Co. meets these criteria, he said, it’s important to look at the source and character of that income. According to Farag, these two factors form the basis of all analysis on this matter.

“If we get that wrong, it won’t matter if the rest of our analysis is correct,” he said.

To get started sourcing an entity’s income, Farag recommended looking at Internal Revenue Code (IRC) sections 861, 862 and 865. Each of these, he said, provides for different approaches for sources, depending on how the underlying income is characterized. According to the regulations, services will generally be sourced where the service is provided, sales will generally be sourced based on the seller’s country of residence, inventory is to be sourced where the title passes and rents and royalties are to be sourced at the location of the property where the license or lease is located.

For income to be taxed in the United States, it must be considered effectively connected to a U.S. trade or business. Noting that the Tax Code does not give a clear definition of what that connection is, Farag said that, generally, if you give a service in the United States, it will give rise to a U.S. trade or business, though practitioners should look for additional guidance and case law and rulings on this matter. A foreign person, he said, who pursues considerable, continuous and regular income-generating activities in the United States will be considered to be engaged in a U.S. trade or business.

Because Cloud Co. does not have any fixed place in the United States, its income is not subject to U.S. tax, he said.

Determining character
While reiterating that the regulations have not fully caught up to the technology, Farag said that Section 861 and Section 7701 of the IRC are good starting points when trying to determine the character of cloud computing income. Generally, he said, Section 861 classifies software as either a sale, a license, a lease or a service. If the transaction is considered a sale, then it gives rise to sales income, while a license would be considered royalty income; everything else falls into the rental income category. But sometimes, a software transaction can be both a sale and a service, such as when one pays for an app that also has a subscription fee (as with Cloud Co.).

In this case, Farag pointed out, it might be prudent to look at Section 7701, which determines whether a transaction is a lease or a service. A transaction is usually found to be a service when there is no physical possession of the property, no control of the property and no significant economic or possessory interest in the property. The transaction is also more likely to be considered a service if the customer does not risk substantially diminished receipts or increased expenses when there is nonperformance. Essentially, when it’s just a payment in exchange for access, it’s usually considered a lease. Other factors include whether there is concurrent use allowed—if not, it’s most likely a lease—and if the customer does not have exclusive access to the product, which makes it more likely that it’s a service. The final factor, he said, is if there’s a contract price in excess of rental value, which would be indicative of a lease.

Another factor in determining the character of Cloud Co.’s income is whether copyright has been transferred. If it has, a customer can create copies and derivative programs and undertake public performances with the program or otherwise publicly display the program. By contrast, in the case of a copyright article, the customer only has the right to use the software. Because Cloud Co. retains all rights, the scenario points to copyright articles, rather than copyright rights.

What if the customer downloaded the software using the app store on his or her phone? That, Farag explained, would probably entail a transfer of a copyright article—end users merely have a right to the software on their personal phones and tablets, but not the rights to the IP. “I think we can again conclude the transaction is more characterized as a service,” he said.

In contrast, if people who downloaded the app got perpetual use of it for as long as they wanted, it would probably be considered a sale. Pulling it all together, Farag said that “using the principles under 7701, income generated from accessing Cloud Co. through the browser is best characterized as a service, so we have service income.”

In looking at the current environment, Farag said that while the United States is, at the moment, unclear on how to determine if the use of cloud computing is connected to a U.S. trade or business, it might wind up taking its cues from the Organisation for Economic Co-operation and Development (OECD), which has begun to tackle this issue. Under OECD rules, if a taxpayer owns or leases a server, it does not necessarily give rise to a permanent establishment—which determines jurisdiction—but it can, under some circumstances, if the server is at the disposal of that particular enterprise.

Farag added that, right now, it’s too soon to tell what sort of approach the United States will ultimately adopt. Until then, cloud companies will need to apply rules that were developed before the technology they affect came into being, in order to determine the proper tax treatment. 

Click here to see more of the latest news from the NYSSCPA.