Cloud activities: check your tax forecasts
Cloud computing might be a complex concept for non-IT specialists. Despite its intangible nature, it is a reality. Hotmail, Gmail, Facebook are well known applications running via the cloud.
Definition of the cloud
There is no fixed definition as the concept evolves with the advancement of IT services. The term is broadly used to refer to the provision of IT services via the internet: a cloud customer is granted a remote, virtual and on-demand access to IT services.
Data storage is the most common but not the only form of cloud services. A 3-part classification of cloud services has emerged, based on the level of services provided. The Infrastructure as a Service (“IaaS”) is the most basic model, where the service provider offers server capacity to the customer. At a further level, the client is provided access to an operating system (Platform as a Service (“PaaS”)) while at the highest level the client is provided access to a fully operating system (Software as a Service (“SaaS”)).
What does the cloud mean for businesses?
Using the cloud, businesses are able to outsource their IT functions in a flexible and scalable way, gain efficiency and reduce operational costs. Some businesses go further and run substantial parts of their business on the cloud with marketing, sales and delivery all being cloud-based. An increasing number of businesses – across industry – are shifting to cloud IT solutions to run some of their activities.
Aside from cloud service providers, some companies develop their own cloud internally designed to meet the specific IT needs of the group. Most commonly, however, businesses will outsource their IT solutions and hire a third party service provider.
The digital industry obviously does not require heavy physical installations for businesses to render their services.
The digital world has therefore created opportunities for taxpayers to (re)locate their activities. Certain countries have seen a massive arrival of technology companies. For example, Luxembourg is often referred to as the main hub to establish European headquarters thanks to its central location, state-of-the-art technical installations, a skilled and multilingual population and an attractive fiscal regime. A number of global IT players such as iTunes, Amazon.com, Skype and PayPal have chosen to establish their European headquarters in Luxembourg.
This absence of physical installations for these services creates concerns for taxpayers. They must ensure that the presence of servers or staff in different countries where they have operations does not affect their tax position. Well-known businesses such as Amazon have seen tax authorities challenging their tax structure, arguing for example that permanent establishments exist in their jurisdiction. In these difficult economic times, taxpayers must give the utmost level of attention to their tax position.
The tax shadow
Unexpected tax costs and an increased tax burden can have a significant impact on the performance of a business. The same occurs with cloud computing: the complexity of cloud transactions combined with the cross-border aspects means tax issues for both the cloud provider and its customer are complicated. Tax has the potential to cast a shadow on cloud transactions.
Two aspects need to be carefully monitored as they have substantial tax implications:
- The location of the cloud and/or its components: the issue of the taxable nexus
- The classification/definition of the nature of the transactions performed via the cloud
In the context of an international environment marked by the concept of permanent establishment, the determination of the taxable nexus of intangible transactions is crucial for both the cloud provider and its customers. Some jurisdictions might try to attract the taxation of the cloud provider, arguing the use of IT servers there. Similarly, in a B2B context, jurisdictions might try to characterise the presence of a permanent establishment of the cloud customer at the place of location of the server, arguing that the cloud customer has a server at its full disposal depending on the terms and conditions of the cloud agreement.
Some countries might also consider the cloud provider as a permanent establishment of the cloud customer.
VAT & cloud services
The concept of what constitutes an establishment will also be key from a VAT perspective. Whether a service provider has human presence is not the sole criteria for defining whether it has VAT obligations in that country. As an example, if a service provider headquartered outside the European Union provides services to European customers, it will have to deal with VAT registrations, VAT returns and VAT payments.
Jurisdictions might have conflicting views on the nature of the transaction. Depending on the definition of the cloud transaction, it will either be considered as business income or as a royalty triggering withholding tax. The definition of the underlying supply impacts the place of location for VAT matters.
Within a group, particular attention has to be paid to transfer pricing requirements applicable to the provision of a private cloud.
Cloud legislation & the OECD's perspective
Only a few jurisdictions have implemented specific legislation dedicated to cloud activities, for example, some states within the USA). Others continue to refer to general taxation principles.
The commentaries to the OECD Model provide some guidance on the interpretation of ‘permanent establishment’ in the context of e-businesses. The OECD makes a distinction between the website and the server. Being deprived of physical presence, as a standalone item, a website does not constitute a permanent establishment. Conversely, the server has a physical presence and constitutes a permanent establishment if the usual conditions are met: ie a fixed place of business through which the enterprise carries on its core business activities. Therefore, the cloud provider that operates the server might therefore be considered as having a permanent establishment at the place of the IT server. The analysis has to be performed more thoroughly for the cloud customer. Depending on the terms and conditions of the cloud agreement, the cloud customer might be considered as being provided with the full disposal of an underlying IT server.
Further, if the cloud customer is not in the business of operating servers and if the activities performed through the cloud are merely preparatory or ancillary to its core business, it cannot – according to OECD commentaries – be considered as having a permanent establishment.
On the basis of OECD commentaries, cloud services qualify as business activities. They are considered as business profits taxable at the place where the activity is carried out (or at the place of the permanent establishment) and will not trigger withholding tax. Within the OECD, however, some countries might have a different approach to taxing cloud activities. To illustrate this, we focused on India, the USA, and France. India and the USA are both major players in cloud computing. The USA hosts, or is at the origin of, major cloud platforms and India is a preferred IT outsourcing jurisdiction. As a result, the two legal systems are among the most advanced in relation to cloud activities. France is currently working on adapting its legal and tax framework to the changes in the digital economy. There are similarities and differences in the approach of all three countries as regards cloud activities.
The US approach: centralisation to remove uncertainty
Generally, the US tax authorities have treated income from operating the cloud as a service. Whether this constitutes a permanent establishment depends on the specific facts and circumstances. A business that effectively rents server space to others will most likely be considered to be conducting its main business as providing a fixed place of business. A mere website hosted by others is unlikely to be considered a permanent establishment alone. Common activities, such as internet advertising, are also generally considered to be the provision of services not subject to withholding tax. The source of such services is determined by the ‘place of performance’ but whether this occurs on the server (and in the country where the server is located), or is performed by some prior act (and in some other place) is subject to some debate. Even if the server is agreed as the dispositive factor, it is common for server traffic to be ‘load balanced’ and may occur in different jurisdictions at different times of the commercial day, unless constrained to a particular country by design (and at some increased cost).
But, if retail orders are accepted through this website for the sale of goods, other rules regarding the passage of title and the risk of loss (as well as whether the authority to conclude contracts has been exercised on the server) must be analysed.
Does the server conclude the contract? Is the contract accepted by the act of performing, ie, shipment? Has the person who prepared the contract which is loaded on the server “effectively” accepted the contract by drafting the terms on behalf of the company?
In the face of this uncertainty, US taxpayers attempt to place as many relevant variables in the same jurisdiction – servers, support personnel, content providers, etc – in order to centralise the facts around a particular set of rules.
The Indian approach: are you in or outbound?
Although electronic commerce has been gaining momentum in India, tax authorities are yet to focus on the taxation aspects of cloud computing, it being a new area. The tax positions are also yet to be tested by the Indian courts. Indian tax authorities have been generally aggressive when it comes to demanding source-based tax (eg royalty/fees for services) on payments generating from India that are related to technology transactions, when there is any use of software or access to servers/hardware. It is expected that the aggression will continue even for cloud computing related transactions that generate payments from India.
In cloud computing transactions, the key issues that may arise from an Indian taxation perspective are the following: Firstly, the determination of whether an Indian website that markets the cloud computing services of an overseas vendor to Indian customers would constitute a permanent establishment in India, if the server hosting the website is located in India, and the attribution of income to the PE. India has, in its reservation to the OECD revisions of 2008 and 2010, taken a view that depending on facts, an enterprise can be considered to have acquired a place of business by virtue of hosting its website on a particular server in a particular location and hence this could constitute a PE in certain circumstances; and Secondly, the determination of the character of passive income that is generated by the cloud computing vendors outside India.
Irrespective of whether the cloud computing model is based on an IaaS, SaaS or PaaS model, there is a substantial exposure to Indian withholding tax in any of the above. The Indian tax authorities are more likely than not to treat cloud computing related payments as being in the nature of either royalty or Fees for Technical Services. In the amendments to the Indian domestic tax law in 2012, the Indian Government has expanded the scope of the meaning of “process” and “equipment” in the context of payments for use of process or for use of equipments – payment for the simple use of software is treated as “royalty”, for example. Since cloud computing services would invariably involve the use of software/hardware/processes, etc, given the recent amendments expanding the scope of ‘royalty’, any cloud computing-related payments originating from India are bound to be treated as ‘royalty’ by the Indian tax authorities and thus subject to withholding tax. As a matter of principle, the meaning of “royalty” under Indian double tax treaties should be narrower and limited to payments which “make available” technology and know-how, etc. However, in the context of double tax treaties, the actual position of tax authorities is to consider that there is no material difference in the language used in domestic tax law and the language in Indian double tax treaties.
Indian Tribunals and Courts are, however, likely to take a balanced view and not regard all payments as payments towards royalty: they have held that payments originating from India that do not entail license of intellectual property rights but are merely payments for technology-related services, cannot be said to amount to royalties.
Therefore, under the Outbound Cloud Computing model (IaaS, SaaS or PaaS for Indian residents availing cloud computing services and making payments to overseas vendors), while the Indian tax authorities are likely to take an aggressive view in taxing the outbound payments, Indian Tribunals and Courts are likely to give relief. This area will therefore see a degree of litigation. Indian service recipients may therefore wish to assess the likely exposure to Indian withholding tax and the commercial aspects of who bears the tax or what indemnities can be provided to them.
Under the Inbound Cloud Computing model (India providing services), if the servers hosting the overseas websites are located in India, there is an exposure that some part of the income derived from the foreign website's operations may be attributed to India. This exposure may be high particularly if the foreign website is owned by a related party of the Indian company on whose server the website is hosted.
From an indirect tax perspective in India, the nature of the underlying supply of ‘IT services' is important to examine, primarily on account of the possible dual levy of VAT and service tax on such supplies. Based on the federal and state structure of taxation of indirect taxes in India, provision of services is under the purview of the federal government and the sale of goods is under the states. General cloud services should typically fall outside the purview of “transfer of right to use” as understood under the VAT legislations. Cloud services therefore should become subjected to service tax alone. In the case of cross-border provision and receipt of cloud services, the Place of Provision of Service Rules, 2012 (which are laid out for determining whether the services are provided in India for levy of service tax) provide that these services shall be liable in the location of the service recipient. Therefore, outbound cloud computing shall not be subject to Indian service tax but inbound cloud computing shall be liable.
The introduction of a comprehensive Goods and Services Tax
(“GST”) in India would bring in complexity of taxation of these services within India, as the states would be empowered to levy State GST on these services, and the place of supply of these services would determine which state could stake a claim on this. This would also impact import transactions too, after determining the state in which the State GST is required to be paid.
The French approach
In inbound situations (eg a foreign company conducting e-business), French tax authorities recognise the presence of a permanent establishment taxable in France provided two conditions are met: computer equipment (ie a server) has a physical location in France and the foreign company hires operating staff in France.
If sale functions (ie conclusion of contracts with end customers, processing of payments and the provision of services) are automatically realised via the computer equipment, the second criterion will not have to be met: the existence of a permanent establishment will be recognised by the mere presence of computer equipment. In most cases, if the foreign company does not hire employees in France, the activity should remain preparatory or auxiliary and should not constitute a permanent establishment.
In outbound situations (eg French company receives cloud computing services from a foreign provider), the main tax issue is the characterisation of the income. Does it qualify as royalties or fees for technical services?
The distinction is crucial. Both fees for technical services and royalties are subject to a domestic withholding tax, which can be reduced or exempt under existing double tax treaties. Fees for technical services paid by a French company are generally exempt from French withholding tax under the provision of the double tax treaty while royalties merely benefit from a reduced withholding tax.
In a double tax treaty context, the income is characterised on the basis of the provisions of the double tax treaty. In the absence of a treaty, the distinction is made on a factual basis, ie, the information shared between both parties. If the information is confidential and result from an experience gained, it could be defined as royalties. On the contrary, it would be defined as fees for technical services.
How should taxpayers face cloud taxation?
The cloud generates tax uncertainties. Taxpayers will try to reduce the negative impacts of these uncertainties. How? Cloud service providers will carefully consider the jurisdictions of their establishment, the location of their servers and the countries they intend to market to. Different international views on the source of the income will impact the place of taxation, and, depending on the jurisdictions, an additional tax burden may result from the levy of indirect taxes. Cloud providers operating a private cloud will also need to analyse the infrastructure of the cloud from a transfer pricing perspective.
The ‘intangible’ challenge for tax authorities
Amazon, Google and Apple, for example, are under the spotlight and being scrutinised by international institutions for their tax planning activities. This recent focus on these multinationals illustrates how the digital economy has become increasingly challenging for tax authorities.
The intangible nature of digital activities seems difficult to reconcile with the concept of permanent establishment currently prevailing in OECD countries. In the specific situation of cloud activities, OECD countries will have some difficulties in recognising the presence of a permanent establishment. Taxpayers might try to take advantage of this issue.
First published in BNA Bloomberg, 23 October 2013
Quality tax advice, globally
What is the future for the taxation of the cloud? In the current economic climate, there is no doubt that tax authorities will try to attract taxation of the profits in their own jurisdictions. It's expected that legislations will shortly catch up with the evolution of IT services so as to ensure that these profits do not evade their jurisdictions. E-commerce is already on the radar of the OECD, which has pinned digital services on its Action Plan on Base Erosion and Profit Shifting (“BEPS”) plan issued in July 2012. The OECD targets the ability of a company to have a significant digital presence in the economy of another country without being liable to taxation due to the lack of nexus under current international laws and the attribution of value created from the generation of marketable location-relevant data through the use of:
- Products and services
- The characterisation of income derived from new business models
- The application of related source rules
- How to ensure the effective collection of VAT/GST with respect to the cross-border supply of digital goods and services
This analysis demonstrates the depth with which “value” will be explored by the OECD to ensure taxation is applied in the relevant jurisdictions across the digital spectrum. EU institutions are also working on the challenges raised by digital economy. In the future, the cloud is likely to be subject increased legislation and guidance, which will reduce tax uncertainty and clamp down on tax evasion mechanisms.