By Anthony Diosdi
New technology and new transactions often raise difficult issues of tax policy and administration in part because existing rules were developed to deal with other situations. The dramatic expansion in electronic commerce facilitated by the use of the Internet and other technology is subjecting existing tax principles to new pressures. One area of concern is the application of source rules to electronic commerce transactions. Suppose, for example, that a corporation delivers software or a digital product to a customer on the Internet. The customer can download the product and use it commercially. Depending upon the nature of the transaction and the property interests involved, the income to the corporation might appropriately be characterized as a rent or royalty for the use of technology, profit from the sale of a product, or a payment for services that it has rendered.
A complex set of regulations provides guidance with respect to computer program transactions. See Treas. Reg. Section 1.861-18. A computer program is defined as “a set of statements or instructions to be used directly or indirectly in a computer in order to bring about a certain result.” The term includes related material such as “any media, user manuals, documentation, data base or similar item if *** [they are] incidental to the operation of the computer program.” See Treas. Reg. Section 1.861-18(a)(3). Transactions involving computer programs will generally be classified as the transfer of a “copyright right” in a computer program, the transfer of a copy of the computer program, the provision of services for the development or modification of the computer program or the provision of know-how relating to computer programing techniques. See Treas. Reg. Section 1.861-18(b)(1).
Computer programs are generally protected by copyright law. Consequently, the rules for characterizing computer transactions are guided by copyright principles found in both U.S. and foreign copyright laws. Copyright law generally protects computer programs and distinguishes between transactions in a copyright and in the subject of a copyright. Under U.S. copyright law, exclusive rights, such as the right to reproduce copies of the copyrighted work, are granted to the owner of a computer program copyright. In contrast, the purchaser of a copy of a computer program generally acquires only the right to sell or use the copy. Under the regulations, a transfer of copyright rights will occur if the transferee obtains any of the following:
1. The right to make copies of the computer program to distribute to the public, by sale, or other transfer of ownership, or by rental, lease or lending;
2. The right to prepare derivative computer programs based upon the copyrighted program;
3. The right to make a public performance of the program; or
4. The right to publicly display the program. See Treas. Reg. Section 1.861-18(c)(2).
If there has been a transfer of a copyright right, the issue is whether the transfer is a sale, generating gain or loss, or a grant of a license, generating royalty income. The transaction will be a sale or exchange if, taking into account all facts and circumstances, “all substantial rights in the copyright” have been transferred. The principles under Section 1222 relating to capital gains and losses and Section 1235 relating to the sale or exchange of patents may be applied when determining whether all substantial rights have been transferred. See Treas. Reg. Section 1.861-18(f)(1).
If the transferee acquires a copy of a computer program, but does not acquire any of the rights listed above, the transaction is characterized as a transfer of a copyrighted article. A copyrighted article is a copy of a computer program from which the work can be perceived, reproduced, or otherwise communicated. Treas. Reg. Section 1.861-18(c)(3). Further, the electronic transfer of software can constitute the transfer of copyrighted articles. See Treas. Reg. Section 1.861-18(g)(2). Once it has been determined that there has been a transfer of a copyrighted article, an analysis of the facts and circumstances, including the intent of the parties as evidenced by their agreement and conduct, may lead to the conclusion that the transaction involves the provision of services. See Treas. Reg. Section 1.861-18(d). If not, the issue then becomes whether there has been a sale or lease of the copyrighted article. The transaction will be a sale or exchange if, taking into account all facts and circumstances, the “benefits and burdens of ownership” have been transferred. See Treas. Reg. Section 1.861-18(f)(2). If a transaction does not constitute a sale or exchange because insufficient benefits and burdens of ownership of the copyrighted article have been transferred, it will be classified as a lease generating rental income. See Treas. Reg. Section 1.861-18(f)(2).
Specific source rules apply to the income derived from transactions in computer programs. Income from the sale or exchange of a copyright right will be sourced under the rules that apply to personal property sales. See IRC Section 865; Treas. Reg. Section 1.861-18(f)(2). Income from the sale of copyrighted articles where the computer program constitutes purchased inventory property will be U.S. or foreign-source income, depending upon where title passes. See IRC Sections 861(a)(6), 862(a)(6); Treas. Reg. Section 1.861-18(f)(2). On the other hand, income from the sale of copyrighted articles where the computer program constitutes non-inventory personal property will be U.S.- or foreign-source income, depending upon the residence of the seller. See IRC Section 865; Treas. Reg. Section 1.861-18(f)(2). Finally, income from either the leasing of a computer program or the licensing of a copyright in a computer program will be U.S. or foreign-source income, depending upon where the property is located in the case of rents and the place where the property is used in the case of royalties. See IRC Sections 861(a)(4); 862(a)(4); Treas. Reg. Section 1.861-18(f)(1)(2).
Analyzing the Software Rules
Probably the most important rules governing the taxation of digital transactions are the so-called “Software Rules” set forth in Treasury Regulation Section 1.861-18. According to the Treasury Department these rules “establish a framework applicable to any type of digitized information, at least to the extent it is protectable by copyright.”
The Software Rules provide guidance as to how to characterize and source income received from transactions involving “computer programs.” The regulations have defined the term “computer program” to mean:
“a set of statements or instructions to be used directly or indirectly in a computer in order to bring about a certain result. For this paragraph, a computer program includes any media, user manuals, documentation, data base or similar item if the media, user manuals, documentation, data base or similar item is incidental to the operation of the computer program.” See Treas. Reg. Section 1.861-18(a) (3).
The Software Rules state that a transaction must be based on substance rather than form. In other words, a transaction will not be classified on how it is described in an agreement. Conversely, an agreement stating that software is a “license” will not necessarily be treated as a “license” for tax purposes. Rather, the Software Rules
provide that each transaction must be carefully analyzed. The taxable income relating to a computer program, the services related to the program, or the know-how of the program can be classified as either: 1) the sale of property (inventory or non-inventory; 2) license; 3) lease; or 4) service.
For the purposes of the “sale of property” in the context of the Software Rules, the Treasury Regulations provides after taking into consideration “all facts and circumstances,” there must be either: 1) a transfer of “all substantial rights” in the copyright to the software; or 2) a transfer of a copyrighted article. See Treas. Reg. Section 1.861-18(f)(1). I will discuss each of these two elements in more detail below.
Transfer of All Substantial Rights in a Copyright
A transfer of a copyright right will result for federal income tax purposes if an individual acquires any of the following: 1) the right to make copies of the computer program for purposes of distribution to the public by sale or other transfer of ownership, or by rental, lease, or lending; 2) the right to prepare derivative computer programs based upon the copyrighted computer program; 3) the right to make a public performance of the computer program; or 4) the right to publicly display the computer program. For the transfer of copyright rights to be characterized as a sale, it must be a transfer of “all substantial rights” which essentially requires the transfer to be exclusive and to be for the remainder of the life of the copyright.
Below, see Illustration 1 which provides an example discussed in the regulations of a transfer of all the substantial rights in a copyright.
Illustration 1.
The regulations provide the following example of a transfer of all substantial rights in a copyright: Corp A owns the copyright in a computer program, Program X, and Corp A transfers a disk for the remaining term of the copyright to copy and distribute an unlimited number of copies of Program X to Corp B, a Country Z corporation, and grants Corp B “an exclusive license for the remaining term of the copyright to copy and distribute an unlimited number of copies of Program X in the geographic area of Country X, prepare derivative works based upon Program X, make public performance of Program X and publicly display Program X, Corp B will pay Corp A royalty of $y a year for three years which is the expected period during which Program X will have commercially exploitable value.” The example concludes that the transfer should be treated as a sale by Corp A because Corp A transferred to Corp B all substantial rights
In the copyright to Program X. This example also illustrates that just because an agreement is classified as a license, it is not controlling for federal income tax purposes. The fact that Corp A is supposed to receive payment classified as a royalty is also not controlling. See Treas. Reg. Section 1.861-18(h), Example 5.
Transfer of a Copyrighted Article
A transfer of a “copyrighted article” takes place if a transferee obtains a copy of a computer program but the transferee does not acquire any of the copyright, rights or acquires only a de minimis right grant of such copyrights. See Treas. Reg. Section 1.861-18(c)(1)(ii). To be treated as a sale of a copyrighted article, there must be a transfer of the benefits and burdens of ownership in the copyrighted article.
Below, see Illustration 2 and Illustration 3 which are taken from the regulations and provide examples of a transfer of a copyrighted article as a sale.
Illustration 2.
Corp A owns the copyright in a computer program “Program X” and copies Program X onto a disk. The disks are placed in boxes covered with a wrapper on which is printed what is generally referred to as a “shrink wrap license.” The license is stated to be perpetual. The transferee receives the right to use the program on two of its own computers, the right to make one copy of the program on each machine as an essential step in using the program, and the right to resell the copy of the program so long as it destroys any other copies it had made. P, a resident of Country X receives a disk. The example indicates that the label in the contract “license” is not determinative and that since none of the copyrights rights have been transferred to P, P has acquired a copyrighted article. The same conclusion applies where the software is made available through a website rather than as a disk. See Treas. Reg. Section 1.861-18(h), Example 1.
Illustration 3.
Corp A transfers a disk containing Program Y to Corp E, a Country Z corporation, in exchange for a lump sum payment. Program Y is a computer program development program, which is used to create other computer programs consisting of several components, including libraries of reusable software components that serve as general building blocks in new software applications. Because a computer program created with the use of Program Y will not operate unless the libraries are also present, the license agreement between Corp A and Corp E grants Corp E the right to distribute copies of the library with any program developed using Program Y. The example concludes that because the copyrights rights to the libraries are considered de minimis, the transaction is treated as a sale of Program Y, which is a copyrighted article. See Treas. Reg. Section 1.861-18(h), Example 17.
Defining the “Rents” for Purposes of Digital Taxation
The Income Tax Regulations use the term “rents” when attempting to classify the lease of software. The term “rents” is an extremely important concept. In this context, the term “rents” typically means the amounts received for the use or the right to use tangible property. In other words, the term “rents” can be defined as a payment or interest reserved by an owner in return for permission to use the property loaned and in proportion to use. For the purposes of defining the lease of software, the Software Rules provide that there must be a transfer of a copyrighted article where all the benefits and burdens of ownership have not been transferred. A transfer will be treated as a lease that generates rental income in a circumstance where the benefits and burdens of ownership of the copyrighted article have been transferred, such that an individual other than the transferee is properly treated as the owner of the copyrighted article. Below, see the example in Illustration 4 in which the regulations describe a lease of software.
Illustration 4.
Corp A owns the copyright in a computer program (“Program X”) and copies Program X onto disks. The disks are placed in boxes covered with a wrapper on which is printed what is generally referred to as a “shrink wrap license.” The transferee receives the right to use the program on two of its own computers and the right to make one copy of the program on each machine as an essential step in using the program. P, a resident of Country X receives a disk but only for one week. The example concludes that the label “license” is not determinative and that none of the copyright rights has been transferred to P. P has acquired a copyrighted article and based on all the facts and circumstances is not considered the owner of the copyrighted article. Therefore, there has been a lease of a copyrighted article and Corp A recognizes rental income. See Treas. Reg. Section 1.861-18(h), Example 1. It should be noted that the same conclusion applies where the software is made available through a website rather than as a disk. See Treas. Reg. Sections 1.861-18(h), Examples 3 and 4.
Defining the Term License for Purposes of Digital Taxation
According to the Software Rules, to be a license, all the facts and circumstances must indicate that a transfer of copyright rights took place, and the transfer must be for less than “all substantial rights.” Thus, the difference between a sale and a license for the purposes of the Software Rules is the amount of rights granted. Typically, the grant of nonexclusive copyright right to use electronic software is a license. The income generated by a license is royalty income rather than a sale.
Below, see Illustration 5 which describes a license of software for income tax purposes.
Illustration 5.
The Software Rules provide the following example of a transaction treated as a license: Corp A, a U.S. corporation, transferred a disk containing Program X to Corp D, a foreign corporation engaged in the manufacture and sale of personal computers in County Z. Corp A grants Corp D the non-exclusive right to copy Program X onto the hard drive of an unlimited number of computers which Corp D manufactures and sells to the public. The term of the agreement is for two years, which is less than the remaining life of the copyright in Program X. Corp D pays Corp A an amount based on the number of copies of Program X it loads onto its computers. In this example, Corp D has acquired a copyright right to make copies of Program X and to load the copies onto the computers it makes and sells. However, after taking into account all facts and circumstances. Corp D has not acquired all substantial rights in the copyright to Program X because the agreement between the two parties ends before the end of the copyright’s remaining life. Thus, there is no sale of the copyright and, instead Corp D has acquired only a license of Program X in exchange for its obligations to pay royalties to Corp A. See Treas. Reg. Section 1.861-1(h), Example 8.
Defining the Term Service for Purposes of Digital Taxation
Services is another area that is extremely important in the digital economy. It is not uncommon for businesses to have agreements between themselves regarding a copyright. These agreements can be manipulated for tax purposes. In order to avoid manipulation, the Treasury Regulations provide that the determination of whether a transaction is treated as either the provision of services or another transaction is based on all the facts and circumstances of the transaction, including, as appropriate, the intent of the parties (as evidenced by their agreement and conduct) as to which party is to own the copyright rights in the computer program and how the risks of loss are allocated between the parties. See Treas. Reg. Section 1.861-18(d).
Below please see Illustration 6 which discusses a service arrangement involving software.
Illustration 6.
The Software Rules provide the following example of a transaction that is treated as a provision of services: Corp H, a Country Z corporation, enters into a license agreement for a new computer program, Program Q. Program Q is to be written by by Corp A and the parties agree that when Program Q is completed, the copyright in Program Q will belong to Corp H. Corp H agrees to pay Corp A a fixed monthly sum during development of the program. If Corp H is dissatisfied with the development of the program, it may cancel the agreement, but Corp A will retain all payments owed prior to termination. All of the payments are labeled royalties. The example concludes that taking into account all of the facts and circumstances, Corp A is treated as providing services to Corp H because Corp H bears all the risk of loss associated with Program Q and is the owner of all copyrights rights in Program Q. See Treas. Reg. Section 1.861-18(h), Example 15.
Introduction to Cloud Computing
In general, cloud computing is the provision of information technology resources in a virtual environment. This virtual environment, or the “cloud,” comprises remote, interconnected computer networks, servers, data storage devices, and software applications operated by third parties. Instead of maintaining their own hardware and information technology infrastructure, companies use information technology resources stored on remote third party servers that are operated by third party cloud service providers.
For instance, a designer may choose to pay Adobe a monthly subscription fee to use Adobe’s graphics software application known as Photoshop. The designer in this example is engaging in a cloud computing transaction with Adobe. More specifically, this is an example of software as a service or (“SaaS”) cloud computing model transaction. The designer is obtaining access to software and applications that are stored on servers that Adobe owns and operates remotely. The designer also obtains space on Adobe’s servers where the designer stores images and other data. Under the SaaS model, the designer no longer needs to install, run, and maintain a program on his or her internal system.
Cloud computing transactions differ from the traditional provisions of traditional software transactions. The most significant feature of cloud computing that differentiates it from traditional software transactions is that cloud computing occurs entirely in the virtual world. In the past, businesses would purchase or license software and applications in digital form from online vendors. Under this business model, sellers would electronically transfer the computer program to the purchaser, who would download the program onto his or her computer for a duration of time. Cloud computing on the other hand, involves neither the physical nor electronic transfer of possession of a computer program to the purchaser. The program does not reside on the purchaser’s computer. In a cloud computing transaction, a cloud vendor solely provides the purchaser with electronic access to a computer program, application, and corresponding data. The only physical components to a cloud transaction are on the vendor’s servers. Because cloud vendors control the program, a cloud transaction may be characterized as the provision of services rather than a transfer of an intangible asset. By eliminating many of the physical components involved in traditional technology transactions, the cloud reduces any connections between revenue-generating activity and a particular geographic location. Under current law, a country’s taxing authority over a cross-border transaction generally requires a geographic connection to the economic activity that creates income. However, a vendor’s servers and other computer infrastructure can be located almost anywhere in the world with little or no economic activity.
U.S. Taxation of Cloud Computing
Approximately four years ago, the Treasury Department and the IRS promulgated Proposed Regulations on how to classify cloud computing transactions and other transactions involving on-demand network access. In addition, the Proposed Regulations supplement the Software Rules, the cloud computing transactions and other transactions involving on-demand network access.
The Proposed Regulations have defined a “cloud transaction” to be “a transaction through which a person obtains on-demand network access to computer hardware, digital content or other similar resources, other than on-demand network access that is de minimis taking into account the overall arrangements and the surrounding facts and circumstances.” See Prop. Reg. Section 1.861-19(b). Examples of a “cloud transaction” are the “streaming music and video, transactions involving mobile device applications, and access to data through remotely hosted software.” See REG-130700-14.
For tax purposes, the Proposed Regulations provide that a cloud transaction is classified solely as either a lease of property or the provision of services, taking into account all relevant factors. See Prop. Reg. Section 1.861-19(c). Each transaction requires a separate classification unless any transaction is de minimis. See Prop. Reg. Section 1.861-19(c)(3). The Proposed Regulations go on to provide a list of factors to determine when cloud transactions will be classified for tax purposes as a provision of services rather than a lease of property. These factors are:
1. The customer is not in physical possession of the property;
2. The customer does not control the property, beyond the customer’s network access and use of the property;
3. The provider has the right to determine the specific property used in the cloud transaction and replace such property with comparable property;
4. The property is a component of an integrated operation in which the provider has other responsibilities, including ensuring the property is maintained and updated;
5. The customer does not have a significant economic or possessory interest in the property;
6. The provider bears any risk of substantially diminished receipts or substantially increased expenditures if there is nonperformance under the contract;
7. The provider uses the property concurrently to provide significant services to entities unrelated to the customer;
8. The provider’s fee is primarily based on a measure of work performed or the level of the customer’s use rather than the mere passage of time; and
9. The total contract price substantially exceeds the rental value of the property for the contract period.
Proposed Regulations, however, do little to clarify the U.S. tax treatment of cross-border cloud computing transactions. The U.S. is fairly unique in taxing on the basis of citizenship, taxing worldwide income even if the citizen is a nonresident. U.S. corporations are subject to U.S. tax on worldwide income even though managed and controlled abroad. As a result, U.S. citizens, U.S. residents, and U.S. entities engaging in cloud transactions will be subject to U.S. federal income tax on their income, regardless where the income is earned.
On the other hand, the U.S. generally only taxes noncitizens and nonresidents on income that is generated within U.S. borders. If a foreign person conducts a trade or business in the United States, the net income effectively connected with the U.S. business activity will be taxed at the usual U.S. rates. See IRC Sections 871(b) and 882. The determination of whether a foreign person is engaged in the conduct of a trade or business in the U.S. generally involves a facts-and-circumstances analysis. A U.S. trade or business will generally be found to exist if a foreign person’s business activity in the U.S. is regular, continuous, and considerable. A mere isolated or sporadic act will not generally constitute a U.S. trade or business.
The trade or business regime for taxing a foreign person’s U.S. trade or business income applies to income that is “effectively connected” with the conduct of the U.S. trade or business, as determined in Internal Revenue Code Section 864(c). The income taxable under this regime includes certain U.S.-source investment-type income and capital gains, but only if such income and gains are treated as effectively connected income. It also includes other types of U.S.-source income of the foreign person (such as income from the sale of inventory) regardless of whether such income has an actual factual connection to the foreign person’s U.S. trade or business. Although foreign-source income of a foreign person is usually not subject to U.S. tax, several specified types of a foreign person’s foreign-source income that are attributable to a U.S. office or fixed place of business may be subject to U.S. tax under this trade or business regime. See IRC Section 864(c)(4) and (5). This regime taxes the foreign person’s net income derived from the U.S. trade or business (effectively connected gross income minus allowable deductions attributable to the U.S. trade or business). The rules for allocating and apportioning deductions are used to determine which of the foreign person’s potential deductions are attributable to the U.S. trade or business income.
If a foreign person receives U.S.-source income in respect of investments not effectively connected with the conduct of a trade or business within the United States (such as dividends, interest, rents or royalties), the gross amount of the payment generally will be subject to a tax of 30 percent. See IRC Sections 871(a) and 881(a). This tax on a foreign person’s nonbusiness income from U.S. sources is collected and enforced through withholding provisions, which require the payor of the income to withhold 30-percent tax from the income and pay it over to the IRS for the account of the foreign person. See IRC Sections 1441 and 1442.
Consider the example of a foreign corporate software developer that has created software for which it currently holds intellectual property rights. The foreign corporation has customers in the U.S. that it charges a monthly subscription fee to electronically access the software stored on servers located outside the U.S. Although the Proposed Regulations address how to classify the foreign corporation’s transactions with its U.S. customers (as either services or leases), they are silent on how to determine whether the subscription fees paid by the U.S. customers constitute income generated in or sourced to the U.S. In the absence of specific rules, the Treasury has usually adopted and applied existing tax principles to new developments in technology. However, because of the unique features of cloud computing, applying these existing principles to cloud computing transactions is challenging.
The starting point in analyzing the tax liability from a cloud computing transaction is characterizing the income that the underlying transaction generates. Characterizing the income is the first step because the income’s characterization affects the source of income arising from cross-border cloud operations, which impacts the extent to which a cloud vendor with a taxable presence in the U.S. has business profits subject to U.S. taxation. The income’s character and source also impact whether cloud income is subject to U.S. withholding tax. Generally, the correct characterization of a transaction depends on a factual analysis of the transaction and the rights of the parties. The Software Rules set forth in Treas. Reg. Section 1.861-18 may provide some guidance in classifying international transactions involving computer programs.
To fall within the scope of the Software Rules, a transaction must first relate to a computer program. For purposes of the Software Rules, a “computer program” is “a set of statements or instructions to be used directly or indirectly in a computer in order to bring about a certain result,” and includes any data base or similar item only if it is “incidental to the operation of the computer program.” See Treas. Reg. Section 1.861-18(a)(1),(3). Because a SaaS arrangement involves software, which generally satisfies the definition of a “computer program,” a cloud computing transaction satisfies the first requirement.
The second requirement of the Software Rules is that the transaction must involve either 1) the transfer of a computer program or 2) the provision of services for the development or modification of a computer program or of know-how with respect to the program. It is unlikely that the service typically provided in a SaaS transaction will constitute the provision of services (or know-how) within the meaning of the Software Rules. This is because the SaaS transaction involves granting customers electronic access to software. It does not involve any development or modification of a computer program and does not relate to computer programming techniques. See Treas. Reg. Section 1.861-18(b)(1). Hence, if a SaaS transaction were to fall within the scope of the Software Rules, it would need to be classified as some sort of transfer of a computer program (i.e., a transfer of a copyrighted article or a copyright right in a computer program). If classified as the transfer of a copyrighted article, the transaction will likely give rise to rental income. If classified as the transfer of a copyright right, the transaction will likely be treated as giving rise to royalty income.
Returning to our example of the foreign corporate cloud vendor (discussed above), its arrangement with its U.S. customers is unlike a traditional software sale where software is purchased or delivered electronically to the customer’s computer where it is installed. The foreign developer’s customers will neither possess nor store the program on their computers. Instead, the developer, as the cloud service provider, hosts the program on its hardware or infrastructure and the customer has no control over the software. Thus, the cloud vendor, rather than the customer owns the software. These differences may mean, however, that no “transfer” takes place when a customer accesses software in the cloud. If so, then such a transaction may fall outside the scope of the Software Rules altogether. Below are brief discussions as to how the Software Rules may treat cloud computing transactions.
Classification of a Cloud Computing Transaction of Services
The Software Rules typically will not classify SaaS transactions as “services.” The regulations only classify a transaction as services if the transaction involves the provision of services for the development or modification of a computer program or the provision of know-how relating to programming techniques.The determination of whether the regulations treat a transaction of a computer program depends on all the facts and circumstances of the transaction.
Classification of Cloud Computing Transaction as a Copyrighted Article
The Software Rules may classify a cloud computing transaction as a transfer of a copyrighted article that gives rise to rental income. See Treas. Reg. Section 1.861-18(b)(1), (c). A transfer of a computer program constitutes a transfer of a copyrighted article if a person acquires a copy of a computer program from which the work can be perceived, reproduced, or otherwise communicated, either directly or with the aid of a machine or device, and such transfer is not de minimis relative to the overall transaction. See Treas. Reg. Section 1.861-18(c). Since the foreign corporate cloud vendor in our example transfers online access to its software to U.S. customers in exchange for a monthly subscription fee, none of the transactions transfer any copyrights. The rights obtained by the U.S. customers are similar to the rights they would have obtained had they acquired an actual copy of the software. In this case, the customer has the right to use the software, but does not have the right of ownership. A SaaS transaction that involves a transfer of a copyrighted article will likely give rise to rental income because the customer does not acquire sufficient benefits and burdens of ownership. The Software Rules treat a transfer of a copyrighted article as a lease of a computer program, rather than a sale, if the facts and circumstances indicate that a transaction does not transfer substantial benefits and burdens of ownership of the program.
Sourcing Cloud-Related Income
The answer to many questions about the income taxation of international transactions depends upon an identification of the country in which the income is properly deemed to have been generated. Put in the language of tax policy and practice, the task is to determine the source of the income concerned. Almost every country, therefore, has adopted rules for determining the source of income. Although the source rules of different countries are not congruent, many reflect approaches similar to those in the United States. The U.S. source rules in general derive from an attempt to identify the geographic locus of the economic activity or financial arrangements that generate the income. The question is always whether income derives from inside or outside the United States.
Most of the source rules are specified in Sections 861 and 865 of the Internal Revenue Code. Section 862 identifies categories of foreign-source income. Section 863 deals with categories of income that are partially U.S. and partially foreign sources. Section 865 establishes elaborate rules for determining the source of income derived from the sale of personal property.
According to the sourcing rules, if services are performed in the United States, the income is U.S. sourced income, and subject to U.S. federal income tax. On the other hand, if the services are performed outside the United States, then the income is foreign sourced income. In certain cases, this means that the services will not be subject to U.S. taxation. Applying these concepts to cloud computing transactions and determining where such services are performed for tax purposes can be difficult. For example, computer equipment that facilitates delivery of the digital product might be located in one country, and the employees that maintain and monitor such equipment might be located in another country, and the coders who develop the software might reside in a third country.
These rules may source cloud computing income either to: 1) the places where the customer is located, or 2) the place where the cloud vendor’s servers are located. Given the nature of cloud computing, the location of the server that hosts the software or application will not necessarily be in the same country as the location of the customers. Thus, different U.S. tax consequences may result depending on how the sourcing rules are applied.
U.S.-Taxation of Cross-Border Cloud Based Transactions
A taxable presence in the U.S. is a threshold requirement for the U.S. to tax the business income of a foreign cloud service provider. A U.S. taxable presence means that the foreign cloud service provider either 1) operates a U.S. trade or business, or 2) has a permanent establishment in the U.S. If a U.S. taxable presence exists, then the U.S. has authority to tax the active business income of the foreign cloud vendor to the extent such income is effectively connected to a U.S. trade or business or attributable to a permanent establishment in the U.S.
If the foreign cloud service provider does not have a U.S. trade or business, the U.S. generally will not have taxing authority over the business profits generated by the cloud computing business. However, if the foreign cloud service provider has engaged in a U.S. trade or business, the U.S. will have the ability to tax the income that is effectively connected with a U.S. trade or business. Income effectively connected with a U.S. trade or business includes certain passive income, portfolio interest, and gain or loss from the sale or exchange of capital assets that have a connection to the U.S. trade or business.
Regardless of whether the cloud service provider is engaged in a U.S. trade or business or has a U.S. permanent establishment, the U.S. has taxing authority over certain nonbusiness income that is sourced to the U.S. Unless a treaty imposes a lower rate, the U.S. imposes a flat tax of 30 percent on U.S. source income that it characterizes as fixed, determinable, annual, or periodical or (“FDAP”) income. See IRC Section 881(a). When the 30 percent tax applies, the tax is imposed on a gross basis and collected through withholding at the source of payment. In the cloud computing context, a foreign cloud vendor’s income may be subject to U.S. withholding tax if such income is sourced to the U.S. and such income is not effectively connected to a U.S. trade or business or attributable to a U.S. permanent establishment. Therefore, if the income that a cloud computing business generates is characterized as rental or royalty income and the income is not effectively connected with a U.S. trade or business or attributable to a U.S. permanent establishment, then it falls within the definition of FDAP. If the cloud computing transaction is characterized as provision of services and the services are performed in the United States, the profits will not constitute FDAP income. However, since the source and nature of cloud-related income are not clearly resolved under existing law, there is a degree of uncertainty as to whether withholding is required. If a cloud service provider is a foreign corporation with U.S. owners, some of its income may also be subject to U.S. tax under U.S. anti-deferral regimes such as GILTI or subpart F income.
Conclusion
As cloud computing continues to grow and replace traditional software transactions, the U.S. tax consequences of cloud computing transactions have become increasingly important. However to date, little meaningful guidance has been issued by the Treasury or the IRS. This leaves tax attorneys with little choice but to apply traditional methods of cross-border taxation to cloud service businesses. Doing so may raise a number of novel tax issues in this area.
We have substantial experience advising clients ranging from small entrepreneurs to major multinational corporations in cross-border tax planning and compliance. We have also provided assistance to many accounting and law firms (both large and small) in all areas of international taxation.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. Anthony focuses his practice on domestic and international tax planning for multinational companies, closely held businesses, and individuals. Anthony has written numerous articles on international tax planning and frequently provides continuing educational programs to other tax professionals.
He has assisted companies with a number of international tax issues, including Subpart F, GILTI, and FDII planning, foreign tax credit planning, and tax-efficient cash repatriation strategies. Anthony also regularly advises foreign individuals on tax efficient mechanisms for doing business in the United States, investing in U.S. real estate, and pre-immigration planning. Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or adiosdi@sftaxcounsel.com.
This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.