Understanding the international taxchallenges of software as a serviceand cloud computingInsights for technology companies October 2011Randy Free, Partner, International Tax Consulting How SaaS and cloud computing are maintaining their own IT infrastructureAlex Baulf, Manager, Value Added Tax changing business in a single location, companies pay SaaS SaaS allows companies to move from providers to do this for them over aThe allure of on-demand computing — licensing software and installing expensive multistate and multinational networkand some caveats hardware to entering into service of servers known as a cloud or cloudSoftware as a service (SaaS) and cloud contracts for the provision of software. computing. In other words, cloudcomputing are fundamentally changing As one might imagine, the potential for computing permits the user to accessnot only companies in the technology cost savings is tremendous, given that software and computing power withoutindustry, but also how companies in all companies have historically spent millions being concerned about the underlying ITindustries do business. Technological of dollars on software, hardware and IT infrastructure. Using the cloud is similaradvances and the economic pressures of support teams. to using electricity: Utility customersa down economy have fueled a dramatic While SaaS has changed how buy electricity through the local electricalincrease in SaaS and cloud computing. companies conduct business, cloud grid without having to worry about howBut while companies are enjoying computing has changed where they or where the electricity was generated.substantial cost savings, whether as users transact business and how they access Instead of producing their own electricity,or providers, they may not understand data, computing power and storage customers are billed by a utility companythe international tax exposures created by services. Cloud computing allows SaaS for the service of providing electricity. Inthese new delivery models. They may not users to gain access to software and the same way, users have access to dataknow how to identify related tax savings computing services almost anywhere, and IT services through the cloud at aopportunities. And they may be hurting across almost any border. Instead of greatly reduced internal cost.their bottom lines. For that reason, before diving intoSaaS and cloud computing, providers andusers should perform a comprehensiveanalysis of their proposed businessmodel. Consulting with qualiﬁed taxprofessionals as part of this analysiscan help companies avoid costly pitfallsand gain insight into the opportunitiespresented by this new technology.
Understanding the international tax challenges of software as a service and cloud computing Further, in a cloud computing Many countries are struggling to SaaS and cloud computing: Paving the wayenvironment, it may not be clear exactly understand SaaS and cloud computing What can savvy executives do to preparewhere in the cloud the transaction While the on-demand characteristics of for the adoption of SaaS or cloudis taking place and therefore which SaaS and cloud computing are a boon for computing?tax authority has jurisdiction. A SaaS global business, they present something The following recommendationsprovider’s cloud may span several of a conundrum for international tax provide a framework that businessescontinents. For many reasons, such authorities that are looking for the best can use to help identify tax savingsas security concerns and speed of way to tax these intangible and often opportunities and reduce liabilities.accessibility, the location of the hard-to-categorize services. Historically,transaction may move through the countries have developed their own tax Understand the risk of creatingcloud as the databases replicate to follow laws to deﬁne and tax tangible forms of a taxable presence or permanenttime zones. It does not require much doing business, including the provision establishment.imagination to comprehend just how of services and the transfer of assets or Generally, to be liable for income tax indifﬁcult it can be for the tax authorities to goods. The power to levy these taxes has a particular country, one needs to createmake sense of cloud computing. As with been based on the existence of a place a taxable presence in that country or earna real cloud, they may be able to see the of business or the provision of services revenue that falls under the purview oftechnological cloud, but they can’t put within the territorial conﬁnes of that the country’s withholding tax regime.their arms around it. country. A country’s income taxes, value- Generally, if the relevant country is party added tax (VAT) and even its import taxes to a treaty, the taxable presence will fall are all predicated on the tangible ﬂow of under the permanent establishment (PE) goods and services. clause. Partly because of the economic But in today’s world, the ﬂow of downturn, countries have become more goods and services is not always tangible. aggressive in asserting the existence of aIn today’s world, the ﬂow Although the Internet has been around PE, thus causing a rise in the number ofof goods and services is not for years, few countries have changed PE controversies. their tax laws to address e-commerce. The Organisation for Economic Co-always tangible. Even when those laws are changed, operation and Development (OECD) has they typically cover only the simplest of taken a close look at the application of PE intangible transactions. concepts to e-commerce. Under most treaties and the OECD Model Tax Convention, a business can create a PE through: • the existence of a ﬁxed place of business within the country in which the company’s business is conducted, or • the activities of a dependent agent. 2
Understanding the international tax challenges of software as a service and cloud computing Develop a supply chain strategy that is tax-efﬁcient and aligned with the company’s commercial objectives. In the context of SaaS and cloud computing, the development of a supply chain strategy involves identifying the user base for services and determining the necessary placement of hardware, software and functions. The company should keep in mind that the ownership and location of hardware may create a taxable presence in a given country. Once optimal locations have been decided upon, the company should assess the risk of creating a taxable presence or PE by analyzing relevant laws and treaties of countries where hardware would be located and SaaS and cloud computing would occur. This analysis should also With regard to SaaS and cloud computing does not lease or own the address VAT implications and transfercomputing, the tax authorities are server hardware, then it is likely that a PE pricing requirements with respect to eachconsidering the ability of a computer does not exist. It may be easier for users country. In performing this analysis, aserver to create a ﬁxed place of business of SaaS or cloud computing to fall under company must gain a clear understandingfor either a SaaS provider or a SaaS user. this exception than it is for providers. But of the activities to be offered or accessedIn addition, they are thinking about as we have seen, countries do levy taxes through SaaS and cloud computing,whether a SaaS provider might be a on the provision of services, and activities and how those activities would bedependent agent of a SaaS user. that involve SaaS or cloud computing may characterized and sourced by the relevant The commentary appended to the not be exempt from those taxes. tax authorities for income tax and VATOECD Model Tax Convention stipulates Recently, the tax authorities’ more purposes. Further, executives shouldthat owning computer hardware signals aggressive enforcement approach has think about how intellectual propertythe presence of a ﬁxed place of business. made it imperative for technology (IP) rights will need to be shared withinHowever, if the activity the company companies to engage in comprehensive the company, among subsidiaries andperforms while using the equipment planning that helps them minimize their across international borders, and theis of a preparatory or auxiliary nature, tax exposure. With proper tax planning, company should be aware of the taxthen a PE is generally not created. In the users of SaaS and cloud computing may implications of shared IP rights. Finally,realm of e-commerce, it can be difﬁcult be able to avoid creating a PE in some the company should work with legalto determine the scope and nature of all countries. For providers that own the advisers to draft third-party contracts andof the activities taking place. If a PE is cloud infrastructure, the proactive use of intercompany agreements that support theformed, then the authorities will apply transfer pricing and the proper placement chosen strategy, and use transfer pricingtransfer pricing methodologies and of substance, functions and risks can lower appropriately. The company shouldallocate proﬁt to the PE on which tax the amount of proﬁt allocated to PEs in review all contracts that cover SaaS andwill be assessed. On the other hand, if a high-tax countries while raising the amount cloud computing in order to know what iscompany such as a user of SaaS or cloud of proﬁt allocated to low-tax countries. being provided and taxed in each location. 3
Understanding the international tax challenges of software as a service and cloud computingKnow the VAT implications. Moreover, when the items are provided Therefore, the company mustThe concept of a PE varies from country by a U.S. supplier that has no presence in know the character of its transactionsto country and is deﬁned in income tax the EU, the place of supply (i.e., where in order to classify them for VAT andtreaties, while in the absence of a treaty the items are taxed) is considered to be withholding purposes. The United Statesthe concept of taxable presence is deﬁned where the customer is located. Business has complicated laws for determiningunder local law. If liability for tax is customers can generally self-assess for the whether a transaction is a license, rental,not created by means of a PE, a liability local VAT in their member states through sale, or provision of service or know-how.may still exist for VAT or withholding the reverse-charge mechanism. However, The relevant country will need to considerpurposes. For instance, within the if software is sold to private individuals, whether accessing the cloud — includingEuropean Union (EU), the electronic the U.S. supplier must register and charge software or servers used for data storagedelivery of software (e.g., when it is VAT where the customer is located. — is the provision of a service, the transferaccessed via the cloud or downloaded) Instead of having to account for VAT of software, or the provision of content oris deemed a service for VAT purposes. separately in each of the 27 EU member information. Making this assessment is not states, the company may obtain a single easy and usually involves a detailed review EU registration number, and the relevant of speciﬁc facts and legal arrangements. amount of VAT that is collected (15–25 percent, based on where the customer is Decide how IP rights should be shared. located) is paid and reported on a single In addition to considering VAT online return. If sales are a mixture of implications, businesses must decide B2B and B2C, then VAT registration how IP rights should be shared among numbers should be requested from EU subsidiaries and across international business customers (and retained as borders, and must examine the tax evidence) in order to distinguish these implications of that sharing. Third-party businesses from private individuals, to contracts and intercompany agreements whom local VAT is charged. may be required to support the chosen These VAT requirements are not strategy and, with regard to the latter, exclusive to software. They apply to almost the method of transfer pricing that all digitally or electronically supplied is used. (For a detailed discussion of services for which the supplier is outside ﬁnancial, operational and compliance the EU — e.g., Web hosting; downloaded risks pertinent to the SaaS sector, see the music and video games; and access to Grant Thornton LLP survey Issues and images, databases, information, virtual trends: Assessing and managing SaaS risk.) goods and e-books. Other jurisdictions outside the EU (e.g., Switzerland) have implemented similar rules with regard to taxation of digital services that are offered to private individuals. 4