U.S. Tax Rules Ill-Suited To Address Cross-Border Cloud Transactions

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Businesses and sales in the cloud can take on a number of service and deployment models, each with a unique structure. Business taxpayers are tasked with piecing together outdated rules and case law to determine the best way to handle these kinds of transactions for tax purposes.

As technology evolves, businesses are increasingly embracing the cloud to sell their software, products and services. This has proven to be a profitable, beneficial model for both users and businesses working in the dynamic environment of global business. But when it comes to applying traditional tax concepts to these new businesses models, the old rules aren’t keeping up.

Businesses and sales in the cloud can take on a number of service and deployment models, each with a unique structure. Common scenarios include U.S. multinationals with foreign subsidiaries, selling both domestically and abroad, and purely foreign companies with no nexus in the U.S., selling to U.S. customers. The products vary, too, from something as simple as a $1.99 game through the app store, to complex service software that manages huge amounts of data and calculations.

Business taxpayers today are tasked with piecing together outdated rules and case law to determine the best way to handle these kinds of transactions for tax purposes. Where was the product sold from? Where is the buyer? What exactly was sold, and what is simply being licensed? These questions aren’t that easy to answer. We’ve come a long way from the fairly streamlined transaction of purchasing packaged software, which was a tangible object with a clear manufacturing and sales location. But without those lines, it’s difficult to characterize income and determine how to apply tax.

While we wait for clarity and modernized rules from the tax authorities, businesses operating in today’s fast-paced environment face the consequences of uncertainty as the current framework is obsolete.

The OECD’s Action Plan on base erosion and profit shifting (BEPS) is looking to put out guidance on addressing the digital economy by September 2014, but for now that is a work in progress. So what can businesses do now to mitigate risk and avoid any penalties later down the line? Other than watching for guidance and digging through case law for the best connections, here are a few ideas:

• For U.S. tax purposes, assess each underlying cloud transaction carefully to determine the character and the source of the income, and whether the income is effectively connected with a U.S. trade or business. Also consider if income from cloud transactions gives rise to fixed and determinable annual or periodical (FDAP) income that may be subject to U.S. tax.

• Foreign software companies that are subsidiaries of U.S. parents will also need to evaluate whether any income generated from cloud activities triggers the anti-deferral rules of Subpart F, or whether it would be considered earnings from U.S. property.

• Keep transactions and strategies well documented and clearly outlined—this can help later with audits and conflicting tax authorities.

We will keep watching for more on how to handle the ever-changing structure of commerce in the cloud. But, unfortunately, until guidance comes, tax professionals will continue to struggle with outdated rules and litigation.

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Carla Yrjanson

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