Building a Successful Cloud Provider Service Accounting and Tax Considerations. kpmg.com

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1 Building a Successful Cloud Provider Service Accounting and Tax Considerations kpmg.com

2 CONTENTS 1 Introduction 2 Accounting implications 14 Tax issues 22 Conclusion 24 How KPMG can help 24 KPMG cloud publications 26 Contact us 2012 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative ( KPMG International ), a Swiss entity. All rights reserved. Printed in the U.S.A. The KPMG name, logo and cutting through complexity are registered trademarks or trademarks of KPMG International NYO

3 Cloud has become one of the biggest revenue growth drivers for technology companies. As cloud continues to enable new business models and creates incremental disruptions in enterprise and consumer markets, cloud service providers need to consider a variety of business, financial reporting, and tax implications to enhance the efficiency and value of their cloud offerings Gary Matuszak, Global and U.S. Chair, Technology, Media & Telecommunications KPMG LLP (KPMG) has been providing guidance that specifically addresses the business issues cloud service providers (CSPs) need to address to deliver their services successfully. This publication is focused on the key accounting and tax areas including: ACCOUNTING IMPLICATIONS Revenue recognition...4 Are cloud arrangements subject to software guidance?...4 Separation criteria...6 Allocating revenue to separate units of accounting...6 Limitations on allocating the consideration...7 Timing of revenue recognition...8 Accounting for costs incurred to develop, maintain, and deliver a cloud offering...9 Costs to develop internal-use software and Web site development...9 Direct costs associated with setup or implementation...10 Costs incurred subsequent to implementation Customer perspective up-front costs incurred for cloud implementation...11 What lies ahead...12 TAX CONSIDERATIONS General considerations...15 U.S. federal tax considerations...16 Classifying cloud computing transactions...16 Sourcing income from cloud computing transactions Outbound and inbound taxation considerations...18 State and local tax considerations...19 Nexus considerations for cloud computing companies...19 Characterization of cloud computing transactions for state and local sales and transaction tax purposes...20 Characterization and sourcing of receipts for state net income tax purposes...20 Transfer pricing considerations...21 Non U.S. tax considerations Cloud business models are constantly creating new business opportunities and risks. CSPs that proactively manage and plan for the accounting and tax issues associated with operating in the cloud may unlock incremental value for their business models.

4 2 Building a Successful Cloud Provider Service Accounting and Tax Considerations Accounting implications 1 associated with cloud 1 The following discussion addresses only general accounting issues; hence, it is not intended to provide in-depth accounting advice for all possible offerings, business models, or contract structures.

5 Building a Successful Cloud Provider Service Accounting and Tax Considerations 3 For cloud service providers (CSPs), common accounting issues relate to the timing and amount of revenue that can be recognized in an ongoing customer relationship, as well as how companies account for the costs associated with providing services in the cloud. Since changes to accounting guidance were issued about two years ago, we have noted certain implementation challenges, as well as evolving policies and practices among various cloud providers. A typical cloud offering will have multiple elements that may be delivered at different points over the relationship, and the accounting model is influenced by the service provider s ability to separate those elements into units of accounting. This ability to separate elements will affect, for instance, the timing of revenue recognition. CSPs may face accounting challenges and opportunities in delivering services through the cloud. In particular, the very nature of cloud computing and the related pricing mechanisms often results in a ratable recognition of revenue over the relevant service period. Thus, a cloud computing model presents a service provider with an opportunity for a more predictable, recurring revenue stream. For example, in a more traditional software licensing model involving the sale of on-premise perpetual licenses, more revenue may be recognized upon the delivery of the software if the vendor has vendor-specific objective evidence (VSOE) of selling price for its other deliverables included in the arrangement. We have noticed many vendors with hybrid offerings in which certain elements are licensed on-premise, perhaps with a future hosting option, while other elements are offered only in a cloud environment. This type of model can result in a different accounting model for different elements, sometimes even within the same arrangement. In some cases, certain elements of a cloud arrangement may qualify for up-front revenue recognition, while in others, fees are required to be aggregated and recognized over a longer service period, regardless of when the respective elements are delivered. For a vendor with a cloud offering, this may require careful forecasting of future revenues and managing stakeholders expectations for growth. In particular, vendors should be mindful of any features that may allow the customer not to pay for delivered services until the vendor provides other goods or services, or features that entitle the customer to a refund equal to the pro rata amount of any undelivered services. A cloud computing model may also result in the need to measure and provide different financial metrics such as billings, bookings, levels of recurring contract value, or similar key performance indicators. Further, the recognition of revenue over time continues to present challenges in managing and delivering consistent or stable profit margins, especially when the effort related to professional services occurs before the associated revenue.

6 4 Building a Successful Cloud Provider Service Accounting and Tax Considerations ACCOUNTING IMPLICATIONS The following is a general overview of the accounting guidance and frameworks relevant to providers of cloud computing services. Cloud service providers (CSPs) will likely encounter implementation challenges when applying the relevant guidance to their specific facts and circumstances. While we have identified the general factors to consider in accounting for a cloud offering, the guidance that follows will not address every potential scenario a CSP will face. We note that while this particular guidance has been applied by cloud vendors for approximately two years, the FASB and IASB (the boards) are working toward a converged revenue standard, expected to be issued in 2013, that would replace most transaction- and industry-specific revenue recognition accounting guidance in U.S. generally accepted accounting principles (GAAP) with broad-based principles applicable to all customer contracts. See the What Lies Ahead section for a preview of the potential impact from the proposed revenue standard. Revenue recognition 2 The following discussion seeks to address some of the more common considerations for CSPs when structuring customer contracts. Please note that, generally, the customer arrangements will be subject to the accounting provisions of Accounting Standards Codification Topic (including the ASU , Multiple-Deliverable Revenue Arrangements, as codified in ASC Topic ), SEC Staff Accounting Bulletin (SAB) No. 104, Revenue Recognition, and ASC Topic , Software Revenue Recognition. A typical cloud offering will have multiple elements that may be delivered at different points during a relationship period. Therefore, the accounting model will be affected by the CSP s ability to separate these elements into discrete units of accounting, and the ability (or inability) to separate the various elements will drive the timing of when revenue can be recognized for each element. Are cloud arrangements subject to software guidance? CSPs often include a license to use the intellectual property, and in some cases CSPs may install software at the customer site that acts as an interface between the customer and the CSP s server. The inclusion of a license that allows the customer to use software hosted by the cloud computing vendor is not in-and-of itself a sufficient basis to conclude that the arrangement is in the scope of ASC Rather, CSPs would need to evaluate the substance of the arrangement to determine whether software is considered a deliverable in the arrangement. A cloud arrangement contains software that is within the scope of ASC if both of the following conditions are met: > The customer has the contractual right to take possession of the software at any time during the hosting period without incurring a significant penalty, and > It is feasible for the customer to run the software either on its own hardware or on a third party s hardware. A significant penalty embodies two distinct concepts: (1) the ability to take delivery of the software without incurring significant costs (i.e., a financial penalty), and (2) the ability to use the software separately without a significant reduction in its utility or value (i.e., a functional penalty). Generally, in a typical cloud arrangement, the customers do not have the contractual right to take possession of software and run the software inhouse or through an unrelated vendor; therefore, cloud service arrangements generally are not in the scope of ASC Questions have been raised whether a software element exists in arrangements where the customer is able to take possession or ownership over partial software elements, but not the entire software, because current guidance is silent about those fact patterns. In those cases, CSPs should evaluate whether a service based on software is being provided to the customer, or whether the software itself is being delivered. Some may conclude that if the customer does not have the right to take possession of significant features and functionalities of the software, a service based on the software is being delivered. 2 Unless otherwise noted, all technical references in this section are to the current FASB Accounting Standards Codification (ASC) Topic , Multiple Element Arrangements. The more familiar, precodification reference is EITF Issue 00-21, Revenue Arrangements with Multiple Deliverables.

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8 6 Building a Successful Cloud Provider Service Accounting and Tax Considerations ACCOUNTING IMPLICATIONS Separation criteria Guidance in ASC requires a CSP to separate the elements of an arrangement when the following criteria are met: > The delivered item or items have value to the customer on a stand-alone basis > If the arrangement includes a general right of return relative to the delivered item, delivery or performance of the undelivered item or items is considered probable and substantially in the control of the CSP. For an item to have stand-alone value to the customer, the element (product or service) must either be sold separately by any CSP or the customer could resell the delivered item or items on a stand-alone basis. Considering that most, if not all, elements being provided by a CSP will consist of services, CSPs generally satisfy this requirement by demonstrating that different services are sold separately, either by the CSP or another service provider, rather than by demonstrating a customer s ability to resell the element. For example, many cloud offerings involve consulting or other implementation services that enhance the value received by the customer by tailoring the service offerings to the customer s needs and operating environment. The CSP may provide implementation services separately through follow-on arrangements, or other service providers may offer implementation services on a stand-alone basis, either of which could satisfy this stand-alone value criterion. However, if the professional services are unique and are not capable of being provided by another vendor due to unique features, knowledge requirements, or complexity, and the CSP does not sell the professional services separately, this may indicate the services would not satisfy the stand-alone value criterion. Additionally, in some arrangements the CSP may charge fees incremental to the hosting services at inception of an arrangement for various activities such as service activation, access, or other required setup activities (i.e., up-front services). Those up-front services in a hosting arrangement would not represent a separate deliverable if the up-front services have little or no value to the customer on a stand-alone basis. In these situations, up-front fees would be deferred and recognized systematically over the period in which the hosting services are performed, which may extend beyond the initial contractual period if the relationship with the customer is expected to extend beyond the initial term and the customer continues to benefit from the up-front services (e.g., if subsequent renewals are priced at a bargain to the initial up-front fee). Allocating revenue to separate units of accounting Assuming a CSP can separate the elements of an arrangement into multiple units of accounting, revenue would be allocated to each unit at the inception of the arrangement based on their relative selling price and recognized when the relevant criteria are satisfied for each element. Multiple-element arrangement guidance includes a hierarchy of evidence to determine the stand-alone selling price of a unit of accounting based on the CSP s own specific objective evidence, third-party evidence (TPE) and estimated selling price. If VSOE is available, it is used to determine the selling price of a unit of accounting. If not, a vendor would determine whether TPE is available and can be used to determine the selling price. If TPE is not available, an estimated selling price is used. > VSOE is generally the price that a vendor charges when it sells a product or service separately (i.e., on a stand-alone basis). For an item not yet sold separately, VSOE is the price established by management having the relevant authority to establish such a price. It must also be probable that the established price will not change before the product or service is introduced into the marketplace. In some cases, it may be difficult for a CSP to establish VSOE due to the significant variability in services pricing, competitive pressures, and introduction of new service offerings. > TPE is generally the price at which a competitor or third party sells the same, or a similar and largely interchangeable, deliverable on a stand-alone basis. TPE may also include the CSP s stand-alone selling price for a similar and largely interchangeable product or service, but not the same product or service. > Estimated selling price is defined as the price at which a vendor would transact if the deliverable were sold by the vendor regularly on a stand-alone basis. A vendor would consider market conditions as well as entity-specific factors when estimating a stand-alone selling price. A vendor s best estimate of selling price should be consistent with the objective of determining VSOE.

9 Building a Successful Cloud Provider Service Accounting and Tax Considerations 7 Limitations on allocating the consideration The guidance on multiple-element arrangements includes a limitation to prevent revenue from being recognized as units of accounting are delivered when the arrangement permits delayed payments, or requires refunds of amounts recognized as revenue if all or some of the remaining deliverables are not delivered, even when delivery or performance is substantially within the vendor s control. A common feature in CSP arrangements is a contractual provision entitling the customer to a refund equal to the pro rata amount of any undelivered services that are not provided (i.e., the CSP s right to receive or retain a portion of the arrangement consideration is linked to its successful delivery of the undelivered items to the customer). In those cases, the amount allocated to the delivered item or services is the lesser of the amount that would otherwise be allocated on a relative selling price basis and the amount that is not contingent on delivery of the undelivered items.

10 8 Building a Successful Cloud Provider Service Accounting and Tax Considerations ACCOUNTING IMPLICATIONS Timing of revenue recognition Once the revenue has been allocated to the unit or units of accounting, SAB 104 is the relevant guidance for determining the timing of recognition for each unit of accounting for items not specifically addressed by other authoritative literature. SAB 104 provides four criteria that a CSP must satisfy to recognize revenue: > Persuasive evidence of an arrangement exists > Delivery has occurred or services have been rendered > The seller s price to the buyer is fixed or determinable, and > Collectability is reasonably assured. SAB 104 indicates service fees should be recognized on a straight-line basis, unless evidence suggests the revenue is earned or obligations are fulfilled in a different pattern over the contractual term of the arrangement or the expected period during which the specified services will be performed, whichever is longer. Determining whether a pattern of performance other than straight-line is evident requires the application of judgment. Many cloud services are provided consistently from period to period so a pattern of performance other than straightline generally will not be evident. However, other elements in an arrangement that are accounted for separately, such as consulting or other professional services, may have a pattern of performance associated more directly with the proportion of the services provided over the total effort expected. Determining when service revenue commences in a cloud arrangement may require judgment and careful consideration of all relevant facts and circumstances. Often, CSPs must perform setup activities such as services to configure the CPS s services to the customer s needs, data, or environment. The customer s ability to use or view data, process transactions, or otherwise use the functionality in the cloud may not be possible until certain setup services are completed by the CSP. Generally, only the activities of the service provider that offer substantive value to the customer would trigger the commencement of revenue. Administrative or setup activities related to preparing the customer s environment, particularly if the customer does not yet have the ability to use the ongoing service offering, generally will not trigger the commencement of revenue.

11 Building a Successful Cloud Provider Service Accounting and Tax Considerations 9 Accounting for the costs incurred to develop, maintain, and deliver a cloud offering In addition to the research and development of products and services offered in the cloud, some examples of the types of costs a CSP can expect to incur include: > Costs to develop Web sites and software used in providing the service > Costs to maintain the portal, delivery engine, or other customer interface > Acquisition of servers and security solutions to maintain accounts and protect customer data > Costs to set up and deliver the services > Sales and field service personnel commissions > Professional services associated with delivering the service > Other related costs. For certain costs, there are some alternatives available to CSPs related to recognizing costs, depending on the nature of these costs. Costs to develop internal-use software and Web site development Generally, since the technology developed to support cloud services and the related customer interface will be used by the CSP to provide that service, the costs associated with this development will be accounted for under ASC Subtopic , Internal Use Software. The nature of many Web site development costs are considered to be software development and therefore subject to the same accounting guidance as software development costs. Typically, all costs incurred in the preliminary design and development stages will be expensed as incurred. Once a technology project or Web site has reached the application development stage, certain internal, external, direct, and indirect costs may be subject to capitalization after development milestones are met. Generally, costs are capitalized until the technology is available for its intended use. Subsequent costs incurred for the development of future upgrades and enhancements, which the CSP expects will result in additional functionality, would follow the same protocol for capitalization.

12 10 Building a Successful Cloud Provider Service Accounting and Tax Considerations ACCOUNTING IMPLICATIONS Direct costs and costs associated with setup or implementation Direct costs and costs associated with setup activities include: > Internal contract/customer relationship origination costs > Salaries for personnel activating the service > Sales commissions of internal sales personnel > Solicitation costs, such as referral fees paid to internal employees. SAB 104 allows a CSP to select from two alternative accounting policies related to setup costs to either: > Expense costs in the period incurred, or > Defer certain costs that are recognized systematically over the period in which the related revenue is being recognized. Expensing costs as incurred and recognizing the associated revenue over time may result in an uneven profit margin over the term of an arrangement. Therefore, many CSPs elect to defer and amortize costs. The types of costs eligible for deferral are based on an analogy to either ASC (formerly FASB Technical Bulletin (FTB) 90-1, Accounting for Separately Priced Extended Warranty and Product Maintenance Contracts, or ASC (formerly SFAS No. 91, Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases. Under the first alternative (the FTB 90-1 model), the costs eligible for deferral need to be directly related both to the arrangement and the service provider s incremental costs as a result of the arrangement. For example, while internal contract processing and setup costs are considered to be direct costs, neither are incremental to the CSP since those costs would be incurred regardless of the arrangement with the customer and would not qualify for capitalization under the FTB 90-1 model. However, if a third party had been hired specifically to perform these services for the arrangement, these costs would have been eligible for deferral under this model. Sales commissions paid to an employee as a result of an arrangement also would be eligible for deferral. The second alternative (the SFAS No. 91 model) permits the deferral of both direct internal and external origination costs, but not solicitation costs. Sales commissions and salaries paid to internal employees may qualify for capitalization to the extent the salesperson performs origination (as opposed to just solicitation) activities, and then only on the amount of time the salesperson spends on successful origination activities. Costs incurred subsequent to implementation The costs of fulfilling the service requirements of an arrangement after revenue recognition commences, or go-live, would be expensed as incurred. Costs incurred to acquire equipment or other infrastructure (e.g., security software, storage) would be subject to standard accounting principles for capital-type expenditures.

13 Building a Successful Cloud Provider Service Accounting and Tax Considerations 11 Customer perspective up-front costs incurred for cloud implementation Rather than purchasing enterprise software for internal use, more companies are outsourcing software from third parties. When the vendor hosts software as a service and the purchaser does not have the right to take physical possession of the software, the arrangement is typically viewed by the customer as the purchase of services rather than of software. Prepayments by the customer for future services generally are capitalized as prepaid expenses and charged to expense as the CSP performs the services. However, no authoritative accounting standard directly addresses how the customer should account for the up-front costs of setup activities in a cloud arrangement that represents the purchase of services. Some relevant guidance that may be helpful to analyze these payments include FASB ASC Subtopics , Intangibles Goodwill and Other Internal-Use Software, and , Other Expenses Business and Technology Reengineering, and the definition of an asset in FASB Concepts Statement No. 6, Elements of Financial Statements. Based on that guidance, the up-front payment to the cloud vendor may be viewed as a prepayment that provides probable future benefits in the form of a contractually enforceable right to use cloud services over time. A customer typically would amortize the capitalized amount over the period during which the CSP provides services. However, other standards, such as FASB ASC Subtopic , Other Expenses Start-Up Costs, by analogy, may support an alternative approach of expensing the costs of the setup activities as the costs are incurred. If the customer pays the cloud vendor to provide other related services that the entity ordinarily would recognize as an expense as incurred, e.g., training for employees or business process reengineering activities, the customer should expense the costs associated with those activities when the services are provided. The implementation guidance in ASC Section , Other Expenses Business and Technology Reengineering Implementation Guidance and Illustrations, may provide a good starting point for determining whether costs represent a prepayment for cloud services or period expenses. If the customer pays other third-party vendors (not the CSP) or incurs internal personnel costs, those costs generally would be expensed as incurred. However, in certain circumstances certain costs may be capitalizable under ASC Subtopic , Intangibles Goodwill and Other Internal-Use Software, where the result of the activities is the development of internal-use software owned by the customer. Where the customer does not have rights to the intellectual property or code, ASC Subtopic would not apply. We encourage CSPs and customers to consult their accounting advisors in analyzing these transactions before selecting an accounting policy.

14 12 Building a Successful Cloud Provider Service Accounting and Tax Considerations ACCOUNTING IMPLICATIONS What lies ahead The boards are working toward a converged revenue recognition standard that would replace most transaction- and industry-specific revenue recognition accounting guidance in U.S. GAAP, including guidance in areas such as accounting for software arrangements, with broad-based principles applicable to all customer contracts. In response to constituent comments, the boards have tentatively agreed to eliminate or modify some of the guidance in their original proposal that would have created significant changes to current U.S. GAAP. Nonetheless, notable differences from current U.S. GAAP still exist. Some selected areas that may warrant CSP attention include the following areas: Identify the Separate Performance Obligations in the Contract. Identifying separate performance obligations would require greater judgment when evaluating a bundle of goods or services to determine whether they should be accounted for as a single performance obligation or as separate performance obligations. A vendor would account for a promised good or service as a separate performance obligation if it is capable of being distinct, and is distinct within the contract s context. The boards tentatively agreed to provide indicators that would be assessed to determine whether a good or service is distinct in the contract s context. For example, a CSP would need to assess whether the software license and services are both distinct. If a vendor grants a software license that is not distinct because the customer cannot benefit from the license without the additional service, the vendor would account for the combined license and service as a single performance obligation satisfied over time (as compared to current guidance where a CSP evaluates whether a hosting arrangement contains a software deliverable within the scope of the software revenue recognition guidance). Allocating the Transaction Price to the Separate Performance Obligations. Unlike the current requirements in ASC on limitations on allocating the consideration, the proposed guidance does not contain such a restriction, and therefore features in CSP arrangements entitling the customer to a refund equal to the pro rata amount of any undelivered services that are not provided (i.e., the CSP s right to receive or retain a portion of the arrangement consideration is linked to its successful delivery of the undelivered items to the customer) may not result in deferral of revenue as long as CSPs are entitled to the amount of contingent consideration. Contract Costs. Under the proposed guidance, costs to fulfill a contract and incremental costs of obtaining a contract recognized as assets would be amortized on a systematic basis consistent with the pattern of transfer of goods or services to which the Additionally, the proposed guidance notes that certain activities a vendor must undertake to fulfill a contract are not performance obligations because those activities do not transfer goods or services to the customer. Many CSPs determined, based on the amendments to ASC Subtopic , that they could separate certain of their implementation and other up-front professional services on the basis that such services have stand-alone value to the customer. CSPs would likely reach similar conclusions relative to similar professional services under the proposed guidance; however, setup activities that do not transfer any good or service to the customer generally would not be considered performance obligations. 3 FASB Accounting Standards Update No , Multiple-Deliverable Revenue Arrangements, available at fasb.org

15 Building a Successful Cloud Provider Service Accounting and Tax Considerations 13 asset relates. In some cases, the asset may be amortized over more than one contract when the asset relates to goods or services that will be provided under an anticipated contract that the CSP can identify specifically (e.g., renewal options). The requirement to capitalize costs would not be new to CSPs that currently capitalize such costs. However, many CSPs currently amortize costs over the noncancellable contract term, whereas the proposed requirement to amortize such costs, under certain circumstances, over a period beyond the initial contract period may result in an accounting change for CSPs whose historical experience indicates that contracts are expected to be renewed. In response to the boards November 2011 revised joint exposure draft on revenue recognition (2011 ED), some CSP respondents requested that the boards limit the amortization period to the initial contract period. At the time of this publication, in response to various comments received on the 2011 ED, the boards plan to deliberate various aspects of the ED again, and expect to issue a final standard in CSPs should stay tuned as adopting the proposed revenue standard may be a significant task for some organizations because of the pervasive effect revenue can have on various financial metrics, reporting, and communication. In closing, there are many variables a CSP should consider when establishing accounting policies related to cloud services. In many cases, these policies will be a factor in how customer arrangements are structured and priced. We recommend consulting with your professional advisors when developing these policies and accounting methods.

16 14 Building a Successful Cloud Provider Service Accounting and Tax Considerations Tax issues associated with cloud

17 Building a Successful Cloud Provider Service Accounting and Tax Considerations 15 Most tax laws governing sales transactions were developed at a time in which the physical transfer of goods was the predominant paradigm. The advent of software licensing has already put these concepts under strain now that the delivery of technology is moving into the cloud, CSPs desiring a specific tax treatment must rely on careful planning to achieve the desired results. On the plus side, however, addressing the issues posed by a cloud computing operation may offer opportunities for a CSP to develop a more tax-efficient structure. General considerations For some CSPs, determining the tax consequences of a cloud computing transaction will be a relatively straightforward exercise the tax treatment will flow neatly from the natural design of the transaction. For other CSPs, especially those that may desire a specific type of tax treatment that may not flow intuitively from the natural design of the transaction, the determination may be more complex. A couple of factors contribute to the potential complexity. First, many of the rules and concepts that will govern cloud computing transactions were born out of a need to deal with so-called old economy transactions, and were not designed to address highly automated businesses. Second, determining the consequences of a cloud computing transaction can be highly fact-intensive. Generally, no one-size-fits-all conclusions can or should be drawn about a CSP s operations. For CSPs desiring a specific tax treatment, careful planning will likely be necessary to achieve the desired results. Generally speaking, CSPs transitioning from a more traditional business model to a cloud computing model will have more to do to adapt their structures to the new issues they face. For new CSPs, the issues may be easier to address, though planning is necessary to avoid unwanted consequences. Whether a CSP is migrating to a new business model or beginning a new one from scratch, however, dealing with the issues posed by a cloud computing operation may offer opportunities for the CSP to develop a more tax-efficient structure. Diligence and planning are key.

18 16 Building a Successful Cloud Provider Service Accounting and Tax Considerations TAX CONSIDERATIONS U.S. federal tax considerations The general approach that should be used to evaluate a cloud computing business from a tax perspective is as follows. First, classify the nature of the transactions conducted by the CSP, e.g., determine whether the transaction is a service, sale, license, or lease transaction. Classification is the first step because the Internal Revenue Code (Code) generally treats the income derived from each of these types of transactions differently, with specific tax provisions applying to each type. Some of the other determinations impacted by transaction classification include: > The source of the income for purposes of computing creditable foreign taxes > Whether the income will be subject to the antideferral rules of the subpart F regime > Whether, or to what extent, the income is subject to U.S. or foreign withholding tax. Second, once the transaction is properly classified, apply the sourcing provisions applicable to the type of income earned by the CSP from such transactions. 4 Classifying cloud computing transactions The proper classification of a transaction depends to a large extent on whether, as part of the transaction, the transaction involves a transfer of a property (including a property right) to the customer. In many, if not most, cloud computing transactions, there will be no such transfer and the rules governing the taxation of services income should apply. However, there may be circumstances where property is transferred to a customer, in which case the CSP will have to consider whether the income earned is treated as sales, rental, or royalty income (all of which involve the transfer of either a copyrighted article or an intangible property right). Where the transaction involves a transfer of property, classification will depend upon the nature of the rights the customer has in the property transferred. Consider the following examples: Example one A customer hires a CSP to provide extra computing capacity to meet seasonal needs. The customer sends data to the CSP to be processed using the service provider s computing infrastructure and software. Through algorithmic load-balancing, the customer s research project is processed on multiple, nonspecific servers. Once the project is finished, the CSP sends the customer a detailed electronic report constructed according to the customer s specifications. This transaction is likely to be characterized as a services transaction since no property or property right is transferred to the customer. 4 For lack of a more comprehensive set of rules, this two-step approach mirrors provisions in the Treasury regulations that are used to determine the tax treatment of computer program transactions. See Treas. Reg The approach is also similar to OECD pronouncements regarding the treatment of software transactions. See Commentary on Article 12 of the OECD Model Tax Convention.

19 Building a Successful Cloud Provider Service Accounting and Tax Considerations 17 Example two On the other hand, consider a customer with very specific research needs that contacts the CSP for access to the service provider s computing infrastructure. The CSP makes a specific, physical portion of its computing apparatus available on a dedicated, but temporary, basis, and the customer is given the right and means to control the apparatus and the activities conducted with it. Through a Web interface, the customer uploads custom software and data onto the CSP s computing infrastructure to accomplish the customer s research tasks. The customer monitors the process remotely through the Web interface, making adjustments as needed to achieve good performance. Income earned from this transaction may constitute rental income since the CSP transfers temporary, exclusive use of a specific portion of its property to the customer. As mentioned above, cloud computing transactions can give rise to different types of income. Any of the three prevailing cloud computing models usage-based, subscription, and adsupported could give rise to services income. The usage-based and subscription models offer the most potential to generate rental income, which is likely to result where the customer has substantial but temporary control over a specific physical portion the CSP s property, e.g., a specific server within the CSP s cloud computing infrastructure. None of the three prevailing models would, prima facie, appear to give rise to a sales transaction. For CSPs desiring sales treatment, careful planning will almost certainly have to be undertaken to achieve the desired treatment. In the cloud computing context, royalty treatment will constitute the least likely transaction classification.

20 18 Building a Successful Cloud Provider Service Accounting and Tax Considerations TAX CONSIDERATIONS Sourcing income from cloud computing transactions Determining the source of income is important because other tax determinations key off whether income is U.S.-source or foreign-source. For example, a U.S. CSP may claim foreign tax credits on a U.S. tax return only to the extent the U.S. taxes against which the credits are being applied relate to foreign source income. A foreign CSP will be interested in the source determination, since the source may affect whether U.S. withholding taxes are imposed on payments it receives from its cloud computing transactions. Generally, income derived from the provision of services is sourced to where the services are performed. The source rule for services income raises certain complexities in the cloud computing context. Rarely will all of the inputs that make up the service offering be conducted in a single jurisdiction, yet under the case law one looks to the location of the activities giving rise to the services income to determine its source. In cases where activities are performed both within and outside the United States, the income must be allocated between U.S. and foreign sources based upon the relative contribution of the activities performed within and outside the United States. If a transaction is classified as rental income, income from the transaction is generally sourced to the place where the property is used (e.g., generally where the servers and other components of the cloud apparatus are located). If a classification analysis leads to a conclusion that a transaction gives rise to sales income (e.g., the transaction is a sale of an item of property), income from the sale of property the CSP has developed generally must be split between the country where the property is produced and the country where the sale takes place (e.g., where title and benefits and burdens of ownership pass to the buyer). As with the location of services inputs, ascertaining the location of production activities in the cloud computing context may not be a straightforward exercise. Careful consideration of the facts will be necessary. Royalties are sourced to where the intangible property is used (exploited) by the CSP s customer. Outbound and inbound taxation considerations The Code s subpart F provisions accelerate the inclusion of income on a U.S. CSP s tax returns where the service provider s controlled foreign subsidiary (i.e., a controlled foreign corporation earns foreign base company income. The transaction classifications described previously can potentially give rise to one or more types of foreign base company income. With planning, CSPs can typically lessen the impact of the subpart F provisions. However, the international tax landscape is not static, and CSPs should keep a vigilant eye on new legal developments and plan or amend their structures accordingly. For foreign CSPs, or U.S. CSPs running cloud operations offshore through foreign subsidiaries, a key component of factual development and planning will be inquiring about the existence of a U.S. office of the foreign provider, or an agent acting on behalf of the foreign provider within the United States. The existence of either suggests a possibility that the foreign provider has effectively connected income taxable in the United States. Finally, CSPs should keep in mind applicable income tax treaties, which may alter the source rules discussed above, lower withholding taxes, and mitigate the application of the effectively connected income rules.

21 Building a Successful Cloud Provider Service Accounting and Tax Considerations 19 State and local tax considerations In addition to the federal tax issues described above, numerous state and local tax issues arise in connection with cloud computing transactions. Nexus considerations for cloud computing companies Traditional notions of physical presence nexus, in which jurisdiction to tax generally is created by the presence of people or property in a state, can be distorted in the electronic and digital services world. While ownership, and likely rental, of a server creates nexus with a state, nexus-creating activities may also include renting space on shared servers and collocating servers in third-party data centers. Additionally, some states may consider software to be tangible personal property, raising the question of whether software maintained in electronic format within a given state will be sufficient to create nexus. In the income tax context, it is important to note that Public Law , the federal law that limits the applicability of a state net income tax where the taxpayer sells tangible personal property, performs only solicitation in the state, and meets certain other conditions, will not be applicable to the extent the cloud computing transaction is treated as the sale of services or the licensing of an intangible. Even if the transaction is deemed to consist of tangible personal property, the safe harbor of Public Law does not apply to a lease or license. In addition, concepts of attributional nexus are also becoming more important. The presence of in-state agents, including instate affiliates participating in a network referral program, may create nexus and, in the sales tax context, a sales tax collection obligation. Approximately nine states have enacted click-through nexus. Further, with regard to income taxes, economic nexus, based on the notion that the use of intangibles in a state can create nexus within that state, continues to be an area in which states have become increasingly aggressive.

22 20 Building a Successful Cloud Provider Service Accounting and Tax Considerations TAX CONSIDERATIONS Characterization of cloud computing transactions for state and local sales and transaction tax purposes Sales and transaction-based taxes can present significant challenges for cloud computing service providers. Because these taxes are measured by a company s gross receipts or gross sales price without a deduction for expenses or cost of goods sold, they are likely to be applicable even when the company generates losses for net income tax purposes. In addition, these taxes create a large monthly compliance burden as well as a significant audit risk as a result of the general lack of interpretive guidance related to cloud computing transactions. Specifically, audit issues may involve whether cloud computing transactions should be treated as a taxable sale of tangible personal property or the sale of services that can be treated as nontaxable. Some states, however, do provide for taxable services that can include cloud computing transactions. Characterization and sourcing of receipts for state net income tax purposes As with state sales and transaction-based taxes and the federal income tax, in the state income tax context the critical issue centers around the characterization of the cloud computing transaction as either a sale of tangible personal property or a sale, lease, or license of services or intangibles. How a transaction is characterized determines whether Public Law is applicable, as well as how receipts will be sourced for apportionment purposes. KPMG Cloud Tax Technical Literature Cloud Computing: U.S. Tax Compliance Complexity for Foreign Subsidiaries, James Carr, Jason Hoerner, Shirish Rajurkar, Chanin Changtor. The Tax Executive, January/February An article by members of KPMG s International Corporate Services (ICS) practice can help tax executives gain greater visibility into these difficult issues. ICS Partner James Carr, Principal Jason Hoerner, Director Shirish Rajurkar, and Senior Associate Chanin Changtor presented a hypothetical case study involving a U.S. multinational s foreign subsidiary to illustrate the potential tax return reporting and filing issues faced by taxpayers engaging in crossborder cloud computing. As the authors stated: Taxpayers operating in the cloud face uncertainty in determining the appropriate compliance obligations due to the age of existing guidance on software-based transactions, the facts-based nature of the technical issues, and the lack of clear guidance on how traditional tax principles are to be applied in the context of a cloud business. Cloud Computing, A Canadian Perspective, Mark Worrall, October 1, 2012 Tax Implications of the Cloud, Brett Weaver and Reid Okimoto, Puget Sound Business Journal, November 4, 2011 State Taxation of Cloud Computing: A Framework for Analysis, Walter Hellerstein and Jon Sedon, Journal of Taxation, July 2012

23 Building a Successful Cloud Provider Service Accounting and Tax Considerations 21 Transfer pricing considerations Establishing and maintaining a cloud computing business will raise issues involving transfer pricing, i.e., the pricing of transactions conducted among controlled companies. Transfer pricing issues raised by cloud computing will involve how the value of the cloud computing business is distributed among the intellectual property, cloud computing infrastructure, and personnel that support the business. Thus, where multiple corporate entities combine efforts to provide a cloud offering to customers, CSPs will need to evaluate each entity s economic contribution to the effort and compensate each entity according to arm s-length principles. Intercompany transactions will need to be documented contemporaneously and supported by economic analyses. CSPs operating multinationally will have to consider both the Code s transfer pricing provisions (i.e., section 482 and its attendant regulations) and also rules employed by foreign jurisdictions, including Organization for Economic Cooperation and Development (OECD) principles. Non-U.S. tax considerations One of the main issues CSPs will need to contend with is whether their operations create a taxable presence in a foreign jurisdiction. Taxation can be governed by a foreign country s domestic law or, if applicable, by the provisions of an income tax treaty. Establishing cloud operations (either data centers or personnel) in foreign jurisdictions will impact a CSP s offshore tax model. The clearest path to managing such risk is to create dedicated offshore operations with minimal assistance from shared employees from the U.S. or other jurisdictions. Some of the other considerations CSPs should keep in mind in establishing offshore operations include appropriate ownership and funding of the cloud business (debt/equity mix, repatriation strategies), ability to credit foreign taxes paid against U.S. taxes, and whether any cross-border payments are subject to withholding tax. CSPs should seek assistance in achieving advance rulings from local tax authorities about the tax treatment of the foreign operations. This will be crucial as many of the issues will be in uncharted waters where clear guidance rarely exists.