Part 2 of a Three-Part Series ---- How Is Your Cloud Taxable? Let Us Count the Ways
The business model is changing rapidly in many industries, especially in the technology sector. Before, customer revenue and operational efficiencies were driven by the sale of on-site hardware and software and by personnel whose job it was to integrate the two with a customer's business model. Now, businesses are increasingly relying on remotely maintained hardware and software, accessed through the internet or intranets in a virtual setting that has been collectively dubbed "The Cloud." Instead of buying or leasing software and investing in the hardware on which the programs would run, businesses are increasingly adopting software as a service (SAAS) models -- with new tax rules.
In the SAAS model, capital investment in hardware is reduced because the performance demands on the user's machine are much reduced, as is the need to constantly update software versions on that hardware. This affects virtually every business. A large corporation that sought in the past to manage data and reporting across global geographies no longer needs to maintain its own server farms and enterprise software packages, instead giving its employees access to such functionality from anywhere secure web access is available. Teenagers across the globe no longer need the most expensive laptop and the latest version of their favorite game because they can now simply buy online time at an internet café. By reducing up-front capital costs, global customer expansion can increase rapidly to new countries that have an emerging consumer base with rising but still financially constrained disposable income.
Amid this shift of business model, tax professionals must cope with tax rules that were not designed for this new world in The Cloud. In the traditional world of on-site hardware, software and integration personnel, well-worn paths had emerged along which multinational businesses' tax structures could follow their customers and streamline their supply chains across the globe. Routine local functions earned low-risk, routine profits for tax purposes in the countries where these functions were performed. Non-routine foreign-source profits, typically associated with intangible value and protected intellectual property (collectively "IP"), have traditionally been migrated to companies that served as a hub for regional expansion (the "HubCo"). Typical HubCo jurisdictions include Ireland, Luxembourg, the Netherlands and Switzerland in Europe, as well as Hong Kong and Singapore in Asia. These countries have relatively low corporate income tax rates but also have the workforce, infrastructure and logistics capabilities to support the operations necessary to oversee and manage regional operations.
This migration process rests on a three-legged stool of tax structuring to align tax profits with non-U.S. customer demand and offshore supplier efficiency:
- The existing baseline or "platform" IP must be obtained by the HubCo at an arm's length price so that the HubCo can develop future IP using the existing platform.
- Future substantive development risk (and costs) must be borne by the HubCo, and the HubCo must have the wherewithal to bear such risk.
- Profits from future-developed IP must be earned in transactions and operations that allow the deferral of taxation of such profits by all countries other than the HubCo's home country, until such profits are remitted or deployed elsewhere. Achieving this deferral generally means complying with the anti-deferral rules of the jurisdiction in which the HubCo shareholders are tax resident and avoiding a taxable presence in other countries where the HubCo has personnel or operations.
For multinational enterprises with parent companies incorporated in the United States, this three-legged stool has generally meant:
- Complying with related-party transfer pricing rules for the licensing or contingent sale of the platform rights in exchange for a royalty;
- Complying with R&D cost-sharing regulations for the bearing of development risk (although these regulations have become increasingly restrictive about the allowed offshore returns to development risk);
- Complying with subpart F anti-deferral rules applicable to controlled foreign corporations; and
- Making sure that the HubCo didn't have a permanent establishment or "PE" (in the case of a HubCo, in a jurisdiction that had a tax treaty with the United States) or a U.S. trade or business that produced "effectively connected income" (in the case of a HubCo, in a non-treaty jurisdiction).
For the traditional business model, the tax planning focus for the U.S. anti-deferral rules concentrates on margins from buy-sell trading transactions, commission payments, and rent and royalty payments. Income from sales of finished goods can be deferred if bought from and sold to unrelated parties, or if manufactured by the HubCo. Income from lease and license transactions can be deferred if the HubCo deals directly with third parties and is actively engaged in marketing, producing or developing the underlying property. Avoiding a PE or other taxable presence involves focusing on restricting the contracting authority exercised on behalf of the HubCo outside its home country and any other physical presence, which is generally possible in business models where locally incorporated subsidiaries can carry on these tasks rather than the HubCo. While not without controversy over the past decades, this set of issues is relatively well known by both taxpayers and the U.S. government. And U.S.-based multinational enterprises have been reasonably successful in structuring their offshore operations in a manner that lowered their global effective tax rates while still complying with these requirements, even after careful and thorough IRS audit review.
In the world of The Cloud, the three-legged stool on which the tax strategy sits is the same, but the practical ways of building that stool are very different. Because the income that will be derived by the HubCo in most instances will be from providing a "service" ---- albeit electronic rather than personal ---- simply determining the source of the income may be a complex task. The source of income from personal services is determined by "place of performance." Where is an internet search service performed? On the user's laptop or smartphone? On the server where the search takes place in an electronic sense? Or was the service performed by the people who programmed the server to function automatically in response to a remote electronic inquiry? Must companies attempt to know where their customers are when they access offered services? Even if everyone were to agree (and they don't) that the place of performance is the server, can it be determined with certainty which server among a global network of servers actually performed the search, since many systems are designed to manage server load by shifting signal traffic to locations where capacity is available? If, for example, a U.S. parent corporation wanted to ensure that its Irish subsidiary had Irish-source income from server-based transactions, would it have to locate its server capacity entirely within Ireland? If so, obtaining this tax result could mean that infrastructure cost would be higher than otherwise possible if the server location (and load management) were not so constrained.
After confronting the uncertainties of applying the source rules, valuing the IP related to the existing electronic services may necessitate the use of different valuation methods and different tax regulations. For example, U.S. Treasury regulations provide for valuation methods for royalties, but they also have recognized that certain services may be subject to contingent fee arrangements that depend on the success of the service offering to customers. A contingent service fee arrangement essentially provides a profit participation element to what has traditionally been compensated using a mark-up over the cost of the service, not a sharing between related parties of the ultimate net margin from customer revenue.
In structuring the agreements under which the HubCo will bear the risk developing future IP, it is no longer a foregone conclusion that a "qualified cost-sharing arrangement" (QCSA) is the only path to serve the needs of the business. Regulations have increasingly narrowed the range of anticipated profits that the HubCo can earn under a QCSA. Depending on the facts of the business, it may be better for the HubCo simply to fund its own future development without a shared research program. Or it may be more advantageous to construct a service arrangement with the developer of the existing IP as a perpetual arrangement for future development rather than simply as a method for paying for the existing value. Or it may be better to enter into a partnership agreement with the developer of the existing IP, with different partners obtaining different divisional interests in the results of the partnership's successful efforts while sharing the downside risk of those activities' failures.
Finally, deferring a HubCo's Cloud profits from U.S. taxation depends on complying with the foreign-base-company services rules. In this regard, the payments to acquire the existing IP may constitute a form of "substantial assistance" to the HubCo in the performance of its electronic services. Under the applicable U.S. Treasury regulations, substantial assistance expenses, when present, generally cause an end to U.S. tax deferral for a HubCo's profits for the period in which the HubCo must make such payments. This could argue for lump-sum payments up front, or accelerated payment periods rather than ongoing, perpetual arrangements. Moreover, server location and time spent by personnel with customers before and after conclusion of contracts to perform services become important factors in the analysis of whether a HubCo PE or other taxable presence exists outside the HubCo's home country, rather than the more traditional focus on an office or the contracting authority of sales personnel.
Alvarez & Marsal Taxand Says:
If your company is moving into "The Cloud" to capture revenue and lower costs, traditional accepted methods for lowering the tax cost of non-U.S. regional operations may not apply to this new world. New considerations for locating infrastructure, interacting with customers, valuing IP, sharing risk and expenses between the U.S. and foreign operations, and financing expansion may be needed. Thus, thinking ahead and proper structuring may get your company a more tax-efficient answer.
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Bill Ling, Senior Director contributed to this article.
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