Part 3 of a Three-Part Series  ----  How Is Your Cloud Taxable? Let Us Count the Ways

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December 1, 2011

As businesses increasingly rely on rapidly evolving remote or outsourced information technology (IT) accessed via the internet (colloquially called “The Cloud”), tax planning in general enters into relatively new territory as well. Setting transfer prices for related-party transactions that have the effect of allocating profits among competing taxing jurisdictions is no exception.

Two main challenges have emerged in the transfer pricing arena as a result of this business trend. First, new valuation methods must be meshed with recently reissued regulations that have been less frequently used (and debated) than the methods typically used before The Cloud became prevalent. Second, isolating exactly what drives value — and therefore profit — in the services offered through and by The Cloud is not always clear, and this lack of clarity is bound to create confusion and disagreements between taxpayers and taxing authorities when new valuation methods are applied. Let’s examine each of these challenges a bit more closely.

In the traditional IT world of hardware, software and systems integration and support, income was generally created in the form of proceeds from the sale of goods, rents, royalties or service fees from personnel demonstrably present in a particular location. In the new world of The Cloud, revenues and profits are most frequently received from the provision of an electronic service. Coincidentally, Treasury regulations that govern services transactions among related parties have recently evolved in their sophistication and complexity. For many years, the transfer pricing regulations governing the intercompany performance of services specified that services were to be priced either at cost (for “non-integral” services) or at an amount “which was charged or would have been charged for the same or similar services in independent transactions with or between unrelated parties under similar circumstances.” In practice, intercompany service fees were typically priced as either cost only or “cost plus” transactions, meaning the fee would be computed as a reimbursement of the costs of the service plus a profit margin expressed as a percentage of such cost (“cost plus markup”). Most controversies between the IRS (or other taxing authorities) and taxpayers over the intercompany provision of services were whether the markup could be justified and whether the costs of the service had been properly included in the cost base. Occasionally, issues would surface regarding the fact that a guaranteed profit over all costs incurred gave the service provider no incentive to economize costs, and was somewhat infrequently found in the third-party world outside large, long-term contracting situations.

Since late 2009, and partly in recognition of the reality that the types of service arrangements and service fees being created by the global marketplace had multiplied, the Treasury regulations have provided several more specific pricing methods that may be used in different circumstances for the intercompany provision of services.

First, under certain circumstances, intercompany services may still be priced at cost. To be eligible for this Services Cost Method, the taxpayer must, inter alia, determine that the services do not contribute significantly to the fundamental risks of success or failure of the business.

Second, for the first time, the regulations specified methodologies that could be used to evaluate the intercompany performance of services. Some of these methodologies already had been contained in the transfer pricing regulations:

  • In the Comparable Profits Method (CPM) prices are set by public third-party financial data according to “profit level indicators” that must be used because of an absence of other more direct comparables.
  • In the Profit Split Method, prices are set to split profit between the related parties.

Other methodologies that could be used to evaluate the intercompany performance of services were variants on methodologies contained in the regulations governing the intercompany sale of goods or use of intangible property:

  • The Comparable Uncontrolled Transaction (CUT) Method is used when relatively exact third-party comparable transactions are available to set prices.
  • In the Gross Services Margin Method, the intercompany service provider also provides its services to third parties, and therefore should cover its own operating expenses out of gross margin if it bears the risk of those third-party revenues.

In perhaps the biggest innovation of the 2009 regulations on related-party services, the Treasury asserted that some transactions should be priced as “contingent service arrangements.” In such arrangements, a “normal” service fee would be paid as the services were provided, but a “success” or “profit-participation” element would be added in the event that milestones or contingencies were reached, generally based on revenue success of the service provider with third parties. Moreover, the Treasury gave the IRS the authority to impose contingent services arrangements on taxpayers who had not established them in form where the circumstances indicated that an arm’s length party would not have provided the service without the incentive of the contingent profit participation.

If these new pricing methods are applied to allocate service profits from The Cloud among taxing jurisdictions, it is not at all clear which method is the “best method.” Some taxpayers may determine that some of their electronic services transactions qualify for the Services Cost Method, while others should be priced on the traditional Cost Plus Method, while still others will best fit within the Profit Split Method. Moreover, each choice of method runs the risk that the IRS will assert that another method is the “best method,” or even assert that a contingent service arrangement is required by the facts even though the related parties themselves did not construct one. The likely outcomes of these disagreements are hard to predict because the audit and advance pricing agreement experience with the new methods is scant. But it is clear that new attention will have to be paid to the larger menu of pricing methods for related-party services transactions, and documentation should be robust in anticipation of greater scrutiny.

Choosing among these new methods also brings up a larger question about valuing related-party electronic services transactions carried on in The Cloud. At a fundamental level, virtually all valuation methods involve projecting and then discounting estimated cash flows that correlate with either returns to assets or expenditures. Expenditures and capital investment can be planned with relative ease; the revenues that such planned outlays will produce are less predictable. In The Cloud, isolating the exact relationships between, on one hand, the expenditures and assets required to provide electronic services and, on the other hand, the resulting cash flows, is murky at best. In The Cloud, businesses are finding inventive new services to offer and non-traditional new ways to derive value from such services.

Take, for example, the valuation of a search engine. If the algorithms used by one company’s search engine are better at returning more relevant and comprehensive results than those used by its competitors, it will attract more searchers (users). But since the users typically do not pay for the search service, the value of attracting more users is derived from being able to sell other businesses access to those users, for example with paid search results or electronically displayed advertising that is targeted to the subject of the search. Therefore, it is not simply increasing the number of users that is valuable, but being able to match users’ search and behavior patterns to particular merchants. This is critical, even though the users may not be actively seeking to purchase anything while using the search engine.

Take, for another example, the value of a social network, either within a business or in society at large. The investment in the software, performance, look and feel of the social network has a direct effect on the ease of use and the likelihood of use by a broad audience. But when access to the social network is free, the real value is derived from giving other businesses access to the users who have gathered in one electronic space for free. One income stream may be related to the ability to mine information on user behavior, style and taste. Another income stream may be related to the ability to identify affinity groups within the broad audience. Still another may be derived from identifying trend-setters who inspire their own following, giving merchants the leverage to influence larger numbers of people’s behavior by motivating a few individuals who then propagate the trend without being directly compensated for doing so.

But it is extremely difficult to distill a direct financial relationship between expenditures to refine the user interface and site features of a social network and the income that can be derived from, and split with, merchants seeking access to those users attracted to a site by those enhanced features. The exercise involves predicting (i) user behavior as a result of the site-enhancing expenditures, (ii) the value third-party merchants will find in that user behavior, (iii) how that value compares with alternatives for third-party merchant expenditures, and (iv) the extent that value will be shared among the market participants.

Alvarez & Marsal Taxand Says:
How can these attenuated, indirect and difficult to distill projections be molded into the related-party transfer pricing methods required by the IRS for electronic services? At least initially, this can only be done with great uncertainty until a body of experience between taxpayers and the government emerges with relatively new rules being applied to extremely new and rapidly evolving business facts. But the chances of success will increase, and the chances of disputes will decrease, to the extent that the economic analysis has been done with rigorous focus on the true value drivers of the electronic service, and rigorous analysis of which pricing methods best approximate those value drivers. In this, the new and evolving Cloud is no different from more traditional business models — a successful transfer pricing analysis will be critically dependent on an understanding of all aspects of the taxpayer’s business and on a careful application of economic and transfer pricing models.

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As provided in Treasury Department Circular 230, this publication is not intended or written by Alvarez & Marsal Taxand, LLC, (or any Taxand member firm) to be used, and cannot be used, by a client or any other person or entity for the purpose of avoiding tax penalties that may be imposed on any taxpayer.

The information contained herein is of a general nature and based on authorities that are subject to change. Readers are reminded that they should not consider this publication to be a recommendation to undertake any tax position, nor consider the information contained herein to be complete. Before any item or treatment is reported or excluded from reporting on tax returns, financial statements or any other document, for any reason, readers should thoroughly evaluate their specific facts and circumstances, and obtain the advice and assistance of qualified tax advisors. The information reported in this publication may not continue to apply to a reader's situation as a result of changing laws and associated authoritative literature, and readers are reminded to consult with their tax or other professional advisors before determining if any information contained herein remains applicable to their facts and circumstances.

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