Cloud computing: U.S. tax compliance complexity for foreign subsidiaries.

• Author: Carr, James
• Position: Company overview

Introduction

In today's technology-driven economy, many multinational enterprises are beginning to take advantage of cloud-computing technology in their global infrastructure and market facing-activities. What is cloud computing? Various definitions of clouding computing exist, perhaps the most concise is the one provided by the research firm Gartner, Inc., which calls it "a style of computing where massively scalable and elastic IT-related capabilities are provided 'as a service' using Internet technologies to multiple external customers." (1)

Despite its rapid acceptance by the business community, little guidance has been issued on how U.S. federal income tax principles may be applied to businesses operating "in the cloud." In addition to creating difficulties in evaluating potential tax issues, the lack of guidance may impede a corporate taxpayer's ability to determine its appropriate U.S. federal income tax return positions and reporting obligations. This challenge may be even more difficult for U.S. multinationals with foreign subsidiaries that enter into cloud computing transactions cross-border.

Case Study

To illustrate the potential tax return reporting and filing issues faced by taxpayers engaging in cross-border cloud computing, this article posits a case study involving a potential fact pattern in which a U.S. multinational's foreign subsidiary provides cloud computing services.

Assume DC, a U.S. corporation, is the parent company of a multinational group engaged in developing proprietary customer service software and marketing the software to its clients. The clients are business vendors who use the software to supplement customer service capacity. The software allows the clients to respond to routine customer service requests and reduces the demands on their physical customer service center. When end-customers submit certain routine customer service requests, the requests are routed to DC software hosted on servers in the United States, which provides customized responses to the requests. The software is fully automated and requires little monitoring or maintenance by employees of DC or its subsidiaries.

The software utilizes a proprietary intellectual property developed under a cost sharing arrangement (CSA) between DC and its Country A subsidiary, FC. Under the CSA, DC and FC share the cost of developing the software. DC owns the U.S. rights to the software, whereas FC owns the rights to the software in the rest of the world (ROW). All development activities are conducted by FC's personnel located in Country A.

DC is the principal for contracts with business clients in the United States, and FC is the principal for ROW clients. For the sake of simplicity, assume that such U.S. and ROW clients can be identified. By paying a subscription fee, the clients have access to the software that allows customers to submit customer service requests. Under the software terms of use, a client does not have any property rights to the software other than online access and use during the subscription period. Upon the expiration of the subscription, clients lose access, and DC and FC retain all rights with respect to the software.

Regardless of the location of the end customers, all submitted requests are processed on servers located in the United States. The fees collected are split between DC and FC based on the geographical location of the end users, with DC functioning as a collection agent for FC.

DC and FC do not own the servers on which the software is hosted. Rather, DC entered into an agreement with an unrelated Server Provider (SP), pursuant to which SP agrees to provide the data network, platform infrastructure, and hardware on which the software operates. SP is solely responsible for the operation and maintenance of the servers, and will credit DC for any network downtime suffered.

FC does not maintain an office or employees in the United States, and does not have a sales representative in the United States.

Both FC and DC are calendar year taxpayers.

Country A has an income tax treaty with the United States (Country A Treaty) that is currently in force. The Country A Treaty is similar to the 2006 U.S. Model Income Tax Treaty.

General Rules

There is no comprehensive set of U.S. guidance specifically governing the tax treatment of cloud computing (e.g., characterization, sourcing, and reporting of income). Instead, the Treasury Department has a policy of adopting or adapting existing principles to the cloud rather than create new or additional tax regimes. (2)

A U.S. person is generally subject to U.S. federal income taxation on all of its taxable income, regardless of the source. (3) A foreign corporation, on the other hand, is generally subject to U.S. federal income taxes under one of two regimes: a net basis tax regime on income connected with a U.S. trade or business, (4) and a gross basis tax regime on so-called "fixed or determinable annual or periodic income (FDAP income). (5)

FDAP income generally includes nearly all types of income, including services income, but does not include gains derived from most sales of property. (6) Foreign corporations are generally subject to 30-percent tax on the gross amount of their U.S. source FDAP income to the extent not effectively connected with a U.S. trade or business. (7) The 30-percent tax rate may be reduced under an applicable tax treaty.

Foreign corporations that have a U.S. trade or business at some time during their tax year are subject to tax on their net income effectively connected with the U.S. trade or business (also known as "effectively connected income" or ECI) at tax rates generally applicable to U.S. corporations. (8) A foreign corporation that earns ECI may also be subject to a U.S. branch profits tax of 30 percent. (9) The amount of U.S. federal income taxes imposed on a foreign corporation, however, may be reduced or eliminated by operation of an applicable income tax treaty.

1. U.S. Trade or Business

   The term "trade or business in the U.S." is not specifically defined apart from services performed in the United States. (10) A foreign corporation will be treated as having a U.S. trade or business if it performs personal services in the United States. (11) In other instances, whether a foreign corporation has a U.S. trade or business is based on the facts and circumstances of the foreign corporation's economic activities in the United States. (12) A foreign corporation's activities in the United States must generally be "considerable, continuous and regular" to constitute a U.S. trade or business. (13)

   A foreign corporation can also have a trade or business in the United States through an agent who performs activities on behalf of the foreign corporation that are substantial, regular, and continuous. (14) In determining whether the activities of an agent rise to the level of a U.S. trade or business, the Tax Court has generally focused on the ability of an agent to bind a principal or to conclude contracts on behalf of a principal. (15) For example, U.S. courts have attributed the U.S. trade or business of a dependent agent to a foreign person based on the agent's authority to bind or to conclude contracts on the foreign person's behalf. (16) The authority of an agent to bind or conclude contracts, however, is not necessarily required. Courts have attributed the activities of an independent agent to a foreign person where the business dealings between the independent agent and the foreign person were substantial, regular, and continuous. (17)

2. Effectively Connected Income

   A foreign corporation with a U.S. trade or business is subject to a net basis tax on its effectively connected income. (18) In general, U.S. source income of a foreign corporation is deemed to be ECI, even if the income and the U.S. trade or business are factually unrelated. (19) U.S. source FDAP income, however, is PCI only if (i) it is derived from assets used or held for use in the conduct of the United States business (the "asset use" test) or (ii) the activities of the U.S. business were a "material factor" in the production of the income (the "business activities" test). (20)

   Foreign source income of a foreign corporation will generally not be ECI unless it is attributable to a U.S. office or fixed place of business that is a material factor in the production of income, and the office or fixed place of business regularly carries on activities of the type from which such income is derived. (21)

   For ECI purposes, an office or fixed place of business is defined as a fixed facility that is a place, site, structure, or other similar facility through which a foreign person engages in a trade or business. (22) This would also include an office or fixed place of business of a dependent agent who has the authority to negotiate and conclude contracts in the name of the foreign corporation and regularly exercises that authority. (23) A foreign corporation is not considered to have an office or fixed place of business, however, merely because the foreign corporation uses another person's office or other fixed place of business, if the foreign corporation's trade or business activities in that office or fixed place of business are relatively sporadic or infrequent. (24)

   If the corporation generating ECI is also a controlled foreign corporation (CFC) under the Subpart F anti-deferral regime, (25) careful consideration should be made to determine what amount, if any, of the CFC's income may be includible in its U.S. shareholder's gross income as subpart F. ECI is generally excluded from treatment as Subpart F income unless the item of income is exempted from taxation by operation of the treaty. (26)

3. Application of an Income Tax Treaty

   An income tax treaty may override or reduce the amount of income tax that would otherwise be due under U.S. domestic laws. A U.S. income tax treaty generally applies to persons who are residents of the United States or the...