CA Ashish Chadha has pointed out that the increased use of cloud-based services has led to cross-border tax implications for the suppliers and the customers. He has analyzed various types of cloud services such as ‘accounting serves’, ‘database’, ‘storage’, ‘support services’ and examined whether the income therefrom can be assessed as “royalty’, ‘fees for technical services’ or ‘business profits’ under the DTAAs and international tax law
Cloud computing, also referred to as ‘the cloud’, is the delivery of on-demand computing resources over the Internet. The cloud has brought out an elementary change in the way information technology (‘IT’) services are developed, maintained, deployed, updated and paid for. Cloud-based services are fattening in both the business sector and among users. Companies that seek greater IT efficiency and reduction of their capital costs are moving towards the cloud. The users opt for cloud-based applications to store their digital content that they wish to share and access on multiple devices.
As the cloud-based services are typically provided in a cross-border scenario, the provisions of international tax law, especially of tax treaties, are of particular relevance to parties engaged in cloud transactions. The aim of this article is to evaluate the most common international tax issues that providers of cloud-based services face.
Cloud computing provides flexible, online and real-time access to a shared pool of computing resources, such as servers, storage and applications, through the Internet. Cloud as a service can be categorized under three major models:
– Software as a service (‘SaaS’) – SaaS (for instance Google Docs) is a software model which provides applications that run on the cloud eliminating the need to install them on the user’s device. The software is run on the service provider’s cloud infrastructure and the user can access it through a web browser.
– Platform as a service (‘PaaS’) – PaaS (for instance Facebook) is a service facilitating developers and helps in development of applications by providing operating system support and software development frameworks. The service provider is responsible for maintenance and control of the underlying infrastructure on which these platforms as a service are hosted. PaaS provides flexibility to users with no involvement of capital expenditure.
– Infrastructure as a service (‘IaaS’) – IaaS (for instance Amazon web services) comprises of resources, such as processing, storage and network, which can be virtualized and delivered as a service. Under this model, the users can avail of the principal computing resources on rent instead of purchasing them. This enables the users to utilize the applications more efficiently by removing the hassles of managing their own infrastructure.
A meaningful and accurate analysis of the income from cloud-based services requires a thorough understanding of the particular transactions under consideration and must always begin by evaluating the contractual terms. The evaluation should consider, in particular, any references to intellectual property rights and the rights to use the underlying infrastructure. It is pertinent to note that the terms cloud computing, SaaS, PaaS and IaaS can cover within their ambit a wide variety of different transactions.
Contracts for cloud-based services are usually complex and include a bundle of services, such as data storage, access to information, data processing or technical services. The OECD Commentary on Article 12 states that the total amount of consideration payable under mixed contracts should be broken down on the basis of the information contained in the contract or by means of a reasonable apportionment. It is only thereafter that an appropriate tax treatment should be applied to each apportioned part. However, if one element constitutes the principal purpose of the contract and the other element is merely of an ancillary and unimportant character, the whole consideration should be treated as relating only to the primary element. Whether or not the contract can be split depends on the relationship of the services with one another, the contractual terms and the approaches of countries to composite contracts.
Identification of nature of income as per provisions of the applicable Tax Treaty
It is of utmost important to highlight that the provision of cloud-based services is impossible in the absence of software and therefore, the tax treatment of software transactions can be used as a starting point to qualify payments for such services. Extensive guidance on the characterization of payments for computer software is provided for in the OECD Commentary on Article 12. Those principles are also applicable to transactions involving other types of digital products.According to the OECD Commentary on Article 12, income from software transactions may be characterized as royalty (Article 12), business income (Article 7) or capital gains (Article 13). The application of each of these Articles results in different tax consequences, which are outlined below:
– Payments for computer software are not explicitly mentioned in the definition of royalties. However, the OECD Commentary on Article 12 explains that research by the OECD among its member countries revealed that software rights are usually protected under copyright rules. Consequently, payments for the right to use software may fall within Article 12 of the OECD Model.Article 12 of the OECD Model allocates the exclusive right to tax royalties to the resident State of the taxpayer, whereas the source State is denied any taxing rights that it may have under its domestic law. Therefore, unless the provider of intellectual property has a permanent establishment (‘PE’) in the source State, that State obtains no tax revenue from the royalty payments that are made in consideration for the right to use the intellectual property. This approach reflects the views of capital exporting developed countries. The UN Model, on the other hand, is more sympathetic to capital importing countries and allows taxation of royalties in the source State by means of a withholding tax.
– As royalties are paid for the use of or the right to usethe intellectual property, Article 12 of the OECD Model does not apply to payments for the alienation of all rights attached to intellectual property. Such payments are not made for the right to use the underlying property, but are rather made for the rights themselves and may be characterized as capital gains under Article 13 of the OECD Model. Capital gains, other than those from alienation of immovable property, business property of a PE, shares in Real Estate Company, ships or aircraft, are taxed only in the resident State of the alienator.
– Article 13 of the OECD Model does not seem to have a broad application in the field of cloud-based services, as such services do not involve any transfer of full rights to an asset. The customer obtains access to remotely operated highly standardized software and/or hardware that runs on the infrastructure of the cloud provider. The cloud provider does not lose control over its software.
– Further, the payments for transactions in which the rights acquired in relation to the copyright are limited to those necessary to enable the user to operate the program, qualify as business income in accordance with Article 7 of the OECD Model. Business income is taxed on a net basis in the resident State of the taxpayer, unless the taxpayer has a PE abroad and certain income is attributable to that PE.
– As Articles 12 and 13 of the OECD Model deal specifically with royalties and capital gains, the provisions of those Articles override the rules in Article 7, if the royalties and capital gains also constitute business profits. Therefore, the characterization for income from cloud-based services will be first examined on the basis of Articles 12 and 13 of the OECD Model.
Characterization of certain cloud-based services:
1. Accounting Software
The accounting software is an application that records and processes accounting transactions. As it constitutes software within the definition provided by the OECD Commentary on Article 12, the rules on the tax treatment of software transactions should be directly applicable. The fact that the software is not transferred to the customer, rather runs on the IT infrastructure of the cloud provider, should not have any effect on the tax consequences as the OECD Commentary on Article 12 explicitly states that the method of delivery of a computer program is irrelevant. Although the OECD Commentary on Article 12 mentions two ways of software transfer, i.e. on a tangible medium or through downloading, the same should apply to making the software available on another party’ s infrastructure as well.
The answer to the question as to which Article applies to the provision of the accounting software depends on the nature of the rights that the transferee acquires under the particular arrangement regarding the use and exploitation of the software.Although cloud-based applications are highly standardized, it is possible that on request of the customer, the accounting software is adapted to fit within its business model. As such, tailor-made software can only be used by a particular customer, and therefore the question arises as to whether or not the whole transaction may be regarded as a sale of all rights in the customized software that gives rise to a capital gain. The fact that the software still runs on the infrastructure of the cloud provider could be interpreted as the provision of IT capabilities for customers to operate their applications, i.e. IaaS. Whether or not the capital gain characterization can be assumed depends on the customer’s possibilities to use the software in the absence of the infrastructure of the cloud provider. If, in such circumstances, the customer does not have access to the accounting software, it cannot be regarded as the owner of all software rights.
An electronic database may be protected by a database right if there has been a substantial investment in obtaining, verifying or presenting its contents. Copyright protection may also apply if the database has originality in the selection or arrangement of the contents. If the database is protected by intellectual property rights, the distinction between transfers of a right in the program and transfers of a copy of the program will have to be made. The observations outlined above for an accounting software will apply accordingly. If the user is not allowed to exploit the database commercially, ratheris only allowed to use it for its own business purposes, the remuneration is likely to be classified as business profits.
In this context, it is important to consider that the characterization of payments for the use of databases has been a contentious issue in some countries. For instance, in India, there have been conflicting rulings by courts and tribunals regarding the distinction between Article 7 and 12 of the OECD Model.
The provision of server capacity for records can be considered as a typical IaaS service. The income from making IT infrastructure available to customers could be classified as either business income or rental income under Article 6 of the OECD Model.Generally, customers are interested in a virtualized data centre space, i.e. the exact location of the IT infrastructure is irrelevant for them. Even if the customer instructs the cloud provider to keep his data in a particular data centre, the customer does not ‘rent’ the underlying infrastructure. The service provider retains the full control over the data centre and remains responsible for equipment maintenance. Thus, income for the provision of IT capabilities can be characterized as business income.
4. Support Services
The provision of support services is not a transaction involving software but a transaction involving services with regard to the software. As there is no transfer of either copyright or a copyrighted article, payments for computer services cannot be regarded as royalties, but, rather as business profits or income from independent personal services, and are not taxable in the source country if the service provider does not maintain a physical presence there. Although both, the Commentary on Article 5 of the OECD Model and the UN Model, provide for a service PE option that strengthens the source state rights to taxation, the service PE also requires physical presence in the source state, i.e. one or more individuals must be present there for a minimum time period.
In this context, it is pertinent to consider that fees for technical services (‘FTS’) has become a regular source of dispute worldwide. In most Indian tax treaties, FTSis included in the scope of Article 12 with taxing rights given to the source state regardless of the existence of a PE.
Cloud computing is here to stay and will grow. The current demand for increased data means that web-based services will continue to flourish and as for the cloud, the sky is the limit.Contracts concluded between cloud-service providers and their customers usually include a wider variety of service offerings. The question of whether or not such contracts must be split has important practical consequences if at leastone component gives rise to the application of withholding taxes.
Under the OECD Model, income from cloud-based services generally falls within Article 12 or 7, depending on the nature of rights with regard to the use and exploitation of the software that the customer acquires under the contract. In both cases, income is taxed in the residence state of service provider, unless it has a PE in the state of the customer and the income is attributable to that PE. Many countries interpret the concept of royalties extensively to include payments for the use of databases and software as well as FTS. Such countries also subject royalties to source taxation.
The current PE concept is based on physical presence and allows cloud providers to offer their services without being subject to source taxation. Given the amount of revenue lost by the source state, proposals to modify the PE concept by extending it to ‘virtual presence’ became attractive to some countries and are discussed within the framework of the BEPS project. Basis the recommendations of the BEPS Action Plan, the concept of ‘significant economic presence’ was introduced in the Income-tax Act, 1961 vide the Finance Act, 2018. If other countries also move ahead without international consensus and adopt such proposals unilaterally, cloud providers having virtual presence everywhere where the Internet can be accessed may become global taxpayers subject to multiple taxation. The concept of a virtual PE would, therefore, not only create barriers to global trade, but also be difficult to apply in practice.
In this regard, it is imperative to take note that the new Finance Minister, Nirmala Sitharaman, recently called upon the G20 members to urgently fix the issue of taxing profits made by digital economy companies in countries where they do not have significant physical presence. The common ‘Digital Tax Rules’ agreed to be introduced by the G20 members that will close the putated loopholes that global technology giants such as Facebook, Google and Amazon use to reduce corporate taxes will also need to be watched out for.
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